Lending markets

A Russian default would increase financial risks for developing and emerging markets

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Artwork by Rob Dobi


About the Author: Carmen M. Reinhart is Senior Vice President and Chief Economist of the World Bank Group.

The global economy faces a combination of challenges rarely seen before, and Russia’s war on Ukraine adds a host of new risks to pre-existing ones created or exacerbated by a once-a-century pandemic. . Rise in global inflation and an uneven economic recovery from the crash of 2020 that widened the gap between rich and poor countries is high on the long list of risks that mark 2022.

The war is already fueling global inflation. Its immediate economic impacts were felt strongly in commodity markets during a supply shock reminiscent of the oil shocks of the 1970s, except this time it was also a spike in food prices. We know that the pandemic has severely compromised global supply chains and led to skyrocketing transportation costs. Government and central bank intervention supported aggregate demand but did little to restore aggregate supply. This imbalance has increased costs and prepared the ground for the return of global inflation. Disruptions from the war have further damaged trade links and blocked agricultural production from two major global suppliers. This will hit developing countries and the poor hardest, who will see much higher prices for food and other basic commodities. However, the negative effects of the war on advanced economies in Europe should not be underestimated either.

Added to this pre-existing problem is a new one: the potential fallout on financial markets if Russia defaults at some point. Here, the more recent past does not necessarily offer a good road map, as the collapse of Lehman Brothers and the implosion of the real estate market in 2008 affected advanced economies very much. This time around, many emerging markets and developing countries are likely to be hit the hardest. Often these impacts are underestimated because they occur in countries that are off the radar screen and not considered consistently important. They are the antithesis of too big to fail.

Regarding the first challenge, before the war, inflation was already proving to be much higher, more persistent and wider than the major central banks initially thought possible. In more than half of advanced economies, 12-month inflation to February 2022 was above 5%. More than 70% of emerging markets and developing economies have seen inflation at or above this level, more than double the share before the Covid-19 outbreak.

Food inflation is particularly strong. The risks of a resurgence of food crises in many parts of the world and the resulting social unrest are significant and should not be underestimated. About 80% of emerging market economies experienced food price inflation above 5% in the year before the war. Furthermore, the impacts of war are likely to be lingering, as the ongoing conflict will continue to interrupt the cycles of planting, producing and transporting food, thus worsening a bad situation. Inflation is a very regressive tax, and food inflation even more so. In low-income countries, as in the poorest households within countries, food and energy expenditures account for a much larger share of expenditures, and higher prices absorb a much larger share of their income. In many developing countries, public finances are about to deteriorate as pressure for increased food and fuel subsidies intensifies.

Regarding the second challenge, the possibility of Russia defaulting on its sovereign external debt due to sanctions, the risks can be grouped into what we do not see and cannot quantify. As markets focus on the sovereign, Russian companies also face the prospect of default. So far, the financial fallout has been limited, but it is premature to claim victory on this front. According to the Bank for International Settlements, European banks have limited exposure to Russia, but the extent of non-bank exposure is much harder to determine. Non-bank interconnections are often only revealed at the time of default. The market volatility that followed Russia’s default in the summer of 1998 brought down the US hedge fund Long-Term Capital Management and prompted the Federal Reserve to intervene to calm international capital markets.

The financial consequences of a Russian default could also be felt disproportionately in emerging markets and developing countries, where the economic recovery from the pandemic has been mostly disappointing. Many simply haven’t recovered yet. Developing countries were already finding it increasingly difficult to repay their debts. Nearly 60% of the world’s poorest countries eligible for the Debt Service Suspension Initiative that ended last year are either in debt distress or at high risk of debt distress. Increasing investor risk aversion and rising international interest rates will make it more expensive to attract new financing and service existing debt. According to the World Bank International debt statisticstotal external debt service relative to exports roughly doubled between 2010 and 2020. And this during a period of exceptionally low international interest rates.

A crisis in developing countries is not inevitable, but the risks are many. It’s never a good time for war, but this one comes at a time when glaring fault lines are emerging in the global economy.

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