External debt vulnerability in emerging markets and developing economies during the COVID-19 shock

Sarah Elkhishin,Mahmoud Mohieldin

doi:10.1108/reps-10-2020-0155

Abstract

PurposeThis paper aims to assess to what extent the COVID-19 shock is expected to create a debt crisis in emerging markets and developing economies (EMDEs) through two main questions: what are the main determinants of EMDEs external vulnerability? How vulnerable are EMDEs to the current COVID-19 shock compared to the global financial crisis (GFC)?Design/methodology/approachIn addition to a descriptive analysis of the determinants of EMDEs external vulnerability, this paper designs two sub-indices of overindebtedness and financial fragility that capture EMDEs’ distinct characteristics. The two sub-indices together illustrate the overall external vulnerability to the current shock.FindingsEMDEs are more vulnerable compared to the GFC era. Current debt threats arise mainly from debt architecture and the domination of volatile debt forms – primarily foreign currency-denominated bonds. Excessive fear of debt-deflation spirals after the GFC prompted EMDEs to expand their growth trajectories through a pattern of cheap private lending, loose measures and unmonitored fiscal expansion.Research limitations/implicationsConclusive post-crisis data are still unavailable.Practical implicationsEMDEs need to balance between temporary accommodative measures and a post-shock policy mix that prevent a deflation spiral without worsening indebtedness and financial fragility. Moreover, financial prudence in face of growing credit demand is crucial, particularly in light of the monetary expansion and injected liquidity.Originality/valueThe indices offer a framework for examining external vulnerability in EMDEs based on theoretical and historical revisions, IMF benchmarks and EMDEs specific debt characteristics. The indices components can be offered for empirical examination in separate future research once conclusive data become available.

Highlights

Since the onset of the COVID-19 crisis, much was said about its likely impact on the already vulnerable debt positions of emerging markets and developing economies (EMDEs) in particular
The above-identified characteristics of debt in EMDEs and the distinct features of the COVID-19 shock together lead us to the main questions of this paper: To what extent is the current shock expected to create a debt crisis in EMDEs and how vulnerable are EMDEs to the current COVID-19 shock compared to the global financial crisis (GFC) shock? we present the methodology and data used to answer the mentioned questions
Will the current shock create a full-fledged debt crisis in emerging markets and developing economies? Analysis We start our analysis by defining a point of the onset of the COVID-19 shock, after which we present the results of the two main indices designed in the previous section to illustrate the potential impact of the COVID-19 shock on external vulnerability in EMDEs

Summary

Introduction

Since the onset of the COVID-19 crisis, much was said about its likely impact on the already vulnerable debt positions of emerging markets and developing economies (EMDEs) in particular. Three short-term challenges are identified: liquidity disturbances, capital outflows and debt risks; especially external debt. Low-interest rates, increased liquidity and monetary expansion might seem to decrease risks. Pre-existing debt distress, weak growth outlook and increased geopolitical vulnerabilities pose more risks. The postshock increased speculation in financial markets, low-cost liquidity, as well as the enlarged disconnection between the real sector indicators and the financial markets are expected to further aggravate EMDEs’ external vulnerability to the current shock. The objective of the paper is to assess to what extent the current shock is expected to create a debt crisis in EMDEs? What are the determinants of EMDEs external vulnerability?

Objectives

Methods

Findings

Conclusion