Assessing the Deterioration of External Debt in Low and Middle Income Countries
Preface
I produced this Research Report for a Mock World Bank Council held by the University of Warwick in 2022. Through this committee, I had hoped to build upon my previous work in Dependency theory to explore how structural inequalities could be maintained or challenged by the action of international financial institutions. I challenged delegates to analyse the intellectual inheritance of existing debt policies and investigate opportunities for change.
Introduction
There is a seriousness and urgency in modern debt trends that imperil the 2030 Agenda for Sustainable Development and could precipitate a new financial crisis. Today international debt is part and parcel of all nations as it has in the past aided economic growth and development. However, debt sustainability in developing countries is deteriorating fast, with the ratio of global debt to global GDP being almost one-third higher than it was on the eve of the world's worst global financial crisis in 2008.
Borrowing however is a double-edged sword and unsustainable debt poses significant risks to global commitments to end extreme poverty, including the Sustainable Development Goals (SDGs). Unsustainable debt burdens compel governments to spend more on debt servicing and less on education, health and infrastructure. Moreso if nations are unable to pay their debt and default instead. This topic is vast, as many member nations represent players in the international external debt market. Problems will thus be intricate and a resolution which suits all will not come easily. However, the dias encourages each delegate’s endeavours to the utmost, challenges the convenience of conventional solutions and seeks to innovate simple, concise ideas that when applied, empower and uplift nations.
Current Situation
After the financial crisis of 2008, Countries around the world took aggressive measures to address the fallout of the financial crisis. The most notable policy actions included the easing of monetary policies, the recapitalization of financial systems, the bailout of the household and corporate sectors, the overhaul of financial regulatory systems, and the launching of fiscal stimulus packages. Most central banks significantly lowered their policy interest rates, with several approaching the zero lower-bound constraint. Many central banks also adopted aggressive balance sheet policies, including credit policies that affected interbank and nonbank credit markets and the purchase of government bonds and foreign currency–denominated securities.
These government interventions have thus inadvertently led to an increased supply of sovereign debt, with implications for growth and debt sustainability outlooks in both mature and developing economies. We are able to analyse and categorise (external) debt sustainability situation by looking at the possible effects of the crisis through burden indicators.
the present value of debt over GDP,
the present value of debt over exports,
the present value of debt over government revenues,
debt service over exports,
debt service over government revenues—used in the World Bank–IMF DSF.
As expected, debt burden indicators deteriorate significantly for all countries with the severity of the crisis, given the financial conditions under which a country's finances (substitutes) its reduced export proceeds. A tightening of financial conditions leads to a significant deterioration in liquidity or debt service indicators. Hence, today many nations unable to handle “shocks” which tighten their financial situation often end up having to make adjustments, in the form of significantly larger cuts in social expenditures and public investment or, if such cuts are deemed politically unfeasible, a sovereign default. This conflict between undertaking external debt in the interest of growth and being unable to grow due to the need to service deteriorating debt can be classified as a “debt trap”
Although this overestimates the actual effect of the deterioration of external debt on low/middle-income countries, the results from the simulations highlight the importance of concessional financing for low-income countries, especially under a severe crisis. Studies have found that under more stringent financial conditions and a protracted crisis, the number of countries at high risk of default increases significantly, reaching about half or more of the overall sample.
Defaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavourable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country's population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country. Examples can be cited such as:
DPRK (1987)
Post-war North Korea required massive investment in order to jump-start economic development. In 1980 it defaulted on most of its newly-restructured foreign debt, and owed nearly $3 billion by 1987. Industrial mismanagement and significant military spending led to a decline in GNP and the ability to repay outstanding loans.
Russia (1998)
A large portion of Russian exports came from the sale of commodities, leaving it susceptible to price fluctuations. Russia's default sent a negative sentiment throughout international markets as many became shocked that an international power could default. This catastrophic event resulted in the well-documented collapse of long-term capital management.
Argentina (2002)
Argentina's economy experienced hyperinflation after it began to grow in the early 1980s, but managed to keep things on an even keel by pegging its currency to the U.S. dollar. A recession in the late 1990s pushed the government to default on its debt in 2002, with foreign investors subsequently ceasing to put more money into the Argentine economy.
Hence the current situation is that which illustrates the importance of debt management. An important factor that contributed to the accumulation of unsustainable levels of external debt in the aforementioned examples was poor debt management and imprudent borrowing practices of the debtor countries. Public sector external borrowing was not carefully managed both in terms of the amount and the terms. Borrowed resources were often used without regard to economic return and debt servicing in the future. A lack of macroeconomic policy adjustment in the face of shocks led to excessive borrowing for consumption and greatly exacerbated debt problems. Maintaining external debt sustainability, therefore, will require significant strengthening of heavily indebted poor countries’ debt management capacity, and implementation of prudent policies on non-concessional and concessional borrowing.
Another important aspect of sustainable financing is the development of new financial instruments that embed more resilience into the debt structure of the recipient country, such as State-Contingent Debt Instruments (SCDIs). SCDIs can play an important role in managing public debt in a world of macroeconomic uncertainty. The impacts of economic shocks on several SSA countries have been exacerbated by structural challenges, including low levels of economic diversification and an acute dependence on commodity markets to drive growth. SCDIs can build fiscal resilience to such shocks and share risk by linking debt service to pre-defined macroeconomic variables. This, in turn, will alleviate pressure on debt obligation and financing needs in difficult times, avoiding the disruption caused by a formal default. dead-weight costs of long-term debt restructuring during a crisis would be avoided, as debt would be modified automatically.
There is then a need today for a strategy implementation which would ensure (i) coordination with monetary and fiscal policies, particularly when economic shocks occur and a timely adjustment of domestic policies is needed for a speedy recovery; (ii) transparency, including public disclosure, and accountability (iii) monitoring, analytical, and negotiation capabilities.
Regional Trends and Country Classifications in Debt Deterioration
For the current 2020 fiscal year, low-income economies are defined as those with a GNI per capita, calculated using the World Bank Atlas method, of $1,025 or less in 2018; lower-middle-income economies are those with a GNI per capita between $1,026 and $3,995; upper-middle-income economies are those with a GNI per capita between $3,996 and $12,375; high-income economies are those with a GNI per capita of $12,376 or more. As these nations vary in terms of development and economic activity, their status and roles regarding international external debt are likely to defer.
There are currently over 40% of Low-Income Developing Countries assessed at high risk of external debt distress or in debt distress, doubling the number of countries in such categories since 2013. Forty-nine percent of IDA-eligible countries assessed under the joint World Bank-IMF Debt Sustainability Framework (33 out of 68 countries) are currently at high risk of external debt distress or in distress. This share declines to 29% without small states. Increased debt vulnerabilities are the result of rising public debt levels and changing composition of debt towards more expensive and riskier sources of financing.
Net financial flows (debt and equity) to low and middle-income countries rose 61% in 2017 to the highest level in three years, driven by a rebound in net debt inflows. Net financial flows climbed to $1.1 trillion in 2017, a level last seen in 2014. While external debt burdens on average remained moderate and were little changed from 2016, one-third of low- and middle-income countries had a ratio of external debt-to-GNI above 60% at the end of 2017 and nearly half the countries had debt-to-export ratios exceeding 150%. External debt stocks on average rose 10 percent in 2017, but increases were much larger for some countries. On average, external debt burdens remained moderate and were little changed from 2016. The ratio of debt-to-GNI and to-export earnings for low- and middle-income countries averaged 25% and 102%, respectively in 2017, but for some countries, those ratios were substantially higher.
The total external debt of low- and middle-income countries rose 10% in 2017 to $7.1 trillion, a faster pace of debt accumulation than the 4% increase in 2016. The rise was driven by net debt inflows of $607 billion and year-on-year exchange rate adjustments about the U.S. dollar (around half the external debt of low- and middle-income countries is denominated in currencies other than the U.S. dollar). Short-term debt was the fastest-growing component of external debt, rising 19%, while long-term external debt rose 7%. Short-term debt rose to 26% of total external debt stocks at the end of 2017, up slightly from 2016, but was little changed about low- and middle-income countries’ imports.
China, which accounted for nearly one-quarter of the combined external debt stock of low- and middle-income countries at the end of 2017, was the main driver behind the rise in short-term external debt. Excluding China, other low- and middle-income countries recorded a 9% increase in short-term debt stocks in 2017. Long-term external debt stocks remained broadly evenly divided between public sector and private sector borrowers but with a slight uptick in the share owed to the public sector, to 53% at the end of 2017 (from 50% in 2016).
Regional-level trends in external debt in 2017 accumulation vary
Countries in Sub-Saharan Africa added 15.5% more external debt, led by Nigeria and South Africa whose external debt stock increased 29% and 21% respectively. Other Sub-Saharan countries increased external debt stocks by an average of 11% . South Asian economies expanded external debt stocks by 13.3% on average, led by Bangladesh (23% ) and Pakistan (17% ).
The Middle East and North Africa region saw external debt stocks rise 11.7% as a 23% rise in the external debt stock of Egypt in 2017 was offset by a 5% increase in Lebanon. Countries in the East Asia and Pacific region other than China increased external debt stocks by an average of 9.3%.
External debt stocks rose 2.5% in Europe and Central Asia and in Latin America and the Caribbean in 2017.
For many low- and middle-income countries, the rise in external debt burdens is contributing to economic vulnerabilities Among low- and middle-income countries, 31% had an external debt-to-GNI ratio above 60% at the end of 2017, double the number of countries with a comparable ratio at end 2008, including 11 countries where the ratio was over 100%. Similarly, at the end of 2017, 45% of low- and middle-income countries had an external debt-to-export ratio over 150%, compared with 24% in 2008, and 29 countries had ratios exceeding 200%. Debt-to-GDP ratio exceeded 70% in a fifth of emerging and middle-income countries and was more than 60% in low-income countries.
This leads to the following observation: in mid-2018, the number of low-income developing countries in over-indebtedness or at high risk of it reached 31 – as against 13 in 2013. The number has practically tripled. The increasing bond market activity of low-income countries has pushed up the amount they spend on servicing their debts. Developing countries’ debt payments increased by 60% in the three years to 2017, according to research published last week by the Jubilee Debt Campaign, which lobbies for debt forgiveness in emerging markets.
Challenges Concerning External Debt
There is often no single factor responsible for the increase in debt and studies have shown that the deterioration of external debt especially in Lower and Middle-income countries can be seen as a culmination of ;
Exogenous factors, such as adverse terms-of-trade shocks or even weather conditions
Adjustment policies, or their lack thereof in mitigating the effects of exogenous shocks giving rise to sizeable financing needs and debt-servicing
Lending and Refinance policies outlined and upheld by Creditors
The lack of prudent Debt Management in Countries
Political factors, such as civil war and strife
Hence bearing in mind what would lead to a deterioration of external debt, Countries often face challenges such as:
Limited Framework structure
An important aspect of debt management includes establishing a clear legal and organisational framework, as well as reporting policies to ensure accountability and transparency. The World Bank must encourage the establishment of systems and procedures to ensure timely debt recording and debt service payments. Looking ahead, effective debt management will require the increasingly active use of mitigating measures to address debt vulnerabilities, especially in frontier countries. A recent evaluation of debt management institutions and capacity based on the DeMPAs of 22 African countries (World Bank, 2018) found that less than 50% of countries fulfil the minimum requirements for sound international standards in the legal framework for debt management to ensure segregation of duties and avoid conflicts of interest. Only 40% adhere to sound practice for domestic borrowing, and only 22% meet the minimum requirements for the effective management of loan guarantees, on-lending and the issuance of derivatives continued deficiencies at a more basic level’ frustrate efforts to build capacity in more technical areas. One ‘basic’ area that has been problematic is the development of a capable and fully functional debt-recording system
Implementation of Weak or Unsatisfactory Policies
While there is a wide consensus that countries need to mobilise more domestic revenue to ensure debt sustainability and create fiscal space for much-needed investment and development spending, we have to recognise the limits of domestic revenue mobilisation as a policy lever. Many SSA countries already have revenue-to-GDP ratios that are higher, by historical standards, than they were in today’s high-income countries when they were at similar levels of development. There needs to be a focus on improving the efficiency of public investment to ensure that it helps to drive economic growth. While borrowing to finance public investment projects is justified because it can generate higher growth, revenue and exports, leading to lower debt ratios over time, this assumed relationship between debt, investment and growth should not be taken for granted.
Lack thereof transparent lending
Although the primary responsibility for avoiding the build-up of unsustainable debt lies with the sovereign borrower, lenders should also lend in a way that does not undermine a country’s future debt sustainability. Both borrowers and lenders can be adversely affected by sovereign defaults, and both are accountable for their conduct in these transactions. Irresponsible borrowing or lending can lead to ‘illegitimate debt’, which can contribute to unsustainable debt burdens Ensuring transparency is becoming even more complicated with the rise of collateralized loans. The terms of these loans are often complex and may be revealed only after countries experience debt distress and begin to default. The terms may appear favourable at first, but debtors may be required to sell commodities to the lender at below-market prices or sell off public assets as part of the conditions. There are often information gaps beyond the basic lending terms on collateralisation and other types of security, which can make it difficult to determine the extent of risks for the debtor country, or even to assess whether the claims are commercial or official in nature. Ultimately, the growing importance of new types of lenders underscores the need to ensure that they exercise due diligence in their lending decisions and develop contingency plans to engage in debt restructuring deals.
Despite significant improvements in debt data, current public debt statistics suffer from limited debt data coverage and debt transparency– which leaves room for unpleasant debt surprises. Data on domestic and external debt is often recorded in separate databases. Contingent liabilities, such as those arising from government guarantees, debt of SOEs, and public-private partnerships (PPP), are rarely collected in the central debt recording system. Several countries lack a systematic mechanism for collecting and recording information on collateralization. As a result, debt coverage is often incomplete as evidenced in DSAs covered under the World Bank
Unpredictable exogenous or “shock factors”
At the same time, longer-term growth prospects can be undermined by natural disasters, war, or health threats such as the AIDS epidemic affecting many of the HIPCs, particularly several decision point cases such as Malawi, Rwanda, and Zambia. In such cases, in the absence of adequate grant financing, external indebtedness (and the NPV-of-debt to exports ratio) may need to rise to accommodate the financing of reconstruction and rehabilitation.
2.4 Past Actions by The World Bank
The Debt Sustainability Framework (DSF) was adopted in 2005 by the World Bank and the IMF as the standard tool for analyzing debt-related vulnerabilities in low-income countries Its objective is to support these countries’ efforts to meet their development goals without creating future debt problems. Under the DSF, the World Bank and the IMF annually perform Debt Sustainability Analyses (DSAs) assessing countries’ risk of debt distress over a 20-year horizon. This forward-looking approach helps countries balance their need for funds with their current and prospective ability to repay. It also allows creditors to tailor their financing terms in anticipation of future debt distress situations.
DSAs conducted under the DSF focus on five debt burden indicators for public external debt: a) the present value of debt to GDP b) the present value of debt to exports, c) the present value of debt to revenues, d) debt service to revenues, e) debt service to exports.
Each of these indicators has an indicative threshold in the framework that depends on a country’s quality of policies and institutions, as measured by the three-year average of the Country Policy and Institutional Assessment (CPIA) index compiled annually by the World Bank. The specific thresholds are as follows: A rating of the risk of external debt distress is derived by reviewing the evolution of the debt burden indicators concerning their indicative policy-dependent thresholds under a baseline scenario, alternative scenarios, and stress tests. There are four possible ratings:
Low risk: All debt burden indicators are well below the relevant country-specific thresholds. Thresholds are not breached under any stress tests or alternative scenarios.
Moderate risk: Although the baseline scenario does not indicate a breach of thresholds, alternative scenarios and stress tests result in a significant rise in debt service indicators over the projection period (nearing thresholds) or a breach of one or more thresholds.
High risk: The baseline scenario indicates a protracted breach of debt burden thresholds, but the country does not currently face any payment difficulties. Alternative scenarios or stress tests show protracted threshold breaches.
In debt distress: Current debt and debt service ratios are in significant or sustained breach of thresholds. Actual or impending debt restructuring negotiations or the existence of arrears would generally suggest that a country is in debt distress.
The World Bank, the International Monetary Fund (IMF) and other multilateral, bilateral and commercial creditors also began the Heavily Indebted Poor Country (HIPC) Initiative in 1996. The structured program was designed to ensure that the poorest countries in the world are not overwhelmed by unmanageable or unsustainable debt burdens. It reduces the debt of countries meeting strict criteria. also aimed to restore market confidence, enhance the ability to borrow and build fiscal space to service debt obligations.
This was done through Increased Spending and Focus on Poverty Reduction Strategies. As the HIPC Initiative evolved, the provision of debt relief was then linked to the preparation of Poverty Reduction Strategy Papers (PRSPs), which are comprehensive, country-authored plans – prepared in consultation with civil society and other partners – that set out a country’s macro-economic and fiscal priorities to foster pro-poor growth, governance and sectoral programs, and ongoing and proposed poverty reduction policies. This Initiative was also meant to provide a “Fresh Start” for the World’s Poorest Countries and was on the way to achieving its fundamental goal of cutting their external debt to a manageable level.
Twenty-seven countries – two-thirds of the HIPCs – have reached their “decision points” and are receiving relief that will amount to more than $ 54 billion over time. Of these twenty-seven, fourteen countries – Benin, Bolivia, Burkina Faso, Ethiopia, Ghana, Guyana, Mali, Mauritania, Mozambique, Nicaragua, Niger, Senegal, Tanzania and Uganda – have reached their completion points. (The following six countries have reached their completion point since September 2003: Guyana, Nicaragua, Niger, Ethiopia, Senegal, and Ghana).
However, Reports have been published calling into question the efficacy of the HIPC policy in helping lower and middle-income countries. Criticisms stem from 3 areas:
The implementation of Arbitrary and unattainable threshold levels to measure debt sustainability -defined in economic terms and neglecting factors of human and social development have resulted in several least-developed countries with significant debt burdens not being included in the HIPC initiative.
The debt reduction on offer is too small as some countries ended up actually having to pay more after subscribing to the initiative.
The piling up of different sets of conditionalities slows down the process. Conditionalities such as the much-criticized Poverty Reduction Strategy Papers (PRSPs) from the IMF and World Bank failed to align macro-economic issues and poverty issues more closely than in the past
2.5 Questions a Resolution Must Answer (QARMA)
How can regional and global institutions encourage/instil greater global coherence and coordination among national economic policymakers?
What role has the council played and what changes will be made moving forward in regard to the deterioration of External Debt internationally?
Considering the reasons for its limitations, how can the previous solutions be altered to improve its effectiveness in tackling the issue? If not, are there any new existing solutions?
Is there a need for greater realism in growth projections and more transparency of the models underpinning debt projections? How would the World Bank do so?
Should there be an emphasis on capacity building to address weaknesses in debt recording, monitoring, and reporting?
How far can the council go to alleviate issues stemming from exogenous factors in Middle and Low-Income Countries?
