## wpiea2022035-print-pdf ## Source details **Canonical URL:** [wpiea2022035-print-pdf](https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022035-print-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2022/english/wpiea2022035-print-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2022/english/wpiea2022035-print-pdf.pdf.json) --- ### 1. Introduction — Key findings on the shock and policy response - COVID-19 caused an unprecedented 3-percent contraction in global output. - Real GDP in EMs dropped 7.4 percent on average in 2020, 10 percentage points below pre-pandemic expectations. - The downturn was particularly deep in countries relying on tourism and those with large service sectors, and in countries with high public debt. - Widespread and unprecedented policy support (fiscal, monetary, and macroprudential) prevented an even worse outcome. - Over 90 percent of EM central banks undertook conventional easing by reducing policy interest rates. - EMs also implemented unprecedented asset purchase programs to ease financial conditions and maintain credit. - Prudential policies were loosened (e.g., relaxation of loan classification and provisioning rules, lowering countercyclical capital buffers); some insolvency frameworks were suspended or temporarily modified. ### 1. Introduction — Policy tradeoffs and accumulated vulnerabilities - The decisive policy response came at the cost of accumulating vulnerabilities across many countries and sectors. - Fiscal responses varied by country depending on borrowing access and pre-crisis debt levels. - Fiscal support in EMs was substantial but noticeably smaller than in AEs. - Private non-financial debt also reached record levels in EMs during the pandemic, raising financial stability concerns. ### 2. Rearview — Depth and distribution of the output shock - In most countries (including 90 percent of EMs), there were outright declines in output in 2020. - The EM impact in 2020 was larger than in AEs and LICs, partly due to lower-capacity health systems and a smaller proportion of “teleworkable” jobs. - Some LICs avoided output decline in 2020 due to younger populations and initially slower virus spread, but 2020 growth for LICs as a group was significantly slower than expected pre-crisis. ### 2. Rearview — Fiscal and monetary response detail - Fiscal response included above-the-line measures (health, social and public works spending, subsidies, tax breaks and deferrals, employment/unemployment support) and below-the-line measures (equity injections, asset purchases, debt assumptions), plus guarantees and quasi-fiscal operations. - The ability to provide countercyclical fiscal support was in part due to forceful action by AE central banks easing global financial conditions. - The median public-debt-to-GDP ratio in EMs at end-2021 stood at 60 percent – 8 percentage points higher than the IMF had expected before the pandemic. - Asset purchase programs in EMs were by and large successful in stabilizing financial markets and reducing bond yields (early evidence cited). - Prudential loosening helped maintain credit flows and prevent a wave of bankruptcies in the short run. ### 3. Where are we now? — Public health and vaccination - COVID-19 remains widespread in many EMs; in most EMs the number of COVID-related deaths in 2021 surpassed that in 2020. - About 63 percent of EM population had received at least one vaccine dose by end-2021. ### 3. Where are we now? — Inflation, labor, commodity dynamics, and policy moves - Median year-on-year inflation among EMs rose to 6.7 percent in November 2021, compared to about 3 percent before the pandemic. - In countries like Argentina, Brazil, Turkey, and Ukraine inflation has exceeded 10 percent. - Many EMs are experiencing a sharp rise in food prices; core inflation has also risen, though more modestly in many cases. - Medium-term inflation expectations appear reasonably well-anchored in most EMs for the moment, but persistent high inflation could unanchor expectations. - Increasing number of EM central banks began tightening monetary policy in 2021 in response to inflationary pressures and currency depreciation. - Private and public debt ratios rose; private non-financial debt attained record levels in EMs during the pandemic. - Capital outflows from EMs at the start of the pandemic were about US$65 billion between February and May 2020 and short-lived; outflows resumed in 2021 from EM ex. China local currency debt. - Yields on EM ex. China local currency debt rose during 2021. ### 3. Where are we now? — Reserves and external buffers - An August 2021 SDR allocation equivalent to US$650 billion increased global reserves; US$224 billion of that went to emerging markets. - At end-2021, 58 percent of EMs were estimated to have international reserves exceeding 100 percent of the IMF’s adequacy metric. - EMs benefited from precautionary IMF arrangements, swap lines with AE central banks, and other elements of the global financial safety net; in aggregate EMs face the uncertain environment with relatively strong external buffers. ### 4. Prospects and Policy Challenges — Overall outlook and risks - The economic recovery is expected to continue but to remain incomplete, uneven, and subject to downside risks. - The IMF projects a significantly slower return to pre-pandemic output for EMs than for AEs; EMs as a group are not expected to catch up to their pre-pandemic trajectory. - Inflationary pressures in EMs are expected to remain elevated through 2022 with significant cross-country variation; inflation pressures are expected to subside in 2023. - Subsuming factors for 2023 disinflation include softening commodity prices, easing supply-demand imbalances, anchoring of inflation expectations from monetary tightening, and further scaling back of fiscal support. ### 4.1 Policy responses - Recovery strength for EMs is constrained by limited policy space compared to AEs, on both fiscal and monetary fronts. - Heterogeneity across EMs is large: some have policy space, others face tight constraints. - Structural growth challenges and sectoral composition impacts are highly country-specific. - Policymakers should tailor measures to boost recovery while acknowledging constraints from elevated debt and external vulnerabilities. ### 4.2 Debt issues — Risks and policy recommendations - Elevated public and private debt represent a key risk; higher interest rates may worsen debt dynamics even if growth recovers. - Countries face a tradeoff between supporting recovery and addressing debt sustainability concerns; this constrains EMs more than AEs during a tightening cycle. - Risk is acute in countries with especially elevated debt levels, large exposures to foreign currency debt, and short maturities with repricing and rollover risks. - High corporate and household debt increases financial system vulnerability to rising interest rates. - Eventual withdrawal of extraordinary support and tightening of financial conditions will likely lead to a spike in insolvencies. - Corporate and sovereign spreads tend to move in tandem; a surge in defaults could affect the banking system and tax collection, exacerbating public debt sustainability concerns. - Policy recommendations: - Rebuild buffers as market conditions allow, including reducing public debt and increasing foreign exchange reserves as needed. - Use SDR allocation liquidity (noted as helpful) and tailor support to viable firms. - Mobilize macroprudential policies to address building financial vulnerabilities (e.g., rising house prices). ### 4.3 Monetary policy tightening - Many EMs moved ahead of AEs in unwinding emergency measures and tightening monetary policy, helping sustain credibility and anchor long-term inflation expectations in most cases. - Calibrating monetary policy is challenging given uncertainty, the tradeoff between supporting the economy and fighting inflation, and exposure to external conditions. - Tightening of US monetary policy could cause significant spillovers via capital flows and exchange rate movements, impacting domestic financial conditions and inflation in EMs. - Countries with strong fiscal positions, robust institutions, and smaller exposure to currency volatility and interest rate shocks will be better able to withstand adverse global spillovers. - Vulnerable countries with elevated debt levels and weaker institutions may struggle to mitigate spillovers from global conditions on domestic economies. ### 5. Potential tightening in global financial conditions and US dollar appreciation — Key findings and risks - Concerns are growing about the impact on emerging markets (EMs) of a significant rise in US interest rates, which could lead to a tightening of global financial conditions and US dollar appreciation. - Recent EM currency depreciation—and its flip side, US dollar appreciation—appears moderate by historical standards, but dollar appreciation episodes are often prolonged and the current trend may continue, putting more pressure on EMs. - When an increase in the expected US policy rate is driven by positive news about US economic activity, on balance this tends to be beneficial for EMs through the trade channel, a reduction in risk premiums, and often stimulated capital inflows. - Tightening driven by concerns about inflation or changes in risk sentiment can be considerably more challenging for EMs. ### 5. Potential tightening — Exposures and vulnerabilities - Private non-financial debt in foreign currency relative to the size of the economy varies considerably across countries; some have significant exposures, particularly on the corporate side. - Some sovereigns remain exposed to exchange rate fluctuations, though much less than in the past due to greater prevalence of borrowing in domestic currency. - Some foreign currency liabilities may be offset by foreign exchange assets or natural/financial hedges, but comparable cross-country data on such offsets is unavailable. - Uncovered Interest Parity (UIP) premiums spiked for many countries during the COVID shock, indicating continued vulnerability to swings in investor sentiment. - Exchange rate pass-through to inflation in EMs has declined since the Global Financial Crisis, but passthrough remains higher in EMs than in advanced economies. ### 5. Potential tightening — Policy implications and recommended responses - For countries without meaningful currency mismatches, with deep foreign exchange markets, and well-established monetary frameworks: - Allow exchange rate flexibility to absorb shocks. - Use the policy rate to control domestic financial conditions. - If inflation expectations are not well anchored or investor sentiment shocks destabilize UIP premiums in shallow currency markets: - Foreign exchange intervention may help contain UIP premiums and limit depreciation—provided international reserves are adequate. - Weigh benefits of intervention against potential impacts on market development and long-term effects. - In countries with high public debt and less credible central banks: - Communicate clear plans for medium-term fiscal consolidation. - Reassert the independence of monetary policy to allay fears of debt monetization. - In the event of a sudden stop, interest rate defense of the exchange rate alongside outflow capital flow management measures may be necessary. ### 5. Potential tightening — Preventive and resilience-building measures - Encourage private sector deleveraging in countries with excessive foreign currency debt. - Use macroprudential policy to address nonfinancial sector vulnerabilities, mitigate future financial stability risks, and strengthen resilience. - Bolster the credibility of monetary policy frameworks where inflation expectations are not well anchored—recognizing this takes time. - Consider precautionary arrangements available through the global financial safety net to install additional buffers. *Source: IMF Working Paper — section 5, "Potential tightening in global financial conditions and US dollar appreciation."* ### 1. Introduction ........................................................................................................ ### 1. Introduction ### Key findings on the shock and policy response - COVID-19 caused an unprecedented 3-percent contraction in global output. - Real GDP in EMs dropped 7.4 percent on average in 2020, 10 percentage points below pre-pandemic expectations. - The downturn was particularly deep in countries relying on tourism and those with large service sectors, and in countries with high public debt. - Widespread and unprecedented policy support (fiscal, monetary, and macroprudential) prevented an even worse outcome. - Over 90 percent of EM central banks undertook conventional easing by reducing policy interest rates. - EMs also implemented unprecedented asset purchase programs to ease financial conditions and maintain credit. - Prudential policies were loosened (e.g., relaxation of loan classification and provisioning rules, lowering countercyclical capital buffers); some insolvency frameworks were suspended or temporarily modified. ### Policy tradeoffs and accumulated vulnerabilities - The decisive policy response came at the cost of accumulating vulnerabilities across many countries and sectors. - Fiscal responses varied by country depending on borrowing access and pre-crisis debt levels. - Fiscal support in EMs was substantial but noticeably smaller than in AEs. - Private non-financial debt also reached record levels in EMs during the pandemic, raising financial stability concerns. ### Focus of the article - Documents recent developments in EMs, assesses prospects and challenges, and discusses appropriate policy settings. - Highlights the risk of a tightening in global financial conditions and appreciation of the US dollar that could be triggered by increased risk aversion or a reassessment of the likely path of US monetary policy. --- ### 2. Rearview ### Depth and distribution of the output shock - In most countries (including 90 percent of EMs), there were outright declines in output in 2020. - The EM impact in 2020 was larger than in AEs and LICs, partly due to lower-capacity health systems and a smaller proportion of “teleworkable” jobs. - Some LICs avoided output decline in 2020 due to younger populations and initially slower virus spread, but 2020 growth for LICs as a group was significantly slower than expected pre-crisis. ### Fiscal and monetary response detail - Fiscal response included above-the-line measures (health, social and public works spending, subsidies, tax breaks and deferrals, employment/unemployment support) and below-the-line measures (equity injections, asset purchases, debt assumptions), plus guarantees and quasi-fiscal operations. - The ability to provide countercyclical fiscal support was in part due to forceful action by AE central banks easing global financial conditions. - The median public-debt-to-GDP ratio in EMs at end-2021 stood at 60 percent – 8 percentage points higher than the IMF had expected before the pandemic. - Asset purchase programs in EMs were by and large successful in stabilizing financial markets and reducing bond yields (early evidence cited). - Prudential loosening helped maintain credit flows and prevent a wave of bankruptcies in the short run. --- ### 3. Where are we now? ### Public health and vaccination status - COVID-19 remains widespread in many EMs; in most EMs the number of COVID-related deaths in 2021 surpassed that in 2020. - About 63 percent of EM population had received at least one vaccine dose by end-2021. ### Inflation and labor/commodity dynamics - Median year-on-year inflation among EMs rose to 6.7 percent in November 2021, compared to about 3 percent before the pandemic. - In countries like Argentina, Brazil, Turkey, and Ukraine inflation has exceeded 10 percent. - Many EMs are experiencing a sharp rise in food prices; core inflation has also risen, though more modestly in many cases. - Medium-term inflation expectations appear reasonably well-anchored in most EMs for the moment, but persistent high inflation could unanchor expectations. ### Monetary policy moves and debt metrics - Increasing number of EM central banks began tightening monetary policy in 2021 in response to inflationary pressures and currency depreciation. - Private and public debt ratios rose; private non-financial debt attained record levels in EMs during the pandemic. - While capital outflows from EMs at the start of the pandemic were about US$65 billion between February and May 2020 and short-lived, outflows resumed in 2021 from EM ex. China local currency debt. - Yields on EM ex. China local currency debt rose during 2021. ### Reserves and external buffers - An August 2021 SDR allocation equivalent to US$650 billion increased global reserves; US$224 billion of that went to emerging markets. - At end-2021, 58 percent of EMs were estimated to have international reserves exceeding 100 percent of the IMF’s adequacy metric. - EMs benefited from precautionary IMF arrangements, swap lines with AE central banks, and other elements of the global financial safety net; in aggregate EMs face the uncertain environment with relatively strong external buffers. --- ### 4. Prospects and Policy Challenges ### Overall outlook and risks - The economic recovery is expected to continue but to remain incomplete, uneven, and subject to downside risks. - The IMF projects a significantly slower return to pre-pandemic output for EMs than for AEs; EMs as a group are not expected to catch up to their pre-pandemic trajectory. - Inflationary pressures in EMs are expected to remain elevated through 2022 with significant cross-country variation; inflation pressures are expected to subside in 2023. - Subsuming factors for 2023 disinflation include softening commodity prices, easing supply-demand imbalances, anchoring of inflation expectations from monetary tightening, and further scaling back of fiscal support. ### 4.1 Policy responses - Recovery strength for EMs is constrained by limited policy space compared to AEs, on both fiscal and monetary fronts. - Heterogeneity across EMs is large: some have policy space, others face tight constraints. - Structural growth challenges and sectoral composition impacts are highly country-specific. - Policymakers should tailor measures to boost recovery while acknowledging constraints from elevated debt and external vulnerabilities. ### 4.2. Debt issues - Elevated public and private debt represent a key risk; higher interest rates may worsen debt dynamics even if growth recovers. - Countries face a tradeoff between supporting recovery and addressing debt sustainability concerns; this constrains EMs more than AEs during a tightening cycle. - Risk is acute in countries with especially elevated debt levels, large exposures to foreign currency debt, and short maturities with repricing and rollover risks. - High corporate and household debt increases financial system vulnerability to rising interest rates. - Eventual withdrawal of extraordinary support and tightening of financial conditions will likely lead to a spike in insolvencies. - Corporate and sovereign spreads tend to move in tandem; a surge in defaults could affect the banking system and tax collection, exacerbating public debt sustainability concerns. - Policy recommendations: - Rebuild buffers as market conditions allow, including reducing public debt and increasing foreign exchange reserves as needed. - Use SDR allocation liquidity (noted as helpful) and tailor support to viable firms. - Mobilize macroprudential policies to address building financial vulnerabilities (e.g., rising house prices). ### 4.3. Monetary policy tightening - Many EMs moved ahead of AEs in unwinding emergency measures and tightening monetary policy, helping sustain credibility and anchor long-term inflation expectations in most cases. - Calibrating monetary policy is challenging given uncertainty, the tradeoff between supporting the economy and fighting inflation, and exposure to external conditions. - Tightening of US monetary policy could cause significant spillovers via capital flows and exchange rate movements, impacting domestic financial conditions and inflation in EMs. - Countries with strong fiscal positions, robust institutions, and smaller exposure to currency volatility and interest rate shocks will be better able to withstand adverse global spillovers. - Vulnerable countries with elevated debt levels and weaker institutions may struggle to mitigate spillovers from global conditions on domestic economies. --- *IMF WORKING PAPERS Emerging Markets: Prospects and Challenges — 1. Introduction* ### 5. Potential tightening in global financial ### 5. Potential tightening in global financial conditions and US dollar appreciation ### Key findings and risks - Concerns are growing about the impact on emerging markets (EMs) of a significant rise in US interest rates, which could lead to a tightening of global financial conditions and US dollar appreciation. - Recent EM currency depreciation—and its flip side, US dollar appreciation—appears moderate by historical standards, but dollar appreciation episodes are often prolonged and the current trend may continue, putting more pressure on EMs (Figure 16). - When an increase in the expected US policy rate is driven by positive news about US economic activity, on balance this tends to be beneficial for EMs through the trade channel, a reduction in risk premiums, and often stimulated capital inflows. - Tightening driven by concerns about inflation or changes in risk sentiment can be considerably more challenging for EMs. ### Exposures and vulnerabilities - Private non-financial debt in foreign currency relative to the size of the economy varies considerably across countries; some have significant exposures, particularly on the corporate side (Figure 17). - Some sovereigns remain exposed to exchange rate fluctuations, though much less than in the past due to greater prevalence of borrowing in domestic currency. - Some foreign currency liabilities may be offset by foreign exchange assets or natural/financial hedges, but comparable cross-country data on such offsets is unavailable. - Uncovered Interest Parity (UIP) premiums spiked for many countries during the COVID shock, indicating continued vulnerability to swings in investor sentiment. - Exchange rate pass-through to inflation in EMs has declined since the Global Financial Crisis, but passthrough remains higher in EMs than in advanced economies. ### Policy implications and recommended responses (by country characteristics and shock nature) - For countries without meaningful currency mismatches, with deep foreign exchange markets, and well-established monetary frameworks: - Allow exchange rate flexibility to absorb shocks. - Use the policy rate to control domestic financial conditions. - If inflation expectations are not well anchored or investor sentiment shocks destabilize UIP premiums in shallow currency markets: - Foreign exchange intervention may help contain UIP premiums and limit depreciation—provided international reserves are adequate. - Weigh benefits of intervention against potential impacts on market development and long-term effects. - In countries with high public debt and less credible central banks: - Communicate clear plans for medium-term fiscal consolidation. - Reassert the independence of monetary policy to allay fears of debt monetization. - In the event of a sudden stop, interest rate defense of the exchange rate alongside outflow capital flow management measures may be necessary. ### Preventive and resilience-building measures - Encourage private sector deleveraging in countries with excessive foreign currency debt. - Use macroprudential policy to address nonfinancial sector vulnerabilities, mitigate future financial stability risks, and strengthen resilience. - Bolster the credibility of monetary policy frameworks where inflation expectations are not well anchored—recognizing this takes time. - Consider precautionary arrangements available through the global financial safety net to install additional buffers. *Source: IMF Working Paper — section 5, "Potential tightening in global financial conditions and US dollar appreciation."* --- _Source: https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022035-print-pdf.pdf_