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How might costly sovereign debt default in emerging economies be averted?

Many low- and middle-income countries face problems servicing their external debts while tackling the global health emergency and the ensuing economic damage. To ensure debt sustainability, the existing stock of debt needs to be restructured, potentially involving substantial debt write-downs.

The first wave of Covid-19 led to a sudden collapse in capital flows to emerging and developing countries. The Institute of International Finance (IIF) estimates that portfolio outflows from emerging market economies amounted to nearly $100 billion over a period of 45 days starting in late February 2020 (IIF, 2020). Total financial assistance for 77 countries has amounted to around $83 billion so far. Moreover, the countries at high or moderate risk of debt distress are disproportionately fragile and conflict-afflicted states, small states and countries dependent on commodities.

There is a real risk that whatever progress has been made towards achieving the Sustainable Development Goals (SDGs) is likely to be reversed in the near future. For example, in a recent report, Oxfam suggests that that 125 million people may fall back into extreme poverty as countries impose austerity measures to service debt repayments.

A recent report by the United Nations Economic Commission for Africa (UNECA, 2020) points out that relative to an initial forecast of 3.2%, Africa’s growth rate in 2020 is likely to decline to 1.8% (in the best case scenario), 0.1% (in the middle case scenario) and minus 2.6% (in the worst case scenario).

None of this takes account of the potential negative consequences of a second wave of the pandemic now unfolding globally. As Li (2020) notes, ‘for the first time in history, the global economy is confronted with a rapidly unfolding, synchronized and severe economic recession, affecting both developed and developing economies and all continents at the same time. …the road to recovery is likely to be long and tortuous’.

What has happened to the sovereign debt of emerging economies?

The economies of most low- and middle-income countries have been hit hard by the pandemic. As the severity of Covid-19 emerged in February and March this year, the UNECA report notes that prices plummeted for more than 67% of Africa’s exports consisting of commodities such as oil, metals and ores, and textiles. Simultaneously, remittances from the rest of the world to Africa have fallen.

Most African bonds are issued in dollars or euros. The dollar value of export earnings has fallen while, in the absence of debt restructuring, the dollar value of debt repayments will remain unchanged, making repayment even more challenging and raising worries of default. The UNECA report estimates that the total stock of outstanding debt in Africa is $400 billion: it calls for $200 billion Covid-19-related funding for Africa (including low- and middle-income countries).

Even before the pandemic, a World Bank report (2020) noted that total developing country sovereign debt in 2018 had registered an increase of 54 percentage points of GDP since 2010. As the UNECA report notes, over 50% of African countries recorded fiscal deficits above 3% in 2019.

Many developing countries are now caught up in a situation of a debt overhang whereby the present value of their existing debt is bigger than their ability to generate the expected revenues to cover future debt repayments (Myers, 1977; Bulow and Shoven, 1978).

This state of affairs has led to calls for immediate payment standstills, with debt payments postponed in the short term (see, for example, Bolton et al, 2020). As the World Bank report points out, ‘Debt service suspension is a powerful, fast-acting measure that can bring real benefits to people in poor countries, particularly countries that don’t have the financial resources to respond to the coronavirus (Covid-19) crisis.’

The International Monetary Fund (IMF) and the World Bank have been pro-active in implementing a debt standstill. The G20 group of countries has agreed to a debt service standstill on bilateral loans for a group of 76 low-income countries. Such agreement, which ensures a transfer of funds to the IMF and the World Bank from the G20 group of countries, is essential for the balance sheets of international financial institutions such as the IMF as interest rate payments are suspended and sovereign debt is written down.

How should sovereign debt be restructured?

The negative shock resulting from Covid-19 was largely unanticipated. A recent study shows that the medium-term consequences of an unanticipated negative shock such as Covid-19 will depend on the debt restructuring process itself (Ghosal and Thomas, 2020). Restructured debt must be sustainable and the debt overhang must be eliminated.

For this to happen, the interest rate at which the debt is restructured must be lower than the expected rate of growth by a factor that takes account of the existing stock of debt. As the UNECA report notes, 22 African countries had debt-to-GDP ratios above the African average of 61%. For a given level of financing (which can consist of existing debt payments being rolled over as well fresh lending), there is an upper bound on the interest rate at which debt can be sustainably restructured.

The UNECA report points out that the yield on ten-year government bonds indicates that current sovereign debt is unsustainable: it varies from 11.03% for South Africa to 16.67% for Uganda, interest rates that are far higher than the projected growth rates for these countries. In contrast, note that the yields on sovereign debt are close to zero (and in some cases negative) for G7 countries.

Using data from the UNECA report, Ghosal and Thomas conduct a calibration exercise in an attempt to quantify how, given the estimated stock of outstanding debt, different levels of financing affect the upper bound on the interest rate at which debt can be sustainably restructured. This allows an understanding of the conditions under which a debt standstill on its own is sustainable. When a debt standstill is not sustainable, it provides an estimate of the magnitude of the debt write-down required to ensure debt sustainability.

The key message from the calibration exercise is that under plausible assumptions about the medium-term growth prospects, there is no positive interest rate at which sustainable debt restructuring can take place. Hence, debt restructuring must involve a mix of suspension of interest rate payments, a substantial debt write-down (ranging from 20% to 50%) and new financing in the form of outright grants (and loans at very low interest rates).

Might contingent debt contracts help (Shiller, 1993)? With these kinds of contract, the interest rate paid on sovereign debt is contingent on the prevailing state of the world. On the face of it, it is an attractive idea to ensure that sustainability holds in all future states of the world, and contingent debt restructuring can be achieved by linking the interest rate on the restructured debt to future GDP growth or future export earnings (Brooke et al, 2013).

Can contingent debt restructuring restore sustainability when non-contingent debt restructuring cannot? A surprising result in Ghosal and Thomas (2020) is that the upper bound on the interest rate at which debt can be sustainably restructured displays diminishing sensitivity to the future growth rate of a country – that is, it is concave in the future rate of growth rate.

A key implication is that there cannot be a sustainable contingent debt restructuring proposal with the same expected present value as an unsustainable non-contingent debt restructuring proposal. Hence, faced with an unsustainable non-contingent debt restructuring proposal, a sustainable contingent debt proposal must entail a debt write-down or additional financing or both.

What other issues need to be resolved?

Even if creditor countries and the international organisations such as the G20 and the IMF agree to debt relief, there are at least two issues that will need to be resolved. Official bilateral lending between countries can be restructured using organisations such as the Paris Club (which led the HIPC initiative for ‘heavily indebted poor countries’). Private creditors, on the other hand, are represented by organisations such as the London Club (a consortium of banks that lend to low- and middle-income countries) and the International Institute of Finance.

First, private creditors will demand to be repaid out of the disbursements by official creditors. For example, the Jubilee Debt Campaign points out that 28 countries at high risk of debt default had received $11.3 billion (£8.9 billion) that would be used to meet private sector debt commitments. Private sector participation in debt restructuring will imply that commercial banks that have lent to developing country sovereigns will need to write down the net present value of their loans.

Second, there is the issue of debtor ‘moral hazard’ whereby the disbursements are misused for private consumption by elites in the debtor states or in wasteful, unproductive investment. To address this issue, Ghosal and Thomas (2020) argue that participation in the debt restructuring process by citizens of the debtor state is imperative.

Such participation can be based on the UNCTAD (United Nations Conference on Trade and Development) road map (UNCTAD, 2015) where women, public health practitioners, key workers, community groups and civil society organisations participate in the debt restructuring process to determine the financing needs of the debtor state, the interest rate at which the financing occurs as well as the use of the finance within the debtor state.

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Authors: Sayantan Ghosal and Dania Thomas, University of Glasgow
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