The great debt conundrum

WASHINGTON, DC — The exponential growth of international capital flows, predominantly in the form of debt, has been one of the great development successes of the past 50 years. But while foreign lending has played a pivotal role for developing economies, loans are a two-edged sword. When used judiciously, they can generate high returns, boost GDP growth, and improve the well-being of borrower countries. But if debts accumulate and the debt-servicing burden increases without a commensurate increase in repayment capacity, the consequences can be severe and even disastrous.

During the COVID-19 pandemic, for example, many countries grappled with a dramatic increase in fiscal demands, driven by rising public-health expenditures and a drop in revenues due to reduced economic activity. Highly indebted countries edged closer to the brink of default, and even those with previously sustainable public finances experienced a dangerous surge in their debt burdens.

When debt levels are high and rising, crises can emerge suddenly and worsen quickly. While several governments have taken steps to reduce their elevated debt levels and introduced reforms to avert potential crises, some countries’ debt-servicing costs are so high that meaningful adjustments are politically or economically unfeasible. Under such conditions, sceptical private creditors sell these countries’ sovereign bonds at reduced prices and refuse to extend further credit. Once this happens and governments default on their obligations, they find themselves shut out of capital markets. The subsequent economic crisis typically persists until these countries can restructure their existing debts, implement policy reforms, and restore confidence in their creditworthiness.

When a private company fails to meet its obligations, bankruptcy procedures determine the extent of liability write-downs and the allocation of the firm’s remaining assets. By contrast, there is no universally recognised legal mechanism for restructuring sovereign debt. As such, any resolution hinges on a voluntary agreement between debtor governments and their creditors.

Over the past few years, as dozens of low- and middle-income economies found themselves heading toward default, there have been growing calls for debt forgiveness. Kenyan President William Ruto, for example, recently proposed granting African countries a ten-year “grace period” on interest payments. Speaking at the inaugural Africa Climate Summit in Nairobi, Ruto suggested that developing countries redirect funds earmarked for debt service towards investments in renewable energy.

But this and other proposals for blanket debt forgiveness or payment moratoria are deeply flawed. Notably, some countries’ debts are inherently unsustainable. Even if their debts were suddenly forgiven, these governments would lack the resources necessary to finance major environmental initiatives. Moreover, without an agreed-upon restructuring plan and access to additional resources, essential imports required for production and consumption would be severely restricted, resulting in underutilised capacity and potential economic stagnation.

Historically, debt-restructuring negotiations have been a protracted, ad hoc process. The International Monetary Fund would collaborate with debtor countries to assess the necessary domestic policy changes and debt adjustments. Meanwhile, sovereign creditors, cooperating through the Paris Club, would consult with private lenders and decide on an appropriate restructuring strategy.

But today’s debt landscape presents even greater challenges. To reach a restructuring agreement, all creditors must be subject to the same haircut. Otherwise, some lenders would receive full repayment while others would endure significant write-downs, and they would surely not agree to that. But China, which has emerged as a major creditor over the past two decades, has refused to join the Paris Club. Instead of taking the same haircut as other creditors, the Chinese government insists on being repaid in full, which would result in preferential treatment for China and exacerbating developing countries’ debt-servicing difficulties. Failure to agree has delayed the restructuring process.

Consequently, countries like Sri Lanka and Zambia have endured unnecessary delays in resolving their debt crises, even after reaching agreements with the IMF on essential policy reforms. To prevent significant and avoidable suffering, the international community must establish procedures to ensure timely and fair burden-sharing among creditors.

The developing world’s ongoing economic turmoil underscores the urgent need to establish a new debt-restructuring framework. The World Bank recently estimated that 60 per cent or more of low-income countries are heavily indebted and “at high risk of debt distress.” Moreover, many middle-income countries, such as Egypt, Jordan, Lebanon, Pakistan and Tunisia, also face significant fiscal and debt challenges.

If multiple countries fail to meet their debt-servicing obligations, international creditors will become reluctant to finance other heavily indebted countries, potentially triggering a global debt crisis. Such a scenario would have devastating consequences for low- and middle-income economies and the world economy as a whole. By streamlining and expediting the restructuring process, we can avoid making a bad situation even worse.

Anne O. Krueger, a former World Bank chief economist and former first deputy managing director of the International Monetary Fund, is senior research professor of International Economics at the Johns Hopkins University School of Advanced International Studies and senior fellow at the Centre for International Development at Stanford University. Copyright: Project Syndicate, 2023. www.project-syndicate.org