The next financial crisis could start with advanced economies’ sovereign debt

FOR much of the past four decades, financial crises were often associated with emerging markets. The Latin American debt crisis, Asia in 1997, Russia in 1998 and Argentina in 2001 shared a familiar pattern of excessive borrowing, capital flight and abrupt reversals in investor confidence.

But major crises have not been confined to emerging markets. The 2007-2008 global financial crisis originated in the US, while the eurozone sovereign debt crisis and the UK gilt market turmoil of 2022 demonstrated that advanced economies can themselves become sources of instability.

Today, the balance of risks is shifting further. Public debt is at historic highs across many advanced economies, deficits remain elevated and sovereign bond markets are more sensitive to inflation, interest rates and investor confidence.

The next major financial shock may therefore originate in advanced economies’ sovereign debt markets. Yet emerging markets are likely to bear a disproportionate share of the adjustment.

This is because sovereign debt markets in advanced economies sit at the centre of the global financial system. US Treasuries, Japanese government bonds and major European sovereign securities underpin global collateral markets, funding arrangements and risk pricing.

At the same time, these markets are changing. Central banks are reducing their holdings of government debt, while non-bank financial institutions now account for nearly half of global financial assets.

Sovereign debt markets increasingly depend on asset managers, hedge funds and private credit funds rather than the central banks, regulated banks and foreign official investors that dominated a decade ago.

Recent strains in private equity and private credit are a reminder that vulnerabilities built during years of ultra-low interest rates are now surfacing. Financial stress can emerge outside the banking system and quickly affect market liquidity.

Exposing weaknesses in emerging markets

When yields rise sharply in major sovereign debt markets, the effects are transmitted globally through tighter financial conditions, stronger reserve currencies and shifts in investor risk appetite.

Indonesia provides one illustration. Despite stronger policies than during the Asian financial crisis, periods of rising US yields have coincided with pressure on the rupiah, capital outflows and tighter financing conditions.

Similar pressures can emerge across many emerging markets when global liquidity conditions tighten.

More broadly, the distinction between external risk and fiscal vulnerability is now increasingly blurred. Many emerging markets have strengthened their external positions through larger reserves and more flexible exchange rates.

Yet debt levels have risen, contingent liabilities have expanded through state-owned enterprises and development banks, and significant fiscal activity increasingly occurs outside traditional budget frameworks. As a result, external shocks and domestic fiscal weaknesses can reinforce one another.

Rising yields in advanced economies may trigger capital outflows and exchange rate pressures in emerging ones. Those pressures can then expose hidden fiscal vulnerabilities, increase borrowing costs and reduce policy flexibility.

Countries with stronger fiscal frameworks and greater transparency are likely to prove more resilient than those with hidden liabilities and weak fiscal reporting.

The implications are systemic. The international financial architecture remains heavily dependent on the assumption that advanced-economy sovereign debt markets will remain capable of supplying safe assets to the world.

If those markets themselves become sources of volatility, demands on the global financial safety net could increase substantially.

Mobilising the Chiang Mai Initiative

The International Monetary Fund (IMF) remains the central pillar of that safety net.

Regional arrangements have also expanded, including Asia’s Chiang Mai Initiative Multilateralization (CMIM), a reserve-pooling arrangement among Asean, China, Japan and South Korea. Yet despite its size and potential importance, CMIM has never been activated.

This reflects a paradox. The facility was created after the Asian financial crisis, yet Asia has largely relied on massive reserve accumulation as its first line of defence, with IMF support remaining the ultimate backstop.

That approach may no longer be sufficient. Asia today accounts for a far larger share of global output and finance than when CMIM was established. At the same time, it remains exposed to shocks transmitted through dollar funding markets and advanced-economy sovereign debt markets.

The prospect of recurring sovereign debt volatility in advanced economies strengthens the case for making CMIM operational.

Member countries should conduct regular simulations, strengthen surveillance through the Asean+3 Macroeconomic Research Office and clarify how CMIM resources would interact with IMF programmes during periods of market stress.

The world has spent decades preparing for crises originating in emerging markets. The next challenge may be different.

A shock beginning in advanced-economy sovereign debt markets could spread rapidly through capital flows, funding markets and investor portfolios, affecting countries with little responsibility for the original problem.

Fiscal vulnerabilities at the centre increasingly create risks for the periphery. Strengthening domestic fiscal resilience and the global financial safety net is an essential component of global financial stability.

And if Asia is serious about building regional financial resilience, the time has come to move the CMIM from a contingency plan on paper to a facility that is genuinely ready for use.

The writer is distinguished fellow at India’s Centre for Social and Economic Progress and former Asia-Pacific director at the International Monetary Fund