Years of crisis drained government budgets worldwide. With runaway inflation and interest rate hikes, financing them is becoming even more difficult. While the poorest countries are struggling, emerging economies’ response is even ahead of rich countries.
Central banks around the world are tightening the interest rate screw to cope with galloping inflation. But these rising interest rates are also exposing old vulnerabilities. Tighter global financial conditions have led to a revaluation of assets and production facilities. However, higher interest rates also imply a rising interest burden for both private sectors and sovereigns, both of which had to borrow particularly deeply to bridge or finance social measures during the COVID-19 pandemic. The mixed situation could prove fatal, where interest rates are now rising and credit is no longer as readily available as it was in the days of cheap money.
Proportion of emerging countries with more restrictive Interest rate policies from 1995 to 2022. (Source: OECD, 2022)
High debt levels meet higher interest rates
Rising private sector debt burdens and lower bond market liquidity are key risks for emerging markets from East Asia to India, South Africa to South America. During the COVID-19 crisis, debt levels built up excessively. Money was abundant; as people were unable to consume in both developed and domestic markets, capital was available cheaply in financial markets. However, these additional funds did not flow into infrastructure and productivity growth, but mainly into short-lived measures to provide for those who had lost their livelihoods due to the lockdowns and widespread social programs. This is particularly evident in China and Thailand, which had built up a particularly large amount of debt in both the private and public sectors. In the meantime, almost all emerging countries, with the exception of Indonesia and Mexico, are scratching the 100 percent mark.
Change in debt levels of emerging markets during the COVID-19-Pandemic, as percentage of GDP (source: OECD, 2022)
With less money on the financial markets, interest rates are now inevitably rising, making it more difficult for both states and private players to restructure their debt burdens. The risk of mass bankruptcies and defaults by households and companies increases. This puts particular pressure on countries whose growth model is based on cheaply available money and which had thus achieved high growth rates in the years before the pandemic, for example through massive investment in the construction sector. The high interest rates in the industrialized countries are now attracting much of the capital that previously migrated there in search of alternative profitable forms of investment due to the negative real interest rates in the West. These capital flows are now reversing and increasing default risk, again leading to higher risk premiums on interest rates – a downward spiral. Combined with high food prices, this is a fatal mix and a breeding ground for political instability, even armed conflict. We are already seeing numerous countries whose governments are countering this instability with more restrictive measures and taking tougher action against the opposition.
While emerging economies are well prepared, the poorest are the hardest hit
This is hitting the lowest-income countries hardest. According to the International Monetary Fund (IMF), the number of developing countries in a critical debt situation is rising. Unsurprisingly, Africa bears the brunt of this with eight countries at high risk of default, including promising growth candidates such as Ethiopia, Ghana, Kenya and Cameroon. They are followed by rather smaller South Asian and Latin American countries, which overall would not represent a major burden for the global financial system if timely action were taken. However, the governments there lack the financial leeway to respond. They are dependent on external aid, but it is questionable how far the populations there will accept financial rescue measures for the poorest when they themselves are under pressure from rising living costs.
Share of low income countries in debt distress in Asia and Pacific, Africa, Latin America, Total. (source: IMF, 2023)
Markets are resilient
Developments show that markets do what they were created to do. A good example of this is the sanctions against Russia: These are being circumvented to a large extent, as the decentralized supply chains shifted within a very short time via friendly states, such as Kazakhstan, Armenia or Turkey. High prices indicate shortages, as people are willing to pay more for scarce goods. But they also allow for high profits and therefore incentives to invest: high food prices say you need fertilizer, farmland, and food-processing industries. High interest rates, as the price of money indicate that the pool of labor, machinery, and energy is scarce. But market forces ensure that these scarce commodities are channeled into the most productive projects. Under current pressures, often for essential goods, the temptation for policy intervention is strong, but experience shows that such interventions usually only prolong the extent of the crisis.
