External Finance in Emerging Markets and Developing Economies: A Tale of Differences in Vulnerabilities*

Dohan Kim and Gian Maria Milesi-Ferretti

No 11274, Policy Research Working Paper Series from The World Bank

Abstract: Over the past two decades, many emerging markets and developing economies have been viewed as increasingly resilient to external financial shocks. This paper assesses whether such resilience is broadly shared across emerging markets and developing economies by classifying them into three tiers based on economic size, income level, institutional strength, and financial integration. The analysis shows that first-tier emerging markets and developing economies have improved their external balance sheets and reduced dependence on official support. However, second- and third-tier emerging markets and developing economies have experienced growing external vulnerabilities since the global financial crisis, marked by rising external debt liabilities and declining foreign exchange reserves. Using a range of indicators, including sovereign defaults, arrears, partial defaults, and International Monetary Fund lending, the paper identifies episodes of external financial distress and shows that distress remains widespread among second- and third-tier emerging markets and developing economies. The empirical analysis confirms that key components of the net international investment position—especially external debt and foreign exchange reserves—predict the onset of external financial distress, with institutional quality shaping the impact. Weak institutions amplify risks, while strong institutions mitigate them. These findings highlight the importance of recognizing heterogeneity across emerging markets and developing economies, strengthening institutional quality alongside external balance-sheet management, and rebuilding buffers to safeguard against renewed global financial stress.

Date: 2025-12-04
New Economics Papers: this item is included in nep-fdg, nep-ifn and nep-inv
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