Emerging market risks to the economic recovery

On Wall Street it is said that when the winds are strong, even turkeys can fly. By this it is meant that when money is very easy, even un-creditworthy borrowers will find it easy to raise money to finance their expansion. But when the winds die down and money becomes tight, those borrowers find themselves crashing down to earth. They also often find themselves unable to repay their creditors without restructuring their debts.

Unfortunately, today this adage would seem to apply to all too many emerging market economies. Over the past decade, when the world’s central banks’ ultra-easy monetary policies flooded the markets with liquidity, the emerging market economies were able to borrow freely. They could do so despite a significant weakening in their underlying economic fundamentals in general and their weak public finances in particular. 

The scale of emerging market economies’ borrowing that ensued was without precedent. According to the Institute for International Finance, over the past ten years, emerging market debt approximately doubled to around $72 trillion or almost 190 percent of GDP. A further indication of how important emerging market debt has become is the fact that around $6 trillion in emerging market syndicated loans and bonds, or more than a quarter of the global total of such loans and bonds, will mature this year.

The onset of the coronavirus pandemic at the start of the year has caused the strong global liquidity winds to come to an abrupt halt. Never before has capital been withdrawn from the emerging market economies as rapidly as it is now being withdrawn. According to the International Monetary Fund, in March alone around $100 billion was withdrawn from the emerging market economies. This pace of withdrawal well exceeded any month in the aftermath of the 2008 Great Recession. 

Judging by the way in which key emerging market currencies are now plunging, it would seem all too likely that the capital flight from the emerging market countries has been picking up pace. In that context, it has to be a matter of considerable concern that since the start of the year, key emerging market currencies like the Brazilian real, the Mexican peso, the South African rand, and the Turkish lira have lost around 30 percent of their value against the U.S. dollar. 

Already before the coronavirus epidemic began, a number of medium-sized emerging market economies were either defaulting or were on the verge of defaulting on their debt obligations. These countries included Argentina, Ecuador and Venezuela.  

Now that the coronavirus has dealt the emerging market economies the severest of body blows, not least by causing a collapse in international commodity prices, it must only be a matter of time before the larger emerging market economies might need debt restructurings. This would be particularly the case for countries like Brazil, Nigeria, South Africa and Turkey, which all now have shaky public finances.

The present economic predicament of Brazil, by far Latin America’s largest economy, is illustrative of the bind in which a number of systemically important emerging market economies now find themselves. At 76 percent, Brazil’s public debt to GDP ratio was very high by emerging market standards even before the coronavirus pandemic. 

After the coronavirus pandemic hit, Brazil’s public debt now looks set to be on a clearly unsustainable path. According to the IMF’s latest estimates, in 2020 the Brazilian economy will contract by more than 5 percent. This will cause its budget deficit to balloon to almost 10 percent of GDP and its public debt level to skyrocket to almost 100 percent of GDP by year-end. 

The global financial system very likely could absorb debt defaults in the frontier and smaller emerging market economies without too much difficulty. But it would be quite a different matter if any of Brazil, Mexico, South Africa or Turkey were to need debt relief. This would seem to be especially the case at a time when debt problems in the world’s high-yield market are already putting significant strain on the global financial system.

Hopefully, U.S. and global economic policymakers are paying close attention to the present travails of the emerging market economies. Maybe then we can hope that they are also making contingency plans to respond to a wave of emerging market debt restructurings to keep the world economic recovery on track.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.