Ishac Diwan is Research Director at the Finance for Development Lab
Low-income countries are in the throes of a liquidity crunch that is not only undermining their economic development but also deepening the global climate crisis. In 2020 and 2021, net financial transfers to Africa were close to zero – their lowest level in a decade – despite record transfers from multilateral development banks (MDBs). That drop-off was due to a reduction in loans from the private sector and China, and now the situation has deteriorated further, with all low- and lower-middle-income countries (LMICs) having lost access to the bond market. Meanwhile, higher food and fuel bills, and falling export receipts, have made matters even worse.
To be sure, only a handful of LMICs have defaulted on their external debts, and many others still hope to weather the storm and re-enter the market when it reopens. But with their debt-service obligations having grown vastly larger than the official support they can secure, their fiscal space is being squeezed, leading to a silent development crisis.
At the same time, global development and climate financing needs are estimated to have risen to $1 trillion per year. The gap between the international community’s aspirations for poorer economies and the sad reality of their finances has never been so large, nor so corrosive to the legitimacy of the global financial system.
A series of international gatherings – culminating with the recent G20 declaration – has sought to reform the global financial and development architecture, placing special emphasis on scaling up MDB support. But if MDB funding rises before the current debt crisis is resolved, much of that additional money will go not toward investments in LMICs but to other creditors, as is currently the case.
During the pandemic, many observers foresaw that massive insolvencies loomed on the horizon. While promising proposals were made for wholesale debt relief, world leaders failed to agree on ambitious solutions. Since then, the grinding difficulties of reaching debt deals selectively have demoralised the international community.
Much of the opposition to debt relief came from China, the largest bilateral donor. It argues that LMICs’ external debts remain relatively low, averaging only 40 per cent of GDP, compared to 100 per cent just before the Highly Indebted Poor Countries (HIPC) Initiative was launched in 1996. China therefore has pushed for debt rescheduling, as happened earlier this year with the long-awaited Zambia deal.
Private lenders have also resisted deep debt relief, even as they remain unwilling to provide liquidity. During the Latin American debt crisis of the 1980s, when liquidity rather than insolvency was seen as the problem, the few banks involved at least could agree on coordinated rescheduling. But now, the wholesale closure of the bond market reflects a collective-action problem that is all too characteristic of fragmented bondholding.
While debt reduction is, understandably, a harrowing process, it should be much easier for countries that are only illiquid to build a bridge to a more financially sustainable future. The good news, here, is that just a handful of countries are currently insolvent. Recent estimates show that 25 LMICs, of which 17 are in Africa, remain below the International Monetary Fund’s insolvency threshold, but exceed its liquidity threshold (with debt-servicing costs in the range of 12-15 per cent of revenues).
But the situation will worsen if these countries cannot refinance the principal on their outstanding debt when it reaches maturity. Consider Kenya. It has embarked on an ambitious program of stabilization and reforms, backed by a large fiscal stabilisation effort equal to 4 per cent of GDP, and generously supported by the IMF and MDBs. But it has $2 billion in bonds maturing in 2024. If global capital markets do not allow for refinancing by then, repayment will require an additional fiscal outlay equal to 1.8 per cent of GDP, and that will increase the risk of popular unrest, as happened recently in response to tax hikes and higher costs of living.
The alternative – defaulting – is equally unattractive, considering that Kenya’s external debt stands at only 38 per cent of gross national income. To overcome this dilemma, the African Union’s Nairobi Declaration on Climate Change proposes that countries be allowed to reschedule debts coming due to create fiscal space for new “green growth” policies and reforms, financed by MDBs.
Our own proposal for a “bridging compact” operationalises this idea. Led jointly by the United Nations, the World Bank, and the IMF, it would support not just insolvent countries in need of debt haircuts, but also illiquid countries in need of rescheduling. Countries that have experienced negative net transfers with important creditors could choose to enter an adjustment programme that postpones their debt obligations in exchange for a commitment to reforms. The goal is to create value through coordination, with the presumption that a country can grow out of debt if it is provided with liquidity, and if it pursues policies to achieve sustainable growth.
To be effective, this bridging compact must be anchored in a national renewal program that includes measures to constrain budgets and reforms to move onto a new growth path. That will require more funding from both the IMF and the World Bank, with conditionalities extending beyond the typical three-year IMF programme. Countries that avail themselves of this option should be the first to benefit from a scaling-up of IMF and MDB funding, which in turn would help to prevent a systemic debt crisis that would hurt everyone.
To avoid leakages to other creditors, some debts would have to be rescheduled during the programme period. The interest rate used should be no higher than the growth rate envisioned under the renewal program, so as not to exacerbate the debt situation. The approach should be accepted ex-ante by all creditor groups, but the obligation to reschedule loans that can’t be refinanced would have to be enforced by an IMF threat to lend into arrears.
Finally, at the end of the program, if external debt appears unsustainable, a debt reduction program would need to be devised – as under the HIPC Initiative. This possibility reduces the need to provide debt reduction to marginally insolvent countries up front, and at a time of high global economic uncertainty.
The world desperately needs to make progress toward a more sustainable future. Our proposed approach would help bridge the great divide between our aspirations and our realities, by allowing the world’s many illiquid countries to get in shape for the challenges that lie ahead. In the absence of such an initiative, the goal of mobilising trillions of dollars for climate-friendly development will remain a pipe dream. @Project Syndicate, 2023
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