Sunday Times 2
How to beat developing-market debt crises
View(s):By Hippolyte Fofack Project Syndicate, exclusively for the Sunday Times in Sri Lanka
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 (IMF) after defaulting on its foreign debt in May, and a growing number of low-income countries are facing similar challenges. The World Bank estimates that around 60% of all emerging and developing economies have become high-risk debtors. As many as a dozen might default over the next 12 months.
Unlike the advanced economies, where sharp increases in government debt following the emergence of COVID-19 encouraged a speedy return to trend growth, developing economies have been constrained by a shortage of vaccines and a lack of monetary and fiscal space. Unable to deficit-finance their way out of the synchronised 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 few exceptions – Sri Lanka and Zambia, for example – most developing economies are not heavily indebted. Collectively, their average debt-to-GDP ratio has increased by just seven percentage points (to 65%) since the start of the pandemic, much lower than the 20 percentage points increase in advanced economies where the combined sovereign debt now averages 122% of GDP. The flow of funds that developing economies receive from global bond markets and banks has remained dismally low. According to the most recent estimates from the Institute of International Finance, their combined sovereign liabilities represent less than 30% of global public debt.
Worse, following post-pandemic credit downgrades, many low-income countries cannot access international capital markets and now face acute liquidity constraints that could morph into solvency crises. And because these countries’ sub-investment-grade credit ratings have raised their borrowing costs, the fiscal impact of their sovereign liabilities has increased, and their governments’ reduced ability to roll them over as they fall de has raised the specter of a developing-country debt crisis.
Ghana, for example, 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, Ghana has effectively been shut out of international financial markets, and its ten-year sovereign bond yield has risen above 22%. After resorting to painful internal adjustments—such as tax increases and cuts to discretionary spending—during the pandemic, Ghana is now contending with 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 toward variable interest rates in a context of increasingly complex lending structures and 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. And now that systemically important central banks are normalising monetary policies 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 sharp exchange-rate depreciation suddenly raises the costs of servicing external debts. This is especially the case during episodes of heightened global volatility and tightening financing conditions, which are often associated with large-scale capital outflows from emerging and developing economies.
Consider the European Central Bank, which recently adopted exceptional measures to reassure investors and stem bond-market volatility in response to renewed concerns about “fragmentation risks” within the eurozone. Under the “anti-fragmentation instrument” it adopted in March, the ECB now “reserves the right to deviate in the future from credit rating agencies’ ratings if warranted, in line with its discretion under the monetary policy framework.” The short-term impact of this move has been remarkable, with yields on the bonds of weaker eurozone members falling sharply immediately thereafter.
But systemically important central banks should be no less concerned about the disproportionately large spreads between advanced and developing economies – what we might call “global fragmentation risk.” 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 exorbitant privilege to other countries. At the height of the pandemic downturn, for example, the Fed reinforced its currency-swap arrangements—first introduced during the 2008 financial crisis—and broadened the geographical coverage of its support to include a few emerging economies. That move led to currency appreciation, improved credit-default-swap spreads, and lower long-term interest rates in beneficiary countries.
And, beyond alleviating liquidity risks, the extension of dollar-denominated swap lines reassured investors, thus 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.
Hippolyte Fofack is Chief Economist and Director of Research at the African Export-Import Bank (Afreximbank).
Copyright: Project Syndicate, 2022.
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