by Joseph Joyce
The Coming Wave of Debt Restructurings
The news that the Federal Reserve will raise interest rates in 2022 sooner than anticipated was not surprising in view of the continued high rates of U.S. inflation. While U.S. asset prices are falling in response to the prospect of higher rates as well as a smaller Fed balance sheet, foreign markets are straining to decipher the spillover effects on their economies. But it is only a matter of time until emerging markets and developing economies face higher financing costs and the need for debt restructurings.
The World Bank pointS out in its most recent Global Economic Prospects that global debt levels in 2020 rose to their highest levels relative to GDP in decades. The publication also shows that economic projections for the emerging markets and developing economies excluding China are for lower growth rates than those of the advanced economies. Consequently, servicing and repaying the debt represents a challenge for those countries. World Bank President David Malpass warned that 60% of the poorest countries need to restructure their debt or will need to.
Ayhan Kose, Franziska L. Ohnsorge and Carmen Reinhart of the World Bank and Kenneth Rogoff of Harvard University examine the options that countries with elevated debt levels face in their NBER working paper, ”The Aftermath of Debt Surges.” They divide the possible responses into orthodox and heterodox solutions. The former includes strong economic growth that reduces relative debt levels as well as fiscal consolidation that can generate surpluses to pay off debt. Other measures are the privatization of public assets and higher wealth taxation, both of which can yield needed revenues. All come with associated downsides hazards, such as higher interest rates if growth comes with more inflation, or a lack of the conditions needed for successful privatization.
Heterodox approaches include unexpected inflation to erode real debt levels, financial repression to maintain low interest rate and debt default or restructuring. The authors point out that external defaults and restructuring impose long-term costs in the form of higher bond yields. Nonetheless, they warn that debt default, both external and domestic, may become more common in the wake of the increase in debt in response to the pandemic.
Similarly, Stephan Danninger, Kenneth Kang and Hélène Poirson of the IMF have a post on the IMF’s Blog, “Emerging Economies Must Prepare for Fed Policy Tightening,” that presents measures that the governments of these countries should undertake to limit the fallout from higher foreign rates. These include allowing their currencies to depreciate while raising their own interest rates. Of course, such measures make supporting a weak domestic economy more difficult. They warn that countries with significant nonperforming debt levels will face solvency concerns.
The IMF, the World Bank and the Group of 20 have joined together to implement a “Common Framework” to help low-income countries deal with their unsustainable debt. Creditor Committees will be created on a case-by-case basis to coordinate debt restructuring by private and official creditors. Private lenders, however, have not shown an interest in joining the program and to date, only three countries—Chad, Zambia and Ethiopia—have applied for assistance.
Another challenge facing the Common Framework is the role of China, which has become the largest bilateral lender to the low-income countries. China has not joined the Paris Club, the organization of creditor nations that deals with bilateral debt between advanced economies and low-income countries. However, it has to date followed the policies of the Paris Club members in deferring debt. One possible complication consists of whether loans form Chinese policy banks, such as the China Development Bank and the Export-Import Bank of China, and state-owned commercial banks, such as the Industrial and Commercial Bank of China, should be treated as private or official creditors.
Anne Krueger of Johns Hopkins University has warned that debt restructuring and further lending should be accompanied by appropriate economic policies. Some countries were engaging in unsustainable spending before the pandemic, and any new lending should be used for spending related to the pandemic. She cites Bolivia, Ghana, Madagascar, Pakistan, Sri Lanka, and Zambia as countries that had excessive expenditures before the pandemic.
The possibility of a debt crisis among the emerging markets and developing nations has long been foreseen (see here and here). The wave of new lending to these countries in the period preceding the pandemic was similar to previous surges that had led to financial crises, and the pandemic further raised debt levels. The combination of higher interest rates in the advanced economies, sluggish economic growth and the possibility of further disruptions due to the pandemic pose a challenge to governments with limited ability to respond.