In Conversation with Carmen Reinhart: Assessing the Global Financial System in the Wake of Covid-19

On May 27th, Carmen Reinhart, the Vice President and Chief Economist at the World Bank, and Bill Dudley, BWC Chair and former President of the New York Fed, discussed the impact of Covid-19 on the global financial system and considered reforms to improve the system’s resilience and inclusiveness.

• Covid-19 and Sovereign Debt: Weak initial conditions combined with the massive impact of the pandemic have put many emerging and developing economies at high risk of debt distress. While the Debt Service Suspension Initiative helped relieve some short-term pressure, Reinhart stated that it will not resolve long-term debt sustainability issues. As such, reforms to the financial architecture may be needed. First, she emphasized that hidden debts may worsen the crisis. Greater transparency could be achieved through consolidating sovereign fiscal accounts, uncovering records of Chinese lending, and outlining the extent of domestic debt. Second, the Common Framework must achieve its promise by bringing new creditors into restructuring efforts. In Reinhart’s view, even if Chad, Zambia, and Ethiopia see quick, significant debt reduction under the Common Framework, resolution could be slow given distrust among creditors that want to minimize losses.
• Challenges to the Global Financial System: Due in part to regulatory reforms put in place after the Global Financial Crisis, the financial system has weathered the Covid-19 pandemic, though Reinhart did list several ongoing challenges. First, she is concerned about the effect of the pandemic – particularly the implications of the forbearance response – on bank balance sheets, a “quieter financial crisis” that has received little attention. Second, Reinhart stated that capital flow reversals caused by the pandemic were dramatic and reminiscent of the 1930s. These reversals, combined with crashing commodity prices and the possibility of U.S. rate hikes, have left Reinhart concerned about a potential wave of defaults, especially in middle-income countries. Finally, Reinhart cautioned that mounting corporate debt could pose a challenge in the U.S. and China.
• Roles of the World Bank and IMF: The World Bank, IMF, and other multilateral institutions have played an essential role throughout the pandemic. That said, Reinhart reminded the audience that these institutions are not able to be lenders of last resort, as they do not have sufficient resources to create stabilization funds to help local governments and corporations. Instead, the Bank and Fund can utilize the tools at their disposal, like SDRs. As sovereign debt restructurings arise, the World Bank can also work with the IMF and private creditors to provide new funding and help countries restore debt sustainability. Reinhart also outlined how the World Bank and IMF have in the past offered guarantees that catalyze private capital inflows to emerging and developing economies.