Countries with Huge Debts Vulnerable to Financial Crises, Recession, IMF Warns

The International Monetary Fund (IMF) has warned that economies with large external debts could be vulnerable to financial crises and deep recessions when capital flows out.

The IMF stated this in a Review of the Institutional View on the Liberalisation and Management of Capital flows it released on Wednesday. It noted that while the overall presumption that capital flows could bring substantial benefits for countries and that capital flow management measures (CFMs) it should not substitute for warranted macroeconomic adjustment.

It stated: “Capital flows can help countries to grow and to share risks. But economies with large external debts can be vulnerable to financial crises and deep recessions when capital flows out. External liabilities are riskiest when they generate currency mismatches—when external debt is in foreign currency and is not offset by foreign currency assets or hedges.

“In a review of its Institutional View on capital flows released today, the IMF said that countries should have more flexibility to introduce measures that fall within the intersection of two categories of tools: capital flow management measures (CFMs) and macro-prudential measures (MPMs).

“Today’s review said that these measures, known as CFM/MPMs, can help countries to reduce capital inflows and thus mitigate risks to financial stability not only when capital inflows surge, but at other times too.”

It further noted that during a capital flow reversal, conventional policy instruments may not be effective in addressing the balance sheet effects related to FX mismatches.

“First, while a currency depreciation due to a capital flow reversal may boost net exports, it may also tighten external borrowing constraints by reducing the FX value of local-currency assets, collateral, and income relative to FX debt and liabilities.

“In such circumstances, monetary policy faces a difficult trade-off: raising the interest rate could result in excessively tight domestic monetary conditions, with pro-cyclical effects on credit and economic activity; while lowering it could lead to further depreciation, tightening external borrowing constraints further.

“Second, the capacity of the government or the central bank to provide FX liquidity to the private sector to satisfy rollover needs on FX debt may be limited, owing to insufficient FX reserves or other sources of FX funding,” it added.

It also added that FX debt inflows may be useful in a pre-emptive manner, in the absence of an inflow surge, to prevent a further accumulation of already-elevated FX mismatches and the associated systemic financial risks.

“If the adverse balance sheet effects of a currency depreciation can be mitigated pre-emptively through CFM/MPMs that reduce FX mismatches, the exchange rate can be allowed to adjust more flexibly after external shocks, hence reducing the cost of capital flow reversals and facilitating the needed external adjustment. Such arguments have been developed in the IPF workstream and the IEO report as rationales the pre-emptive use of inflow CFM/MPMs.

“The accumulation of external debt in local currency can also pose financial vulnerabilities in the private sector, but a wider set of policy tools is typically available to address them. “Maturity mismatches and excessive leverage in local-currency debt positions increase rollover risks and the probability of fire-sales of domestic assets during capital flow reversals. In those cases, adequate MPMs would typically address these risks effectively,” it added.

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