The spiraling debt crisis and what to do about it
Global debt has reached an all-time high, surpassing levels recorded during the infamous crisis of the 1980s. For over-indebted countries, the COVID-19 pandemic has severely affected their ability to repay due to increased spending of crisis. Low-income countries (LICs) bear the brunt of this crisis, taking on more debt.
At the start of the pandemic, half of the 31 LICs fell into the high-risk category of over-indebtedness. LIC debt burden increased by 12% to a record $860 billion in 2020, while developing country debt payments doubled between 2010 and 2021, reaching the highest level in 20 years.
LICs and emerging economies have seen an increase in sovereign spreads and the share of government debt in revenue. Markets are pricing in a restructuring discount on high borrowing costs, while many emerging economies have seen their debt downgraded in 2020 and 2021. Headwinds and tighter market conditions ahead increase the risk of market interruptions. debt repayment, with a growing belief that a significant number and developing countries will need debt restructuring over the next two years.
Urgent action is needed to address the current problem of unmanageable debt and to provide sustained, long-term support to affected countries to prevent them from taking on more debt.
While all developing countries have been affected by the COVID-19 pandemic, Small Island Developing States (SIDS) have faced particularly severe financial challenges. Tourism accounts for up to 50% of GDP and 30% of total employment in these countries. It is estimated that a 25% reduction in tourism would lead to a 7.3% drop in the collective GDP of SIDS. In 2021, the Maldives experienced a 19% decline in overall production. Similarly, the average GDP of tourism-dependent Pacific states such as Fiji, Palau, Samoa, Tonga and Vanuatu contracted by 6.6% in 2020.
These economies, which are often service-based, rely on public and publicly guaranteed loans. Experiences of debt distress among SIDS already existed before the pandemic, but the COVID-19 crisis has exacerbated the liquidity and solvency problems of these countries. High exposure to climatic hazards further aggravates their vulnerability, with poor populations, including women and people with disabilities, being the most exposed.
The international response to this impending debt crisis has been to buy time and provide new financing, as well as to delay the resolution of the underlying debt problem.
As a first step, about $12 billion in debt payments have been postponed for nearly 50, mostly low-income countries, through the Debt Service Suspension Initiative (DSSI), an initiative launched by the G20 in May 2020 to temporarily suspend debt service payments to bilateral authorities. creditors. A total of 73 low- and lower-middle-income countries have become eligible to temporarily suspend debt service payments to their official creditors until the end of 2021.
Second, international financial institutions (IFIs), including the International Monetary Fund (IMF) and the World Bank, have increased the volume and pace of their financing. Together, the IMF and World Bank disbursed nearly $200 billion in their fiscal years 2020 and 2021. In August 2021, the IMF approved the allocation of Special Drawing Rights (SDRs) – international reserve assets to support member countries’ reserves – totaling $650 billion. However, only 42% or $275 billion of this allocation will go to emerging markets and developing countries, of which only $21 billion goes to LICs. Most SDRs will be allocated to upper- and middle-income countries to align with existing quotas.
Third, the Common Framework, which was put in place by the G20 in partnership with the Paris Club in November 2020, aimed to go beyond the DSSI in order to restructure public debt on a case-by-case basis. Under the new framework, creditor countries, including China, are able to negotiate with debtor countries “to facilitate the expeditious and orderly treatment of the debt of DSSI-eligible countries, with broad participation from creditors, including the private sector “.
Despite high hopes, the common framework has stalled. To date, only three countries have formally requested assistance from the Framework, and none have received support. Coordination issues between the Paris Club, new creditors like India and China, private creditors, and creditor country institutions and agencies have slowed decision-making and delayed deployment.
Fourth, China, as a major creditor, is also dealing with the debt crisis bilaterally with its borrowers. Over the past decade, China has overtaken the Paris Club as a lender to LICs. Of the US$35 billion that the world’s 74 poorest countries will have to pay in debt service this year, about 37% – or US$13.1 billion – is owed to Chinese entities, and a a similar amount – US$13.4 billion – is due to the private sector. Official bilateral debt to countries other than China is only US$8.6 billion.
The World Bank and others have raised concerns about the lack of transparency in loan terms applied by Chinese creditors, as well as the collateral nature of some of these loans. In 2021, a study by the Center for Global Development found that Chinese contracts included “unusual confidentiality clauses”, promises against collective restructuring and cancellation-related clauses that allow lenders to “influence domestic policies and foreign debtors”.
These concerns notwithstanding, it is important to recognize that China has provided more debt relief through the DSSI than any other country and has bilaterally negotiated up to $10.8 billion in relief with countries. debtors since the start of the pandemic.
As international actors and IFIs struggle to sort out the coordination and implementation of debt relief, LICs and emerging markets are sinking into deeper debt distress, with the worst yet to come. The DSSI is now complete and debt service payments will resume soon. The war in Ukraine and the associated rise in food and fuel prices are hitting many LICs hard who depend on imports of these two products for their economic needs. SDR allocations are already being used, with fiscal space in many countries more limited than at the start of the pandemic. The combination of vaccine inequality, new variants of COVID-19, tightening global financial conditions, rising interest rates and shrinking fiscal space resulting in reduced health spending and social security, increases the risk of a debt crisis in 2022.
It is increasingly recognized that the mechanisms for dealing with debt problems themselves are not fit for purpose. The composition of creditors has changed, with China and the private sector playing a bigger role compared to the historically dominant traditional Paris Club lenders.
Sustainable and long-term solutions are essential to support LICs and prevent spiraling debt. The common framework in its current form is not sufficient to alleviate protracted fiscal problems. Many proposals have been put forward on how to improve the framework, the most important of which would be to create more incentives for participation among borrowers and creditors. This could include imposing a debt service halt as soon as countries request assistance, clarifying the process and timelines for processing, creating pressure for private sector participation through of the IMF’s policy on overdue loans, increasing transparency on sovereign debt volumes and terms, accelerating the preparation of preliminary debt sustainability assessments (DSAs), and expanding the country coverage of the Framework.
There is also a large body of expert advice on how to go beyond the common framework to address issues of debt sustainability and restructuring processes. Proposals from the World Bank, the G30, the Friedrich-Ebert-Stiftung and the Consensus Building Institute, and the Bretton Woods Committee recommend improving the transparency of procedures and the official sector, increasing incentives for participation private sector, sustain development investments through additional financing and strengthen crisis preparedness mechanisms in multilateral development banks.
Overall, what is needed is a collaborative effort across sectors to improve LIC debt support by tackling the problem head-on. Debtor governments must lead this process, working to mitigate sovereign debt risks through proactive policy approaches. No doubt it will be difficult to agree on a better debt management framework. What is important to remember, however, is that cleaning up after a debt crisis is always much more difficult than the steps taken to avoid it.
This blog is based on a presentation given during the 2022 AAC Speaker Series, a monthly online event co-hosted by the Development Policy Center and The Asia Foundation. Watch the presentation or watch Masood Ahmed present the prospects and challenges of debt for developing countries amid the lingering pandemic.