Tackling the pandemic of debt

The COVID-19 pandemic increased low and middle-income countries’ debt levels to a 50-year high. With soaring inflation, rising interest rates and the strengthening US dollar compounding their debt service burdens, a crisis is now unfolding in several countries of the developing world.

The Economist has identified 53 vulnerable countries that have either defaulted on their debts or are at high risk of debt distress. While it is true that most of these countries are among the world’s poorest, a growing number of middle-income economies are also facing severe debt problems. According to the World Bank, nearly 60 percent of all emerging and developing countries have become high-risk debtors.

To gauge the full scope of this crisis and identify possible solutions, we must first consider these economies’ key characteristics and their public sector liabilities. The 53 debt-distressed countries that The Economist identified represent 18 percent of the world’s population — more than 1.4 billion people — but just 5 percent of global gross domestic product.

Their higher debt burden is a direct result of the pandemic. And while debt levels have decreased in every region but Asia since 2020, they are still higher than they were in 2019. Moreover, tightening financial conditions have made it much more difficult for developing countries, already struggling to access financing, to restructure their existing debts and avoid insolvency.

Currency depreciation is another risk. Many developing and emerging economies’ currencies have fallen steeply against the US dollar, raising the costs of servicing dollar-denominated debt. Although some emerging market governments have developed domestic sovereign debt markets and several multilateral lenders have issued loans in local currencies, 16 percent of emerging market public debt is denominated in foreign currencies. This problem is particularly pronounced in Latin America and the Caribbean and in sub-Saharan Africa, where the ratio of external debt to exports is expected to reach 167 percent and 147 percent, respectively, in 2023.

Creditors can and must play a critical role in providing debt relief for low-income countries. Multilateral development banks typically offer long-term loans at concessional interest rates — a competitive advantage in the current environment, particularly for poorer countries. For low-income countries, the ratio of multilateral debt to total external debt has been about 36.5 percent over the past decade, compared to 8 percent for middle-income countries, which depend heavily on costlier private sector financing.

Before COVID-19, the main body providing debt relief to low and middle-income countries was the Paris Club of sovereign creditors. But, in response to the liquidity crisis caused by the pandemic, the G20 and the Paris Club introduced the Debt Service Suspension Initiative. With support from the World Bank and the International Monetary Fund, this initiative suspended $12.9 billion in payments owed by 48 low-income countries between May 2020 and December 2021. Yet this was only a temporary solution: It did not reduce debt levels and attracted minimal participation by private sector creditors. Since it expired, access to financial markets has tightened and nearly half of the 73 eligible countries are now at risk of debt distress.

Tightening financial conditions have made it much more difficult for developing countries to restructure their existing debts and avoid insolvency

Jose Antonio Ocampo

At the end of 2020, the G20 and the Paris Club endorsed the Common Framework for Debt Treatments, which is meant to coordinate and provide debt relief to countries eligible for the Debt Service Suspension Initiative. But only three nations — Chad, Ethiopia and Zambia — have applied to it so far. Earlier this year, the World Bank and the IMF offered a roadmap for improving the program, featuring four recommendations: A clear timeline, suspension of debt payments during negotiations, establishment of clear processes and rules, and expanded eligibility requirements.

But several countries that require immediate debt relief are not among those eligible for the Debt Service Suspension Initiative. Some middle-income countries, such as Lebanon, Sri Lanka and Suriname, have already defaulted. Others, including Egypt, Ghana, Pakistan and Tunisia, face severe debt distress. And Argentina and Ecuador already restructured their foreign debts in 2020, using traditional mechanisms and with implicit IMF support.

But more ambitious reforms are clearly needed. In October 2020, the IMF emphasized the need to improve its existing debt restructuring mechanism — the so-called contractual approach — which was last redesigned in 2014. At the same time, the IMF highlighted the growing problems associated with nonbond and collateralized debts and noted the lack of transparency in this domain. But these contractual arrangements are also insufficient, because half of the sovereign debts of emerging and developing countries lack enhanced collective action clauses, which allow several debt contracts to be renegotiated simultaneously.

Another possible approach would be to create an independent panel for sovereign debt negotiations that would operate within the UN. The IMF already tried to create a similar body at the beginning of this century, but the idea was rejected. It was proposed again by the UN Conference on Trade and Development during the pandemic.

While such an undertaking is necessary (I have expressed support for it previously), it would take too long to make any difference in addressing the current debt crisis. Nonetheless, any future reform must allow for the greater provision of multilateral financing and create a temporary mechanism to facilitate debt renegotiations.

A large issuance of special drawing rights (the IMF’s reserve asset), like the one undertaken during the pandemic, should be part of the solution. To the extent that the problem of many middle-income economies is more one of access to finance than of insolvency, it should be complemented with abundant low-interest, long-term financing from multilateral lenders.

As for effective debt restructuring models, three historical examples come to mind. During the Latin American crisis of the 1980s, developing countries restructured debts through US-backed “Brady bonds.” In 1996, the IMF and the World Bank launched the Heavily Indebted Poor Countries Initiative, which allowed for the cancellation of debts to multilateral creditors in exchange for economic reforms. The Multilateral Debt Relief Initiative, which was launched in 2006, took this approach a step further and canceled eligible countries’ debts to the IMF, the World Bank and the African Development Fund.

But the best way to ensure that low and middle-income countries get the relief they need would be for the World Bank or regional development banks to create a credit facility that distressed debtors could tap voluntarily. The facility would apply to all bilateral and commercial debts on equal terms and, during debt renegotiations, it would be subject to strict monitoring by the multilateral bank managing the process. Moreover, international financial institutions could facilitate debt restructuring agreements by offering complementary credit to the countries involved.

But given that the level and nature of debt vary greatly from country to country, international institutions must make decisions about relief on a case-by-case basis. This should be complemented by more financing from multilateral development banks, not only to countries requiring debt relief but also to those that do not. And, of course, all developing countries should implement structural and fiscal reforms to ensure long-term debt sustainability.

• Jose Antonio Ocampo is Colombia’s Minister of Finance and Public Credit.

Copyright: Project Syndicate