Stark warnings about the COVID-19 shock’s potentially devastating effects on emerging markets (EMs) have become ubiquitous.

With the pandemic engulfing ever more countries, EMs face a mass exit by foreign investors seeking safe assets. As a result, capital outflows and currency depreciations have become unprecedentedly synchronized.

A first round of policy interventions to blunt the pandemic’s financial and economic impact on EMs is already underway. But although these actions – mainly aimed at alleviating stress in foreign-exchange (FX) markets – are welcome, the ongoing currency depreciations present financial-stability challenges that have long-term implications going far beyond immediate liquidity problems.

When an EM currency depreciates, that country’s foreign-currency-denominated debt burden – both its absolute value and debt-service costs – can escalate rapidly. Such balance-sheet effects often presage corporate defaults, financial instability, and output declines, as we saw during previous EM crises.

In devising an appropriate economic policy response to COVID-19, therefore, EM policymakers must answer a key question: how much financial trouble linked to balance-sheet effects is this wave of currency depreciations likely to cause? Estimating the potential damage is complicated by the fact that the magnitude of unhedged FX debt in EMs is hard to pin down.

Over the last 40 years, the debt landscape in EMs has changed dramatically. On one hand, EM governments have significantly reduced the extent of their “original sin” of relying on FX borrowing, owing to improved macroeconomic fundamentals and better fiscal and monetary discipline.

In the meantime, however, EM companies have gone in the opposite direction: as it became cheaper for these firms to borrow in global currencies, their FX borrowing grew. And recent research shows that when the cost of borrowing in foreign currency drops, more firms issue FX debt.

This migration of FX exposure from EM sovereigns to corporate borrowers has brought new challenges. In particular, private firms’ finances are less regulated than those of governments and banks, so we know much less about their balance sheets.

Nonetheless, our research – using a variety of private and public sources – gives a sense of the magnitudes involved. Figure 1 shows the FX debt of households and non-financial firms in major EMs, both as a share of their total debt and as a share of GDP.