A developing-country debt crisis is looming, but it can be headed off

Developing economies are coming under increasing pressure and an estimated dozen are at risk of defaulting on their debts in the next 12 months
As global financial conditions tighten, advanced economies can lend a hand using policy tools that are already available

Hippolyte Fofack

Published: 1:32pm, 27 Jul, 2022

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Since the Latin American debt crisis of the 1980s, sovereign debt crises have become a regular occurrence for emerging and developing economies. Today, Sri Lanka needs a bailout from the International Monetary Fund after defaulting on its foreign debt in May, and a growing number of low-income countries face similar challenges.

The World Bank estimates that around 60 per cent of all emerging and developing economies have become high-risk debtors. As many as a dozen might default in the next 12 months.

Unlike advanced economies, where sharp increases in government debt following the emergence of Covid-19 encouraged a speedy return to growth, developing economies have been constrained by a lack of vaccines and a lack of monetary and fiscal space. Unable to deficit-finance their way out of the global downturn, these countries now must contend with the economic fallout from the Ukraine crisis, which all but eliminates a near-term return to pre-pandemic growth rates.

With a few exceptions, most developing economies are not heavily indebted. The flow of funds that developing economies receive from global bond markets and banks has remained dismally low, though. According to recent estimates from the Institute of International Finance, their combined sovereign liabilities represent less than 30 per cent of global public debt.

Worse, following post-pandemic credit downgrades, many low-income countries cannot access international capital markets and face acute liquidity constraints that could morph into solvency crises. Because their sub-investment-grade credit ratings have raised their borrowing costs, their governments’ reduced ability to roll over their liabilities as they come due has raised the prospect of a developing-country debt crisis.

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For example, Ghana planned to issue a bond to refinance its foreign currency-denominated debt earlier this year. But with a wave of ratings downgrades driving up international bond yields, it has effectively been shut out of international financial markets, and its 10-year sovereign bond yield has risen above 22 per cent. After resorting to painful internal adjustments during the pandemic, Ghana faces soaring food prices and its government is seeking IMF assistance.

Two other factors are combining to increase the risk of a liquidity crisis in developing markets: the currency of lending and the shift towards variable interest rates in a context of increasingly complex lending structures, and the growing reliance on international capital markets.

Between 2000 and 2020, the number of low-income countries with variable-rate external debt rose sharply from 13 to 31. Now that systemically important central banks are normalising monetary policy to fight inflation, these countries will incur significantly higher costs when servicing their external debts.

While reliance on foreign currency-denominated debt can reduce the risk of runaway inflation, it can also increase the risk of sovereign default, especially when a sharp exchange rate depreciation raises the costs of servicing external debts. This is especially the case during heightened global volatility and tightening financing conditions, which are often associated with large-scale capital outflows from emerging and developing economies.

Historically, sovereign defaults have been driven by markets’ unwillingness to roll over existing debt or only doing so at prohibitively high interest rates. Overinflated risk premiums driven by distorted perceptions have amplified the fiscal impact of sovereign debt and been a major driver of liquidity crises and default risk.

Advanced economies with the privilege to issue reserve currencies usually do not face such risks. Because their currencies are regarded as safe havens, they can sustainably attract foreign investment in government treasuries and bonds, continuously roll over their debts at low costs and run deficits.

But systemically important central banks should be no less concerned about the disproportionately large spreads between advanced and developing economies. The tightening of financing conditions by the US Federal Reserve and other major central banks has exacerbated developing economies’ macroeconomic management challenges by heightening exchange rate volatility, increasing liquidity risks and widening spreads.

In the past, systemically important central banks have successfully extended some of the benefits conferred by their privilege to other countries. At the height of the pandemic downturn, for example, the Fed reinforced its currency swap arrangements and broadened the geographical coverage of its support to include a few emerging economies.

The US Federal Reserve building in Washington. The Fed’s decision during the height of the Covid-19 pandemic to extend its currency swap arrangements with other central banks helped emerging economies stem capital outflows and roll over their debts. Photo: Reuters

That led to currency appreciation, improved credit default swap spreads and lower long-term interest rates in beneficiary countries. Beyond alleviating liquidity risks, the extension of US dollar-denominated swap lines reassured investors, stemming capital outflows and enhancing those countries’ ability to roll over their debts.

Even though low-income countries do not pose a systemic risk to the international financial system, a concerted effort to mitigate liquidity risks should be a high global priority, not least because debt restructuring has huge costs. According to the World Bank, it leads to lower output growth in the short term.

For countries that lack the protection of systemically important central banks, default-driven borrowing rates undermine macroeconomic stability and reduce the supply of patient capital in the medium and long term. Without these, developing economies cannot undergo the transformation needed to break the negative correlation between growth and commodity-price cycles.

In the long term, the most sustainable solution to recurrent liquidity crises is to develop deep, efficient, well-regulated domestic capital markets in emerging and developing economies. Highly integrated markets will help build proper yield curves to improve investment decisions.

The world already has effective, well-tested tools to prevent recurring liquidity crises, which is a prerequisite for building these integrated markets. Democratising the global financial system to maximise its positive impact on development is perhaps the most important challenge on the road to international debt sustainability.

Hippolyte Fofack is chief economist and director of research at the African Export-Import Bank (Afreximbank). Copyright: Project Syndicate