COVID-19 has plunged almost all nations into significant financial shock, with governments expected to run budget deficits to support unprecedented levels of economic stimulus and public health spending. Developing nations are particularly vulnerable as lending begins to dry up, reducing the funds available for COVID-19 responses.
At the start of 2020, the International Monetary Fund (IMF), a global financial institution, projected positive per capita income growth in 160 countries. As a result of the lockdowns induced by the pandemic, the IMF now warns that 170 countries could instead see incomes shrink.
To avoid the worst permutations of the crisis, most countries need historic levels of stimulus and public investment, which could be at least 10 per cent of global GDP.
However, mobilising this spending is extremely difficult for developing nations that have seen export demand and tax revenues collapse. For example in the Maldives, COVID-19’s impact on international travel is expected to sink the government’s tax revenue by at least 48 per cent. Global trade in goods could decline 20 per cent with South Asia and the Middle East particularly vulnerable.
This poses significant problems because countries rely on foreign currency received from exports to purchase imports for their population. These imports include vital food and textiles along with essential items to combat COVID-19 such as personal protection equipment for health workers. Usually, if exports dry up and budgets are strained, governments can resort to drawing upon their foreign exchange reserves to satisfy balance of payments issues.
More aggressive foreign capital outflows than the GFC
Unfortunately, the pandemic has catalysed extreme withdrawals of foreign capital in emerging markets. As markets became gripped by fears of a global health and economic crisis in March, foreign direct investment flows declined 40 per cent and emerging market currencies were sold off steeper than the falls observed during the 2007 global financial crisis. This triggered significant declines in foreign reserves across emerging markets.
With lower reserves, vulnerable nations have less insurance to mitigate crumbling export demand, offset domestic currency weakness and meet near-term foreign-denominated debt obligations.
Developing nations are already beginning to deplete these reserves. Pakistan resorted to using US$1.7 billion of its reserves within a single week in June to meet debt repayments. Sri Lanka’s reserves have continued falling whilst they seek a US$1.1 billion currency swap facility with India.
Leadership from the IMF and its shareholders will be crucial to prevent a larger liquidity crisis and avoid debt defaults and trade payments issues for countries most vulnerable to the pandemic.
Special Drawing Rights
Since 1969, the IMF has had the ability to inject additional liquidity to bolster foreign exchange reserves by issuing Special Drawing Rights (SDRs). SDRs are an international reserve asset that, when issued, are held by the central banks of all IMF member countries.
When SDRs are issued, each member receives an allocation proportionate to their IMF shareholding which can be held on its balance sheet or converted to a desired currency. Members are either charged 0.5 per cent interest on the difference if their SDR balance is lower than their allocation or receive 0.5 per cent interest if their SDR balance is higher. For example, Tonga was previously allocated SDR 6.5 million although their current holdings are SDR 5.4 million. This means they have converted SDR 1.1 million into foreign currency and would pay 0.5 per cent interest on that source of funding.
A fresh SDR issuance can improve the reserves of developing nations at a very low interest rate, compared to the premia currently charged on debt from international capital markets. Experts have called for a US$1 trillion issuance of SDRs by 2022. This would generate a US$330 billion boost in reserves for low and middle income countries almost overnight.
Leadership is required
Eighty-five per cent of votes held by IMF members are required to approve a new issuance. With 16.5 per cent of votes (an effective veto), the United States has resisted this proposal. The April G20 Communique also recognised that no consensus was achieved.
US Treasury Secretary Mnuchin has argued that employing existing IMF lending facilities would be more efficient than issuing new SDRs. However, arguably SDRs should be combined with these facilities in order to reach anywhere near the US$2.5 trillion of assistance that is expected to be required for emerging economies. IMF lending facilities are currently capped at only US$787 billion.
It has also been argued that most new SDRs would be allocated to advanced economies, rather than countries that need the assets to avoid crisis. Nonetheless, developing countries would still disproportionately benefit from SDR allocations in light of the major capital outflows they have faced in 2020.
Another option might involve advanced economies agreeing to an a priori reallocation of SDRs that can distribute more SDRs towards vulnerable nations even after the allocation is made. This will require leadership from the IMF and advanced economies to moderate self-interest and negotiate a reallocation that can avert liquidity crises in the near term.
Developing nations need to unlock substantial reserves to withstand this crisis and protect their populations. It’s on the IMF and key members to turn the key.
Brendan Ma is Australia's Representative to the Y20, an academic tutor in the University of Sydney Discipline of Finance and studying a Bachelor of Laws (Honours) at the University of Sydney.