of the pandemic was higher for countries with higher public debt (Presbitero and Wiriadinata 2020). Furthermore, EMDEs are at greater risk of a sudden reversal of interest rates than advanced economies, especially if there are other vulnerabilities like foreign currency debt, overvalued exchange rates, financial system fragilities and commodity dependence (Gnimassoun and Do Santos 2021).

# IV.2. Shifts in policy frameworks

Fiscal, monetary, and financial policy frameworks in EMDEs improved significantly in the 2000s, helping these countries weather the global recession of 2009 and bouts of volatility over the subsequent decade (Kose and Ohnsorge 2019). While a variety of policy moves were necessary to soften the impact of the pandemic-induced recession in 2020, some of these may erode underlying policy frameworks: fiscal support measures have required a relaxation of fiscal rules; the reach of central banks into new financial market segments has broadened; governments have heavily encouraged credit extension; and regulators and supervisors have eased restrictions.

# IV.2.1. Fiscal policies

In the face of unprecedented fiscal support measures, fiscal rules risk being eroded. Many fiscal rules have escape clauses intended to be invoked in times of major economic stress, and a large number of countries activated these clauses as a result of the pandemic (Budina et al. 2012; IMF 2020a, 2021b; World Bank 2021b). It is important, however, that the use of this flexibility is temporary and transparent. While exact timelines for a return to normal will vary, clear communication will be critical: if countries fail to reverse their path to these escape clauses as the recovery gains traction, investors may begin to question the long-term sustainability of government finances, undermining the credibility of fiscal rules (IMF 2021b). Broader temporary fiscal interventions in response to COVID should also have timelines for their removal as precrisis economic activity levels are restored (OECD 2021b; World Bank 2021c).

Government support packages have also encouraged continued credit extension to corporates. During the 2020 global recession, about 40 percent of the fiscal support from governments in EMDEs constituted liquidity support measures such as loans, equity injections, and guarantees (IMF 2020b).<sup>4</sup> Some governments have also encouraged banks to make use of available capital and liquidity buffers to support lending (Feyen et al. 2020a; IMF 2020a, 2020c). While these were necessary to avoid widespread bankruptcies, they may support nonviable “zombie” firms if maintained far into the recovery. In addition, these contingent liabilities could eventually migrate onto government balance sheets, either in a financial crisis or, indirectly, in a period of sustained low growth (Mbaye, Moreno-Badia, and Chae 2018).

# IV.2.2. Monetary and financial policies

Central bank credibility. In 2020, several EMDE central banks expanded their remit by starting asset purchase programs to stabilize financial markets (Arslan, Drehmann, and Hofmann 2020; IMF 2020d). These have helped ease borrowing conditions in financial market segments that would otherwise only be indirectly affected by monetary policy rate cuts. While appropriate in the midst of a deep recession, the prolonged use of these tools could dampen investor confidence and risk de-anchoring inflation expectations if central bank credibility is undermined by extended funding of large fiscal deficits (Ha and Kindberg-Hanlon 2021).

In some countries, central banks have also supported small and medium-size enterprises directly via back-stops for bank lending, such as by purchasing corporate securities (Borio 2020). This has

> 4 Despite the size of these packages there are concerns about their effectiveness: in a survey of firms in 51 countries (between May and August 2020) only around one-fifth of firms reported that they had received any type of policy support (World Bank 2021e).

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