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 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 significantly with regard to the average interest rate and maturity of the debt stock. If this condition is met, increases in domestic income and export earnings are expected to cover the servicing of outstanding debt obligations. A second key criterion concerns the contractual conditions of (re-) financing such debt. The more closely lending conditionalities are aligned with 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 2020, with worsening risk profiles

In the wake of the COVID-19 pandemic, external debt stocks of developing countries reached US$10.6 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$2.3 trillion in 2000 (see 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 GDP from 23 per cent in 2008 (its lowest point in the last 20 years) to 31 per cent in 2020, as shown in figure 2. Moreover, 2020 has seen the highest annual increase since the financial crisis, probably as a result of the COVID-19 crisis.

These trends are largely influenced by China, whose economy accounted for 23 per cent of total external debt stocks of developing economies and 44 per cent of their GDP in 2020. During the period 2009-2020 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 economies excluding China is 13 percentage points higher, reaching 44 per cent of their GDP in 2020. This gap between China and the rest of the developing countries has widened in 2020. 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 practically remaining at similar levels since then. In addition, the share of short-term debt (characterised by higher risk profiles) increased, from 16 per cent of overall external debt in 2000 to 26 per cent in 2020, with a peak at 33 per cent in 2013.

Figure 1. External debt stocks, developing economies
(Billions of current US$)
Source: UNCTAD calculations based on data from World Bank -—
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and national sources.

Note: Figures for 2020 are UNCTAD estimates.

Figure 2. External debt stocks as a percentage of GDP, developing economies
(Percentage)
Source: UNCTAD calculations based on data from World Bank -—
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and national sources.

Note: Figures for 2020 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 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 economies, by region
(Billions of current US$)
Source: UNCTAD calculations based on data from World Bank -—
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and national sources.

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. 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 economies
(Percentage of total PPG debt)
UNCTAD calculations based on data from World Bank -—
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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 governments owed to private creditors reached 62 per cent of the total in 2019, compared to around 20 per cent in the 1970s and 43 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 by groups of economies (SDG 17.4.1)
(Percentage of exports of goods and services)
Source: UNCTAD calculations based on data from World Bank -—
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and national sources.
Notes: Figures for 2020 are UNCTAD estimates. Income groups follow World Bank’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 3.3 per cent in 2012 to 7.1 per cent in 2020 and in low-income countries from 2.9 to 6.7 per cent. SIDS saw this ratio rise from a low point of 9.2 per cent in 2014 to 19.2 per cent in 2020. 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 9.4 per cent in 2019, falling slightly to an estimated 6.6 per cent in 2020. 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 10 per cent in 2020.

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 -—
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and national sources.

Note: Figures for 2020 are UNCTAD estimates.

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.

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.2

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 – 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.3

Notes

  1. For more information on this topic, see Robust and predictable financing sources and Official support for sustainable development.
  2. See -—
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    for more detail.
  3. See -—
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    for more detail.

References

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