Plans for ambitious reform in Egypt, Turkey and Argentina could fold in the face of public unrest. A second Trump term may change how the IMF and World Bank respond.
One remarkable phenomenon these days is the sheer number of governments in economically fragile countries that are implementing tough economic reforms.
Argentina, Turkey, Egypt, Ecuador, Nigeria, and Pakistan for example are all adopting, in differing degrees, painful economic policies. The intention is to live more within their means, kill inflation, attract foreign investment and engage with the global economy in a more effective way.
Last month's riots in Kenya serve up sobering evidence of how such reforms can strain a country's social fabric.
Financial markets have been responding to these reforms with predictable enthusiasm. An investment in dollar-denominated bonds issued by high-yielding, or risky, governments at the frontier of emerging markets have returned some 8.5 per cent since the start of the year, compared to -0.4 per cent for bonds issued by 'investment grade' sovereign borrowers.
Kenya's warning
Yet last month's riots in Kenya serve up sobering evidence of how such reforms can strain a country's social fabric. The immediate trigger for the protests, in which dozens of people died, was a government effort to raise taxes needed to meet the IMF's fiscal targets for the country. Measures included a 16 per cent VAT on bread, and a tax on environmentally harmful products that would have raised the price of sanitary towels, nappies, packaging, plastics and tyres.
The protests compelled President Ruto to shelve the finance bill in late June. In response, Moody's downgraded Kenya's sovereign risk rating, with the result that the effective interest rate that Nairobi pays to borrow overseas has risen sharply, to around 11 per cent.
Kenyan policymakers now face a full-blown dilemma, since the requirements of social peace on the one hand, and of financial stability on the other, are pulling in opposite directions. Ruto is hoping that more spending cuts can substitute for the loss of additional tax revenues. But Kenya's public finances will inevitably weaken. The country's access to external financing from commercial sources is at risk, and default may loom.
Others could follow
Where Kenya has gone, others could follow. Egypt, Argentina, and Turkey, for example, are all in the early days of reform efforts. In each country the intended fiscal adjustments will have unpleasant consequences for the social fabric, not least because all plan considerably more aggressive measures than in Kenya, where the point of the relatively modest budget plan was to avoid public spending cuts and protect the poorest.
Cairo inhabitants suffering in 40-degree heat might have limited tolerance for painful economic tightening.
And while each country has its own story, many show signs of simmering social unease that might not react well to the economic sacrifices associated with reform.
In Egypt, for example, frustration has been building in a population subjected to, regular blackouts - a feature of life since last summer, when declining domestic gas production finally made supply interruptions inevitable. Cairo inhabitants suffering in 40-degree heat might have limited tolerance for painful economic tightening.
That pain seems more likely to come than not: the IMF's expectation is that Egypt's primary surplus - that is, the surplus before interest payments are counted - will need to rise from 2 per cent of GDP in 2023/4 to 5 per cent in three years, relying on a combination of both spending cuts and tax increases.
In Argentina, too, President Milei's government is targeting an extremely ambitious fiscal adjustment which aims to take the government's primary budget balance from a deficit of 1.8 per cent of GDP last year to a surplus of over 3 per cent in 2026.
That risks significant social upheaval: an effort to achieve a fiscal adjustment half that size helped to end the administration of former President Macri just a few years ago.
In Turkey, where recent violent protests directed at Syrian refugees offer a sign of existing social strains, the government is planning a budget adjustment of a similar scale to Argentina's. President Erdogan aims to turn what was a primary deficit last year of 3.9 per cent of GDP into a surplus of 1.2 per cent by 2026.
The IMF and Trump
Any country that spends more than it earns has a basic choice: either to get rid of the deficit through some combination of spending cuts or revenue increases; or to plug the deficit by borrowing.
Governments forced to abandon their plans to adjust will naturally seek more financing from institutions like the IMF and World Bank.
Put more bluntly, you either 'adjust' or you 'finance'. If neither option is available for any reason, then a third one, default - in which creditors provide a kind of financing involuntarily - becomes inevitable. Governments forced to abandon their plans to adjust will naturally seek more financing from institutions like the IMF and World Bank.
Both are nowadays (correctly) more sensitive to the strains these economies are under. And currently they can be expected to show a good deal of tolerance for some slippage if the result of fiscal tightening is social collapse. The IMF has already referred to 'potential modifications' to its agreement with the Kenyan government.
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That's all well in theory. In practice, a lot will hinge on the outcome of the US presidential election. Donald Trump's first presidency had little negative impact on the IMF and World Bank - indeed, his government approved a capital increase for the World Bank back in 2018. But there could be reasons for pessimism in the event of the former president winning a second term.
Project 2025, a blueprint for conservative foreign policy drafted by the Heritage Foundation, would likely to be picked up by a second Trump administration.
The authors call straightforwardly for the US to 'withdraw from both the World Bank and the IMF and terminate its financial contribution to both institutions'.
If anything like that approach to the Washington-based lending institutions sees the light of day, it would have a deeply unpleasant impact not only on social stability in financially fragile developing countries, but also on their relations with international capital markets.
The absence of strong, Washington-based international lenders of last resort would be a diplomatic gift to China. Beijing would surely seek to capitalize on the idea that the US is walking away from any concern about the financial stability of the world's poorest countries.
