External Debt Vulnerability in Emerging Markets and Developing Economies During the Covid-19 Shock

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 subindices 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.

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