Developing country external debt: From growing sustainability concerns to potential crisis in the time of COVID-19

SDG indicators

SDG target 17.4: Assist developing countries in attaining long-term debt sustainability through coordinated policies aimed at fostering debt financing, debt relief and debt restructuring, as appropriate, and address the external debt of highly indebted poor countries to reduce debt distress.
SDG indicator 17.4.1: Debt service as a proportion of exports of goods and services (Tier I)

Debt is a key component of all financing strategies for governments and private firms, particularly from the point of view of long-term financing for sustainable development and structural transformation. The most important criterion for the long-term sustainability of debt obligations is that borrowing serves the purpose of increasing productive investment. If this is the case, increases in domestic income and export earnings are expected to cover the servicing of outstanding debt obligations, given the average interest rate and maturity of the debt stock. A second key criterion concerns the contractual conditions of (re-)financing such debt. The more closely lending conditionalities are aligned to the objective of mobilizing debt finance for structural transformation in developing countries, the higher the chances the debt can be serviced promptly.

External indebtedness poses important challenges for developing countries, particularly in a 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 debt 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,1 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 inflows. 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.

External debt grew to a record high in 2019, with worsening risk profiles

At the outbreak of the COVID-19 pandemic, external debt stocks of developing countries and economies in transition reached US$9.9 trillion, their highest level on record, more than twice their value of US$4.4 trillion registered in 2009, and more than four-fold their level of US$2.2 trillion in 2000 (see figure 1).2 Given the sluggish growth in both groups of economies since the global financial crisis of 2007-2008, this translated into a renewed increase in the average ratio of external debt to GDP from 23 per cent in 2008 (its lowest point in the last 20 years) to 29 per cent in 2019, as shown in figure 2.

This trend is largely influenced by China, whose economy accounted for 20 per cent of total external debt stocks of developing and transition economies and 37 per cent of their combined GDP in 2019. During the period 2009-2019 China’s external debt stock grew at a slightly higher rate than the developing countries average, but its GDP grew much faster. As a result, the average ratio of external debt to GDP for developing and transition economies excluding China is almost ten percentage points higher, reaching 38 per cent of their combined GDP in 2019. At the same time, the public-private composition of long-term external debt changed, with the share of private (PNG) debt in overall external debt surpassing that of public (PPG) debt from 2011 to 2016 and remaining at similar levels since then. In addition, the share of short-term debt (characterised by higher risk profiles) in overall external debt increased continuously, from 15 per cent of overall external debt in 2000 to 24 per cent in 2009 and 28 per cent in 2019.

Figure 1. External debt stocks, developing and transition economies
(Billions of current US$)
Source: UNCTAD calculations based on data from World Bank (2020a) and Economist Intelligence Unit (2020).
Note: Figures for 2019 are UNCTAD estimates.
Figure 2. External debt stocks as a percentage of GDP, developing and transition economies
(Percentage)
Source: UNCTAD calculations based on data from World Bank (2020a) and Economist Intelligence Unit (2020).
Note: Figures for 2019 are UNCTAD estimates.

As figure 3 shows, over the past two decades, overall external debt stocks have not only risen markedly across all developing regions, but this increase has also been accompanied by a rising share of short-term debt and PNG long-term debt in total external debt. Given their deeper financial systems, the majority of international private lending into developing and transition 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.

Figure 3. External debt stocks, developing and transition economies, by region
(Billions of current US$)
Source: UNCTAD calculations based on data from World Bank (2020a) and Economist Intelligence Unit (2020).

This increase of private sector participation in developing country PPG external debt accelerated after 2009 (see 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. Household debt also rose in emerging economies from 26 per cent of GDP in 2009 to 43 per cent by 2019. The bulk of the overall increase in lending to private non-financial sectors was lending to non-financial corporations in these economies, increasing from around 60 per cent of GDP just before the global financial crisis to over 100 per cent by 2017.3 This ratio, however, has fallen recently due to growing financial distress in some of these economies.4 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.

Figure 4. Long-term external PPG debt by creditor, developing and transition countries
(Percentage of total PPG debt)
Source: UNCTAD calculations based on data from World Bank (2020a).
Notes: Averages by group of economies. Only countries with available data were included.

The fragility of developing countries’ debt positions prior to the COVID-19 outbreak was further increased by accompanying changes to the ownership of long-term external PPG debt. As shown in figure 4, the share of PPG external debt of developing and transition governments owed to private creditors reached 62 per cent of the total in 2019, compared to around 20 per cent in the 1970s and 41 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 in 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 service ratios are considered important indicators of a country’s debt sustainability. In this sense, SDG 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.

Figure 5. Debt service on long-term external PPG debt in developing and transition economies (SDG 17.4.1)
(Percentage of exports of goods and services)
Source: UNCTAD calculations based on data from World Bank (2020a) and Economist Intelligence Unit (2020).
Notes: Figures for 2019 are UNCTAD estimates. Income groups follow World Bank’s definition; SIDS group follows UNCTAD’s definition.

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 avoid currency mismatches. However, while greater reliance on local-currency denominated public debt reduces the 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: in middle-income countries this ratio rose from 3.1 per cent in 2012 to 6.9 per cent in 2019 and in low-income countries from 2.5 to 7.0 per cent. SIDS saw this ratio rise from a low point of 4.9 per cent in 2013 to 8.2 per cent in 2019. 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 over recent years, particularly in the poorest developing economies. As figure 6 illustrates, whereas in 2012 low-income developing countries spent 3.3 per cent of their government revenues to meet external public debt obligations, this figure rose to 8.1 per cent in 2018, falling only slightly to an estimated 7.9 per cent in 2019. 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 3.3 per cent in 2011 to an estimated 18.2 per cent in 2019. In other words, governments in this region now spend, on average, almost one fifth of their revenues on servicing external public debt.

Figure 6. Debt service on long-term external PPG debt, selected groups of developing countries
(Percentage of government revenue)
Source: UNCTAD calculations based on data from World Bank (2020a), Economist Intelligence Unit (2020) and IMF (2020a).
Notes: Figures for 2019 are UNCTAD estimates. Groups follow World Bank’s definition.

This is of concern since low-income developing countries still rely predominantly on public financing to mobilise resources for structural transformation, 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

The COVID-19 pandemic has translated into a shock that has put a glaring spotlight on the rapidly deteriorating debt sustainability in many developing countries, since it threatens to turn what was already a dire situation prior to the pandemic into a series of sovereign defaults. As mentioned above, as a consequence of their rising indebtedness, developing countries face a wall of debt service repayments throughout the 2020s.

Figure 7. Redemption schedules for public external debt, developing countries, 2020 and 2021
(Trillions of current US$)
Source: UNCTAD calculations based on World Bank (2020b, 2020c), Institute of International Finance (2020) and IMF (2020b).
Notes: Data refer to sovereign debt for high-income countries and public external debt for middle- and low-income countries. Country groups follow World Bank’s definition.

Figure 7 shows that redemption schedules for 2020 and 2021 already accumulated external public debt obligations alone amount to an estimated US$2 to 2.3 trillion in high-income developing countries and between US$700 billion to $1.1 trillion in low-and middle-income countries.5

The challenge posed by large debt overhangs must, however, be placed in the wider context of economic challenges arising from the COVID-19 crisis. While developed countries are putting 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. But with volumes of international trade experiencing a sharp contraction, core commodity prices in free fall, tourism at a virtual standstill, remittances drying up and private capital outflows from developing countries reaching unprecedented levels in recent history, many developing economies are increasingly cut off from conventional sources of income when they need them most.6

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. Early multilateral initiatives to provide some breathing space to hard-hit developing countries include US$215 million in debt cancellation by the IMF of repayments due by the 25 poorest developing economies between May and October 2020, as well as the G20 “Debt service suspension initiative for poorest countries” between May and December 2020.7 73 primarily low-income developing countries are eligible under this initiative that could see the temporary suspension of up to around $18 billion in repayments on official bilateral debt. While these initiatives are welcome, they are unlikely to be sufficient in either scale or scope. New borrowing, for example in fast growing COVID-19 bond markets as well as through increased access to concessional multilateral lending, can help bridge immediate liquidity needs but it is bound to add to, rather than resolve, unsustainable external debt burdens. Well-designed debt relief – through a combination of temporary standstills with sovereign debt reprofiling and restructuring – will therefore be essential 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.8

Notes

  1. For more information on this topic, see Robust and predictable financing sources and Official support for sustainable development.
  2. These figures include long-term external PPG debt, long-term external PNG debt as well as short-term external debt, as available in World Bank (2020a). If the use of IMF credits is also included, the figures for 2019, 2009 and 2000 increase to US$ 10.1 trillion, US$ 4.5 trillion and US$ 2.3 trillion, respectively.
  3. UNCTAD calculations, based on conversion to US dollars at market exchange rates, from BIS (2020) data.
  4. See also UNCTAD (2019 pp. 76-81).
  5. The range estimates for redemption schedules for public external debt in 2020 and 2021 for developing countries results from the combination of observed redemptions schedules for 44 developing countries, including major developing economies, and estimated redemptions for all others, considering their income group. Developing countries, especially within the same income group, show some degree of synchronization in their external debt redemption schedules, which is mostly shaped by the financial conditions prevailing in international financial markets. This explains why, as a whole, they periodically face “walls of maturity”: the bonds and loans that they contract in international markets often come to maturity in simultaneously. The estimation therefore consists in applying the distribution of redemption schedules relatively to public debt stocks from the 44 observed countries. The low and high estimates refer to the lower and higher bounds of the distribution, respectively, defined as the 10th and 90th percentiles.
  6. See UNCTAD (2020a) for more detail.
  7. See G20 (2020, Annex II).
  8. See UNCTAD (2020b) for more detail.

References

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