The debt question today

The author is Professor of International Economics and Economic Policy at Queen Mary University of London, is the author of Remembering Inflation

Like death and taxes, debt is an unavoidable feature of human life. Unlike those two certainties, however, unbearable debt burdens occasionally are relieved – or even eliminated.

Whether the motive is moral, religious, or simply financial, those campaigning for the cancellation of poor countries’ debts have sometimes succeeded. Recall the Jubilee 2000 movement, which took its name from the biblical precept of offering periodic debt forgiveness.

The “positive-sum” case for wiping the slate clean – namely, that it ultimately benefits creditors and debtors alike – is a throughline from ancient religious traditions to modern-day debt-relief efforts, including those being discussed at the Summit for a New Global Financing Pact in Paris this month.

But the Paris summit’s goals extend well beyond addressing the latest resurgence of debt distress among poor countries. As French President Emmanuel Macron put it when he announced the gathering at the COP27 Climate Change Conference last November, those assembled will consider “all the means and ways of increasing financial solidarity with the South.” Hence, a top priority is to boost the capacity of the World Bank and the other (regional) multilateral development banks.

The summit reflects a sense of moral and political urgency that is about more than just the perennial challenges of fighting poverty and public-health crises in vulnerable developing countries. This is not just another effort to counter complacency and restore momentum to the 2030 Sustainable Development Agenda, because we are now living in an age of climate change and global warming. That harsh new reality will fall hardest on poor and vulnerable countries that contributed the least to the problem.

Yet advancing the international community’s increasingly climate-focused agenda requires that we first tackle the mushrooming debt problems of developing countries. Failing to confront that challenge would be like falling at the first fence in a horse race. That is why the first of the summit’s four goals is to “restore fiscal space to countries facing short-term difficulties.”

Unlike boosting “green” infrastructure investment and other relatively novel objectives, resolving debt problems is an old challenge that has not changed much in living memory. The current debt crisis closely resembles the archetypal wave of developing-country sovereign defaults that began in Mexico in 1982, when, like today, abundant, cheap debt financing came to a sudden stop, and sharp hikes in global interest rates caused the cost of servicing accumulated debt stocks to spike.

The International Monetary Fund currently classifies 39 low-income countries – all but four in Africa – as being in actual or potential “debt distress.” And this tally does not even include some of the most dramatic cases, such as Sri Lanka and Pakistan, whose per capita incomes rank them just above the poorest category.

As in the past, the question today is how to deal with debt that cannot be serviced and repaid according to the original contracts. How does one strike a proper balance between rescheduling payments and writing off some debts altogether, and are debt-relief agreements even possible among so many different types of mutually suspicious creditors?

With the Paris summit fast approaching, it is worth exploring some of the most promising up-to-date answers to these old questions. Not surprisingly, the most compelling contributions come from economists and (former) policymakers who have long studied and managed debt difficulties.

For a scene-setting analysis, a good place to start is “The Resistible Rise of External Debt,” by the French economists Brendan Harnoys-Vannier of the Finance for Development Lab (FDL) and Daniel Cohen, president of the Paris School of Economics. Part of the working-paper series published by FDL, a leading think tank in the field, Harnoys-Vannier and Cohen’s overview offers clearer perspectives and interpretations than one will find by perusing World Bank data or piecemeal journalistic coverage.

Harnoys-Vannier and Cohen identify two new features of this otherwise unchanging landscape. The first concerns the scale and growth rate of sovereign debt. Excluding China, low- to upper-middle-income countries’ external obligations increased by 65 per cent – reaching a combined $6.4 trillion – in the ten-year period ending in 2021.

Second, the composition of the creditor base has shifted. At the turn of the century, most lenders to developing countries were international financial institutions (IFIs) such as the IMF and World Bank, rich-country governments (the “Paris Club”), and commercial banks (the “London Club”). Now, nearly half of all developing-country debt is held in roughly equal portions by private bondholders and China, which together have accounted for 58 per cent of all new lending.

The rise of these new creditors has further complicated the task of striking debt-relief deals that distribute the burden fairly among creditors. It might actually be easier to herd cats than to coordinate the thousands of private investors who bought successive issuances of Zambian Eurobonds during the 2010s “hunt for yield” triggered by central banks’ quantitative easing programs, which drove interest rates down toward (or even below) zero. Private bondholders then refused to participate in the G20’s pandemic-era Debt Service Suspension Initiative – a decision that drew sharp criticism from then-World Bank President David Malpass and many others.

Since then, legislation has been proposed in the State of New York and the United Kingdom (the two main host jurisdictions for foreign-law sovereign bonds) to force private investors to match taxpayer-funded debt-relief commitments. But such initiatives are largely redundant. The vast bulk of sovereign Eurobonds already include so-called collective-action clauses that prevent “vulture” minority holders who oppose widely supported restructuring programs from suing for full repayment.1

In fact, there already is no structural barrier to bondholder participation in debt rescheduling and write-downs (“haircuts”). The difficulty lies in devising terms that will be acceptable to such a diverse cohort of creditor interests. The biggest obstacle is China, which objects to the idea that it should soften its claims while IFIs are allowed to maintain their own “super-senior” creditor status. Though China has recently shown some willingness to play ball, the G20’s Common Framework for Debt Treatments has yet to restructure any debts owed by sovereign borrowers that have defaulted.

Moreover, these creditor-coordination difficulties pale in comparison to a more fundamental problem: the prospect of private lending to vulnerable countries drying up altogether. In principle, the inclusion of Eurobond claims in orderly debt-restructuring schemes should restore borrowing countries’ “market access.” But that does not mean it will happen in practice.

Even poor countries that have not (yet) defaulted may struggle to access international capital markets now that interest-rate hikes have made refinancing their previous borrowing unaffordable. The median developing country’s debt-servicing burden is expected to reach 10% of GDP in 2026, after nearly doubling since 2015. And the situation is considerably worse for developing countries in the third quartile, with debt service projected to amount to 18 per cent of GDP by 2025, up from 10 per cent in 2015. This is equivalent to the typical developing country’s combined health-care and education budgets.

This is one of several striking findings of “The Coming Debt Crisis,” an FDL working paper published last year. Charles Albinet and Martin Kessler looked at 113 low- and middle-income countries and concluded that their total financing gap could grow to a total of $2.5 trillion between 2022 and 2026. Without reliable access to international capital markets, how will they meet their financing needs? @Project Syndicate 2023