Emerging Markets’ Hidden Debt Risk
As the COVID-19 crisis continues, understanding the extent of emerging-market firms’ unhedged foreign-currency borrowing will be critical. Central banks and regulatory agencies, which have access to such data, should use it to anticipate the damage arising from currency depreciations and design policy responses accordingly.
WASHINGTON, DC/LONDON – Stark warnings about the COVID-19 shock’s potentially devastating effects on emerging markets (EMs) have become ubiquitous. With the pandemic engulfing ever more countries, EMs face a mass exit by foreign investors seeking safe assets. As a result, capital outflows and currency depreciations have become unprecedentedly synchronized.
A first round of policy interventions to blunt the pandemic’s financial and economic impact on EMs is already underway. But although these actions – mainly aimed at alleviating stress in foreign-exchange (FX) markets – are welcome, the ongoing currency depreciations present financial-stability challenges that have long-term implications going far beyond immediate liquidity problems.
When an EM currency depreciates, that country’s foreign-currency-denominated debt burden – both its absolute value and debt-service costs – can escalate rapidly. Such balance-sheet effects often presage corporate defaults, financial instability, and output declines, as we saw during previous EM crises.
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