the IMF will be key in the next emerging market debt crisis

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The headquarters of the International Monetary Fund in Washington, DC

Daniel Slim / AFP via Getty Images

About the Author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department of the International Monetary Fund and Chief Emerging Market Economics Strategist at Salomon Smith Barney.

Those who dismiss the International Monetary Fund as an institution that has long exceeded its usefulness have ignored the alarmingly deteriorating economic fundamentals of emerging markets in the wake of the Covid-19 pandemic. Nor have they paid attention to the return of inflation in advanced economies, which should soon force the world’s major central banks to turn off the monetary taps that have been keeping emerging markets afloat. This in turn will force these economies to seek large-scale assistance from the IMF as lender of last resort.

The pandemic has taken a heavy toll on emerging market economies. Not only have these economies suffered deep economic recessions and high unemployment rates. They also found that their public finances were severely compromised. According to the IMF, never before have emerging market economies been as indebted as they are today. And rarely before have their budget deficits and gross financing needs been as great as they are today.

Brazil’s dire state of public finances illustrates how the economic fundamentals of a number of large emerging markets have deteriorated in the wake of the pandemic.

Brazil’s public debt-to-GDP ratio is now approaching a record high of 100%, which is unusually high for an emerging market economy. At the same time, his government’s gross annual borrowing needs now hover around 25% of GDP due to a yawning budget deficit and shortening debt maturities. With a presidential election scheduled for next year, there is a real risk that, far from improving, Brazil’s public finances will deteriorate.

To date, the very easy access of emerging market economies to the international capital market has masked the considerable extent of the deterioration in these countries’ public finances. Over the past eighteen months, it is estimated that in their desperate quest for returns, foreign investors have invested up to $ 1.5 trillion in emerging market economies despite deteriorating economic fundamentals in those countries. These flows were more than enough to keep emerging markets afloat and saved them from having to turn to the IMF for painful economic adjustment loans.

Unfortunately for emerging market economies, it must only be a matter of time before the music of ample global liquidity stops playing. This could happen either because the world’s major central banks are being forced to raise interest rates to curb inflation, which is currently reaching decades-long highs. Indeed, by announcing that the Fed may soon step up the pace of its tapering, President Jerome Powell has paved the way for Fed interest rate hikes in the first half of next year. Alternatively, it could happen because the new Omicron mutation could prove to be much more transmissible and resistant to vaccines than the delta variant was. If this were indeed the case, it could halt the global economic recovery in its tracks.

Higher interest rates or slower global economic growth could be the trigger for the bursting of the current global asset price and credit market bubble. This seems to be all the more the case as these bubbles have been hypothesis-based that interest rates will remain at their current ultra-low levels indefinitely; and that the world economy will continue to grow at a satisfactory pace indefinitely. When these bubbles burst, emerging market economies must prepare for a large-scale capital repatriation that could precipitate a wave of emerging market debt crises.

The IMF has been called upon to play a major role in resolving previous global economic crises, including the Asian currency crisis and the European sovereign debt crisis. With all signs now pointing to a rapid drying up of global liquidity and with emerging market economies more indebted than ever before, we will again need the IMF to help resolve an emerging market debt crisis. Hopefully the IMF is ready to play this role again.

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