Sovereign debt

© Adobe Stock For the first time in two years, some low-income and lower-middle-income countries can access the bond market. But many others remain still in dire need of liquidity and face punishing interest rates. Amid this ongoing crisis, the Finance for Development Lab’s proposal for a “liquidity bridge” that would enable developing economies to extend the maturity of their debts by 5-10 years and allocate resources toward climate mitigation and adaptation remains as necessary as ever. The good news is that LMICs’ external debt ratios remain relatively modest, at around half the level before the Highly Indebted Poor Countries debt-reduction initiative. In 2023, only one country, Ethiopia, defaulted on a $1bn Eurobond. The bad news is that liquidity pressures on LMICs have continued to increase. After 2010, a spike in medium-term loans has enabled developing countries to fund critical infrastructure projects. Typically, these loans would be rolled over, but this became impossible as major economies embarked on quantitative tightening, causing a sharp rise in interest rates and net capital outflows. The liquidity crisis has been compounded by a series of exogenous shocks: reduced flows from China, the lingering effects of the Covid-19 pandemic, and a surge in fuel and food prices. Moreover, global support for developing economies dwindled prematurely. By 2022, the G20 had ended its Debt Service Suspension Initiative, international financial institutions had reduced lending, and no new allocations of special drawing rights (SDRs, the IMF’s reserve asset) were announced. This exacerbated the shock, forcing LMICs dealing with foreign-exchange shortages to devalue their currencies. To put this in perspective, the number of LMICs that devalued their currencies by more than 10 per cent rose from eight in 2021 to 36 in 2022 and 24 in 2023. Contrary to some analysts’ expectations, the liquidity crisis is far from over. Net transfers in long-term debt to LMICs were negative in 2022, and estimates suggest that 2023 was even worse, as rising interest rates made floating-rate debt and new borrowing more expensive. Furthermore, the effectiveness of aid appears to have waned. While multilateral development banks and some bilateral creditors accounted for roughly $42bn in net-positive inflows to LMICs in 2022, these contributions were more than offset by large debt payments to private lenders and China. Increased support from MDBs, advocated by the G20 under India’s presidency, is crucial to facilitating a green transition. But to ensure that these funds are used to finance climate action, rather than to service existing debts, all creditors must share the burden and refrain from reducing their exposure too soon. The reduction in China’s lending must be managed more smoothly. And sovereign bonds should be gradually replaced as an asset class by green bonds. To be sure, Côte d’Ivoire, Benin, and Kenya have each issued bonds in the first quarter of 2024. Nevertheless, creating a liquidity bridge remains the most effective way to support LMICs’ green transition and stabilise developing economies, for four reasons. First, higher interest rates and the surge in currency devaluations have raised the domestic cost of servicing external debt. Up to 34 developing countries’ debt-servicing obligations are now estimated to exceed 15 per cent of revenue. For this group of LMICs, the median debt-service burden has increased from 13 per cent to 23 per cent of fiscal revenue between 2021 and 2023. Although some countries have regained access to financial markets, many continue to grapple with high debt-servicing costs, putting them at risk of being unable to refinance their liabilities. Second, most LMICs continue to face very high interest rates. Consequently, countries like Nigeria, Pakistan, Senegal, or Tunisia, where debt-servicing costs have increased beyond 15 per cent of revenues, must maintain primary surpluses, placing further strain on their budgets and foreign-exchange reserves. This forces governments to implement austerity measures, which impede investments in human and physical capital, aggravate social tensions, and hinder climate initiatives. Third, MDBs are not equipped to finance every illiquid LMIC while also supporting the green transition. To help Kenya re-enter the bond market, the IMF increased its lending to five times its quota, while the World Bank pledged $12bn. Extending such substantial financial support to all debt-distressed developing countries would be unfeasible. The liquidity-constrained LMICs collectively owe more than $40bn annually to investors and China – more than three times the total flows from MDBs to them. Lastly, even countries that have successfully regained market access are not out of the woods. Kenya’s annual debt service, for example, stands at around 25 per cent of exports. If it continues to roll over maturities at an interest above its growth rate, its debt will increase rapidly, raising the risk of default. Countries that have previously defaulted are struggling to restructure their debts. Zambia’s restructuring agreement, which required three years of intense negotiations with private investors, is a prime example. That is why pre-emptive refinancing is a preferable solution for illiquid countries, compared to risking mass insolvency in the future. This has become recognized by key actors, including the International Monetary Fund, the World Bank, and the US Treasury. Kenya’s recent liquidity injection offers a model for avoiding such a scenario, but there is significant room for improvement. Debt rollovers must become cheaper. International institutions should scale up their financing more rapidly. And LMICs need to develop ambitious medium-term plans for accelerating their climate transitions. To achieve this, a concerted strategy is necessary. Encouragingly, the IMF and World Bank have already started to increase their support, and private-sector financiers have come back to the table. But improved coordination among these various stakeholders, along with more coherent and transparent rules, is crucial to the success of these efforts. As president of the G20, Brazil is well-positioned to spearhead the efforts to restructure LMIC debts by encouraging a select group of countries to launch ambitious and innovative pilot projects. These efforts could then be scaled up during South Africa’s presidency. By that point, the MDBs, one hopes, will be able to increase lending. Ishac Diwan is Research Director at the Finance for Development Lab. Vera Songwe is Senior Adviser at the Bank for International Settlements’ Financial Stability Institute. Copyright: Project Syndicate, 2024.www.project-syndicate.org