The Spectre of a Poor-Country Debt Crisis
By Dylan Barry, GCPPP staff, October 1st 2021
The global economy has become both volatile and divergent. It is volatile thanks to uncertainties caused by the Delta variant, waning vaccination-induced immunity in the advanced economies, and supply-chain bottlenecks which risk turning transitory price inflation into something more lasting, perhaps forcing earlier intervention by the US Federal Reserve than was previously expected. But it is also highly divergent because in the developing world low rates of vaccination (especially in Africa) have led to a fresh wave of hospitalisations, deaths and lockdown restrictions, the heavy economic costs of which are now all-too-familiar. Higher US dollar borrowing costs prompted by rising inflation promise to hit low and middle-income countries hard just when they are economically down, bringing the potential for a cascading developing world debt crisis.
In this ANALYSIS—which follows on from an article published last year by the GCPPP—we look at the problem of indebtedness in the developing world, the efforts of the multilateral institutions to prevent a debt crisis, and the risk of such a crisis in the near future.
The state of sovereign debt in the developing world
The reason economists are concerned is that indebtedness in relevant developing economies was already at hard-to-sustain levels before the start of the pandemic. In the last decade, the International Monetary Fund (IMF) estimates that in proportion to GDP total debt in emerging market, frontier market and low-income countries (both public and private) rose by 60 percentage points—topping 170 percent of GDP by late-2019.
There are three reasons for this. In the aftermath of the 2008 Euro-American financial crisis, the ultra-low interest-rate regime in advanced economies sent investors hunting for higher yields, driving down borrowing costs in the developing world. This was reinforced by the rise of China as the world’s biggest bilateral lender through the Belt and Road Initiative. By the end of 2020, outstanding claims owed to China were equal to more than 6% of global GDP, with China surpassing the lending of all OECD governments combined, and far exceeding that of the World Bank and IMF—generally with much less stringent conditionality.
With markets flush with cheap cash, developing countries—still growing strongly on the back of a commodity supercycle driven by then-booming Chinese demand—borrowed comfortably and freely. Then in 2014-15 commodity prices collapsed. As a result, many commodity-exporting countries had to choose between dramatic cuts to public spending or running heavy budget deficits—generally choosing the latter. The result was even higher levels of borrowing by now-less-than-solvent governments. Going into the pandemic, roughly half of low-income countries (LICs), as well as several important emerging market economies, were already at a high risk of sovereign default, according to the IMF’s evaluation.
The pandemic has only worsened matters. To finance direly needed fiscal support, governments have been forced to borrow even more—often at less generous rates—even as their economies have shrunk. That has already resulted in some defaults. In 2020, the total value of sovereign debt in default rose to US$ 443.2 billion (0.5 percent of world public debt), up US$143.6 billion (48%) from a total of US$299.6 billion in 2019. This reflects new defaults by Argentina, Belize, Ecuador, Suriname and Zambia, a first-time default on foreign-currency bonds in Lebanon and a worsening of the debt-service arrears from ongoing defaults in Venezuela and Puerto Rico.
This situation has also undermined several larger emerging market economies—including Brazil, Mexico and South Africa—whose rising debt-to-GDP ratios have made it much more expensive for them to borrow in their domestic currencies. The nightmare scenario is that an acceleration in the number of sovereign defaults—perhaps even including one of those three really big debtors—could trigger an outflow of capital and a widespread liquidity crisis that leaves governments unable to roll over their debts. The result would be a contagion of defaults, one even capable of causing a global recession.
The efforts of the World Bank, IMF and G20
To prevent this scenario, the multilateral institutions have gone to great lengths during the pandemic. In the early days of COVID-19, the IMF acted decisively to ensure adequate access to liquidity in developing markets, efforts which it has maintained. Over the course of the pandemic, the IMF has lent US$114.6 billion to developing countries through its Catastrophe Containment and Relief Trust (CCRT), Rapid Financing Instrument (RFI), Rapid Credit Facility (RCF), Extended Credit Facility (ECF) and other structures.
In addition to these efforts, on August 2nd 2021, the IMF’s board of governors approved a general allocation of Special Drawing Rights (SDRs)—an international reserve asset, convertible into a basket of currencies—to member countries equivalent to US$650 billion, to further boost global liquidity. The general allocation became effective on August 23rd with countries credited in proportion to their existing quotas in the fund—with US$275 billion allocated to emerging market, developing and low-income countries. That proportion ought to rise as wealthy countries transfer some of their SDR allocation to poorer ones—the G7 has already signalled it will seek to reallocate the SDR equivalent of USD 100 billion. The IMF also acted to contain, manage and assist in negotiating debt restructurings between creditors and countries in default.
Independently, the World Bank Group (the World Bank, plus a handful of sister organisations) has deployed over US$157 billion to fight the pandemic’s health, economic, and social impacts. This is the largest crisis response in the World Bank Group’s history in nominal terms and represents a more than 60% increase over the 18 months prior to the pandemic.
Finally, perhaps the most visible multilateral effort has been the G20 Debt Service Suspension Initiative (DSSI), a joint effort of the World Bank, IMF and G20. The DSSI made a total of 73 of the poorest developing economies eligible for a temporary suspension of debt-service payments owed to official bilateral creditors. Since it took effect on May 1, 2020, the initiative has delivered more than US$5 billion in temporary debt relief to more than 40 eligible countries. The G20 and Paris Club—a club of 22 of the most important creditor nations, but which China has not joined—also agreed, for the first time, on a common framework for restructuring sovereign debt in poor countries at risk of default.
The success of these combined efforts is reflected in the fact that following 2020’s run of trouble there have only been two further sovereign defaults in 2021, both by countries (Belize and Suriname) which had already defaulted on financial instruments the previous year.
Kicking the can down the road
These are positive signs, but has the risk of a major sovereign debt crisis been averted? Not exactly. There are three primary factors that have kept the heads of developing countries above water this year. The first is the better-than-expected recovery of the global economy, led by the advanced economies and China, which has revived demand for poor-country exports, especially commodities. The second is the generous level of support from the multilateral institutions, outlined above. The third is the ultra-low interest rate regime maintained by central banks in the advanced economies to support their own recoveries. These factors all face headwinds in the coming 12 months.
The global economic recovery has already been a two-speed affair. In the advanced economies, generous fiscal and monetary stimulus mitigated the worst of the shock of the pandemic—a luxury not available to most developing countries—and then fuelled a rapid rebound, combined with pent-up consumer and investment demand. Most low and middle-income countries have fared far worse, even though world trade has rebounded to above pre-pandemic levels.
Now, vaccinations represent the sharpest divide. According to the GCPPP’s estimates, at current rates of vaccination, the majority of the advanced economies are expected to have vaccinated 70-80% of their populations within a matter of months. The continent of Africa, by contrast, is not expected to cross that milestone for another three years. Moreover, tourism is not expected to recover fully, especially in countries with low levels of vaccination, until well into 2023. As a consequence, developing countries are still expected to face an extended period of economic pain that will weigh heavily on their solvency.
Both the World Bank and IMF will struggle to maintain their current levels of support without greater investment by their main shareholders, including the United States, European countries and China, which does not at present look like being forthcoming. Neither US domestic politics nor the current US-China rift look likely to permit a recapitalisation. The row over whether the IMF managing director, Kristalina Giorgieva, did or did notshow bias towards China while CEO of the World Bank is emblematic.
In January, the ratings agency Fitch slightly downgraded the solvency of the primary lending arm of the World Bank—the International Bank of Reconstruction and Development (IBRD)—from a rating of ‘aa+’ to a rating of ‘aa’, something the bank will be wary of given how reliant it is on issuing bonds to cheaply finance its own lending. The DSSI—already twice extended by the G20 after its originally scheduled termination at the end of 2020—will also pack up at the end of 2021, with the G20 making it clear that it will not extend the program a third time.
Finally, in terms of interest rates, worldwide inflationary pressures due to persistent global supply bottlenecks are raising the spectre of a reduction or reversal of monetary stimulus measures—including interest-rate hikes—over the next year in many of the advanced economies. That is likely to encourage capital outflows from the developing world, risking a liquidity crisis in some economies. This prospect is already placing low- and middle-income countries in a bind, forcing them to raise interest rates themselves at the likely expense of growth.
In sum, the risk of a major developing world debt crisis has simply been punted into the near-future.
What is to be done?
In our previous ANALYSIS, we argued that given the unprecedented scale of emerging market indebtedness , restructuring and other forms of temporary debt relief will be insufficient to prevent a future crisis. As a consequence, it may be time to move on to some level of targeted debt forgiveness.
The most recent initiative of this kind was the 1996 Highly Indebted Poor Countries (HIPC) initiative, later supplemented by the 2006 Multilateral Debt Relief Initiative (MDRI). The programs were coordinated by the World Bank in partnership with major international creditor nations. Over the last 25 years, the two (still ongoing) initiatives have relieved 37 participating countries of more than US$ 100 billion in debt—with Sudan recently added to the first program.
These initiatives offer a model for what a broader program of debt forgiveness might look like, but this time there will be new challenges. The move towards debt-forgiveness in the late-1990s was led by the United States––then the world’s only superpower and a major creditor to the original 36 HIPC countries—and consequently drew the support of another 55 creditor nations. The modern geopolitics of a similar initiative, however, would be fraught. The United States is now a relatively small international creditor, dwarfed by China. The Chinese, however, have been loath to extend debt forgiveness or even blanket debt relief for fear of taking a unilateral economic hit and have so far avoided joining the Paris Club, the group of (now 22) creditor nations which since its inception in 1956 has been involved in all major sovereign debt negotiations. Amid ever-rising tensions, getting the two superpowers to work together to help prevent—or clean up—an emerging-market debt crisis will be far from easy.
Short of forgiveness, the multilateral institutions and the other major creditor nations should be willing to apply more pressure on both private creditors and international ratings agencies to establish better norms in the face of debt restructuring. Recent research by the IMF suggests that waiting to restructure debt until after a country defaults is associated with greater declines in output, private sector credit and worse capital outflows than in the case of a pre-emptive debt restructuring.
Nevertheless, pre-emptive debt restructurings are generally punished both by ratings agencies and financial markets, perhaps because they take outsiders by surprise and are taken as as a signal of hidden underlying problems. A salient example is the case of Ethiopia, which saw heavy ratings downgrades and capital outflows after pursuing a pre-emptive debt restructuring earlier this year. This kind of response creates a chilling effect in which debt-distressed nations act too late to seek relief, to the detriment of both debtors and creditors. This is largely why only 40 of the 73 countries eligible for the DSSI ultimately sought relief.
The behaviour of private creditors—bondholders and institutional investors—is also often unhelpful. Over the course of the pandemic, private creditors have so far resisted blanket debt-relief measures and insisted on prolonged, case-by-case restructuring negotiations, frequently mired in litigation. These can be mitigated by adding stronger Collective Action Clauses (CACs) to sovereign bonds, clauses which allow for a supermajority of creditors to impose restructuring terms on minority of holdout creditors. New legislation in jurisdictions that govern international bonds (importantly but not exclusively New York and London) can also help ensure more orderly debt restructurings by creating greater balance between sovereign debtors and creditors.
Finally, there is some momentum behind the idea of introducing sovereign GDP-linked bonds. These are special bonds designed so that, when a country’s growth is weak, its government’s debt-servicing costs would decline and its debt-to-GDP ratio would stabilise rather than rise—reducing the need for an immediate fiscal consolidation. The flip side is that, when growth is strong, the return to investors on a GDP-linked bond would rise to reflect higher revenues. The widespread use of GDP-linked bonds—which are explicitly counter-cyclical—could go a long way towards preventing both current and future debt crises of all kinds.
The actions of the multilateral institutions (the World Bank and IMF) and major bilateral creditors (the G20 and Paris Club) have helped to prevent an emerging market debt crisis over the last 18 months. But their actions have only postponed a reckoning with unsustainable debt levels. With the DSSI winding up at the end of 2021, and multilateral support likely to start tapering, the risks of an emerging market debt crisis remain high.
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