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ERF Working PaPers series
External Debt Vulnerability
in Emerging Markets
and Developing Economies
During the Covid-19 Shock
Sarah El-Khishin and Mahmoud Mohieldin
Working Paper No. 1413
November 2020
2020
EXTERNAL DEBT VULNERABILITY IN EMERGING MARKETS
AND DEVELOPING ECONOMIES DURING THE COVID-19
SHOCK
Sarah El-Khishin
1
and Mahmoud Mohieldin
2
Working Paper No. 1413
November 2020
Send correspondence to:
Sarah El-Khishin
The British University in Egypt
Sarah.elkhishin@gmail.com
1
Assistant Professor of Economics, the British University in Egypt.
2
Professor of Economics and Finance, Cairo University. Mahmoud.mohieldin@feps.edu.eg
The Authors appreciate the contribution of Jailan El-Saeed for providing research assistance
and data work.
First published in 2020 by
The Economic Research Forum (ERF)
21 Al-Sad Al-Aaly Street
Dokki, Giza
Egypt
www.erf.org.eg
Copyright © The Economic Research Forum, 2020
All rights reserved. No part of this publication may be reproduced in any form or by any electronic or
mechanical means, including information storage and retrieval systems, without permission in writing
from the publisher.
The findings, interpretations and conclusions expressed in this publication are entirely those of the
author(s) and should not be attributed to the Economic Research Forum, members of its Board of
Trustees, or its donors.
1
Abstract
In this paper we assess to what extent the COVID-19 shock is expected to create a debt crisis in
emerging markets and developing economies (EMDEs). We propose two questions: (1) what are
the main determinants of EMDEs external vulnerability? And (2) How vulnerable are EMDEs to
the current COVID-19 shock compared to the Global Financial Crisis (GFC)? In addition to a
descriptive analysis of the determinants of EMDEs external vulnerability, we design two sub-
indices of overindebtedness and financial fragility that capture EMDEs' distinct characteristics.
The sub-indices together illustrate the overall external vulnerability to the current shock. Results
show EMDEs are even more vulnerable than they were at the onset of the global financial crisis
(GFC), suggesting the impact of the current shock might be more devastating and recovery more
distant. 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 accommodative policy measures, and in some cases unmonitored fiscal
expansion. Current debt threats in examined EMDEs arise mainly from debt composition,
architecture and the domination of volatile debt forms - primarily foreign currency-denominated
bonds. This emphasizes the need for country-level debt portfolio management as well as timely
global actions in response to the shock. Furthermore, EMDEs need to strike a balance between
temporary accommodative measures and the post-shock monetary-fiscal policy mix that prevent a
deflation spiral without worsening indebtedness and financial fragility. It is necessary that EMDEs
maintain stronger financial prudence in the face of growing credit demand. This is particularly
important in light of the perceived too-optimistic sentiment driven by monetary expansion and
injected liquidity; it already increased speculative activities and raise concerns about growing
Ponzi finance activities and fears of a repeated Minsky’s moment after the COVID-19 shock.
Keywords: External Debt, COVID-19, Financial Fragility, Debt Sustainability.
JEL Classifications: E44, E62, F3.
2
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. However, pre-existing debt distress, weak growth outlook and increased
geopolitical vulnerabilities pose more risks. The post-shock 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? We raise two main questions: (1) what are the determinants of
EMDEs external vulnerability? (2) How vulnerable are EMDEs to the current COVID-19 shock
compared to the GFC shock?
To characterize external vulnerability in the context of this paper, we first revise some theoretical
propositions - mainly from Irving Fisher Debt Deflation Theory (Fisher, 1933) and the subsequent
contributions of (Minsky, 1986) and (Bernanke, 1995, 2018a). According to these works, while
causes and triggers for global shocks might occur periodically, several factors affect whether they
cause traumatic crises and depressions, or just repetitive cycles of growth slowdown that may
reverse quickly. Countries in a state of overindebtedness and are more financially fragile are more
vulnerable to external shocks. Second, we identify EMDEs debt characteristics, related to their
growth patterns, debt architecture, exchange rate imbalances and fiscal distress where we expect
to play a role in aggravating the impact of external shocks. Finally, IMF benchmarks of external
vulnerability that comprise debt and reserves position are integrated in the framework of building
EMDEs vulnerability criteria (International Monetary Fund, 2000b). Based on this framework, we
design EMDEs External Vulnerability Index that consists of two main sub-indices of
overindebtedness and financial fragility. The index is calculated for a sample of EMDEs five-years
preceding the COVID-19 shock and five-year preceding the global financial crisis (GFC).
Results show increased external vulnerability in sample EMDEs compared to the GFC era,
suggesting the current crisis could be deeper and require longer time to recover. EMDEs’ excessive
fears of entering a deflationary spiral after the GFC has prompted them to adopt growth patterns
and financial policies that aggravated overindebtedness and financial fragility. Slowing growth
rates preceding the COVID-19 shock worsened these conditions. Current expansionary responses
to the shock are intuitive. However, we stress that countries should make such accommodative
measures as short-lived as possible. To avoid an anticipated recession and restore growth and debt
sustainability, we discuss needed revisions of growth patterns and tools for financing gaps in
EMDEs. We also provide some policy recommendations to counter the expected implications of
the current shock on debt in EMDEs.
3
The paper is organized as follows: In section two we review the political economy of debt during
crises in theory and literature. EMDEs debt characteristics are discussed in section three. In section
four, we discuss our methodology and data. In section five we present the analysis of external
vulnerability in sample EMDEs. Finally, we discuss conclusions and policy measures to avoid a
debt crisis in EMDEs after the COVID-19 era.
The Political Economy of Debt Management During Crises
(Chenery & Strout, 1966) two gap models offer influential presentation of the relation between
debt and growth. They established that reasonable debt levels are crucial for fueling growth,
enhancing capital accumulation, and raising total factor productivity, especially in countries in
early development phases. However, research has also identified increased dependence on debt to
finance development as a core reason for increased vulnerability to economic and financial
domestic and global shocks and crises. Extensive scholarly examinations of the role of finance in
growth cycles in EMDEs continued, based on historical events and theories analyzing real-
financial interactions during economic crises. In this vein Irving Fisher, Hyman Minsky, and Ben
Bernanke have presented seminal contributions establishing the crucial role of financial stresses
in crisis origination and impact on the real side of the economy. Using these works, this section
presents four interlinked propositions that constitute a foundation for our design of the specific
external vulnerability criteria in EMDEs and our subsequent analysis of the anticipated impact of
current COVID-19 shock in those economies.
Proposition (1): What distinguishes a mild downturn from a severe depression is the degree of
involvement of the financial sector and financial fragility in the shock.
In his paper “The Debt-Deflation Theory of Great Depression,” Irving Fisher (1933) identified a
nine-step process of real-financial interactions that produce deflation in an economy that has
“overindebtedness,” “financial fragility,” and an uncertain environment, when it faces a shock.
The steps are as follows: A shock spurs (1) debt liquidation which leads to (2) excessive distress
selling and (3) local currency depreciation. These in turn lead to a (4) direct decline in business
net worth and arising bankruptcies, (5) a fall in overall level of profit and hence (6) a severe decline
in GDP, employment, and trade. The overall economic contraction will lead to (7) further
pessimism and loss of confidence in the business climate, whereby the financial sector will witness
(8) more hoarding activities and the velocity of circulation will decrease. This will finally result in
an overall decrease in (9) nominal interest rates and a rise in real/commodity interest rates. The
theory gained little academic acceptance at the time and proponents of “macroeconomic
neutrality” criticized it. However, as financial and economic crises continued to coincide through
the twentieth century, Hyman Minsky and Ben Bernanke among others revisited these crises in
the context of Fisher’s theory. Refuting the macroeconomic neutrality assumption, Bernanke
extended Fisher’s debt deflation arguments and provided evidence that financial collapse makes
4
recessions deeper, rather than merely being a symptom of them (Bernanke, 1983, 1990, 1995).
Bernanke linked overindebtedness and financial fragility in his argument that high reliance on
external finance to finance low net worth investment results in high agency costs. This in turn leads
to inefficient investment and creates a financially fragile environment in the economy. Applying
his model to the GFC, he demonstrated that changes in liquidity preference, surges in the external
finance premium and increases in risk aversion after the shock quickly transmitted into the U.S.
economy and caused disruptions in the real economy, deepening the recession that followed
(Bernanke, 2018a).
Hyman Minsky also concurred with Fisher that financial fragility is a core determinant that
distinguishes mild cycles from severe depressions, in that the financial system remains relatively
stable in mild cycles while they get distracted during serious cycles through the debt deflation
mechanism (Minsky, 1981, 1986, 1994). Minsky’s famous financial instability hypothesis and
what’s called the Minsky’s cycle extended Fisher’s arguments on the causes of debt crises.
According to Fisher (1933), new investment opportunities are primary causes of cycles and they
put countries in a state of overindebtedness that can result in deflation. À la Minsky, crises occur
after calm economic periods that involve elevated economic confidence where financial
malpractices, amplified speculative behavior, and debt deleverage pave the way for crises.
‘Minsky’s moment’ then arrives when markets start to collapse and experience severe liquidity
shock that quickly transmits into the real economy (Vercelli, 2009).
Proposition (2): History shows that a debt deflation process can be interrupted and reversed
through: (1) big government, (2) big bank (3) global monetary harmony and (4) financial
regulations.
Comparing the Great Depression with the subsequent crises that occurred between 1944 and 1970,
Minsky showed that during this period countries were less vulnerable to shocks and financial
sector growth was gradual. Minsky attributed financial tranquility during this period to sound
policies that were adopted, curing the early onset of economic cycles. Sound policies that are a
mix of fiscal, monetary, and financial policies as well as international policy coordination—that
is; (1) big government, (2) big bank, (3) global monetary harmony (Bretton Woods), and (4)
financial regulations (Minsky, 1986)—averted economic disasters.
Bernanke picked up Minsky’s big government hypothesis, as did Paul Krugman. (Bernanke,
2018b, 2018a) empirically show that active monetary policy and the Federal Reserve’s activity to
act as a lender-of-last resort averted a depression, affirming the value of the extended lending
programs, debt swaps, and measures taken to support the credit market and avoid to further
collapse of financial institutions. (Eggertsson & Krugman, 2012) argued that the solution to the
GFC debt-induced slump is more debt and in the COVID-19 crisis (Krugman, 2020) advocated
5
for a permanent stimulus package to counteract the current shock,
3
reflecting as his support for the
big government and big bank theories.
Proposition (3): The Relevance of big government theory to EMDEs with structural macro-fiscal
imbalances.
The above arguments focus mainly on mature economies, typically the U.S. economy, however,
researchers must apply it to EMDEs with caution. Fiscal stimuli might be inevitable after a crisis;
yet, macro-fiscal structural imbalances in many EMDEs might make countercyclical interventions
ineffective, even hazardous. Many EMDEs suffer from structural problems that persist regardless
of economic cycles. Many suffer prolonged recessions and short boom times, leading to continued
expansions in fiscal policy compared to short periods of rationalized spending. While
countercyclical fiscal policy implies rationalizing spending during boom times, some EMDEs only
have big government during recessions (El-khishin & Zaky, 2019). This results in fiscal illusions,
where politicians tend to quickly resort to stimulus packages during recessions without
counterbalancing during booms (Alesina & Passalacqua, 2015).
Another important determinant of big government efficiency is the effectiveness of fiscal
multipliers and automatic stabilizers. During crises, loss of confidence in the economy, rising
interest rates after the crisis, and crowding out of private investments may weaken fiscal
multipliers in EMDEs (BIS, 2003). By the same token, automatic stabilizers tend to be weaker in
EMDEs compared to advanced economies, because of the low tax elasticities, low shares of taxes
to GDP, large proportions of fixed expenditures, and absence of unemployment insurance. All
these inefficiencies lead to more dependence on discretion where many EMDEs, while trying to
pursue countercyclical polices, will end up with a larger structural deficit and hence more threats
to long term debt sustainability (El-khishin, 2020).
Proposition (4): Non-linearities in the debt-growth relationships in EMDEs and changes in debt
architecture make them more vulnerable to recurrent global external shocks.
Arguments about non-linearities in debt-growth relationships are highly consistent with the debt
sustainability policy advice to set specific debt thresholds. While debt is inevitable for EMDEs
adopting high growth trajectories, research documents that surpassing specific debt thresholds will
constrain growth.
4
(Reinhart & Rogoff, 2010) empirical findings show that external debt in
EMDEs has more detrimental effects on growth than advanced economies and that foreign-
currency denominated debt impact on growth is much more severe than public debt denominated
3
Krugman 2020 suggests that in a world of already low interest rates, fiscal stimulus packages will not be harmful and that countries
should not be concerned with high debt figures.
4
Empirical literature that has examined the relation between growth and debt in emerging markets shows a non-linear relationship
such as an inverted U-shaped relation, where it starts positive then turns negative past a certain threshold. For example, Pattillo,
Poirson, and Ricci (2004) show that in high indebted countries, doubling debt reduces growth by 1%.
6
in home currency.
5
,
6
On the other hand, literature also referred to the possible reverse causality
between debt and growth. For example (Easterly 2001; Pattillo, Poirson, and Ricci 2004) found
that slower growth rates are core reasons for debt distress and that growth slowdown is a reason
behind some historical debt crises.
Evidence shows that changing debt architecture towards more household debt and external debt
are key players in recurring financial crisis. Krugman and Eggertsson (2012) identify household
debt and external debt as determinants of the ‘accelerator effect’ of the Fisherian debt deflation
mechanism during a crisis. Open capital markets create lending booms, which lead to maturity
mismatches in the financial system and exchange rates and can result in assets price bubbles. When
this occurs in a country pursuing high growth rates, and hence high inflation, the inevitable result
is macroeconomic overheating and appreciation in real effective exchange rate (REER).
Vulnerability in this context increases when the debt is largely composed of short-term flows and
portfolio investment (Combes et al., 2011) . According to (International Monetary Fund, 2020b),
sudden cutback of household lending by the banking sector during a crisis amplify vulnerability,
as it raises liquidity strains and risk aversion, aggravates external finance premium, and leads to
sudden and quicker credit losses.
(Bernanke, 2018a) argued that that financial deleveraging was channeled into the real economy
through (1) financial fragility and (2) surging growth in household debt. Conditions of financial
fragility created supply-side disruptions, while growth and deleveraging in household debt and
weakened household balance sheets resulted in effective demand disruptions and deteriorated
household spending. Bernanke suggests that, to prevent such panics, conservatism in the financial
system would seem a safer option even if it will be at the expense of credit growth.
The above propositions put forward a base for addressing potential EMDEs external vulnerabilities
to the COVID-19 shock. In the following section, we present some observations on debt and
growth in EMDEs, as a foundation for our analysis of external vulnerability in a sample of EMDEs.
EMDEs External Debt Characteristics Before the COVID-19 Shock
In a webinar in April 2020, Ben Bernanke argued that the COVID-19 economic shock is not very
comparable to the Great Depression, which was a result only of human error, stating that the U.S.
government’s “response [in the COVID-19 relief bill of March 27, 2020] is more like emergency
relief than it is a typical stimulus or anti-recessionary response” (Bernanke, 2020). Indeed,
5
When external debt reaches a threshold of 60% of GDP, annual growth declines by 2% and can be cut in half for higher external
debt levels (Reinhart & Rogoff, 2010).
6
Other literature such as (Fincke & Greiner, 2014) found a positive relation between debt and growth in emerging markets and
denoted that this could be because of the specifics of these economies characterized by surging growth rates and thus an expanding
public sector. For more empirical evidence, see Reinhart and Rogoff (2010), Kumar and Woo (2010), Fincke and Greiner (2015)
and Pattillo, Poirson, and Ricci (2004; 2002).
7
COVID-19 is an exogenous event that does not result from economic and financial error, unlike
the antecedents to the Great Depression and the GFC. However, being concerned with EMDEs -
not the U.S. economy as is the focus of Bernanke’s work- and given the noted unique
characteristics of the COVID19 shock, we anticipate that the crisis, shall have a significant impact
on economic performance in general and on debt profiles in particular in EMDEs.
Debt vulnerability in EMDEs is different from other world countries. EMDEs debt is mainly built
through their access to international capital markets, while low-income countries meet their
financing needs mainly through concessional loans (International Monetary Fund, 2018). In
EMDEs, balance of payments imbalances result in disturbances in capital flows that, if coupled
with insufficient foreign direct investment, typically results in mounting external debt (Stiglitz &
Rashid, 2020a).
While EMDEs have acted to stabilize their external debt burdens since the GFC (figure 1), many
are adopting debt architecture and maturity compositions that lead to increased vulnerability and
weak resilience to sudden shocks. In EMDEs, shocks result in sudden reversals of foreign inflows
and maturity disturbances whenever foreign investors hold a substantial amount of domestic debt.
Foreign shares of local currency bond markets, while reducing the borrowing costs, may also
induce price volatility if the domestic market lacks depth (United Nations Conference on Trade
and Development, 2019).
Figure (1): External Debt as Percentage of GDP in EMDEs (1995-2019)
Source: IMF, World Economic Outlook Database, 2019.
Likewise, increased household and non-financial corporations borrowing still create high risk of
debt distress for EMDEs during growth slumps. The recent Global Financial Stability Report
shows that vulnerabilities are higher in countries with increased corporate and nonfinancial sector
debt involving higher-risk activities within a low-yield environment (International Monetary Fund,
2020b). As (Roxburgh et al., 2010) and similar works analyzing debt post the GFC note, the
40.2
37.1
27.3
30.9 31.0
20.0
25.0
30.0
35.0
40.0
45.0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
%
The COVID-
19 Shock
The Asian Crisis
The GFC
8
household-debt-to-personal-income ratio increased significantly worldwide in the years preceding
the GFC. While economics predicted this would reverse after the GFC, household and nonfinancial
borrowing continued to rise, as figure (2) indicates. Figure (3) also finds a rising debt-to-GDP ratio
in most of the sample EMDEs in the first quarter of 2020 compared to the same quarter of last
year, driven in many countries by the increase in household and non-financial corporations’ debt.
The effects were most extreme in Chile and China, both of which witnessed a more than 10%
increase in this component of debt.
Figure (2): Total Stocks of Loans and Debt Securities Issued by Households and Non-
financial Corporations % of GDP in Selected EMDEs
Source: (International Monetary Fund, 2020c)
Figure (3): Sectoral Indebtedness in Sample EMDEs, 2020Q1 versus 2019Q1
Source: Institute of International Finance (IIF) data; in: (Tiftik & Mahmood, 2020).
Total stocks of loans and debt securities issued by households and non-financial corporations as a
share of GDP increased significantly in recent years. Today, household debt and non-financial
9.2
21.3
-1.2
6.9
2.5
19.5
30.1
20.8
-19.4
1.8
12.0 12.4
6.0
10.3
-9.4
0.4
-2.6
-30.00
-20.00
-10.00
0.00
10.00
20.00
30.00
40.00
-30.00
-20.00
-10.00
0.00
10.00
20.00
30.00
40.00
Russia
S. Korea
Turkey
Ukraine
Argentina
Brazil
Chile
China
Lebanon
Malaysia
Mexico
South Africa
Thailand
UAE
Egypt
India
Indonesia
% of GDP
% of GDP
HH and non-financial corporations Government Financial sector Total
0.0
50.0
100.0
150.0
200.0
250.0
Russia
Singapore
Korea
Turkey
Ukraine
Argentina
Brazil
Chile
China
Colombi a
Lebanon
Malaysia
Mexico
South Africa
Thailand
UAE
Egypt
India
Indonesia
2014-2018 2004-2008 Linear (2014-2018) Linear (2004-2008)
9
corporations’ debt together constitute more than 60% of total EMDEs debt according to recently
published Institute of International Finance data (figure 4).
7
Corporate bonds constitute the largest
share of foreign currency bond issuance in emerging markets (EM-30) as shown in the left side of
figure (4). On average, emerging markets corporate bonds have appealing advantages over
government bonds and equivalent bonds in mature markets because of their relatively lower default
rate, higher yields, and larger spread, among other benefits (Nelson & Hardingham, 2019).
However, hazards arising from the domination of such volatile forms of debt become clearly sound
during shocks and uncertainty periods. Both sovereign and corporate foreign-currency
denominated bonds pose enough reasons for a debt crisis because of their relatively high-volatility,
default risks, and restructuring ineligibility compared to other debt forms (Stiglitz & Rashid,
2020a).
Figure (4): Overall Debt Composition in Emerging Markets
Source: IIF data, in Tiftik and Mahmood (2020).
The pre-COIVD-19 weak growth outlook and geopolitical tensions are also important
determinants debt distress crisis in EMDEs. The COVID-19 shock has met a slowing down global
economy and an already deteriorated financial and economic performance in many EMDEs. This
raises red flags about EMDEs’ growth models and tools used to finance gaps, and the fact that,
unlike in the pre-GFC era, growth rates were already slowing intensifies concern (figure 5). Given
decreasing growth rates are a cause for debt distress under the reverse causality assumption, the
ultimate impact is likely to be deeper than the GFC’s.
7
Institute of International Finance. https://www.iif.com/.
42.7
28.9
28.4
60.2
23.4
16.4
HH AND NON-
FINANCIAL
CORPORATIONS
GOVERNMENT FINANCIAL
SECTOR
%
Mature Markets Emerging Markets
10
Figure (5): Average Real Growth Rates in Sample EMDEs, Pre-COVID-19 versus Pre-
GFC
Source: International Financial Statistics.
Fiscal distress in some EMDEs due to fiscal problems are also worsening debt instabilities.
EMDEs with problems of fiscal dominance and poor monetary autonomy during shocks
incentivize open-end “lender-of-last-resort” activities that amplify macro-fiscal imbalances (El-
khishin & Kassab, 2020). Moreover, structural problems, fiscal illusions and weak multipliers
would further aggravate fiscal and debt distress as highlighted earlier (El-khishin 2020).
Economies with a high domination of public debt, such as Argentina, Egypt, Ukraine, Lebanon,
and India are particularly vulnerable (Figure 6).
Figure (6): Government Debt as Percentage of Total Debt in Sample EMDEs, 2020-Q1
Source: IIF data, in (Tiftik & Mahmood, 2020).
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Korea
Russia
Singapore
Turkey
Ukraine
Argentina
Brazil
Chile
China
Colombia
Lebanon
Malaysia
Mexico
Saudi Arabia
South Africa
Thailand
UAE
Egypt
Ethiopia
India
Indonesia
Nigeria
2004-2008 2014-2018 Linear (2004-2008) Linear (2014-2018)
78.9
71.5
57.6 53.6 52.8 49.6
42.3 40.2 38.1 36.6 34.8
27.3 26.5 24.7 24.5
17.7 17.4 14.9 13.2 12.3 12.3 12.1
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
Argentina
Egypt
Ukraine
Lebanon
India
Nigeria
Brazil
Colombia
South Africa
Mexico
Indonesia
Saudi Arabia
Singapore
Turkey
Malaysia
Thailand
China
Russia
Chile
Hong Kong
S. Korea
UAE
%
Axis Title
11
Finally, many EMDEs have relatively large populations and young age structure but still suffer
from income disparities and significant poverty levels. While those countries have great potential
to utilize their population structure and create demographic dividends (Nassar et al., 2017), many
still suffer from weak financial institutions and capital markets that are incapable of channeling
the dividends of their demographic windows and leveraging domestic savings. Poor domestic
savings and weak financial institutions not only negatively affect per capita income and growth in
those countries (Mohieldin et al., 2019), but also put more pressure on debt sustainability. Using
external debt as the prime source of finance increases such pressures and risks. The current
pandemic is thus expected to leave many EMDEs with much greater deterioration in social
spending, longer growth slowdown, higher unemployment rates than the GFC, which will
consequently reflect on external debt levels and sustainability (Stiglitz & Rashid, 2020a).
The above identified characteristics of debt in EMDEs as well as 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 GFC shock? In the next section we present the methodology
and data then used to answer the mentioned questions.
Methodology and Data
We hypothesize that the initial conditions of overindebtedness and financial fragility status
together determine EMDEs’ degree of external vulnerability. We construct two indices to discuss
external vulnerability position in a sample of EMDEs during and after the current shock. The first
index is the COVID-19 Crisis index, which illustrates the initial impact of the COVID-19 shock
on sample EMDEs inspired by (Sachs et al., 1996) and (Bussiere & Mulder, 1999) crisis index
method. The second index is the External Vulnerability Index which incorporates the two
aforementioned dimensions of external vulnerability: overindebtedness and financial fragility.
The COVID-19 Crisis Index
(Sachs et al., 1996), and (Bussiere & Mulder, 1999) - hereafter STV/BM - both created crisis
indices based on beliefs that the highest economic contagion risks occur within five months of a
crisis outbreak, when economies are most vulnerable to liquidity problems. The authors identified
fundamental liquidity-related variables as the likeliest causes of external vulnerabilities to crises.
Like the International Money Fund’s Early Warning System, these indices were constructed to
assess external debt vulnerability during crisis times.
8
To create our crisis index, we average (1)
changes in reserves and (2) changes in REER, both of which Bussiere and Mulder (1999) and
8
IMF has developed the Early Warning System (EWS) in end 1990s to assess countries’ external vulnerabilities to shocks and
crises. Early Warning System variables are current account deficit, short-term debt over reserves, export growth, real exchange rate
appreciation and the change in reserves(Berg & Pattillo, 1998).
12
Sachs, Tornell, and Velasco (1996) represent as key indicators. We present the full definitions of
the used variables and data sources later in this section.
The External Vulnerability Index
We calculate the External Vulnerability Index and its sub-indices for the average five years
preceding December 2019, which we call the pre-COVID-19 period, and for the average five years
preceding the GFC, which we call the pre-GFC period. An average of both indices shows the
overall status of external vulnerability in the two specified periods. In the remainder of this section,
we present our perception of external vulnerability followed by the rationale and components of
the mentioned indices are presented.
• Defining External vulnerability
According to IMF debt and reserve-related indicators and benchmarks, external vulnerability
comprises debt and reserves position. From a balance sheet perspective, external debt and reserves
affect market-access countries’ external vulnerability through their impact on the country’s ability
to meet their external obligations without witnessing liquidity or solvency problems (International
Monetary Fund, 2000b).We integrate this with the theoretical propositions of overindebtedness
and financial fragility presented in section two and the debt characteristics of EMDEs presented
in section three. The comprehensive characterization of EMDEs external vulnerability henceforth
adopted in our analysis is:
“External vulnerability in EMDEs is determined by both the status of overindebtedness and
financial fragility. Overindebtedness is measured by the liquidity and solvency of EMDEs
external balance sheets. Financial Fragility is measured by their external debt architecture in
terms of maturity, reserve adequacy and the contribution of private debt to overall debt”.
• Overindebtedness sub-index
External debt is identified the chief component of debt that directly affects the resilience of EMDEs
resilience to shocks and crises, where external debt refers to the non-equity elements of external
liabilities, all debt instruments held by nonresidents regardless of currency of denomination
(International Monetary Fund, 2000b). In their remarkable book This Time Is Different: Eight
Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff define an external debt crises
as one that involves “outright default on payment of external debt obligations, repudiation, or the
restructuring of debt into terms less favorable to the lender than those in the original
contract”(Reinhart & Rogoff, 2009). A year later they argued that, in times of crisis, external debt
becomes the most significant indicator of indebtedness where both public and private debt matter
and the distinction between them will be distracting once bailouts, collaterals, and currency
constraints are considered (Reinhart & Rogoff, 2010).
13
In the External Debt Statistics guide published by IMF in 2014, indebtedness is the numerator
measure for debt sustainability
9
based on two main dimensions: (1) solvency and (2) liquidity.
Debt stock indicators reflect solvency while debt service indicators reflect liquidity. Liquidity
problems can cause solvency risks if not adequately addressed. (Bussiere & Mulder, 1999) provide
empirical evidence that a strong liquidity position can offset weak fundamentals in EMDEs and
can decrease vulnerability during crises and contagion periods.
According to the IMF (International Monetary Fund, 2014), debt stock indicators reflect solvency
while debt service indicators reflect liquidity. Given the distinct debt characteristics of EMDEs,
we use external debt-to-exports ratio as an indicator for solvency and debt service-to-exports-ratio
as an indicator for liquidity. Generally speaking, using exports as a denominator is more relevant
for market-access countries as advised in IMF guides and manuals. Debt-to-exports ratios has
some advantages over debt-to-GDP, top of which is that it is less volatile with respect to changes
in real exchange rates and it also provides a basis for repayments.
10
Table (1) presents a list of
definitions of the used variables.
• Financial fragility sub-index
We address three main dimensions of financial fragility in EMDEs: (1) reserve adequacy, (2) debt
maturity, and (3) debt composition. (Calvo et al., 1995) suggest that reserves have to be compared
to monetary base in order to assess countries’ vulnerability to panics. Bussiere and Mulder (1999)
and Sachs, Tornell, and Velasco (1996) affirm reserves to short-term external debt as a measure
of reserve adequacy in predicting the depth of EMDEs’ vulnerabilities during crises and that this
indicator empirically outperforms other reserve adequacy indicators, both money-based and
import-based. Likewise, according to the (International Monetary Fund, 2000a) reserves-to-short-
term debt offer a better indicator in countries with “significant but uncertain access to capital
markets”; where a smaller reserves to short-term debt ratio would indicate a greater incidence and
depth of crises. Reserves/short-term debt (STD) benchmark of value “one” is a widely used
standard of reserve adequacy for EMDEs. Targeting a reserve cover close to unity is advised, not
just to decrease monetary authorities’ dependence on short-run debt but also to guide fiscal
authorities to decrease public debt with short-run maturities (International Monetary Fund, 2000a).
9
Debt sustainability is measured based on the indebtedness (debt stock and service) relative to the repayment capacity (e.g. GDP,
exports, revenues,…etc.; IMF 2014).
10
However, debt-to-GDP is also useful in the cases where (1) public debt is dominant, as the ratio relates to the primary source of
repayment such cases and (2) economies would switch to servicing the debt from domestic resources (IMF 2014).
14
Table (1): Overindebtedness and Financial Fragility sub-indices: Components and Data
Sources *
OVERINDEBTEDNESS INDEX
FINANCIAL FRAGILITY INDEX
LIQUIDITY
Debt Service to Exports Ratio
• The ratio of external debt-service
payments (principal and interest)
to exports of goods and services
for any one year. It is used to
assess liquidity risks as part of
debt sustainability criteria.
• Dataset: (World Bank, 2020b)
RESERVE
ADEQUACY
Reserves to Short-Term Debt Ratio
• The ratio of reserves to short-term external
debt (R/STD). We use the inverse of
reserves to short-term debt indicators in the
index, as suggested in (International
Monetary Fund, 2000a) to capture reserve
in-adequacy. The higher the value, the
higher the reserve inadequacy in the sample
country to group.
• Dataset: (International Monetary Fund,
2020d)
SOLVENCY
External Debt to Exports Ratio
• The ratio of total outstanding debt
at the end of the year to the
economy’s exports of goods and
services for any one year.
• Data: Author's calculation
based on (World Bank, 2020b)
data on Exports of goods, services
and primary income (BoP, current
US$) & External debt stocks, total
(DOD, current US$).
DEBT
MATURITY
Short-Term External Debt as Percentage of
Total External Debt
• Debt that has an original maturity of one
year or less. It is considered a good measure
to assess how fast a country will be able to
adjust if it was subject to a sudden decrease
in external borrowing.
• Dataset: (World Bank, 2020b)
DEBT
STRUCTURE
Household and Non-financial Corporations
Debt
• We use Private Debt, Loans, and Debt
Securities issued by IMF as an indicator for
the share of household debt and non-
financial corporations’ debt in total debt.
• Dataset: (International Monetary Fund,
2020c)
* For more on the definitions and concepts, see (International Monetary Fund, 2000b, 2014; World Bank, 2020b).
Regarding the debt maturity, short-term external debt is considered a good measure to assess how
fast a country will be able to adjust if it was subject to a sudden decrease in external borrowing.
As established earlier and as argued in Reinhart and Rogoff (2009), high reliance on short-term
borrowing to finance growth increases vulnerability to crises and can “provoke” sudden and
“unexpected” financial crises. We use Short-term external debt as percentage of total external debt
as an indicator of the degree of the dominance of short-term debt in the overall debt structure.
Finally, debt composition and the share of household debt constitute an important determinant of
the severity of the crises and the consequent debt problems. We use “Total stocks of loans and
debt securities issued by households and non-financial corporations (percentage of GDP)” as an
indicator for household debt growth in sample EMDEs.
Finally, regarding sample countries and data, we follow (Reinhart & Rogoff, 2010) and (Fincke &
Greiner, 2015) in the selection of sample EMDEs.
11
Selected EMDEs vary in terms of
development status; yet they are considered in reviewed literature as might be subject to higher
possibilities of external vulnerabilities during this crisis. For a full list of the selected sample of
EMDEs, see Annex (A1). As noted in table (1), we depend on International Debt Statistics-The
11
With minor modifications due to data availability.
15
World Bank and International Financial Statistics-IMF published data. For data on Real Effective
Exchange Rate (REER), we use Bruegel Datasets published in (Darvas and Zsolt, 2020).
Will the current shock create a full-fledged debt crisis in EMDEs? 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.
Defining the onset point of the COVID-19 crisis
Research suggests stock market performance and capital outflows are primary determinants of a
crisis onset. Following (Bussiere & Mulder, 1999) we use the JP Morgan Emerging Market Bond
Index to track stock market performance from December 2019 to August 1, 2020. As figure (7)
shows, a sharp descent started in January 2020. Increased uncertainty and a pessimistic outlook
began to emerge in December 2019, well ahead of the World Health Organization’s announcement
of a global pandemic in March 2020. Figure (8) shows a sharp drop in accumulated non-resident
portfolio flows to emerging markets starting January 2020, which affirms JP Morgan Emerging
Market Bond Index trend during the same period.
Figure (7): JP Morgan Emerging Markets Bond Index
Source: JP Morgan
We define January 2020 as the onset of the COVID-19 crisis. Nonetheless, we acknowledge that
the disconnection between real and financial markets became more evident over time. Financial
markets overcame early losses later, reflecting either investors’ denial of the severity of the crisis,
or in response to stimulus packages and debt restructuring plans. Increased low cost finance, large
monetary expansion, and injected liquidity are increasing disturbing the connection between
financial markets and real sector performance during the crisis. The increased speculative activities
and concerns about growing Ponzi finance activities together suggest that Minsky’s moment may
be approaching.
85.000
90.000
95.000
100.000
105.000
110.000
115.000
120.000
01-Aug-2019
01-Sep-2019
01-Oct-2019
01-Nov-2019
01-Dec-2019
01-Jan-2020
01-Feb-2020
01-Mar-2020
01-Apr-2020
01-May-2020
01-Jun-2020
01-Jul-2020
01-Aug-2020
USD
Closing Price
16
Figure (8): Accumulated Non-Resident Portfolio Flows to Emerging Markets (EMs)
Source: IIF daily Portfolio Tracker, in: Hevia and Neumeyer, 2020. “A perfect storm: COVID-19 in emerging
economies,” CEPR Policy Portal, April.
An Illustration of the Components of the Crisis Index Indicators in Sample EMDEs
The below illustration shows loss in reserves in most of the sample EMDEs during the period
January-May 2020. Reserve losses are among the indicators that deteriorate early in times of crises
since central banks inject liquidity as part of the initial response to the shock. Results are also
intuitive given the appreciation of US dollar and other advanced economies’ currencies against the
EMDEs’ currencies during the examined period (Corsetti & Marin, 2020; OECD, 2020). Country-
level rankings of the initial crisis impact (figures 9 and 10) are discussed below with the analysis
of overall external vulnerability in the sample EMDEs.
Figure (9): An Illustration of the Components of the STV/BM Crisis Index Indicators in
Sample EMDEs after the COVID-19 Shock Began
* January-April.
** January-March.
*** An increase in the REER indicates appreciation of the home currency against the basket of currencies of trading
partner.
Source: Author calculations based on International Financial Statistics. See Annex for data for technical notes.
Rus, -1.77
Kor*, -1.49
Tur, -27.37
Ukr, -4.17
Brz, -3.93
China*, -0.75
Col, 5.52
Mal , -1.27
Mex, 4.20
SA , -5.06
Thai, 2.82
UAE*, -7.31
EGP**, -13.40 IND*, 1.46
INDO*, -3.27
-30.00 -20.00 -10.00 0.00 10.00
Change in Reserves (January-May)
Rus, -9.20
Kor*, -3.26
Tur, -5.23
Ukr, -7.39
Brz, -20.39
China*, -0.54
Col, -8.20
Mal , -6.21
Mex, -14.99
SA , -14.90
Thai, -7.05
EGP**, 10.43
IND*, -2.71
INDO*, -4.38
-30.00 -20.00 -10.00 0.00 10.00 20.00
Change in REER (January-May)***
17
Figure (10): The Simple COVID-19 Crisis Index
* January-April.
** January-March.
Source: Author calculations based on International Financial Statistics. See Annex (A4) for data sources and technical
notes.
The crisis has triggered significant exchange rate disruptions in most sample countries and an
evident REER depreciation. This is primarily due to capital outflows and halted portfolio
investments after the crisis. The variation in the initial magnitude in REER depreciation across the
sample countries can be attributed to (1) composition of capital flows (FDI, portfolio investment,
sovereign bonds, commercial loans, and remittances), (2) size of monetary injections and (3) type
of exchange rate regimes adopted and interventions in the foreign exchange market during the
shock. The share of foreign-currency denominated bonds in debt composition is one of the main
reasons behind post-crisis currency depreciation (Stiglitz & Rashid, 2020b). Some EMDEs
intervened in the foreign currency markets and relaxed capital control measures in an attempt to
soften the initial impact of the crisis while others kept their systems rather tight, which significantly
affected the magnitude of initial depreciation after crises (OECD, 2020).
12
Some data may be incomplete to give even an initial sense of the impact of the shock. Data shows
relative stability in the Egyptian pound versus the U.S. dollar. We lack information about Egypt’s
reserves or REER post March 2020, and it seems probable that the crisis had not have started to
impact the economy at that time. Egypt’s trade partners overall started showing a depreciation in
their currencies against the US dollar in January as indicated earlier, suggesting that Egypt’s REER
appreciation is temporary.
13
Updated data will likely reveal procyclical impacts. Remittances in
Egypt have already dropped since March 2020, as have tourism in the Suez Canal sector, due to
12
(Combes et al., 2011) assert that more flexible exchange rates minimize exchange rate fluctuations and recommend that
countries with poor and less prudent financial markets adopt more flexible exchange rates during shocks.
13
For more explanation on the possible reasons behind REER appreciation, see (Noureldin, 2017).
0.63
0.65
1.34
1.48
2.12
2.38
3.74
3.82
5.40
5.48
5.78
9.98
12.16
16.30
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00
IND*
China*
Col
EGP**
Thai
Kor*
Mal
INDO*
Mex
Rus
Ukr
SA
Brz
Tur
Low Crisis Impact
Medium
Crisis
Impact
High Crisis
Impact
18
the global economy slump which will definitely affect the size of capital flows in the Egyptian
economy (IMF 2020a).
Overindebtedness and Financial Fragility in EMDEs
A presentation of calculated indices and EMDEs country rankings is presented in figures (11)
through figure (16) followed by our analysis and interpretation of results.
Figure (11): Average Overindebtedness and Financial Fragility Index in a Sample EMDEs,
Pre-COVID-19 vs. Pre-GFC Crisis
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
Figure (12): Overindebtedness Index in sample EMDEs, by country, Pre-COVID-19 vs. Pre-
GFC Crises
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
2.87
4.07
0.00
1.00
2.00
3.00
4.00
5.00
2004-2008 2014-2018
Average Financial Fragility Index in Sample EMDEs
6.3
9.7
0.0
2.0
4.0
6.0
8.0
10.0
12.0
Average 2004-2008 Average 2014-2018
Average Overindebeteness Index in Sample EMDEs
Russia
Ukraine
Turkey
Argentina
Brazil
China
Colombia
Lebanon
Mexico
South Africa
Thailand
Egypt
Ethiopia
Nigeria
India
Indonesia
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
Overindebteness Index 2004-2008
Russia
Ukraine
Turkey
Argentina
Brazil
China
Colombia
Lebanon
Mexico
South Africa
Thailand
Egypt
Ethiopia
Nigeria
India
Indonesia
0.0
5.0
10.0
15.0
20.0
25.0
Overindebteness Index 2014-2018
19
Figure (13): Financial Fragility Index in Sample EMDEs by Country, Pre-COVID-19 vs.
Pre-GFC Crises
* Short-term debt/total debt is missing; hence, the index is a simple average of the other two indicators only.
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
.
Figure (14): Sample EMDEs Rankings in Overindebtedness, Financial Fragility, and
External Vulnerability Pre-COVID-19
* Short-term debt/total debt is missing; hence, the index is a weighted average of the other two indicators
only.
** We use the inverse of Reserves/Short-Term Debt as a measure of reserve inadequacy.
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
Rus
Kor*
TurUkr
Arg
Brz
Chile*
China
Col
LBN
Mal *
Mex
SA
Thai
UAE*
EGP
IND
INDO
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
Financial Fragility Index (2014-2018)
Rus
Kor*
Tur
Ukr
Arg
Brz
Chile*
China
Col
LBN
Mal *
Mex
SA
Thai
UAE*
EGP
IND
INDO
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Financial Fragility Index (2004-2008)
9.1
8.5
7.1
7.1
5.6
5.1
3.8
3.7
3.2
3.1
2.7
2.6
2.5
2.5
1.9
1.8
1.6
1.3
0.0 2.0 4.0 6.0 8.0 10.0
Kor*
China
Mal *
Chile*
Thai
UAE*
Ukr
Tur
LBN
SA
Brz
Rus
IND
Col
Mex
INDO
Arg
EGP
High FragilityMedium FragilityLow Fragility
Financial Fragility Index 2014-2018
19.8
18.7
15.0
12.7
12.5
11.1
11.1
10.1
8.8
7.8
6.3
5.7
5.6
3.4
3.4
2.8
0.0 10.0 20.0 30.0
Lebanon
Ethiopia
Argentina
Colombia
Brazil
Ukraine
Turkey
Indonesia
Egypt
South Af rica
Russia
Mexico
India
Nigeria
China
Thailand
Very High
Indebted ness
High
Indebted ness
Medium
indebtedness
Low
Indebdte d
ness
Overindebteness in Sample EMDEs, 2014-2018
20
Figure (15): Sample EMDEs Rankings in Overindebtedness, Financial Fragility, and
External Vulnerability - Pre- GFC
* Short-term debt/total debt is missing; hence, the index is a weighted average of the other two indicators
only.
** We use the inverse of Reserves/Short-Term Debt as a measure of reserve inadequacy.
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
Figure (16): External Vulnerability Pre-COVID-19 vs. Pre- GFC
Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical notes.
[
EMDEs External Vulnerability during the COVID-19 Crisis: Main Findings
Generally speaking, EMDEs seem to be not less vulnerable, if not more, than they were in the pre-
GFC era. While most EMDEs recently show relative stability in external debt indicators, this
stability does not necessarily indicate an improvement in resilience to the current shock.
Oppositely, more countries appear to be at very high risk of overindebtedness and worsened
7.4
5.3
4.1
3.8
3.4
3.3
3.2
3.2
2.3
2.1
2.0
1.9
1.9
1.8
1.8
1.5
1.3
1.3
0.0 2.0 4.0 6.0 8.0
Kor*
China
Thai
Mal *
SA
Chile*
Ukr
LBN
UAE*
Brz
IND
Tur
Col
Rus
EGP
Arg
Mex
INDO
High
Fragilit
yMedium FragilityLow Fragility
Financial Fragility Index 2004-2008
3.81
4.08
4.21
4.44
5.05
5.47
5.93
5.98
7.38
7.42
7.58
7.63
8.27
11.49
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00
Mex
IND
Thai
Rus
EGP
SA
China
INDO
Tur
Ukr
Col
Brz
Arg
LBN
Low External
Vulnerability
Medium
External
Vulnerabilit
y
High
External
Vulnerabilit
y
External Vulnerability in Sample EMDEs,
2014-2018
2.78
3.15
3.34
3.36
3.41
3.52
3.57
4.50
4.57
5.11
5.39
5.88
6.14
7.06
0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00
Mex
EGP
Thailand
India
Rus
China
SA
Indonesia
Ukr
Col
Brz
Tur
LBN
Arg
Low External
Vulnerability
Medium
External
Vulnera
bility
High
External
Vulnerabilit
y
External Vulnerability in Sample EMDEs, 2004-
2008
12.6
9.9
9.9
9.1
8.7
8.4
7.7
5.9
5.0
4.7
4.5
4.2
3.7
2.5
2.3
1.7
0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0
Argentina
Ethiopia
Turkey
Lebanon
Brazil
Colombia
Indonesia
Ukraine
Russia
India
Egypt
Mexico
South Africa
Thailand
Nigeria
China
V
hi
ghHighMediumLow
Overindebtedness in Sample EMDEs 2004-2008
21
financial fragility conditions compared to the pre-GFC era. The subsections below reveal the
details supporting this analysis.
The overall value of the Overindebtedness and Financial Fragility indices are higher in the pre-
COVID-19 period than the pre-GFC period. Average Overindebtedness Index for the sample
countries was 6.3 points in the pre-GFC period and 9.7 points in the pre-COVID-19 period.
Similarly, Average Financial Fragility Index for the sample countries increased from 2.87 points
in the pre-GFC period to 4.07 points in the pre-COVID-19 period. The only countries where
financial fragility did not worsen were Egypt and South Africa, both of which showed a mild
improvement. Deteriorated reserve adequacy and worsened debt architecture and maturity are
expected to create supply side disruptions which will increase the initial magnitude of the shock
and lead to slow recovery.
Higher household debt and increased share of short-term debt to total external debt are driving
much of the increased financial fragility in the sample. With the slowing growth rates, demand
disruptions that might result from the shock might lead to a deflation spiral.
While many countries appear to be currently reserve adequate; that is, their reserves to short-term
debt ratio is higher than unity (figure 17), comparing current reserve adequacy with the pre-GFC
period shows that there is significant deterioration in this indicator.
Strong reserve adequacy in some of the examined EMDEs might counter the effect of the fragile
financial status revealed in weak debt architecture and maturity mismatches and can help absorb
the initial impact of the shock on the foreign exchange market. Nevertheless, we expect this
countering effect to occur only in the short term. In the longer term, an economy with fragile debt
architecture, in terms of debt composition and maturity, would still be vulnerable to shocks, even
if it has a strong reserve adequacy position.
Likewise, more flexible responses to the shock in some EMDEs created a high initial crisis impact
doesn’t not necessarily indicate the crisis will have a larger impact on their external vulnerabilities.
Russia, Mexico, South Africa, and Indonesia were subject to higher initial effect of the crisis than
others. This could be partially attributed to their relatively more flexible response, via either
monetary expansion or more flexible exchange rates. However, strong liquidity and solvency
indicators as well as relatively low financial fragility indicate that those countries might be more
resilient to the current crisis and would show a relatively quick recovery.
There were five more countries (Argentina, Brazil, Colombia, Ethiopia and Lebanon) in the “very-
high indebted” category in the pre-COVID-19 index than the pre-GFC period. This is driven by
22
worsening liquidity and solvency conditions. We expect that Brazil, Ukraine, Lebanon, and Turkey
are at the highest risk of debt distress. Large decrease in reserves as well as the initial depreciation
in REER resulting from a substantial decline in portfolio outflows in those countries (OECD, 2020)
added to the high external vulnerability together indicate the possibility of a large magnitude of
the crisis as well as a possibly longer time to recover.
14
Figure (17): Reserves to Pre-COVID-19 vs. Pre-GFC
Source: Source: Authors’ calculations, see Annex (A2) and table (1) for definitions, data sources and technical
notes.
In Egypt, Thailand, and India, external vulnerability is relatively adequate, mainly because of
sound financial fragility as well as average indebtedness position. Nevertheless, problems in Egypt
and india would still persist as a result of the dominance of inflated public debt as highlighted in
section three. It is worth re-affirming here that, while we depend on the ratio of external debt to
exports as the main advisable indicator for EMDEs, in economies where government debt is
predominant, the ratio of external debt to GDP is also a sound indicator of an economy’s external
vulnerability that should not be overlooked. This would explain why Egypt – where government
debt accounts for more than 72% of external debt obligations – appears among the medium-low
vulnerable countries in our results, while other analyses that use GDP as the main denominator
classify it as highly vulnerable (Wheatley 2020; The Economist 2020).
15
14
Data on initial crisis impact are not available for Lebanon and Argentina.
15
According to IIF Global Debt Monitor (Tiftik & Mahmood, 2020).
0.4
0.4
0.5
0.6
0.8
0.9
1.0
1.6
1.8
1.9
2.1
2.1
2.3
2.5
2.6
2.7
2.7
4.0
0.0 1.0 2.0 3.0 4.0 5.0
Argentina
Ukraine
Lebanon
Turkey
Malaysia
Chile
South Af rica
Colombia
India
Mexico
United Arab Emirates
Indonesia
Korea
Thailand
Brazil
China,
Egypt
Russia
Reserve
inadequate Reserve Adequate
Rerserves to Short-Term Debt in Sample EMDEs-
Average 2014-2018
0.37
0.46
0.76
0.82
0.91
0.95
1.41
1.55
1.70
1.71
1.82
1.82
2.20
2.92
3.02
3.85
4.97
5.97
0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00
LBN
Arg
Tur
Ukr
Chile*
SA
Mex
Col
Brz
Thai
INDO
Kor*
Rus
UAE*
IND
Mal *
China
EGP
Reserve
inadequate Reserve adequate
Rerserves to Short-Term Debt in Sample EMDEs-
Average 2004-2008
23
A spotlight on China. As Kose et al. (2020) highlighted in their analysis of ‘global debt waves’,
debt accumulation in China accounts for around 80% of total average EMDEs’ debt rise above the
third wave, which preceded the GFC and predominantly consisted of private debt. According to
the Global Debt Monitor, non-financial corporations’ debt in China is largely driving the 230%
soar in emerging markets debt-to-GDP ratio in 2020 (Tiftik & Mahmood, 2020). However, despite
this surge in household debt in China and the increased short-term debt ratio, improved reserve
adequacy, as well as liquidity and solvency indicators leave the country less externally vulnerable
than in the pre-GFC period.
On balance, the observed increase in external vulnerability in many of the sample EMDEs implies
that the anticipated impact of the COVID-19 shock on debt will be larger than the impact of the
GFC both in terms of magnitude and in the length of time for recovery. EMDEs are at high risk of
witnessing serious debt distress and a possible prolonged recessionary wave unless they introduce
timely interventions to interrupt the loop at its early stages as advised in theory and learned from
past historical events.
Concluding Remarks
In this paper, we revisit external vulnerability of EMDEs during the COVID-19 crisis through an
integrated approach that incorporates propositions from theory, historical events along with
fundamental vulnerability assessment indicators and benchmarks advised by international
financial institutions. Results show that, all other factors being constant, EMDEs appear to be more
vulnerable than they were the pre-GFC era. Our main observations are as follows:
• Three pre-existing conditions are driving the external vulnerabilities in EMDEs today: (1) debt
architecture in the form of highly volatile, short-term and foreign currency denominated debt,
(2) exchange rate imbalances and (3) fiscal distress. This is added to the observed poor
domestic financial institutions and weak domestic savings rates, demographics, inequalities,
and poverty rates as discussed in relevant works. The COVID-19 shock will accelerate a debt
crisis that would have necessarily occurred anyway.
• Reactions to the GFC aggravated much of these pre-existing conditions. EMDEs, in excessive
fear of entering a debt-deflation spiral, expanded their growth trajectories through a pattern of
cheap private lending, loose accommodative policy measures, and in some cases unmonitored
fiscal expansion. Such measures, usually advised to be temporary, have further expanded
overindebtedness and financial fragility conditions in the examined countries.
• Pre-COVID-19 weak growth outlook, rising geopolitical tensions, evident non-linearities in
debt-growth relations in EMDEs, and high reliance on external finance to fund low net worth
investment all contribute to making the financial environment in many of the examined
countries more fragile.
• EMDEs with high domination of foreign-currency denominated bonds are (1) highly
vulnerable to the initial contagion effect of the COVID-19 shock, and thus show (2) massive
24
capital outflows and exchange rates disturbances, then a (3) alarming surge in bond buying
resulting from the global monetary and financial expansion.
• EMDEs have already started early corrective actions to counter the effect of the shock.
Nevertheless, increased monetary liquidity and declining borrowing costs led to a surge in
corporate bonds and speculative activities. This raises concerns about growing Ponzi finance
activities and fears of an approaching Minksy’s moment.
Full conclusive evidence on the crisis impact on debt vulnerabilities in EMDEs continues to
unfold, and the analysis in this paper will be repeated in the future. Nonetheless, the analysis here
provides sufficient evidence of a dire need for action. In this vein we offer the following proposals.
First, growth models in EMDEs need to be remastered in the long term towards more reliance on
sustainable, domestic sources of finance. EMDEs with relatively young populations and potential
demographic dividends need to adopt inclusive growth policies and develop their domestic
financial markets to channel dividends, leverage domestic savings, and fill financing gaps.
Sustainable domestic sources of finance are key to decreasing the reliance on short-term external
finance, widening fiscal space, overcoming maturity mismatches, and hence decreasing external
vulnerability.
Second, post-shock accommodative measures should be balanced with longer-term policies that
ensure the prudence of financial systems in the face of growing credit demand. The continuation
of current monetary and financial ease in light of the perceived growth slump is alarming. EMDEs
need to adopt more conservative policies where credit growth patterns need to be revised, even if
this means some sacrifice in growth rates over the medium term. Fears of deflation should not lead
to the preservation of systems of cheap unmonitored finance or fiscal expansion. In line with
Bernanke (2018a), we argue that maintaining financial system resilience with prudent policies is
necessary to prevent panics, even if this will have undesirable impacts on credit growth. Likewise,
while Krugman’s “permanent stimulus” proposal may work for the U.S. economy – given the low
interest rate environment and the U.S dollar characteristics – EMDEs already characterized by
fiscal imbalances, prolonged recessions, weak multipliers, and in many cases politically driven
discretionary interventions, must handle them more cautiously.
Third, while overall debt accumulation is always alarming, current debt threats arise mainly from
debt architecture. In more than two-thirds of the examined EMDEs, non-government debt largely
drives debt distress. Despite their appealing yields, relatively high ratings, and other benefits
compared to mature markets, corporate bonds pose high risks during crisis times. Such volatile
forms of debt are accompanied with high default risks and are not eligible for re-structuring than
other debt forms. Middle- and low-income countries, where financial and non-financial bond
markets are still immature, may suffer more from the domination of sovereign bonds as a main
25
source of finance. Sovereign bonds pose the same, if not higher, risks of high volatility and
ineligibility for re-structuring. Hence, debt portfolio management in EMDEs is essential in light
of perceived risks arising from highly volatile, short-term, and foreign currency denominated
bonds; both corporate and sovereign.
We also recommend that EMDEs maintain flexibility in their exchange rates during the shock.
More flexible exchange rates reduce financial fragility during shocks and can discourage short-
term speculative activities in bonds markets, particularly in imprudent and underdeveloped
financial systems.
Finally, on the global level, Hyman Minsky’s argument that global monetary and financial
management have a role in preventing debt crises cannot be more relevant. While global initiatives
such as the G20 Debt Service Suspension Initiative (DSSI)
16
have been designed to help low-
income IDA countries deal with debt vulnerability, such initiatives should also include debt-
vulnerable middle-income countries (MICs). Moreover, such initiatives, while providing some
breathing space for countries during the shock, will not address fundamental debt problems
addressed in this paper. We hence highlight the importance of renovating the global financial
architecture to consider currency exchange realignments, management of capital flows and more
actions related to debt moratorium and restructuring; especially in light of the current low-interest
environment which should facilitate debt reform processes in EMDEs. Recent global efforts and
actions are advancing in this regard. Member States of the United Nations and international
institutions are discussing actions to address debt issues through introducing global harmonized
actions, as well as accounting for heterogeneity of debt conditions across different countries
(United Nations, 2020a). This is in addition to the aforementioned calls for DSSI extension, private
sector participation in debt relief, debt buybacks, and debt swaps (Ellmers, 2020; United Nations,
2020b). Should these global discussions be turned into timely actions, we expect EMDEs to show
significant improvement with regards to external vulnerability during the COVID-19 shock and to
further achieve better debt sustainability outcomes after the crisis.
16
The G20 DSSI was announced April 15th, 2020, by the G20 as a World Bank-IMF Initiative in response to the COVID-19
pandemic. The initiative calls for “an NPV[net present value]-neutral, time-bound suspension of principal and interest payments
for eligible countries that make a formal request for debt relief from their official bilateral creditors, and encouraging private
creditors to participate on comparable terms” (World Bank, 2020a) .
26
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Annex (A1): The Sample EMDEs
Our sample EMDEs includes a set of EMDEs:
o NAEs (new advanced economies): Russia (Rus), Korea (Kor), Turkey (Tur),
Ukraine (Ukr).
o HICs (high income developing countries): Argentina (Arg), Brazil (Brz), Chile,
China, Colombia (Col), Lebanon(Leb), Malaysia (Mal), Mexico (Mex), Saudi
Arabia (KSA), South Africa (SA), Thailand (Thai), UAE;
o MICS (middle-income developing countries): Egypt (Egp), India (Ind), Indonesia
(Indo), Nigeria (Nig).
o LICS (Low-income countries) only Ethiopia (Eth) is included in the analysis, upon
data availability, due to its high growth rates that exceeded an average of 10% and
observed economic success in the past years (Rafoul and Raju, 2019).
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Annex (A2): Technical Notes
• All indices are calculated as simple average of their components mentioned in table (1).
• Countries are ranked in terms of level of indebtedness and fragility through statistically
dividing them into four main quartiles as in the following table.
Table (A2.1): Quartile ranges for the calculated indices
Index range
Overindebtedness index
Financial fragility
External vulnerability
Very high
12.6
9.1
11.5
High
8.8
5.5
7.5
Medium
5.5
3.1
6
Low
4.1
2.5
4.6
