Like the coronavirus crisis itself, the response of the world’s governments has been on a scale never seen before. The IMF estimates that fiscal spending and tax cuts worldwide add up to more than $11.7tn so far, on top of a monetary policy response in which trillions of dollars have been pumped into the global financial system by the US Federal Reserve and other central banks.
Old policy prescriptions have been torn up. Once the guardian of austerity, the IMF has urged countries to spend as much as possible. Carmen Reinhart, the eminent economic historian who is now chief economist at the World Bank, recommended they should borrow heavily. “While the disease is raging, what else are you going to do?” she asked. “First you worry about fighting the war, then you figure out how to pay for it.”
But, also like the crisis, the response itself has left the finances of governments and businesses, especially in low and middle-income countries, looking extremely vulnerable. Their debts cannot be ignored and their ability to fund them through growth is uncertain.
Several factors compound their difficulties.
The initial shock was accompanied by a burst of panic selling of emerging market assets in March as investors woke up to the pandemic. About $90bn left bond and stock markets in developing countries, according to the Institute of International Finance, bringing access to finance to a sudden stop.
The amount of emerging market assets held by foreign investors was at a low level before the crisis struck, as developing economies were already struggling to deliver the growth and returns investors expected. The only country to have seen a significant return of investor flows since March is China — the only large economy expected to grow at all this year. The others are still in a capital flows drought. Nevertheless, they have had to spend heavily, just as government revenues have collapsed. Moody’s Investors Service warned in October that the crisis would cause long-lasting revenue losses for governments in emerging markets, with an average decrease in public income this year equal to 2.1 per cent of gross domestic product, more than twice the size of the comparable loss in advanced economies.
Several countries have turned to foreign and domestic bond markets. Overall, emerging economies raised about $145bn on international bond markets between January and September and an additional $630bn on domestic markets, according to the IIF. That is about $135bn more than they raised in the same period last year.
Those less able to borrow have been supported by the IMF, the World Bank and other multilateral lenders. The IMF has provided about $100bn of emergency funding to more than 80 countries. The multilateral development banks, led by the World Bank, have committed $75bn this year out of $230bn earmarked for their response to the pandemic. Much of that support is in grants or concessional loans. But it also comes with strings attached. Despite its exhortations to spend, the terms of IMF loans still call for budget cuts, notes Adam Wolfe of Absolute Strategy Research, a consultancy.
“We expect tighter domestic and international financing conditions to push most EMs towards austerity next year,” he said.
Some emerging economies will not be able to keep a handle on their debts without defaulting, he warned. But even those that can consolidate their debts without default or IMF support are likely to suffer permanent scarring, he added, resulting in lower potential growth rates.
Fitch Ratings had made 35 downgrades of emerging market sovereign credit ratings by mid-October, affecting 24 sovereign bond issuers. It had 30 EM sovereigns on a negative outlook, suggesting more downgrades were likely this year and next.
The risk of downgrade and default is not evenly spread. S&P Global Ratings put the potential for downgrades among sovereign and corporate borrowers in Latin America at 56 per cent in September, more than double the 10-year regional average of 27 per cent. In Asia excluding China the risk had risen from 17 per cent to 41 per cent. But in eastern Europe, the Middle East and Africa it had fallen from 25 per cent to 11 per cent and in China it was stable at 18 per cent.
Analysts warn that a clear assessment of the funding risks for EM governments and businesses is not yet possible. S&P noted in October that the pace of recovery in developing countries had slowed from August to September. Bhanu Baweja, chief strategist at UBS’ investment banking arm, warns that the real test will come after the initial support from the IMF and others has been absorbed.
“Emerging markets’ own investment to GDP ratio has been coming off for an extended time, and that is a much bigger issue in terms of EM assets and growth than the potential investment in grants and loans from the rest of the world,” he said.
With many economies set to suffer permanent damage from the pandemic, their ability to invest and grow is likely to take a lasting hit.