Bank of Lithuania
2020-10-26
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With the use of munition that has not been applied until recently, emerging market economies have so far succeeded in withstanding the financial impact of the COVID-19 pandemic. This has resulted in a debate at the International Monetary Fund (IMF) on whether to continue with the readily available financing policy for countries or to reapply the requirements to implement structural reforms? This is one of the critical issues in the agenda of the Annual Meetings of the IMF and the World Bank, held on 12–18 October. Further direction chosen by the Fund may have an impact on the future developments in the global economy and thus also on the prospects of the economy of Lithuanian.

Comment by Simonas Algirdas Spurga, Principal Economist of the Economic Policy Analysis Division of the Bank of Lithuania

A new weapon in the arsenal of the emerging markets   

In spring, emerging market economies experienced the most significant outflow of financial capital in their history. In a few months, foreign investors ‘exported’ more than USD 100 billion in financial assets from developing countries (three times more than during the relevant period of the global financial crisis). Investors rushed to sell their shares and bonds in the emerging markets, considering the fragility of their health care systems and not expecting the authorities to manage the pandemic and cope with its consequences effectively. Almost all the countries belonging to the group have been affected, from the Balkans and Russia to Latin America and South-East Asia.

At the same time, the IMF received the largest number of requests from member states in the history of the institution. The IMF President, Kristalina Georgieva, announced that the Fund would shield the global economy with the mobilisation of the ‘war chest’ in the amount of USD 1 trillion, focusing primarily on the situation in developing countries.

However, as early as in April, capital flows started to show signs of stabilisation, and today capital is gradually returning to emerging markets. The outflow of capital proved to be only short-lived, followed by stabilising exchange rates that had experienced a severe decrease initially. Difficulties are currently mainly faced by countries the economic fundamentals of which started to crumble even before the COVID-19 crisis, such as Argentina or Turkey.

Investor confidence has been restored even though this summer, compared to April, the GDP projections of emerging market economies for 2020–2021 had deteriorated much more than the corresponding estimates for advanced economies. A similar trend can also be expected from the updated forecasts that the IMF will publish on 13 October. In countries such as India, Indonesia, Brazil, Colombia, Peru or the Republic of South Africa, the infection has spread rapidly, putting a significant number of emerging market economies among the countries with the most severe ongoing restrictions in the world. Their restrictions on mobility and economic activity are more significant than in most European countries.

Other factors also harm the prospects of the developing world. Emerging market economies, for example, are more dependent on falling commodity prices and shrinking tourism than developed countries.

How did developing countries in this vulnerable state manage to stabilise capital flows? One of the most essential and most unexpected factors is that their central banks have surprised the world by successfully using quantitative easing.

Quantitative easing comprises the purchase of financial assets to stimulate economic activity and inflation and to ensure effective monetary policy transmission. Through asset purchase programmes, central banks, including the European Central Bank (ECB), purchase government debt securities and other financial assets on secondary markets (from private investors), thereby providing liquidity to the financial system.

For a long time, quantitative easing, which is sometimes referred to as money printing, has been an instrument applied exclusively by the central banks of advanced economies. This printing has been considered too risky for emerging markets. Their institutions are more vulnerable than in the developed world. Their politicians are more susceptible to the temptation of a printing machine, thus offending the principle of independence of a central bank. Politicians can also lead to hyperinflation by responding to the political rather than the business cycle.

Besides, to participate in international markets, emerging economies need to accept liabilities denominated in foreign currency, the so-called ‘natural sin’ of the developing world. Increasing the quantity of the local currency would make it more challenging to service external debt due to the depreciation of the exchange rate. It has therefore been argued that it is vital to contain inflation in emerging markets at the time of a shock and to restrain from stimulus measures. Otherwise, there is a growing risk to lose investor confidence: increased government borrowing could result in emerging economies losing access to both international and domestic capital markets in general.

Thus, in times of previous crises, emerging market economies would mostly tighten monetary policy and raise interest rates. These actions aimed to avoid the effect of inflationary currency depreciation, to increase the return on financial assets and to bring the outflow of capital to a standstill.

However, this time, part of the developing world has responded to the crisis in the opposite way. To stabilise markets, both small and open economies (Croatia, Romania, Chile) and major developing countries (Brazil, India, Indonesia) have launched quantitative easing programmes. Investors responded positively to them, and government borrowing has not appreciated, but, on the contrary, has become cheaper over the long term in most cases. This accordingly increased governments’ access to borrowing and their possibilities of applying fiscal measures to tackle the pandemic by raising health spending and business support.

The hands of the central banks of emerging market economies were untied by a combination of factors. Firstly, there has been a reduction in macroeconomic imbalances in these countries after the global financial crisis. Second, the central banks have strengthened their independence from governments and better anchored inflation expectations – they improved their ability to manage the expectations of market participants concerning future price increases. Thirdly, emerging market economies have developed sovereign bond markets in local currencies, thereby reducing their dependency on external financing.

Thus, the emerging markets have started to resemble the advanced world. As far as crisis management options are concerned, it can reasonably be said that a qualitatively new era has begun in emerging market economies.

It is certainly important to emphasise that the actions of the central banks of advanced countries have also contributed to the enlarged opportunities of the emerging market economies. The central banks in the US and the euro area have considerably increased the volume of financial asset purchases as well. For example, the ECB launched the Pandemic Emergency Purchase Programme (PEPP) in March, which will have injected additional liquidity in the amount of EUR 1.35 trillion of into the euro area’s financial system by mid-2021, which accounts for 12% of the euro area GDP. The decisions of the major central banks have strengthened investors’ positions and fostered market optimism around the world. At the same time, they have lowered interest rates, which has steered market participants towards more risky emerging markets where higher returns can be expected.

Will the Fund’s DNA be altered?

One of the main topics of the IMF and World Bank Annual Meetings (on 12–18 October) is the strategy of lending to member states. In the first phase of the fight against COVID-19, the IMF has primarily used the emergency financing mechanism, which allows countries to borrow funds under an accelerated procedure without significant conditionality in the event of an unexpected external shock (e.g. a natural disaster). Amid the crisis, new emergency financing loans were being approved almost daily, including for emerging market economies. Although small, these loans have helped countries plug holes and react quickly to the crisis.

The IMF’s initial response to COVID-19 was based on the understanding that the challenges in the balance of payments faced by countries applying for Fund’s support had not been caused by structural economic factors (such as poor labour market regulation) but by a horizontal external shock — a global pandemic — affecting all countries. The IMF has therefore provided liquidity mostly without conditionality, namely the requirement to carry out reforms aimed, under normal circumstances, at addressing the underlying balance of payments issues. In the context of COVID-19, the quick and relatively easy provision of liquidity has indeed performed its function. The fight against the pandemic required extraordinary expenditure here and now. Structural reforms in the context of a disaster and the outflow of capital were naturally not the priority for politicians.

However, the circumstances are different today. The world is learning to live under a pandemic regime. Financial conditions are favourable in most emerging market economies, partly because of the quantitative easing provided by central banks, which has provided ample liquidity to the global financial system. The significant share of the ‘war chest’ of the IMF in the amount of USD 1 trillion has remained mostly unused so far.

While uncertainty about the future is still present, an increasing number of the Fund’s member states are in favour of returning the IMF’s borrowing programmes to the conditionality policy and reform agenda. The IMF’s conditionality policy is historically the DNA of the institution and a global public good. The requirement to carry out economic reforms in return for financing has helped to mobilise structural adjustments in a number of countries, particularly in emerging market economies.

For example, conditionality has played an important role in Ukraine (in the fight against corruption and gas price liberalisation) and Moldova (in the restructuring of the banking sector). At the same time, conditionality helps to ensure that a recipient of funds can stand on its own feet, accelerate economic development, and repay its debt to the Fund. Finally, a country transforming its economy is more likely to regain investor confidence, which is why the IMF programmes play a catalyst role in attracting additional financing from other sources.

The world is most likely to look different after COVID-19. Some sectors (e.g. airline business) may lose their positions, while others (e.g. digital services) will gain a higher market share than in the past. Countries declare their intention to restore the production of strategically essential goods to their territory and to increase economic autonomy, which will mean changes in global value chains. The impact of the COVID-19 shock on global aggregate demand may have a long-term adverse effect on commodity prices.

Thus, the pandemic is programming the need for structural adjustments, including in emerging market economies. The IMF can play a leading role in this area and, based on conditionality, steer the economic vessel of the countries applying to the Fund in the right direction, thus facilitating their adaptation to the new post-pandemic global reality. This would also have a positive impact on further developments in the global economy, including Lithuania.

On the other hand, a significant weakening of the conditionality policy would change the Fund’s DNA, leading to countries losing an essential engine for a systemic change. In the light of this, the IMF is likely to revert to the previous IMF programme model gradually; however, the content of conditionality will be more flexible for some time to take into account further developments in the pandemic.