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External debt vulnerability in
emerging markets and developing
economies during the
COVID-19 shock
Sarah Elkhishin
Department of Economics, The British University in Egypt, Cairo, Egypt, and
Mahmoud Mohieldin
Faculty of Economics and Political Science, Cairo University, Giza, Egypt
Abstract
Purpose –This 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/approach –In 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.
Findings –EMDEs are more vulnerable compared to the GFC era. Current debt threats arise mainly from
debt architecture andthedomination 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/implications –Conclusive post-crisisdata are still unavailable.
Practical implications –EMDEs 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 ofthe monetary
expansion and injected liquidity.
Originality/value –The 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.
Keywords Emerging markets, External debt, COVID-19 shock, External vulnerability,
Financial fragility
Paper type Research paper
© Sarah Elkhishin and Mahmoud Mohieldin. Published in Review of Economics and Political
Science. Published by Emerald Publishing Limited. This article is published under the Creative
Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and
create derivative works of this article (for both commercial and non-commercial purposes),
subject to full attribution to the original publication and authors. The full terms of this licence
maybe seen at http://creativecommons.org/licences/by/4.0/legalcode
The authors appreciate the contribution of Jailan El-Saeed for providing research assistance and
data work.
Emerging
markets and
developing
economies
Received 11 October2020
Revised 13 December2020
Accepted 13 December2020
Review of Economics and Political
Science
Emerald Publishing Limited
e-ISSN: 2631-3561
p-ISSN: 2356-9980
DOI 10.1108/REPS-10-2020-0155
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/2631-3561.htm
1. 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:
Q1. What are the determinants of EMDEs external vulnerability?
Q2. How vulnerable are EMDEs to the current COVID-19 shock compared to the global
financial crisis (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 GFC.
Results show increased external vulnerability in sample EMDEs compared to the GFC
era, suggesting the current crisis could be deeper and require a 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.
The paper is organized as follows: In Section 2, we review the political economy of debt
during crises in theory and literature. EMDEs debt characteristics are discussedin Section 3.
In Section 4, we discuss our methodology and data. In Section 5, we present the analysis of
external vulnerability in sample EMDEs. Finally, in Section 6, we discuss conclusions and
policy measures to avoid a debt crisis in EMDEs after the COVID-19 era.
REPS
2. The political economy of debt management during crises
(Chenery and Strout, 1966) two-gap models offer the 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.
P1. What distinguishes a mild downturn from 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 debt liquidation which leads
to excessive distress selling and local currency depreciation. These, in turn, lead to a direct
decline in business net worth and arising bankruptcies, a fall in the overall level of profit,
and hence a severe decline in gross domestic product (GDP), employment and trade. The
overall economic contraction will lead to further pessimism and loss of confidence in
the business climate, whereby the financial sector will witness more hoarding activities and
the velocity of circulation will decrease. This will finally result in an overall decrease in
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 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 surge in the external finance premium and increases in risk aversion
after the shock quickly transmitted into the US 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 is called the Minsky’s cycle extended Fisher’s arguments on the causes
of debt crises. According to Fisher (1933), new investment opportunities are the primary
causes of cycles and they put countries in a state of overindebtedness that can result in
Emerging
markets and
developing
economies
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).
P2. History shows that a debt-deflation process can be interrupted and reversed
through big government, big bank, global monetary harmony and 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:
big government:
big bank;
global monetary harmony (Bretton Woods); and
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 and Krugman, 2012)
argued that the solution to the GFC debt-induced slump is more debt and in the COVID-19
crisis (Krugman, 2020) advocated for a permanent stimulus package to counteract the
current shock [1], reflecting as his support for the big government and big bank theories.
P3. The relevance of big government theory to EMDEs with structural macro-fiscal
imbalances.
The above arguments focus mainly on mature economies, typically the US 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 a big government
during recessions (El-khishin and Zaky, 2019). This results in fiscal illusions, where
politicians tend to quickly resort to stimulus packages during recessions without
counterbalancing during booms (Alesina and 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
REPS
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).
P4. 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 [2]. (Reinhart and 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 in home currency [3], [4]. On the other hand, literature
also referred to the possible reverse causality between debt and growth. For example,
Easterly (2001) and Pattillo et al. (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 toward more household debt and
external debt are key players in recurring financial crises. 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 asset 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 the 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 financial deleveraging was channeled into the real
economy through financial fragility and 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.
3. Emerging markets and developing economies external debt characteristics
before the COVID-19 shock
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, the balance of payments imbalances results in disturbances in
Emerging
markets and
developing
economies
capital flows that, if coupled with insufficient foreign direct investment, typically results in
mounting external debt (Stiglitz and Rashid, 2020a).
While EMDEs have acted to stabilize their external debt burdens as 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).
Likewise, increased household and non-financial corporations borrowing still create a
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 non-financial sector debt involving higher-risk activities within a low-yield environment
(International Monetary Fund, 2020b). While economics predicted this would reverse after
the GFC, household and non-financial 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 1.
External debt as
percentage of GDP in
EMDEs (1995–2019)
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
Source: IMF, World Economic Outlook Database, (2019)
Figure 2.
Total stocks of loans
and debt securities
issued by households
and non-financial
corporation’s%of
GDP in selected
EMDEs
0.0
50.0
100.0
150.0
200.0
250.0
Russia
Singapore
Korea
Turkey
Ukraine
Argenna
Brazil
Chile
China
Colombia
Lebanon
Malaysia
Mexico
South Africa
Thailand
UAE
Egypt
India
Indonesia
2014-2018 2004-2008 Linear (2014-2018) Linear (2004-2008)
Source: International Monetary Fund (2020c)
REPS
Today, household debt and non-financial corporations’debt together constitute more than
60% of total EMDEs debt according to the recently published Institute of International
Finance data (Figure 4)[5]. Corporate bonds constitute the largest share of foreign currency
bond issuance in emerging markets (EM-30) as shown on the left side of Figure 4.On
average, EM 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 and 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
and Rashid, 2020a).
The pre-COIVD-19 weak growth outlook and geopolitical tensions are also important
determinants of debt distress crisis in EMDEs. The COVID-19 shock has met a slowing
down the 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
Figure 3.
Sectoral indebtedness
in sample EMDEs,
2020Q1 versus
2019Q1
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
Argenna
Brazil
Chile
China
Lebanon
Malaysia
Mexico
South Africa
Thailand
UAE
Egypt
India
Indonesia
% of GDP
% of GDP
HH and non-financial corporaons Government Financial sector Total
Source: Institute of International Finance (IIF) data; in Tiftik and Mahmood (2020)
Figure 4.
Overall debt
composition in EM
Emerging
markets and
developing
economies
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.
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 and 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 high domination of public debt, such
as Argentina, Egypt, Ukraine, Lebanon and India areparticularly vulnerable (Figure 6).
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 use 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
Figure 5.
Average real growth
rates in sample
EMDEs, pre-COVID-
19 versus pre-GFC
–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
Argenna
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)
Source: International Financial Statistics
Figure 6.
Government debt as
percentage of total
debt in sample
EMDEs, 2020-Q1
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
Argenna
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
Source: IIF data, in Tiftik and Mahmood (2020)
REPS
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 risks.
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 GFC shock? In the next section, we present the
methodology and data then used to answer the mentioned questions.
4. 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 the 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 and 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 and 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 (EWS),
these indices were constructed to assess external debt vulnerability during crisis times [6].
To create our crisis index, we average:
changes in reserves; and
changes in REER, both of which Bussiere and Mulder (1999) and Sachs et al. (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 2 and the debt
Emerging
markets and
developing
economies
characteristics of EMDEs presented in Section 3. 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 as 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 non-residents
regardless of the 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 the 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 and Rogoff, 2009).
In the External Debt Statistics guide published by IMF in 2014, indebtedness is the
numerator measure for debt sustainability [7] based on two main dimensions: solvency and
liquidity. Debt stock indicators reflect solvency while debt service indicators reflect
liquidity. Liquidity problems can cause solvency risks if not adequately addressed.
(Bussiere and 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.
We use the external debt-to-exports ratio as an indicator for solvency and the 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 have 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 [8]. 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 the monetary base to assess
countries’vulnerability to panics. Bussiere and Mulder (1999) and Sachs et al. (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
(STD) offers a better indicator in countries with “significant but uncertain access to capital
markets”; where a smaller reserve to STD ratio would indicate a greater incidence and depth
of crises. Reserves/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
REPS
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
Data set: (World Bank,
2020b)
Reserve adequacy Reserves to STD ratio
The ratio of reserves to
short-term external debt
(R/STD). We use the
inverse of reserves to STD
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
Data set: (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$) and external
debt stocks, total (DOD,
current US$).
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
Data set: (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
Data set: (International
Monetary Fund, 2020c)
Note: *For more on the definitions and concepts, see (International Monetary Fund,2000b, 2014;World
Bank, 2020b)
Emerging
markets and
developing
economies
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).
Regarding 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 a
percentage of total external debt as an indicator of the degree of the dominance of STD 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 and Rogoff, 2010) and
(Fincke and Greiner, 2015) in the selection of sample EMDEs [9]. 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 Appendix 1. As noted in Table 1, we depend on
International Debt Statistics –The World Bank and International Financial Statistics –IMF
published data. For data on REER, we use Bruegel Data sets published in Darvas and Zsolt
(2020).
5. 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 theCOVID-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 crisis onset. Following Bussiere and 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
Figure 7.
JP Morgan EM bond
index
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
Source: JP Morgan
REPS
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 EM starting in January
2020, which affirms the JP Morgan Emerging Market Bond Index trend during the same
period.
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 thecrisis or in response to stimulus packages and debt restructuring
plans. Increased low-cost finance, large monetary expansion and injected liquidity are
increasingly 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.
An illustration of the components of the crisis index indicators in sample emerging markets
and developing economies
The below illustration shows a loss in reserves in most of the sample EMDEs during the
period of January–May 2020. Reserve losses are among the indicators that deteriorate early
in times of crises as central banks inject liquidity as part of the initial response to the shock.
Results are also intuitive given the appreciation of US$ and other advanced economies’
currencies against the EMDEs’currencies during the examined period (Corsetti and 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.
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 thesample countries can be attributed to:
composition of capital flows (FDI, portfolio investment, sovereign bonds,
commercial loans and remittances);
Figure 8.
Accumulated non-
resident portfolio
flows to EMs
Emerging
markets and
developing
economies
size of monetary injections; and
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 and 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)[
10].
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 US$. We lack
information about Egypt’s reserves or REER post in March 2020, and it seems
probable that the crisis had not have started to impact the economy at that time.
Figure 10.
Simple COVID-19
crisis index
0.63
0.65
1.34
1.48
2.12
2.38
3.74
3.82
5.40
5.48
5.78
9.98
12.16
16.30
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00
IND*
China*
Col
EGP**
Thai
Kor*
Mal
INDO*
Mex
Rus
Ukr
SA
Brz
Tur
Low Crisis Impact
Medium
Crisis
Impact
High Crisis
Impact
Notes: * January-April; ** January-March. See Annex for data for technical notes
Source: Author calculations based on International Financial Statistics.
Figure 9.
An illustration of the
components of the
STV/BM crisis index
indicators in sample
EMDEs after the
COVID-19 shock
began
Rus, –1.77
Kor*, –1.49
Tur, -27.37
Ukr, –4.17
Brz, –3.93
China*, –0.75
Col, 5.52
Mal , –1.27
Mex, 4.20
SA , –5.06
Thai, 2.82
UAE*, –7.31
EGP**, – 13.40 IND*, 1.46
INDO*, –3.27
–30.00 –20.00 –10.00 0.00 10.00
Change in Reserves (January-May)
Rus, –9.20
Kor*, –3.26
Tur, –5.23
Ukr, –7.39
Brz, –20.39
China*, –0.54
Col, –8.20
Mal , –6.21
Mex, –14.99
SA , –14.90
Thai, –7.05
EGP**, 10.43
IND*, –2.71
INDO*, –4.38
–30.00 –20.00 –10.00 0.00 10.00 20.00
Change in REER (January-May)***
Notes: * January-April; ** January-March; *** An increase in the REER indicates
appreciation of the home currency against the basket of currencies of trading partner
Source: Author calculations based on International Financial Statistics
REPS
Egypt’s trade partners overall started showing a depreciation in their currencies
against the US$ in January as indicated earlier, suggesting that Egypt’s REER
appreciation is temporary[11]. 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 the global economy slump which will definitely affect the
size of capital flows in the Egyptian economy (IMF, 2020a).
Overindebtedness and financial fragility in emerging markets and developing economies
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.
Emerging markets and developing economies 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 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 in the pre-GFC period. The average overindebtedness index for
Figure 12.
Overindebtedness
index in sample
EMDEs, by country,
pre-COVID-19 vs pre-
GFC crises
Russia
Ukraine
Turkey
Argenna
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
Argenna
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
Note: See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
Figure 11.
Average
overindebtedness and
financial fragility
index in a sample
EMDEs, pre-COVID-
19 vs pre-GFC crisis
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 Sa mple EMDEs
Note: See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
Emerging
markets and
developing
economies
the sample countries was 6.3 points in the pre-GFC period and 9.7 points in the pre-COVID-
19 period. Similarly, the 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.
Higher household debt and increased share of STD 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.
Figure 13.
Financial fragility
index in sample
EMDEs by country,
pre-COVID-19 vs pre-
GFC crises
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)
Notes: * STD/total debt is missing; hence, the index is a simple average of the other two
indicators only. See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
Figure 14.
Sample EMDEs
rankings in
overindebtedness,
financial fragility and
external vulnerability
pre-COVID-19
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
Argenna
Colombia
Brazil
Ukraine
Turkey
Indonesia
Egypt
South Africa
Russia
Mexico
India
Nigeria
China
Thailand
Very High
Indebtedness
High
Indebtedness
Medium
indebtedness
Low
Indebdted
ness
Overindebteness in Sample EMDEs, 2014-2018
Notes: * STD/total debt is missing; hence, the index is a weighted average of the other two
indicators only. ** We use the inverse of reserves/STD as a measure of reserve inadequacy.
See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
REPS
While many countries appearto be currently reserve adequate; that is, their reserves to STD
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 does not necessarily indicate the crisis will have a larger impact on their
external vulnerabilities. Russia, Mexico, South Africa and Indonesia were subject to a higher
Figure 15.
Sample EMDEs
rankings in
overindebtedness,
financial fragility and
external vulnerability
–Pre-GFC
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
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
Argenna
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
Notes: *STD/total debt is missing; hence, the index is a weighted average of the other two
indicators only. **We use the inverse of Reserves/STD as a measure of reserve inadequacy.
See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
Figure 16.
External
vulnerability pre-
COVID-19 vs pre-
GFC
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 Samp le 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 Samp le EMDEs, 2004-
2008
Note: See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
Emerging
markets and
developing
economies
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 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 and
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 and a possibly longer time to recover [12].
In Egypt, Thailand and India, external vulnerability is relatively adequate, mainly
because of sound financial fragility and 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 3. 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 countriesin our results, while
other analyses that use GDP as the main denominator classify it as highly vulnerable
(Wheatley, 2020;The Economist, 2020)[13].
A spotlight on China. As Kose et al. (2020) highlighted in their analysis of “global debt
waves,”debt accumulation in China accountsfor 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 EM debt-to-GDP ratioin 2020 (Tiftik and Mahmood, 2020).
However, despite this surge in household debt in China and the increased STD 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 the debt will be larger
Figure 17.
Reserves to pre-
COVID-19 vs pre-
GFC
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
Argenna
Ukraine
Lebanon
Turkey
Malaysia
Chile
South Africa
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
Note: See Appendix 2 and Table 1 for definitions, data sources and technical notes
Source: Authors’ calculations
REPS
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.
6. Concluding remarks
In this paper, we revisit the 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 in the pre-GFC era. Our main observations are as follows:
Three pre-existing conditions are driving the external vulnerabilities in EMDEs today:
debt architecture in the form of highly volatile, short-term and foreign currency-
denominated debt, exchange rate imbalances and 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 highly
vulnerable to the initial contagion effect of the COVID-19 shock, and thus show
massive capital outflows and exchange rate disturbances, then 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. 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 toward 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.
Emerging
markets and
developing
economies
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 toprevent panics,
even if this will have undesirable impacts on credit growth. Likewise, while Krugman’s
“permanent stimulus”proposal may work for the US economy –given the low-interest rate
environment and the US$ 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. Sovereign bonds pose the same, if nothigher, 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 bond 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) [14] 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 addressedin this paper.
We 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 the 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 regard to external vulnerability during the
COVID-19 shock and to further achieve better debt sustainability outcomes after the crisis.
Notes
1. 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.
2. Empirical literature that has examined the relation between growth and debt in EMs shows a
non-linear relationship such as an inverted U-shaped relation, where it starts positive then turns
REPS
negative past a certain threshold. For example, Pattillo et al. (2004) show that in high indebted
countries, doubling debt reduces growth by 1%.
3. 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 and Rogoff, 2010).
4. Other literature such as Fincke and Greiner (2014) found a positive relation between debt and growth
in EMs 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)andPattillo et al. (2004,2002).
5. Institute of International Finance. https://www.iif.com/
6. IMF has developed the EWS in the end 1990s to assess countries’external vulnerabilities to
shocks and crises. EWS variables are current account deficit, STD over reserves, export growth,
real exchange rate appreciation and the change in reserves (Berg and Pattillo, 1998).
7. 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).
8. However, debt-to-GDP is also useful in the cases where public debt is dominant, as the ratio
relates to the primary source of repayment such cases and economies would switch to servicing
the debt from domestic resources (IMF, 2014).
9. With minor modifications due to data availability.
10. 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.
11. For more explanation on the possible reasons behind REER appreciation, see Noureldin (2017).
12. Data on initial crisis impact are not available for Lebanon and Argentina.
13. According to IIF Global Debt Monitor (Tiftik and Mahmood, 2020).
14. The G20 DSSI was announced April 15, 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).
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Appendix 1. Sample EMDEs
Our sample EMDEs includes a set of EMDEs:
New advanced economies: Russia (Rus), Korea (Kor), Turkey (Tur), Ukraine (Ukr).
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.
Middle-income developing countries: Egypt (Egp), India (Ind), Indonesia (Indo), Nigeria
(Nig).
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).
Appendix 2. 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.
Corresponding author
Sarah Elkhishin can be contacted at: sarah.elkhishin@bue.edu.eg
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Table A1.
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
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