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Gloomy, though better than it seems: A new sovereign debt crisis of the poor?

Afrikanische Hände zählen nigerianische Naira und US-Dollar

For many developing countries, the clouds in the debt sky seem to be darkening. But so far, the global community has reacted pragmatically. Debt relief has prevented an escalation spiral.

In the late 1980s and early 1990s, numerous low-income countries (LICs) slid into a severe debt crisis. Weakening economic performance, fragile institutions and an increasingly crushing debt burden undermined the confidence of the capital markets. The international financial institutions (IFIs) in namely the World Bank and the International Monetary Fund (IMF) responded to the precarious situation in 1996 by creating the Heavily Indebted Poor Countries (HIPC) initiative. A lifeline designed to alleviate the over-indebtedness of the world’s poorest countries in the 1990s.

Anyone looking at the debt landscape in LICs today might remember this troubling time in the 1990s. The COVID-19 pandemic, the freezing of global supply chains and a downturn in commodity markets, costly measures to alleviate the worst social dislocations of lockdowns and school closures tore at the budgets of the poorest countries. Russia’s war in Ukraine sent them into further shock as the cost of imported fuel and gas, fertilizer and food prices skyrocketed. This forced governments to hand out even more aid to cushion these shocks. Governments around the world were forced to introduce restrictive monetary policies – in other words, to raise interest rates. This dried up the global financial markets and made it more difficult – or almost impossible – for governments in LICs to raise new money. Are we facing a repeat of the sovereign debt crisis of the 1990s?

How worrying are the figures?

In 1994, the average ratio of debt to gross national income (GNI) – i.e. all income earned by a country’s citizens at home and abroad – was 112 percent in the LICs. However, there were high variations between the countries. Thanks to the HIPC debt relief initiative, this ratio was quickly reduced to around 30 percent. Now, in a gloomy environment of high interest rates, the debt level is beginning to rise rapidly again. Although there are still no escalating exponential compound interest effects to be seen, as in the 1990s. On average, the LICs are currently scratching the 45 percent threshold.

The statistics probably do not reflect all the important factors on the ground. On the eve of the HIPC initiative, the ratio of foreign debt to export earnings was 318 percent – according to the IMF, today it is just 137 percent. By the end of 1994, more than half of the 69 LICs had exceeded the 150 percent threshold of foreign debt to export earnings – by the end of 2021, this only applied to a third. Debt sustainability can therefore be classified more much more stable today than it was 25 years ago.

External debt levels as a percentage of gross national product for least developed countries, low-income countries, low- and middle-income countries, lower middle-income countries and sub-Saharan Africa. High increase in debt burden until 1995, followed by a continuous and steep decline. A spike upwards again from 2022.

External debt levels as a percentage of gross national product

Liquidity risks measured in terms of external debt service ratios have also improved remarkably. LICs currently spend a median of around eight percent of their export revenues on servicing their external debt – a considerable decline compared to ten percent in 1994. Nevertheless, the risks remain high and defaults by individual countries could lead to contagion effects for entire groups of countries if confidence in them disappears out of a sudden. Risk premiums could rise and pull even previously solid countries into an escalating debt spiral.

Not unfounded: Currently, 60 percent of LICs are classified as being in debt distress or at least at high risk of it. Most of these are concentrated in sub-Saharan Africa. They are also facing the steepest rise in interest rates for decades, further increasing the risk of an escalating debt spiral. Given current trends, vulnerability could therefore soon reach a dangerous level again, as we know it from the 1990s.

Drivers of debt accumulation: history does not always repeat itself

However, the drivers of debt have also changed over the decades. Exchange rate devaluations and primary deficits, i.e. government budget deficits that do not include interest payments, remain important factors in government debt. Conversely, factors that lead to debt reduction have shifted: Growth and debt cuts now play a decisive role in curbing the debt ratio. In contrast, inflation and income from privatisations reduced the debt levels from 1987 to 1996. Overall, the debt side predominated. This is different today; the debt reduction factors are much more pronounced.

In addition, the share of domestic debt in LICs has increased from around 19 percent in the mid-1990s to 35 percent by the end of 2021. This reduces the debt distress of the respective governments, although the risk of a possible default has now shifted to their own citizens. However, they are likely to act less speculatively and therefore more sustainably in the long term. The IMF interprets this as a sign that the debt situation is less serious today than it was 30 years ago and that there is less likelihood of a widespread default. Nevertheless, this could ultimately massively undermine citizens’ confidence in their own state and its institutions – as in Russia in 1996. On the contrary, we are even seeing economic growth where we would least expect it, such as in the notorious Sahel region of West Africa. Even though the constant succession of crises has hit the LICs particularly hard, they have learned from their past and are more resilient than before.

Financing requirements increase

Nevertheless, the financing requirements of these low-income countries are increasing significantly due to the high costs of food, fertilizer and energy due to war in Europe. After all, Russia and Ukraine are the largest exporters of wheat, fertilizer and fossil fuels – LICs own refinery capacities are generally not sufficient. This leads to extremely high import prices for basic goods. Many people have already used up their savings during the COVID-19 pandemic. In 2019, LICs typically needed 5.5% of their GDP to refinance their debt; by the end of 2022, this had jumped to 9.3%, and in some countries even to 15%. This in turn unsettles lenders and investors, who demand higher risk premiums for government bonds.

Interest payments on external debt as a share of gross national income. for least developed countries, low-income countries, low- and middle-income countries, lower middle-income countries and Sub-Saharan Africa. High increase in debt burden until 1995, followed by a continuous and steep decline. A spike upwards again from 2022.

Interest payments on external debt as a share of gross national income

The repayment periods for traditional loans and government bonds have also shortened. This is exerting more pressure, as refinancing on the capital markets and therefore new debt must take place earlier. Many LICs are facing large repayment rounds in 2024, especially to private creditors: over eight billion US dollars in 2024, compared to less than four billion in 2023 and two billion in 2022. To make matters worse, LICs have recently resorted to riskier financial and debt instruments. These include Eurobonds and credits from private banks and investors, guaranteed public-private partnerships (PPPs) linked to securitized and collateralized contracts, state-owned enterprises and pension and social security funds. During the relatively loose international financing conditions after the 2008 global financial crisis, these were very popular, although they are riskier and also much more complex to restructure. But now these debts are maturing and need to be refinanced under much more restrictive interest rate conditions.

The new diversity of creditors is challenging

The composition of creditors has also become more diverse. This poses new challenges for the coordination of debt relief and debt haircuts. In the pre-HIPC era, it was mainly multilateral institutions and the Paris Club, an association of rich industrialized nations for the purpose of sustainable lending to LICs. Today, their composition has changed significantly in the direction of bilateral agreements with non-Paris Club countries, private bondholders such as commercial banks and funds to form a heterogeneous group. This complicates debt restructuring immensely.

Shift in the creditor structure of low-income countries from 1996 to 2021.

Shift in the creditor structure of low-income countries from 1996 to 2021.

Nevertheless, the concentration of the largest creditors has increased further and now accounts for 75% of the total loan amount to LICs. Four multilateral institutions lead the way: the African & Asian development banks, the IMF and the World Bank. In addition, there are numerous other, less well-known financiers: New Common Framework Countries, Inter-American Development Bank, International Bank for Reconstruction and a few more. This shift is also due to donor fatigue on the part of the governments of the HIPC Initiative countries and a shift in aid towards Ukraine. Some countries, especially African countries, owe these multilateral institutions 50 to 90 percent of their outstanding debt, according to a report by the NGO Debt Relief for a Green & Inclusive Recovery from September 2023.

This changes the dynamic, because all of these multilateral lenders have different agendas and mandates to promote and achieve economic development and poverty reduction goals. In addition, the goal of debt relief for the poorest is now also competing with other goals, such as climate financing. This fragmentation is also accompanied by a multitude of different interests of development bank stakeholders – many influential countries project their influence through development aid.

Much more important, the large number of stakeholders in debt relief negotiations is causing many individual players to worry about free riders. Many fear that other creditors will not contribute their fair share to the debt cut. Zambia, for example, experienced this when it was the first sovereign country to have to file for default during the pandemic. As part of the Debt Service Suspension Initiative (DSSI) of the G20 group of countries, the South African country applied for debt relief of 8.4 billion US dollars between 2022 and 2025. Asset manager BlackRock, which holds the majority of Zambia’s government bonds with 215 million dollars, categorically rejected debt relief on the grounds of possible losses for its clients. Others estimated that the Group could even make a 110 percent profit if it were able to pass on the debt service to others. 100 economists and development experts urged BlackRock to agree to the write-off of the assets, as continued payment by Zambia would be “economically inefficient and also morally” wrong. Particularly in view of the fact that private investors demanded a high risk premium from African countries for the default risk anyway.

China, the largest creditor, enters the scene

Conversely, when it comes to bilateral loans between two countries, attention immediately turns to China (and increasingly also India). Beijing now accounts for around 10 percent of the 1 trillion foreign debt of LICs. This has raised fears that China is luring these countries into the debt trap and could use payment defaults to push through its own political interests. In Sri Lanka, for example, ports and airports were taken over without further ado in return for debt restructuring. Accusations that Beijing regularly rejects: “No one was ever pressured into accepting debt and no political conditions were ever attached to loan agreements.”

Protests against the government break out in July 2022 due to the ongoing economic crisis triggered by the state bankruptcy. Here in Colombo, Sri Lanka in front of the presidential palace (Source: Ruwan Walpola/Shutterstock, 2022)

Protests against the government break out in July 2022 due to the ongoing economic crisis triggered by the state bankruptcy. Here in Colombo, Sri Lanka in front of the presidential palace (Source: Ruwan Walpola/Shutterstock, 2022)

China also participated in the G20’s DSSI debt relief initiative in the aftermath of the COVID-19 pandemic. Given China’s emergence as a major creditor, its commitment to the initiative was a significant step. “Even a miracle”, as one conference participant put it. The DSSI forced the Chinese government to align its interests among its fragmented banks and bureaucracies, which also had very different objectives when it came to foreign lending. This started a learning process within China. On the one hand, for debt restructuring in general, and on the other, to protect its own interests by participating in a multilateral round of creditors. The DSSI thus represented an important first step towards integrating China into these coordinated global negotiations.

 Analyses show with success. Chinese creditors held 30 percent of all claims of the DSSI-eligible countries and ultimately contributed the lion’s share of 63 percent to the debt relief initiative. However, as in Zambia, private banks – in this case Chinese banks – were sceptical about further debt relief. Although non-Chinese private and multilateral banks benefited from China’s settlement, they themselves wanted to contribute very little. Despite the major concessions, Chinese institutions have since been reluctant to lend to countries benefiting from the DSSI initiative.

Pragmatic response

Unlike during the HIPC era, when the restructuring process dragged on for over a decade, this time the creditors acted faster and more courageously within the framework of the DSSI, according to the IMF, and were thus able to avoid an escalation. The level and speed of debt development of a typical LIC is lower and with fewer deviations from the average than in the 1990s. Other inflows, such as direct investments, portfolio investments and remittances from emigrants from the diaspora also reduce the vulnerability of LICs. The local authorities have therefore succeeded in building up greater resilience. Nevertheless, uncertainty remains regarding the outlook for LICs and risks that could lead to a spiral of over-indebtedness predominate in the forecasts: slower growth, unfavourable primary balances, higher interest rates and strongly fluctuating exchange rates continue to dominate the global economy.

Nevertheless, there is still an urgent need for a comprehensive and coordinated approach to reduce the vulnerability of LICs to global shocks and high interest rates. Increasing conditional financial assistance could be an efficient way for the international community to support these countries. The transformed and heterogeneous creditor landscape and the increased complexity of many new debt instruments pose a significant challenge. Transparency and accountability in lending practices must therefore be further harmonized in order to achieve equitable participation of all creditors.

The G20 must therefore continue to innovate and act together to prevent future debt crises and promote sustainable economic growth. Although wildfires across entire groups of countries, which might even have plunged promising emerging markets back into the poverty trap, have been avoided, individual LICs remain vulnerable to global economic shocks. However, a learning process from previous debt crises is already evident, which ultimately promises a better future for the poorest and most vulnerable countries.

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