Covid-19’s likely economic impact is a moving target. What started as a supply shock, with businesses losing access to their supply chains, inputs and international trading partners, quickly became a demand shock, with consumers cutting back spending, staying home and increasing their savings.
Now comes the next dangerous phase: a financial shock. Violent shifts in financial markets mean that a wave of financial crises across several countries is all but inevitable unless urgent action is taken. Governments have been warned for years that the world’s financial institutions are dangerously inadequate to cope with a large-scale crisis. The cost of this neglect is about to become clear.
To illustrate what’s happening, imagine your income is paid in Australian dollars but your mortgage repayments are in US dollars. How have the last few weeks been for you? Stressful, to say the least. The US dollar has appreciated by more than 22 per cent against the Australian dollar since January, increasing the cost of your mortgage by the same amount. If you also had to refinance this debt every few months, your stress levels would be higher still.
This is the situation in which many emerging and developing countries find themselves. Years of historically low interest rates caused a sharp increase in borrowing by governments, banks, companies and state-owned enterprises in emerging economies, much of which was denominated in US dollars and borrowed short-term. It’s not small change, either. These economies hold $5.8 trillion of debt denominated in US dollars. Total external debt in emerging economies has increased from 100 per cent of exports to 160 per cent since 2008. These countries now face a perfect storm.
First, the value of the US dollar is rising rapidly as investors flee for safe-haven assets and currencies. With that rise, the size of the US dollar–denominated debt held by emerging and developing economies has increased substantially. Debts that were previously sustainable may now be unmanageably large.
Second, the cost of servicing debt is rising fast. Interest rates on ten-year government bonds have increased by 2.75 percentage points in South Africa, 2.5 percentage points in Brazil and more than 1 percentage point in Russia, Mexico and Indonesia.
Third, because much of it was borrowed short-term, this debt needs to be refinanced regularly. Brazil needs to roll over US$210 billion of government debt this year alone. For India and Mexico, the amounts are US$150 billion and US$120 billion respectively.
Fourth, although rolling over these debts is vital, it may no longer be possible. As investors scramble to get out, we are seeing the largest capital outflows from emerging economies in modern history. The Institute of International Finance has warned that many economies are already unable to borrow internationally. Capital outflows from these economies are double what we saw during the global financial crisis.
It gets worse. While these debts and the cost of servicing them are rising, income is falling. Many of these countries get their earnings — and the foreign currencies they use to pay for imports and debt servicing — from their exports, particularly exports of oil and other commodities, and tourism. The fall in their exchange rates and the global collapse in trade, commodity prices, oil prices and international tourism is substantially cutting the incomes of these countries, and thus their ability to obtain foreign exchange. Combined with the impact of closing shops and industries because of Covid-19 and the inability of these economies to borrow internationally, the fall in income puts these countries on a knife’s edge.
Some of these countries might be able to fend for themselves. Low inflation means some governments can increase spending or cut taxes to stimulate their economies, more so than was the case during the Asian financial crisis, for example. If countries are unable to roll over or repay their debts, their central banks can purchase the debt without the usual risk of spurring inflation, and their governments can increase spending and cut taxes to boost demand while their exchange rates help cushion the blow.
But this is not true for most of these countries. Argentina, Brazil, India, Indonesia, South Africa and many others have limited flexibility to deal with this mix of pressures. Italy faces special challenges: although it is a developed economy, its membership of the eurozone means it doesn’t have its own exchange rate to depreciate or its own central bank to purchase its debt. Fear of an Italian default could quickly become a self-fulfilling prophecy. It also has a substantial existing stock of debt that markets, and its euro partners, are already concerned about. This is especially worrying given Covid-19 is hitting Italy, a very large economy, very hard.
When these economies start falling into crisis, they will be seeking urgent support from the global and regional institutions dedicated to helping countries facing financial crises and preventing them from spreading — collectively referred to as the global financial safety net. And this safety net is dangerously inadequate.
Modelling of crisis scenarios shows that the safety net struggles to provide even the same level of financial support that has been required of it in the past. This is a huge problem given that the crises associated with Covid-19 — the combination of demand, supply and financial shocks — will be far worse than before.
The increase in the safety net’s resources since 2007 has come at the cost of increased fragmentation. Historically, the International Monetary Fund and the World Bank represented two-thirds of its resources. Today they represent only one-third. The rest is spread across untested regional institutions, unreliable development banks and opaque bilateral central bank support. These institutions are poor substitutes for the IMF, and coordinating them all during a crisis will be very difficult.
Urgent action is required. Currency swap lines, which allow the central bank of one country to exchange its currency with another, give countries immediate access to foreign exchange, which can be vital during a crisis. The US Federal Reserve has extended bilateral swap lines to a range of countries (including Australia), giving them access to US dollars as needed. But the Fed has excluded all emerging and developing economies other than Brazil and Mexico. This creates far greater hazards than any credit risk associated with extending swap lines more widely. The United States and other G20 countries, including Australia, should urgently extend bilateral swap lines to these emerging and developing countries while treasuries and finance ministries prepare to provide loans to those that are in trouble. Australia should assist our neighbours to minimise the damage to their economies, and ours.
The IMF needs to issue at least twice as many international monetary assets (called Special Drawing Rights) as it did in 2009 and provide precautionary financial support to countries before they get into trouble. G20 countries should commit to increasing bilateral loans to the IMF to make such lending possible and bolster its resources, much of which is due to expire in the next two years, and the IMF should hold immediate consultations with regional institutions and development banks to plan and coordinate their response.
All of this should have been done years ago. But as the old saying goes, if the best time to plant a tree is ten years ago, the next best time is today. The severity of the Covid-19 shock means financial crises are a question of when, not if. The world best prepare now. •