World economy: Liquidity injections buy time for vulnerable economies

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Economist Intelligence Unit
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Uganda, Pakistan, Afghanistan, Bangladesh, Japan, China, Sudan, Indonesia, Turkey, Ukraine, Moldova, Canada, India, Mongolia, Kazakhstan, South Korea, Kuwait, Tajikistan, France, South Africa, Brazil, Argentina, Yemen, Sri Lanka, Germany, Cuba, Saudi Arabia, Romania, Hungary, Australia, Albania, Italy, Mozambique, Sierra Leone, Zimbabwe, Ethiopia, Mexico, Jordan, Bahrain, Singapore, Tunisia, Chile, Oman, Angola, Zambia, Ghana, New Zealand, Ecuador, Malawi, Namibia, Mauritius, Panama, Belarus, United States of America, Equatorial Guinea, Gabon, Seychelles, Democratic Republic of Congo, UK, Russian Federation, Syrian Arab Republic, Tanzania, United Republic of, Venezuela, Bolivarian Republic of
  • Liquidity injections by the Federal Reserve (Fed, the US central bank) and other major central banks have forestalled the immediate threat of a global financial crisis, but many emerging and low-income countries remain vulnerable to liquidity shortages.
  • The IMF and the World Bank have both announced significant increases in emergency financial support. These measures come with little conditionality and will be drawn on by a range of countries in the coming months.
  • The agreement by the G20 on April 15th to suspend debt-service payments for the world's poorest countries until the end of the year will also grant much-needed financial space.
  • However, with the economic impact of the pandemic likely to be long-lasting, some countries' finances will prove unsustainable. Private investors will face increasing pressure to agree to debt restructurings in 2021 and beyond.

Since the novel coronavirus (Covid-19) began to spread outside China, financial markets have experienced an extraordinary level of volatility. Wild swings have been seen across the board, for emerging as well as advanced-economy exchange rates and an increasingly wide range of asset classes. Several factors have contributed to this spike in volatility. In addition to a general flight to safe-haven assets, there was a surge in demand for US dollar funding from corporates around the world as the pandemic began to disrupt international supply chains. By mid-March this caused the value of almost all other assets to fall in US dollar terms, including other safe-haven currencies and US government bonds. Finally, the collapse in the dated Brent Blend price on March 9th led to additional downward pressure on the currencies of commodity-exporting economies and added to corporate debt distress in the US shale industry.

Central bank action has reduced the threat of a global financial crisis

Since mid-March markets have calmed, largely in response to the extraordinary set of financial support measures announced by the world's major central banks and governments. The most important policy initiatives have come from the US.

  • The Fed announced liquidity backstops for the commercial paper market and large employers directly, via the Primary Market Corporate Credit Facility.
  • On March 23rd the Fed also announced that it would conduct unlimited bond purchases if necessary.
  • Crucially for global financial stability, on March 19th the Fed intervened to act as the lender of last resort for the international US dollar system, lowering the rate on its existing dollar swap lines with the central banks of Canada, the UK, Japan, the euro zone and Switzerland, and reactivating dollar swap lines with nine other central banks that had been implemented during the 2008-09 financial crisis (Brazil, Mexico, Sweden, Denmark, Norway, Australia, New Zealand, South Korea and Singapore).

These measures, combined with fiscal and monetary support in other major economies, have lowered the likelihood of a global liquidity crunch. Liquidity has come back into the US corporate bond market, government bond yields in both the US and Europe have eased and other markets have rallied. However, governments and central banks have been unable to dispel the underlying uncertainty surrounding the duration of the pandemic and economic disruption, and the impact of the virus on the long-term prospects of some businesses, industries and sovereigns remains in question.

We therefore expect market volatility to remain high in the coming months. The currencies of energy and other commodity exporters will be particularly reactive to developments in the world's major economies; in many other cases we expect investors to focus on local epidemiological developments, lockdown policies and economic data.

Individual emerging economies remain financially vulnerable

The liquidity measures introduced by developed country central banks have helped to calm financial markets, but they do not directly support most emerging and low-income countries. Those without their own financial war-chests therefore continue to face liquidity risks. The chart below highlights those countries that, at end-2019, had insufficient foreign-exchange reserves to cover their estimated external funding needs (their current-account deficit and debt-servicing costs) in 2020. This metric alone does not presage a balance-of-payments crisis. In Chile and Panama, funding needs largely reflect their status as regional financial and trading hubs. Accordingly, both countries have been treated leniently by markets; the Chilean peso has depreciated by less than other Latin American currencies, despite a collapse in copper prices, and Panama succeeded in issuing US$2.5bn in bonds on international markets in late March. More broadly, countries with solid long-term economic prospects and reputations for resilient institutions should maintain market access on reasonable terms. However, countries that were already struggling financially before the onset of the pandemic, such as Turkey and South Africa, will face choppier waters. For countries such as Argentina, which is already in the midst of difficult negotiations with creditors, the crisis could not have come at a worse time, and a devastating disorderly default in that country looks increasingly likely.

Multilateral and bilateral financial assistance will help

For countries with limited financial buffers of their own, the IMF, the World Bank and other multilateral lenders will play a critical role in the containment of the crisis. The World Bank has begun to roll out an initial US$2bn in fast-tracked projects covering 25 countries, mostly in South Asia; this will be supported by financial assistance worth US$14bn from the International Finance Corporation and the Multilateral Investment Guarantee Agency. All in all, the World Bank expects to spend up to US$160bn over the next 15 months. Meanwhile the IMF, which has about US$1trn in lending capacity, has announced that it will double its rapid-disbursing emergency lending facility to US$100bn via the zero interest rate Rapid Credit Facility (RCF) for low-income countries and the Rapid Financing Instrument (RFI) for emerging markets. An additional measure under discussion is for the IMF to issue additional Special Drawing Rights (SDRs) that could be used to supplement countries' dwindling reserves, but the US has not yet agreed to support the proposal. The total current stock of SDRs is worth about US$275bn.

There is also considerable political support for temporary debt-relief. With support from the IMF, the World Bank and the Paris Club group of creditors, on April 15th the G20 announced that it would suspend bilateral government loan repayments until end-2020, with the possibility of an extension. Encouragingly, the communiqué referred to participation by all bilateral official creditors in the G20, which includes China. The International Institute of Finance, which represents private institutional lenders, has encouraged private-sector participation in the payment suspension on a voluntary basis. The suspension will give the world's poorest countries much-needed financial space this year.

Private investors will face increasing pressure to participate in debt-relief

However, there are limits to what these support measures can achieve. Although the IMF's RCF and RFI do not entail the same level of conditionality as a fully fledged IMF programme, the Fund will only disburse funds to a country if its debt is deemed sustainable (or on track to sustainability) and if it is pursuing what the IMF assesses are prudent policies to tackle the crisis. The Fund has already rejected two requests from Venezuela to access US$5bn through an RFI. For a wider range of countries, additional loans will not be enough to get them back to financial health. Meanwhile the debt-relief measures agreed by the G20 only cover the poorest countries as classified by the World Bank, and will therefore not be available to crisis-stricken economies such as Argentina, Lebanon and Ecuador.

As the pandemic takes a lasting toll on growth prospects, and repayment schedules become more onerous from 2021 onwards, calls for debt restructuring and cancellation will grow, and negotiations will in some cases be complicated by the increasingly diverse composition of low-income country debt. In Africa, for example, significant funding has come from Chinese project-based loans and from US dollar-denominated Eurobonds. For now, most debtor governments will want to avoid signalling any waning in their commitment to fulfilling their obligations to private creditors beyond the near term, but as the crisis drags on, private investors will face increasing pressure to share the burden of debt restructurings.

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