Nowadays more and more impoverished countries find themselves unable to repay their public debt. Nine low-income economies such as Zambia, Ghana, and Mozambique have already defaulted and there are likely to be more to come. According to a recent IMF report, by the end of 2022, 13% of low-income countries (with GDP per capita below $2700) could not pay back their government debt. Moreover, another 43% of low-income economies had a high risk of debt distress. In contrast, 10 years ago, in 2013, the situation was radically different: no low-income country was in debt distress and just 21% faced a high risk. What led to this change? And how can the global community help poor countries resolve their credit problems?
What caused the debt crisis
Before the COVID-19 pandemic, two primary factors that contributed to the unsustainability of low-income countries’ debt were the falling prices of primary commodities and the increased borrowing at market conditions.
Low-income economies tend to focus their exports on primary commodities instead of manufactured goods. Primary commodities are goods that are sold for production or consumption as found in nature, such as iron ore, coal, and wheat. Meanwhile, poor countries generally import manufactured goods that they cannot produce domestically.
During the 2010s, the prices of primary commodities decreased significantly, with the aggregate index of primary commodity prices dropping by more than 70% between 2011 and 2020. In contrast, prices for manufactured goods increased during this period. As a result, the value of low-income economies’ exports declined while the price of imports grew, leading to a deterioration of countries’ trade balances and a decrease in foreign currency inflows. Since the sovereign debt of low-income countries is typically denominated in foreign currency (most commonly the US dollar), the decline in foreign currency inflows made it harder for these countries’ governments to service their debts, increasing the risk of debt distress.
Another reason for the debt crisis is the increased borrowing in market conditions by low-income countries. In the 2000s, low-income countries received many development loans to help them fund infrastructure projects and social initiatives. These loans were usually provided by the OECD Development Assistance Committee, the IMF, or the World Bank at preferential conditions, including low-interest rates.
However, in the 2010s, development loans became scarcer, forcing low-income countries to rely more on debt markets. By 2016, the proportion of sovereign debt issued in low-income countries at market conditions reached 46%, twice as high as it was in 2007. Market loans typically carry higher interest rates and shorter maturities, making it much harder for low-income economies to service their debts.
During the 2010s, the factors mentioned above caused the debt-to-GDP ratio in low-income countries to increase by an average of 1% per year. The COVID-19 pandemic in 2020 forced governments to increase public spending further increasing their sovereign debt. The economic contraction resulting from lockdowns and supply chain disruptions led to a 13% surge in the debt-to-GDP ratio in poor countries.
The post-pandemic years also have not been favourable for low-income countries. In 2022, most developed countries raised interest rates to combat inflation stemming from excessive public spending during the pandemic and fuel price spikes following the Russian invasion of Ukraine. For instance, the Federal Reserve has increased the Federal Funds Rate from 0.25% to 5% since March 2022.
The increasing returns on practically risk-free government bonds issued by developed countries make investors seek higher interest rates on the riskier government debt of low-income countries. As the debt burden for low-income countries continues to rise, it increases the likelihood of repayment challenges, thereby further heightening the perceived risk of their bonds. Consequently, investors now demand even higher interest rates to offset the mounting risk of default, resulting in elevated borrowing costs for the low-income countries trying to service their debt.
The consequences of the debt crisis
When countries default on their debt, they often cannot receive further loans due to prohibitive borrowing costs. This can force governments to rely on central bank bond purchases to finance fiscal deficits, which can lead to inflation or cuts in government spending, depressing aggregate demand and, consequently, the GDP. Additionally, private companies in these countries also struggle to borrow from debt markets, reducing investment and further dampening aggregate demand.
Research from the World Bank has found that, on average, low-income countries that default on their debt experience an 8% decline in GDP per capita within three years, with long-term declines of up to 17%. The social consequences can also be severe, with poverty levels in defaulted countries typically rising by 30% shortly after default and remaining elevated for up to a decade. Moreover, the World Bank study reveals that 10 years after default, countries can face a 13% increase in infant mortality rates and a 1.5% decline in life expectancy. The defaults experienced by sub-Saharan African nations, such as Kenya, Nigeria, and South Africa, during the late 20th century, serve as a testament to these findings.
Can the global community help?
Essentially, two tools can be used to support a country facing debt distress: debt restructuring and rescue loans. Debt restructuring involves extending loan terms, reducing interest rates, or decreasing the amount owed. Rescue loans are offered to countries in debt distress with favourable terms to help make their current debt sustainable.
Before the 1990s, developing countries mainly borrowed money from a small group of Western governments and banks. This allowed for coordinated debt restructuring by creditors through the Paris Club, an organization of major creditor countries, and the London Club, an unofficial group of bank lending to foreign countries. Together with IMF providing rescue loans, this formed a framework that helped a few developing countries such as Chile and Mexico recover from debt distress.
However, after the 1990s, the situation became more complex as low-income countries increasingly issued bonds to borrow from debt markets. This trend has only intensified in recent times. As a result, the debt of low-income countries is now held by a myriad of private entities that are unable to coordinate debt restructuring. One solution to this challenge is the “collective action clause” which allows the majority of bondholders to make a debt restructuring decision legally binding to all holders, even those who voted against it. Unfortunately, many low-income countries’ bonds still lack this clause.
Another significant change is the emergence of China as the world’s largest creditor to low-income countries. IMF rescue loans typically require a country to reach a debt restructuring agreement with its creditors, which is usually impossible without China’s approval. China’s reluctance to coordinate on debt restructuring has led to low-income countries facing prolonged periods of debt distress, such as Ghana and Zambia, who are still waiting for China’s consent to open the way for a bailout loan from the IMF.
In conclusion, the international community currently lacks effective institutions capable of devising a comprehensive roadmap for low-income countries to achieve sustainable debt. The establishment of such institutions requires considerable international cooperation, a task that proves difficult in the current landscape full of economic and political uncertainties.