Emerging economies at risk of "doom loop" into default

By:

Public Finance Focus staff

19 Apr 22

A record amount of sovereign debt held by banks in emerging economies puts poorer countries at risk of a “doom loop” leading to government defaults, according to IMF economists.

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Progress in financial accountability in different countries can be seen at a glance and compared using a new international index

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In a blog post, senior members of the fund’s monetary and capital markets department said that the average ratio of public debt to GDP hit 67% in poorer countries last year.

Meanwhile, banks in these countries saw government debt as a percentage of their assets rise to 17% and as high as a quarter in some jurisdictions.

The blog said: “Large holdings of sovereign debt expose banks to losses if government finances come under pressure and the market value of government debt declines.

“That could force banks—especially those with less capital—to curtail lending to companies and households, weighing on economic activity.

“As the economy slows and tax revenues shrivel, government finances could come under even more pressure, further squeezing banks. And so on.”

It said that this “doom loop” has previously been seen in Russia in 1998 and in Argentina in 2001-02.

The IMF staff said that a new loop could be triggered by higher interest rates and weaker currencies caused by monetary policy normalisation in advanced economies, along with increasing geopolitical tensions caused by the war in Ukraine or a domestic shock.

These could undermine investor confidence in the ability of emerging market economies to repay debts.

To protect themselves, the blog authors said, policy makers should:

Develop resolution frameworks for sovereign domestic debt to facilitate orderly deleveraging and restructuring in case they are needed;
Improve transparency on all banks’ material sovereign exposures to assess the risks from possible sovereign distress;
Conduct bank stress tests by taking into account the multiple channels of risk transmission in the nexus;
Consider options to weaken the nexus—such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds—once the economic recovery is more firmly established and depending on market circumstances;
Strengthen procedures to wind down banks in an orderly fashion if needed and to provide liquidity in a crisis;
Promote a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets.