The output losses in low- and middle-income countries triggered by the Covid-19 crisis are likely to leave long-lasting scars, reducing potential growth. The UK is not insulated from the economic fallout due to trade links and financial exposure.
A perfect storm: that is how the International Monetary Fund (IMF), the World Bank and the Bank for International Settlements (BIS) define the situation that emerging market and developing economies (EMDEs) are facing as the pandemic intensifies.
Like advanced economies, they have implemented mitigation measures resulting in partial shutdowns of economic activity, shrinking output. But the economic fallout in EMDEs is amplified by several domestic vulnerabilities, including a larger informal sector, a higher proportion of jobs that cannot be performed remotely and limited fiscal space to offset the economic impacts (Djankov and Panizza, 2020).
The external environment has brought further headwinds, namely capital outflows. Indeed, the reversal in portfolio flows that took place in March was unprecedented (Institute of International Finance, IIF, 2020, see Figure 2).
These flows have since stabilised, but the tight financial conditions that they have left behind – worsened by the fall in remittances and tourism – increase the possibility of financial instability and lower growth prospects (IMF, 2020).
What does evidence from economic research tell us?
Historically, in periods of rising uncertainty in the global economy, international investors become more risk-averse and revise their portfolio allocation. As they cut their exposure to risky assets and stop rolling over maturing positions, they trigger capital outflows from EMDEs. At the same time, they increase demand for safe heaven assets, notably US Treasury securities. This ‘flight to quality’ has two immediate consequences.
First, capital outflows from EMDEs depreciate these countries’ currencies against the US dollar. The large movements in the foreign exchange market recorded since February follow this historical pattern (Corsetti and Marin, 2020 – see Figure 1). Traditionally, despite differences across sectors, a cheaper exchange rate should boost exports. But recent research shows a weak effect because exporting firms, especially in EMDEs, price their products in dollars (Gopinath, 2020).
Second, capital outflows tighten domestic financial conditions, increasing funding costs. Indeed, spreads on EMDEs’ bonds have widened since the crisis began (BIS, 2020 – see Figure 3).
There is an amplification mechanism between these two effects: currency depreciation lowers the dollar value of local currency bonds, leading to sales by foreign investors and widening interest rate spreads. As the pandemic intensified, the relationship strengthened (Hofmann et al, 2020), tightening liquidity further.
These financial dynamics have real effects as they push up the cost of capital, increase lenders’ risk aversion and worsen borrowers’ balance sheet quality. Critically, firms’ net worth – needed to secure a loan – takes a double hit: the market sell-off lowers the value of the assets, while the currency depreciation increases the value of the foreign-denominated liabilities. As a result, access to credit is impaired. The funding freeze is particularly acute for smaller firms and those with debt in foreign currency (Hardy, 2018).
Identifying the sectors most exposed to external funding is important in the context of the Covid-19 crisis: if the sectors that are most reliant on external funding are also those most affected by the mitigation measures, the fragilities are amplified – with possible consequences for the UK.
Currently, these funding pressures are at work: in some emerging and frontier economies, credit markets have dried up (BIS, 2020; IMF, 2020). Real effects kick in with a lag: without access to credit, firms cannot refinance their maturing debt nor increase investments, with negative consequences for growth and financial stability.
Overall, episodes of sudden capital outflows result in sharp output contractions (Eichengreen and Gupta, 2016). Accordingly, and compounding the effects of the mitigation measures, the forecasts of the IMF and World Bank respectively predict emerging market economies shrinking by 3% and 2.5% in 2020.
The UK is not insulated from the economic fallout in EMDEs. On the trade side, as supply chains are disrupted, UK businesses are affected by reduced availability of imports. In addition, UK exports to EMDEs fall: not only because of the weaker overseas demand, but also because they become more expensive due to the currency depreciation of trading partners.
On the financial side, the sell-off of EMDEs’ assets affects UK banks directly – weakening their balance sheets – and indirectly, through their exposure to other international banks affected by the lower returns on EMDEs’ assets. Without policy intervention, the result in the UK is wider credit spreads, lower credit growth and lower investment.
Figure 1: Financial turmoil in emerging markets generated by the Covid-19 crisis
Sources: Bloomberg; Institute of International Finance; JPMorgan Chase; national data; BIS calculations.
Notes: Exchange rates are simple average of individual local currencies vis-à-vis the US dollar. A decrease indicates an appreciation of the US dollar. Asian EMEs = CN, HK, ID, IN, KR, MY, PH, SG, TH and TW; Latin America = AR, BR, CL, CO, MX and PE; other EMEs = CZ, HU, PL, RU, SA, TR and ZA. Portfolio flows are the sum across BR, CN, HU, ID, IN, KR, MX, MY, PH, PL, SA, TH, TR, TW and ZA. Sovereign bond spreads are the spread of JPMorgan GBI-EM (local currency) and EMBI Global (foreign currency) yields over 10-year US Treasury yield.
How reliable is the evidence?
There is strong evidence from national statistical agencies, international organisations and central banks that the health crisis in EMDEs is having a severe impact on economic activity.
But little is known about the pandemic’s long-term effects on output in those countries. Possible outcomes are then drawn from two well-studied vulnerabilities that might amplify the contraction: high debt; and reliance on commodities.
The record-high level of debt with which the low- and middle-income countries entered the crisis makes them particularly vulnerable to financial stress. Historically, recessions in EMDEs triggered by financial crises have decreased potential output more than recessions without financial crises (Candelon et al, 2016). At the same time, oil exporters entered the pandemic relying on commodity exports as much as they did during the last oil crisis in 2014 (World Bank, 2020).
Historically, the ‘double busts’ in commodity markets and capital flows anticipate periods of emerging markets’ sovereign defaults (Reinhart et al, 2016).
In short, despite the high degree of uncertainty about the outlook, the risks are tilted to the downside, with highly persistent output losses.
Finally, there are no substantive quantitative studies of the implications for the UK of the Covid-19 crisis in emerging markets. The Bank of England highlights that the disruption of supply chains has contributed to slower economic activity and overall higher uncertainty (Saunders, 2020).
To have a sense of the impact, it is helpful to consider the United States, for which a study has been carried out (Akinci et al, 2020): without policy intervention, GDP growth as a result of the emerging markets fallout could shrink by as much as 1.5% by 2021.
What might be effective policy responses?
Policies in EMDEs should focus on providing the appropriate level of resources to the healthcare system, cushioning households’ lost income and implementing mitigation polices in a targeted manner (Tekin-Koru, 2020). In fact, lockdowns affecting the whole population, as applied in several high-income countries, save fewer lives per unit of lost GDP in low- and middle-income economies (Alon et al, 2020).
Since financial crises have devastating long-term implications, EMDEs are focusing their policies on averting them. To this end, monetary and financial stability policies play a crucial role. The exchange rate should be allowed to depreciate in order to absorb external shocks. Policy rate cuts should be implemented to ease financial conditions further in countries with low inflation and without large currency mismatches.
When funding pressures increase and interbank markets are impaired, the central bank should intervene with lending provisions to avoid a liquidity crisis. To ease liquidity conditions further, several central banks in emerging markets have started local currency bond purchase programmes, acting as buyers of last resort. While there is evidence that they were successful in lowering bond yields (Arslan et al, 2020), the weaker institutional settings should limit the use of such programmes to avoid ‘de-anchoring’ inflation expectations (Benigno et al, 2020; Çakmaklı, 2020). Finally, swap lines and the IMF’s financial support are part of the toolbox to avoid liquidity stress.
Watch a Royal Economic Society seminar on “Developing Nations and Covid-19”, from April 2020:
Where can I find out more?
Global Economic Prospects, June 2020: The World Bank assesses the impacts of the pandemic, analyses possible outcomes and presents best policies, with a special focus on emerging markets.
Modelling the global effects of the Covid-19 sudden stop in capital flows: Ozge Akinci, Gianluca Benigno and Albert Queralto assess quantitatively the macroeconomic effects of the Covid-19-induced sudden stop of capital flows to emerging markets.
On the legacy of financial crises: lessons from Mexico’s sudden stop history: Gianluca Benigno, Andrew Foerster, Christopher Otrok and Alessandro Rebucci argue that sudden stop crises can have a very long-lasting negative economic impact.
Covid-19 in developing economies: this VoxEU eBook summarises research on the economic effect of the pandemic on developing and emerging economies.
Monetary and financial policy responses for emerging market and developing economies: the IMF provides an overview of central bank policy responses to the Covid-19 pandemic in emerging markets.
Global Financial Stability Report Update: Financial conditions have eased, but insolvencies loom large: the IMF analyses the latest developments in financial stability, highlighting vulnerabilities and recommending policies.
Capital flow cycles: a long global view: the 2020 Economica-Phillips Lecture delivered by Carmen Reinhart (incoming World Bank chief economist), analyses Covid-19, crises and capital flows in a historical perspective.
How important are spillovers from major emerging markets? Raju Huidrom, Ayhan Kose, Hideaki Matsuoka and Franziska Ohnsorge provide empirical estimates of spillovers from the seven largest emerging market economies.
Who are experts on this issue?
- Giancarlo Corsetti, Cambridge
- Gianluca Benigno, LSE
- Carmen M. Reinhart, Harvard
- Ugo Panizza, Graduate Institute Geneva
- Fabio Natalucci, IMF
- Hyun Song Shin, BIS