The Pandemic Depression
The Global Economy Will Never Be the Same
The novel coronavirus plunged emerging markets into crisis. As investors rushed to safety, major emerging economies lost more than $100 billion in foreign currency reserves in the month of March alone. Trade flows shrank. New capital inflows dried up. In many ways, the pandemic has been harder on emerging economies than the 2008 global financial crisis.
But not all emerging markets have suffered equally or from the same ailments. Some economies are still included in emerging-market indices even though they have mostly emerged: South Korea and Taiwan, for example. These, along with other emerging economies, such as Thailand, that have strong balance sheets, face what might be called “First World problems”: worries over how to maintain employment while managing the public health threat from COVID-19, the disease caused by the novel coronavirus.
Another group of emerging markets is not at immediate risk of default but faces significant financial pressures that will undermine growth and thus the global economy. This group includes countries, such as Brazil and Indonesia, that have seen rapid capital outflows and the withdrawal of foreign financing. It also includes countries that are now experiencing large falls in commodity exports and thus pressure on their current accounts from falling trade. Even if these countries are not in urgent need of standard bailouts from the International Monetary Fund (IMF) to avoid default, the actual and perceived constraints on their ability to borrow may prevent them from spending all that they should to combat the pandemic.
A third category of emerging economies, including Argentina, Lebanon, and in all probability, Turkey, was headed for trouble even before the pandemic and is likely to emerge from it in worse shape still. The IMF has the tools to handle this most troubled category; governments in these countries are likely to be desperate enough to eventually seek traditional IMF programs conditioned on deep structural and fiscal reforms. But the countries that are in a slightly less precarious position—weakened by the coronavirus, but not yet on the verge of economic and financial collapse—face an uncertain future. The IMF doesn’t have effective instruments to help countries that are too strong to accept traditional conditionality but too weak to stand entirely on their own during a pandemic. The novel coronavirus thus poses a stress test for the IMF as well as for emerging economies—and it is one that the IMF may not pass.
The countries that were headed toward difficulty or default before the pandemic are now in the worst shape financially, but they are also the easiest cases to resolve. Take Lebanon, for example, which took on enormous debts in recent years to finance fiscal and trade deficits. Last fall, the government took steps to close the budget deficit, but those measures triggered political protests that eventually brought down the government. Since then, Lebanon’s central bank has burned through nearly all of its usable foreign currency reserves trying prop up the value of the Lebanese pound. As a result, it can’t repay the dollars it has borrowed from Lebanese banks. Lebanon needs to restructure its domestic banking system as well as its government’s external debt. It is now poised to accept a classic conditional IMF program.
Turkey was on a similarly worrying trajectory prior to the pandemic. Turkey didn’t—and still doesn’t—have dangerously high levels of fiscal debt, and it isn’t heading for a sovereign bond default. But not all financial problems stem from government borrowing. In an effort to mask its low level of foreign currency reserves, the Turkish government used regulatory incentives to encourage its banks to borrow foreign exchange from abroad and deposit it at the central bank. Turkish banks have eagerly done so, but those borrowed reserves will ultimately have to be paid back. As a result, they don’t give the central bank the level of protection it needs to bring interest rates below the rate of inflation, as President Recep Tayyip Erdogan has called on the bank to do.
Last fall, Turkish state banks went on a lending spree designed to pull the country out of the recession that followed its 2018 currency crisis. But rising lending quickly put Turkey’s trade back into deficit. Rather than allow the Turkish lira to fall and find a new equilibrium, the government began selling off its remaining foreign exchange reserves to prop up the currency. Now, with the added stress of the coronavirus, Turkey is almost certainly headed for a classic balance-of-payments crisis.
Absent a large rebound in oil prices, countries that finance their budgets with oil exports, such as Angola, Ecuador, Oman, and perhaps Iraq, will run out of money and ultimately be forced to accept conditional IMF programs.
Some of the world’s weak oil-exporting economies are in a similar bind, although for different reasons. While strong petrostates, such as Saudi Arabia, can likely ride out a period of low oil prices by drawing on accumulated reserves and borrowing in the international market, weaker ones have fewer reserves and less access to international credit. Absent a large rebound in oil prices, countries that finance their budgets with oil exports, such as Angola, Ecuador, Oman, and perhaps Iraq, will run out of money and ultimately be forced to accept conditional IMF programs.
Emerging economies that were in better shape before the pandemic confront more uncertainty today. Now that foreign investors have fled, these countries face mounting financial pressures as their currencies depreciate. Often, they have one glaring balance sheet weakness—be it low foreign currency reserves or a high fiscal deficit—but also at least one offsetting source of strength. International financial assistance would help these countries weather the pandemic, but their governments are not desperate enough to accept traditional (and often painful) IMF programs. So far, these countries have kept the IMF at arm’s length. As a result, the fund’s financial firepower has been underused during the pandemic.
Indonesia is a good example of a country in this position. Its government debt is only about 30 percent of GDP, much lower than that of the United States or most advanced economies, and its fiscal deficits have been responsibly low in recent years. The country’s central bank has kept interest rates relatively high. But a large fraction of Indonesia’s debt is held by foreign investors who are now fleeing the local bond market. The government recently placed a dollar bond with foreign investors, so it is far from needing a traditional IMF program. But to avoid getting into fiscal trouble and to limit pressure on its comparatively small reserves, Indonesia may spend too little to counteract the economic shock of the pandemic. That will compound this year’s economic downturn and make it harder for Indonesia to mount a rapid recovery.
It wouldn’t help the global economy if all remaining foreign investors in Brazil find themselves in the financial equivalent of a lockdown while the country struggles to respond to the pandemic.
Brazil is another case in point. Default is not a risk, because Brazil’s foreign currency reserves are large enough to cover both the government’s external debt and that of the state oil company, Petrobras. But Brazil has accumulated a sizable domestic public debt. And with revenues falling amidst a pandemic that demands extra expenditures, Brazil’s fiscal deficit could reach 15 percent of GDP this year even as foreign investors head for the exits. The bulk of that deficit can be financed domestically. But any emerging economy that relies too heavily on its own central bank for financing risks a currency collapse and a broad run on its banks and markets. It wouldn’t help the global economy if all remaining foreign investors in Brazil find themselves in the financial equivalent of a lockdown while the country struggles to respond to the pandemic.
Indonesia and Brazil used to be able to finance a portion of their fiscal deficits by placing local currency denominated bonds with foreign investors. Now, both countries need a new source of long-term financing, ideally at a fairly low rate (if not in their own currencies). The IMF would be the natural answer, but the fund isn’t set up to play that role for most of the emerging world.
To be sure, the IMF has offered some assistance to emerging economies battered by the pandemic. Through its Rapid Financing Instrument, for instance, the IMF is poised to provide a small amount of money to a large number of countries. But the $100 billion available through this facility pales in comparison to the more than $2 trillion in need that the IMF itself has identified. The IMF has also created a new Short-Term Liquidity Line, through which countries that have demonstrated what the fund considers “very strong” performance—good fiscal management, low and stable inflation, well-regulated and solvent banks—can obtain small amounts of assistance. The pandemic, however, calls for financing in much larger amounts than this line provides, over longer terms, and available to a wider range of countries, including those without spotless policy records.
To meet a portion of this need, the IMF should authorize a one-time increase in the world’s foreign exchange reserves. A so-called Special Drawing Rights (SDR) allocation would distribute the IMF’s internal currency—the SDR—to all countries in proportion to their existing IMF contributions. (SDR could then be exchanged for hard currency reserves, be they dollars or euros.) The IMF authorized a $250 billion SDR allocation in 2009. But now, in the face of what is in many ways a bigger shock, the IMF hasn’t pushed to make use of this mechanism, seemingly for fear of offending the administration of U.S. President Donald Trump. The fund should ask its board for authority to use the SDR allocation mechanism and force the United States to take the political heat that would come from explicitly blocking the move.
The IMF shouldn’t risk being hamstrung by a U.S. veto of the SDR allocation, however. It needs to find more creative ways to put more of its $1 trillion balance sheet to work. Specifically, the IMF should create a new instrument that would help countries cover the cost of emergency public health measures for the duration of the pandemic. This instrument should be designed to appeal to a broad range of countries that previously had sustained access to private-market financing. And unlike the IMF’s Short-Term Liquidity Line, this instrument should be designed so that countries have five or more years to repay the funds. It is in everyone’s interest for countries to borrow more so that they can spend more to fight the pandemic. This new special instrument should reflect that reality.
The IMF faces two broad categories of risk. The first stems from lending too much to too many countries on terms that are too easy. The second stems from lending too little to too few countries—and having the fund’s considerable financial resources go unused in a time of global need. At this moment, the greater risk falls in the latter category. Some countries, including Lebanon and Turkey, do need conventional IMF programs. But many more need a new long-term source of financing to make up for the private financing that has vanished.
So long as the IMF limits the amount of pandemic financing to a portion of countries’ 2020 fiscal deficits, the risks associated with a one-time broad increase in lending to emerging-market countries would be manageable. This is a once-in-a-century pandemic that calls for a once-in-a-century response. The IMF has yet to deliver.
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