Act now to avoid another sovereign debt crisis in the developing world

The authors are Co-Chairs of the Bretton Woods Committee Sovereign Debt Working Group

Since late February, the world’s attention has focused on Russia’s brutal invasion of Ukraine. However, some of the most damaging economic and financial impacts of this act of aggression will be felt by the non-oil exporting developing economies of Africa, Asia and Latin America.

Even before the invasion, many of these countries were over-indebted, reflecting the strains of their response to the Covid-19 pandemic. Recent events in Ukraine have made the prospect of another sovereign debt crisis both more imminent and more damaging.

In addition to the potential downside risks for these countries, the mechanisms currently in place to deal with sovereign debt issues have become dysfunctional. While the need for reform had previously been recognised, recent G20 efforts in this direction appear to have failed. Renewed international action is urgently needed to avoid a crippling stalemate. However, the current crisis will make the search for a solution more difficult, just as it has increased the cost of failure.

The additional risks for low-income countries resulting from recent events are obvious: the economic and financial fallout from the Ukraine conflict—including the unprecedented sanctions imposed on Russia and its expected default on its sovereign debt—has already prompted substantial revisions downward revisions to global growth forecasts, but upward revisions to inflation expectations in the near term.

Before the start of the war, the impact of the pandemic on government spending and revenue in low-income countries had led to an increase in their gross sovereign borrowing equivalent to about 25% of their gross domestic product. As World Bank data shows, this increase was somewhat larger in percentage terms than that of high-income borrowers. However, as IMF calculations show, the increase in debt servicing costs for these countries relative to government revenue has been considerably larger than for higher-income economies.

Cooperative political action after the Covid strike averted an immediate debt crisis for low-income borrowers. In addition to providing new financial support packages, the IMF and World Bank agreed in May 2020 on a Debt Service Suspension Initiative (DSSI) which was subsequently endorsed by G20 finance ministers, and finally extended to all official multilateral and bilateral loans until the end of 2021.

With the DSSI now complete, a major challenge is to make the debt exposure of low-income countries sustainable. This will undoubtedly require the establishment of a viable sovereign debt restructuring mechanism. However, as noted in the World Bank’s latest World Development Report, the G20’s efforts to create a new debt renegotiation system — the Common Debt Framework — appear to have failed.

According to an analysis by the Bretton Woods Committee’s Sovereign Debt Working Group, a key factor that significantly weakened pre-existing arrangements for sovereign debt renegotiation was the lack of transparency regarding the size and terms of obligations in Classes. This partly reflects the dramatic shift in sources of lending to low-income countries after the global financial crisis. China is now the largest lender to these borrowers, but Chinese institutions often fail to provide consistent or complete data reporting on their loans.

An immediate objective of reform should be to achieve real progress in transparency, while addressing the related challenge of enhancing the degree of engagement, fairness and trust in the process of sovereign restructuring. To be successful, reforms must go beyond simple data transparency and bring greater clarity about the entire restructuring process. It won’t be easy or quick: the latest communiqué from G20 finance ministers backed the goal of increased debt transparency, but in practice merely mentioned existing — and seemingly failing — efforts .

Nevertheless, progress is possible. The task force has developed a menu of concrete measures that would significantly reduce the risk of a crisis. The main uncertainty is whether the main protagonists are capable of meaningful cooperation, or whether the current spiral of great power confrontation will prevent mutually beneficial action. Global leadership is urgently needed. The potential costs of failure include a new sovereign debt crisis that would cause the worst damage to the poorest and most vulnerable.

Letter in response to this article:

Too many sovereign borrowers still fail the corruption test / By Frank Vogl, Washington, DC, USA

Robert P. Matthews