Developing country external debt: A cascade of crises means more countries face debt distress

External indebtedness poses important challenges for developing countries, particularly in the context of floating exchange rate systems, open capital accounts and fast integration into international financial markets. The historical position of developing countries as debtors in foreign currency has been a recurrent source of vulnerability to external shocks, for example, during a commodity price slump. This is because the servicing of external debtExternal debt is understood as outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy -—
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—-. obligations ultimately requires generating sufficient export earnings or other forms of income. At the same time, exchange rate volatility is likely to affect the value of debt owed externally and that of export earnings in opposite directions. Thus, a depreciation of the local currency against hard currencies may result in increased export earnings (provided that the fall in the dollar price of local exports is compensated by a commensurate increase in export volumes), but will automatically imply an increase in the value of foreign-currency denominated debt obligations in local currency.

Against a backdrop of insufficient international public finance flows and limited access to concessional resources -—
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—-, developing economies have increasingly raised development finance on commercial terms in international financial markets. They have also opened their domestic financial markets to non-resident investors, and they have allowed their citizens and firms to borrow and invest abroad. While increased access to international financial markets can help capital-scarce countries to quickly raise much-needed funds, it also exposes them to higher risk profiles of debt contracts, i.e., shorter maturities and more volatile financing costs, as well as to sudden reversals of private capital I in flows. In conjunction with other exogenous shocks, such as natural disasters, pandemics or episodes of political instability, external debt burdens deemed sustainable by international creditors can quickly become unsustainable.

In the light of this analytical background, upcoming years appear very challenging for debt sustainabilityA country’s capacity to finance its policy objectives through debt instruments and service the ensuing debt -—
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—-. in developing countries due to the unfortunate crossroads of various exogenous shocks and the systemic fragility of the international financial architecture. The COVID-19COVID-19 is an infectious disease caused by the strain of coronavirus SARS-CoV-2 discovered in December 2019. Coronaviruses are a large family of viruses which may cause illness in animals or humans. In humans, several coronaviruses are known to cause respiratory infections ranging from the common cold to more severe diseases such as Middle East Respiratory Syndrome (MERS) and Severe Acute Respiratory Syndrome (SARS). The most recently discovered coronavirus causes coronavirus disease COVID-19 -—
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—-. pandemicCommonly described by the WHO as ‘the worldwide spread of a new disease’, no strict definition is provided. In 2009, they set out the basic requirements for a pandemic: • New virus emerges in humans
• Minimal or no population immunity
• Causes serious illness; high morbidity/mortality
• Spreads easily from person to person
• Global outbreak of disease.
The US Centre for Disease Control uses a similar approach, but with a reduced set of criteria. It is very difficult to gauge whether the spread of a disease should be termed an outbreak, epidemic or pandemic. In other words, when to declare a pandemic isn’t a black and white decision -—
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—-. hit developing countries’ external debt sustainability through several transmission channels simultaneously, in the form of unprecedented non-resident portfolio capital outflows and reductions in foreign direct investmentForeign Direct Investment (FDI) is an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate) -—
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—-. during the first months of the pandemic, and then sharp falls in export earnings and the virtual collapse of the tourism industry, compounded with slumps in commodity prices and remittancesThe term remittances can refer to three concepts, each encompassing the previous one. “Personal remittances” are defined as current and capital transfers in cash or in kind between resident households and non-resident households, plus net compensation of employees working abroad. “Total remittances” include personal remittances plus social benefits from abroad, such as benefits payable under social security or pension funds. “Total remittances and transfers to non-profit institutions serving households (NPISHs)” includes all cross-borders transfers benefiting household directly (total remittances) or indirectly (through NPISHs) -—
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—-.. The immediate consequence was drastically reduced fiscal space in many developing countries. In the longer term, other shocks, including climate-related disasters and the triple impact of the Ukrainian conflict on food, energy and finance prices - as well as rising global interest rates aimed at curbing inflation - have further reinforced those forces that jeopardise growth and progress with the SDGsSustainable Development Goal. Coordinated efforts by international governance has so far managed to prevent a tidal wave of sovereign defaults but the expiration of exceptional measures for debt relief coupled with the tightening of monetary conditions in advanced economies do not bode well.

External debt stocks of developing countries grew by 8 per cent to US$11.1 trillion in 2021, with worsening risk profiles

As the COVID-19 pandemic continued to dominate in 2021, external debt stocks of developing countries reached US$11.1 trillion, their highest level on record, more than twice their value of US$4.1 trillion registered in 2009, and nearly fivefold their level of US$2.1 trillion in 2000 (Figure 1). Given the sluggish growth since the global financial crisis of 2007-2008, this translated into a renewed increase in the average ratio of external debt to GDPGross domestic product (GDP) is an aggregate measure of production, income and expenditure of an economy. As a production measure, it represents the gross value added, i.e., the output net of intermediate consumption, achieved by all resident units engaged in production, plus any taxes less subsidies on products not included in the value of output. As an income measure, it represents the sum of primary incomes (gross wages and entrepreneurial income) distributed by resident producers, plus taxes less subsidies on production and imports. As an expenditure measure, it depicts the sum of expenditure on final consumption, gross capital formation (i.e., investment, changes in inventories, and acquisitions less disposals of valuables) and exports after deduction of imports -—
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—-. from 22.8 per cent in 2008 to 30.6 per cent in 2021, as shown in Figure 2. The share of external debt stocks slightly declined in 2021 (-2.4 percentage points), probably due to global efforts to provide “breathing space” to developing countries in the need via debt relief programmes and a historic SDRSpecial Drawing Rights (SDR) -—
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—- allocation -—
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—-, as discussed in the chapter Official Support for Sustainable Development. During the past decade, external debt stocks of developing countries have grown on average 7.1 per cent annually.

These trends are largely influenced by China, whose economy accounted for 21.1 per cent of total external debt stocks of developing economies and 41.6 per cent of their GDP in 2020. During the period from 2009-2020, China’s external debt stock grew at a rate twice as fast as the developing country average (16.1 per cent), while its GDP grew on average 10.1 per cent per year. As a result, the country’s external debt to GDP ratio increased from 8.9 per cent to 15.9 per cent in the period. Excluding China, the ratio of external debt to GDP for developing economies is 14.5 percentage points higher, reaching 45.4 per cent of their GDP in 2021.

As Digure 2 shows, over the past two decades, overall external debt stocks have continued to rise, with the shares of short-term debtDebt liabilities having a maturity of one year or less; maturity can be defined on an original or reminaing basis -—
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—-. Interests in arrears on long-term debt are included within short-term debt. and PNGPublicly Non-Guaranteed debt (PNG) is an external debt of the private sector that is not contractually guaranteed by a public sector unit resident in the same economy -—
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—-. Unless otherwise indicated, only long-term debt (maturity of more than one year) is included. (private) long- term debt contributing to a rising share of total external debt. The regional comparison in Figure 3 shows that, given their deeper financial systems, the majority of international private lending into developing countries went to high-income and upper-middle income economies, particularly in Asia and Latin America. But the trend has also been upward in other developing regions, including those with a large share of low-income economies, such as Sub-Saharan Africa.

This increase of private sector lending participation in developing countries’ PPGPublicly guaranteed debt (PPG) is an external debt liabilities of the private sector, the servicing of which is contractually guaranteed by a public unit resident in the same economy as the debtor -—
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—-. Unless otherwise indicated, only long-term debt (maturity of more than one year) is included. external debt accelerated after 2009 (Figure 4), and this trend has not always been warranted by positive developments in these economies’ domestic financial and banking systems. Instead, the driving forces have mostly been global “push factors”, such as the impact of accommodative monetary policies in many developed economies in the aftermath of the global financial crisis. High levels of private external indebtedness are of concern since they represent a large contingent liability on public sector finances, ultimately backed by international reserves held in the domestic economy. In the event of wide-spread private sector debt distress, governments will have little choice but to transfer the bulk of distressed private debt to public balance sheets.

The fragility of developing countries’ debt positions during to the COVID-19 outbreak was intensified by changes in ownership of long-term external PPG debt. As shown in figure 4, the share of PPG external debt of developing governments owed to private creditors reached 61.6 per cent of the total in 2020, compared to 43.1 per cent in 2000. Its most volatile component, public bond finance, is clearly on the increase relative to financing through commercial bank loans and other private creditors. This reflects the growing reliance of developing country governments on refinancing their external debt obligations in international financial markets with strong speculative features rather than borrowing from official bilateral and multilateral creditors, which is generally more stable and on more favourable terms.

Debt service costs on public external debt continue to pose a serious challenge

Rising external debt burden along with increased risk profiles of such debt translate into rising servicing costs. Debt servicePayments made to satisfy a debt obligation, including principal, interest and any late payment fees -—
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—-. ratios are considered important indicators of a country’s debt sustainability. In this sense, SDGSustainable Development Goal indicator 17.4.1 measures “debt service as a proportion of exports of goods and services”. This indicator reflects a government’s ability to meet external creditor claims on the public sector through export revenues. A fall (increase) in this ratio can result from increased (reduced) export earnings, a reduction (increase) in debt servicing costs, or a combination of both. A persistent deterioration of this ratio signals an inability to generate enough foreign exchange income to meet external creditor obligations on a country’s PPG debt, and thus potential debt distress in the absence of multilateral support or effective sovereign debt restructuring.

As Figure 5 shows, only high-income developing countries have maintained a stable ratio of external long-term PPG debt to export revenues of around two to four per cent in the last decade. This is largely due to their greater capacity to issue domestic public debt, with a view to avoiding currency mismatches. However, while greater reliance on local-currency denominated public debt reduces vulnerability to exchange rate volatility, it frequently creates maturity mismatches. Even governments in high-income developing countries are often unable to issue long-term government securities at a sustainable rate of interest, yet they need to be able to pay off or roll over maturing short-term obligations. In contrast, a marked increase of debt service ratios has been registered since 2012 across all other income categories, with a dip in the value for several groups of countries – especially the LICsLow-income developing countries – related to the G20Group of Twenty DSSIDebt Service Suspension Initiative -—
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—- of the G20, beginning of April 2020. The DSSI made 73 countries eligible to suspend their interest payments to official bilateral creditors until December 2021. In the end, 48 countries took up the option – gaining short-term relief on debt servicing, as reflected in the data here -—
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The amounts suspended will have to be repaid over a period of five years, with a one-year grace period, so this ratio is likely to rise again. Among the 38 UN member states that are SIDSSmall island developing states (SIDS) were recognized as a distinct group of developing countries at the Earth Summit in Rio de Janeiro in June 1992. More information on UNCTAD official page., 22 were eligible to the DSSI, and only 13 joined the initiative. The group of SIDS saw the ratio of debt servicing to long term PPG debt continue to rise from 13.6 per cent prior to the pandemic (2019) to 17.9 per cent in 2021, due to worsening of export performance and little debt relief as only lower-income SIDS were eligible for DSSI. As these economies increasingly tapped into international capital markets, this reflects rising external public debt stocks since 2012 in a context of commodity price volatility, sluggish global economic growth and rising debt service.

Moving beyond SDG indicator 17.4.1, the share of government revenues dedicated to servicing PPG debt rose sharply in recent years, particularly in the poorest developing economies. As Figure 6 illustrates, whereas in 2012 low-income developing countries spent 4.8 per cent of their government revenues to meet external public debt obligations, this figure rose to 12.0 per cent in 2020, before falling slightly to an estimated 9.7 per cent in 2021, along the same lines as those observed for indicator 17.4.1. The squeeze on government revenues from service payments on external PPG debt was particularly drastic in Sub-Saharan Africa, where this ratio jumped from a low point of 3.4 per cent in 2011 to an estimated 15 per cent in 2021.

This is of concern since low-income developing countries still rely predominantly on public financing to mobilise resources for structural transformationStructural transformation or change can be broadly defined as the reallocation of economic activity across three broad sectors, agriculture, manufacturing and services, which accompanies the process of economic growth -—
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—-. It usually refers to the transfer or shift of production factors — especially labour, capital and land — away from activities and sectors with low productivity to those with higher productivity, which are typically different in location, organization and technology -—
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—-., yet also struggle the most with limited fiscal space given their shallow domestic financial and banking systems and limited options to refinance maturing debt obligations in the international financial markets.

The challenges posed by the COVID-19 shock

While developed countries have put together massive stabilisation packages to flatten both the pandemic curve and the curve of economic and financial crisis, this is not an option open to many developing economies, at least not at the required scale. On one hand, developing countries cannot easily lock down their largely informal economies effectively without more people being affected by hunger rather than by illness. On the other, they face substantive limitations on their fiscal space to mount rescue packages comparable to those currently under way in developed economies.

To pay for imports and to meet external debt obligations, the vast majority of developing countries are heavily reliant on access to hard currencies, earned primarily through commodity and service exports, such as food, oil and tourism, or received through remittances, as well as access to further concessional and market-based borrowing. Their central banks cannot act as lenders of last resort to their governments to the extent central banks in developed economies can without risking a large depreciation of their local currencies and its effects in terms of steep increases in the value of foreign-currency denominated debt. This has the potential to unleash destructive inflationary pressures and rising borrowing costs, as hinted by recent developments.

It is against this backdrop that already existing debt vulnerabilities and distress in developing countries require decisive action to avoid liquidity constraints turning into wide-spread insolvency crises. Well-designed debt relief – through a combination of temporary standstills with sovereign debt reprofiling and restructuring – including further enhancing the scale and scope of the G20 Common Framework for Debt Treatments - to help developing countries cope with the wall of upcoming sovereign debt payments. This is likely to be necessary to address not only immediate liquidity pressures, but also to restore long-term external debt sustainability in many developing countries, not least with a post-COVID-19 view of achieving the 2030 Agenda for Sustainable Development -—
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References

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