The pandemic has plunged developing countries deeper into debt. Is there a way out?
The COVID-19 pandemic has forced every government in the world to face the public health emergency and the corresponding collapse in livelihoods. Governments are thus spending a great deal more while taking in far less in tax revenues, which means they are borrowing heavily to cover substantial deficits. For many developing countries, this is inexorably pointing to future government insolvency. These governments will need a significant reduction in what they must pay their creditors, in fact more than they usually can arrange through what serves as sovereign bankruptcy proceedings, which squeezes social spending in a generalized context of fiscal austerity. While the problem is increasingly being recognized, there is not yet an agreed way to deal with it.
Why developing countries are heavily borrowing abroad
Unlike in developed economies that can cover their fiscal deficits by borrowing from domestic financial markets or (indirectly) from their central banks, most developing countries have needed to borrow heavily abroad, and in foreign currency. These economies have small domestic financial sectors and limited opportunities for non-inflationary central bank financing. Only a few countries could draw on fiscal “rainy day” or prudential funds (e.g., Chile, Colombia) and pay for essential imports with ample foreign exchange reserves (e.g., China, Saudi Arabia).
Before the pandemic began, the International Monetary Fund (IMF) classified over half of 69 “lower-income” economies as either at high risk or actively in debt distress. Several higher income developing countries were also in parlous debt situations as 2020 began, including Argentina, Ecuador, Lebanon and Venezuela. Putting aside individual country specifics, there is a systemic problem today in developing country finance and the world is not prepared for it.
“What is most noteworthy in 2020 is that the donor governments have reduced their bilateral ODA commitments by almost 30% in the first five months of 2020 from the same period of 2019 (falling from $23.9 billion to $16.9 billion)”
Why was there no other option?
Developing countries would be borrowing less if sources of international grant financing were growing. While there are increasing grants from international philanthropy and “South-South” cooperation, the primary source of grants has been foreign aid from developed economies, usually denoted “official development assistance” (ODA). The governments of the donor countries provide more than 80% of their ODA as grants of money, goods and technical assistance. The remainder of their country-to-country (“bilateral”) assistance is provided as loans on highly concessional terms. While those loans can be very useful to the recipients, they do add to the receiving governments’ foreign debt.
What is most noteworthy in 2020 is that the donor governments have reduced their bilateral ODA commitments by almost 30% in the first five months of 2020 from the same period of 2019 (falling from $23.9 billion to $16.9 billion). This is not to say that aid targeted to fighting the pandemic per se has been short-changed, only that the overall supply of the overwhelmingly grant-based bilateral ODA has declined, when it would have been very helpful had it increased.
A potential source of additional non-debt-creating official international finance is a unique asset called the “special drawing right” (SDR), which the IMF may create from time to time. While most official funds can be traced back to tax revenues, SDRs work in the same way that national monetary authorities create purchasing power by issuing money. IMF rules, however, limit member country use of SDRs to payments to other member country central banks, IMF itself, and a list of 16 “prescribed holders,” which include the World Bank and the main regional development banks. In short, SDRs are a limited but useful form of international money.
Since the extent of the pandemic began to be recognized in March, many governments, academics and civil society organizations have called for a new SDR allocation. It has not happened only because the United States is blocking it. In the words of US Treasury Secretary Steven Mnuchin, “In our view, an SDR allocation is not an effective tool to respond to urgent needs. Almost 70 percent of an allocation would be provided to [the member countries of the Group of 20], most of which do not need, and would not use additional SDRs to respond to the crisis…” In fact, there seem to be other reasons for the US opposition. According to Representative French Hill (R-Arkansas), an SDR allocation would send funds to China, Iran, Russia, Syria and Venezuela. Yes, if every IMF member gets SDRs, those countries will too. It seems a rather narrow perspective to take on a systemic problem.
While the new SDR allocation has thus been stymied, this author and others have argued that the advanced economy countries could transfer some of their idle SDRs to the IMF for its use and to the development finance institutions that are prescribed SDR holders. As of December 2019, those countries held $177 billion in idle SDRs, some of which could be transferred to the IMF to expand two special funds for low-income countries, the Poverty Reduction and Growth Trust (PRGT) and the Catastrophe Containment and Relief Trust (CCRT). The former extends interest-free loans to the poorest countries and the latter pays the interest and principal falling due on low-income country obligations to IMF. Comparable facilities could be established in the development banks and more countries could be deemed eligible to access them. Although not yet enacted, this option is still on the table, at least at the IMF itself. Meanwhile, countries mainly must borrow to cover their deficits.
The surge in foreign borrowing
When the extent of the pandemic became apparent, financial investors panicked and pulled $83 billion out of the major developing countries in a few weeks. However, the panic ended in April and was succeeded by net inflows of $69 billion from April to July, of which $55.3 billion was debt related. While not a measure of sovereign borrowing per se, this was an indication of renewed government access to foreign sources of credit.
For the short run and most likely for the medium run, countries with access to such funds will draw on them. International bond issues and bank loans are relatively straightforward to arrange and do not entail the policy quid pro quos and negotiating time that accompany most multilateral loans and bilateral credits. On the other hand, international financial investors are subject to sudden losses of confidence and will run from countries for sound and unsound reasons. One can be sure that countries with market access will constantly worry about retaining that access.
Developing countries are also borrowing heavily from the main international official lenders, some of which have made special emergency loans available to their members in good standing. The IMF has led this effort, answering requests for quick-disbursing loans from 102 countries as of June 29. It also created a short-term liquidity line of credit that countries that are deemed to have “very strong policies and fundamentals” can tap if needed. In addition, as of May 19, the World Bank had arranged loans for 100 developing countries “tailored to the health, economic and social shocks” that they have been facing, drawn from the $160 billion in counter-crisis loans that the Bank promised to make available over 15 months, of which $50 billion is highly concessional and some of which will be grants (it is not clear how much of the loans are additional to what was planned pre-crisis). Other international official lenders are also expanding their lending to crisis-affected countries.
Each of the funding sources mentioned thus far entails an increase in the government’s foreign currency debt. In June, the IMF estimated that the gross public debt (foreign and domestic) of the emerging economies will rise in 2020 by almost seven percentage points of gross domestic product (GDP) compared to its January estimate for 2020 (ending at 63% of GDP), and that the comparable figure for the low-income developing countries will be a rise of over four percentage points of GDP (ending at 48% of GDP). The Jubilee Debt Campaign estimates that the average external debt servicing of the developing countries will reach 14.3% of fiscal revenue in 2020. As this is an average, it means that many countries will be paying foreign creditors even higher shares of their diminished revenue. Creditors are presumably paying attention to these data.
“Absent agreed policy initiatives to provide more non-debt creating assistance or a magical economic recovery, many developing countries will need a significant reduction in their external debt at some point in this continuing global crisis.”
Little debt relief offered thus far
As noted above, the IMF uniquely offers to cancel the debt servicing payments due from the poorest and most seriously affected countries through its CCRT. Although the eligible countries have small economies with modest debts compared to the global scheme of things, it frees governments to repurpose budgeted financial resources without further financial obligation. IMF recently extended the period of relief for 28 eligible countries from October to April 2021 and it is seeking funds from richer countries to extend the relief to April 2022.
The only other current debt relief initiative accords temporary relief from obligations to a limited set of creditors. That is, the Group of 20 (G20), the informal committee of the world’s major economies, offered to postpone the interest and principal payments that low-income countries were due to make to them between May and December 2020 (in the end, with limited participation of China). The payments would not be forgiven, but would be repaid over four years, including a year of grace in 2021. Interest will be charged on the delayed payments, making the offer essentially a refinancing loan with no element of a grant. On October 14, the G20 extended its relief offer for six months and extended the repayment period to six years including a first year of grace.
The response of the target countries was unexpected. The G20 finance ministers reported that as of July 18, only 42 countries requested an estimated $5.3 billion in relief, which is far less than the approximately $12 billion that it had expected in April would be requested by 73 eligible countries. One reason for the relatively low take up of the G20 offer, besides it not being very generous, is the fear that eligible debtor countries might lose whatever access they enjoyed to private sources of funds. After all, creditors might reasonably assume that if their borrower was seeking relief from servicing other credits, perhaps their financial situation was less robust than it seemed.
Managers of investor portfolios of sovereign bonds are not generally asked by their clients to show any form of global social responsibility, but to choose bonds that make as much money as possible for their investors while accepting some stipulated level of risk of loss. It is thus hardly surprising that when the G20 requested in April that bondholders voluntarily offer the same debt-servicing moratorium as the governments offered to low-income countries, it fell on deaf ears. The default view of the private creditor is something else: if the debtor can pay, it should pay; if the debtor cannot pay, then delaying repayment (with interest) for a few years is not going to make an insolvent country solvent.
In fact, one of the big three financial rating agencies, Fitch Ratings, downgraded the credit ratings of 33 countries in the first half of 2020 and placed another 40 countries on “negative” outlook, each of which was unprecedented. Not all were developing countries and not all were only the consequence of the pandemic. Nevertheless, this is striking, and the concern was also echoed by the other major agencies. Legitimate criticisms have been raised about whether the rating agencies arrived at proper assessments during a pandemic, but that hardly matters. The rating declines signal that the international financial markets are nervous, even if they are apparently also keen to earn more by lending to developing countries (e.g., Ethiopia would have to pay an annual interest rate in the range of 9-12% had it issued a new bond in April or May, compared to 5-6% in January-February, based on the market yield of its existing Eurobond).
The coming debt renegotiations
Absent agreed policy initiatives to provide more non-debt creating assistance or a magical economic recovery, many developing countries will need a significant reduction in their external debt at some point in this continuing global crisis. They will then begin the standard process to “restructure” their sovereign obligations to their multiple creditors.
Each creditor enters a sovereign restructuring negotiation seeking to protect as much of the value of what it is owed as possible, shifting as much of the cost of paying to the debtor government or the losses to the other creditors. The debtor government seeks as much relief as possible, usually from a relatively weak bargaining position. The IMF informally guides the process by estimating how an overall restructuring of given size would improve the country’s fiscal situation, leaving the actual negotiations to the parties directly involved. That is how the game is played. It usually begins when the debtor fails to honor one or more of its contracted payment obligations. In other words, bankruptcy.
While there is much to criticize in how sovereign debts are renegotiated, the political and legal complexity has precluded reforming the negotiation process except at the margins, where the efforts have focused on processes by which separate bond, bank and bilateral creditor groups could come to agreement on a timely basis. Indeed, the IMF has recently proposed a further set of limited improvements in how debts owed to private creditors should be handled.
There is no guarantee that the actual outcomes cohere into an adequate reduction of repayment obligations and governments often struggle under austerity budgets while they make their remaining debt payments. While such outcomes generally lead countries back to financial market access after losing it, this is not the same as debt sustainability. Further negotiated restructurings often follow. As some of us have been arguing for years, deeper reform requires the world’s governments to negotiate a comprehensive process to emulate some of the features of a national bankruptcy regime for corporations (e.g., chapter 11 of the US bankruptcy code) and sub-national governmental units (chapter 9). Unfortunately, that is not likely in the current era of circumscribed multilateralism.
IMF regularly emphasizes “crisis prevention” when engaging with its members by encouraging prudent fiscal policies so as to reduce the need for “crisis resolution.” However, the IMF has overemphasized achieving fiscal balance by reducing essential government expenditures rather than curtailing inappropriate expenditures and corruption and adopting effective and progressive increases in tax revenues. The push back from international social and human rights organizations, academia and civil society, however, has promoted a rethinking of macroeconomic adjustment strategies at the IMF, including adoption of a new institutional view on the priority of adequate, efficient and sustainable social spending.
Indeed, senior IMF management has recently reflected the new thinking, not to mention the horrendous human impact of the current crisis, by warning against “earlier-than-warranted fiscal retrenchment” and calling on countries to adopt a “credible medium-term fiscal plan that relies on improving revenue mobilization—including through minimizing tax avoidance, greater tax progressivity in some cases, carbon pricing and higher efficiency in spending (for example, eliminating fossil fuel subsidies).” If this indeed is the new policy, then when debt renegotiation becomes unavoidable, creditors will have to take greater “haircuts.”
Civil society watchdogs are skeptical and expect the IMF to demand austerity again once the fear of the pandemic subsides. More than 500 organizations and academics thus called on IMF to instead “advance gender justice, reduce inequality, and decisively put people and planet first.” The problem is that austerity is inescapable when tax revenues are low, creditors are not willing to lend more, and governments find they cannot escape making contracted interest and principal payments.
This bears watching.
(This article draws heavily on a paper posted to Research Gate {DOI: 10.13140/RG.2.2.17803.31526}. It benefited from valuable discussions with Jomo Kwame Sundaram and Anis Chowdhury and the welcomed editorial eye of Sakiko Fukuda-Parr, but they are all innocent of any of the errors contained within it.)
Barry Herman (hermanb@newschool.edu) is a Visiting Scholar at The New School, and formerly a Senior Advisor in the Financing for Development Office of the UN Department of Economic and Social Affairs. He was part of the UN Secretariat team that prepared the Monterrey Summit on Financing for Development in 2002.