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  • Emerging markets entered the current downturn with lower rates than in past recessions, leaving them with a diminished ability to prop up their economies, Nobel-winning economist Paul Krugman told Bloomberg on Friday.
  • Such nations now face a liquidity trap, where interest rates sit at the floor and monetary easing loses its relief effect.
  • While developed countries can borrow trillions of dollars for economic aid, emerging markets aren't as able to counterbalance monetary easing with fiscal stimulus, Krugman warned.
  • By entering the current slump with low rates and smaller debt balances, developing nations "managed to make themselves vulnerable to first-world kinds of problems", the economist added.
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Emerging markets are sliding into liquidity traps and might exhaust their best defence against a deep recession, Nobel-winning economist Paul Krugman warned.

Such traps come to fruition when interest rates are pulled to the floor and monetary policy loses its relief effect. Where the issue mostly affected developed nations with already low rates, emerging countries are now facing the same problem as the coronavirus freezes global economic activity.

"There's nothing about the logic of a liquidity trap which says it can't happen in a developed country," Krugman told Bloomberg in a Friday interview.

Rate cuts are central banks' go-to tool for fighting economic slumps. When interest rates reach the floor and additional relief is needed, monetary authorities are forced to use less tried-and-true methods.

Latin American nations have been the first to grapple with weakened monetary policy arsenals. Peru and Chile have already pushed their benchmark rates close to zero, while Brazil and Colombia are poised to join them.

Peru's central bank announced earlier in May it would begin using other policies to prop up activity. Chile's authority has followed the Federal Reserve and started buying corporate bonds to lift credit health.

Where developed nations can also take on swaths of debt for economic aid, emerging markets aren't as able to counterbalance monetary easing with fiscal stimulus, Krugman said.

"If I were a finance minister in an emerging market I might call for some, but I'd probably be nervous about doing it on the scale that we're seeing in Europe and the US right now."

Part of the problem faced in emerging markets is their pivoting to typical developed-nation meltdowns. Where such countries would typically see their currency's value plummet during a recession, their downturn symptoms are more similar to those of their richer peers.

By entering the current economic backdrop with low rates and smaller debt balances, developing nations are stuck in an uncomfortable middle ground, Krugman said.

"If we're looking at Turkey or Argentina, they're experiencing relatively classic sort of emerging market crises with a cut off of capital inflows," he told Bloomberg. "But a lot of the emerging world has made a lot of progress on those issues, and the perverse thing is that by gaining some sort of first-world style credibility, they've managed to make themselves vulnerable to first-world kinds of problems."

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