Since the Latin American debt crisis of the 1980s, sovereign debt crises have become commonplace in emerging and developing economies.

Now Sri Lanka needs a bailout from the International Monetary Fund, the IMF, after defaulting on its external debt in May, and a growing number of low-income countries face similar challenges.

The World Bank estimates that around 60% of all emerging and developing economies have become high-risk debtors. Up to a dozen could default over the next 12 months.

Unlike advanced economies, where steep increases in public debt following the emergence of COVID-19 encouraged a rapid return to trend growth, developing economies have been constrained by a shortage of vaccines and a lack of headroom. monetary and fiscal maneuver. Unable to deficit finance their exit from the synchronized global downturn, these countries must now deal with the economic fallout from the Ukraine crisis, which virtually eliminates a short-term return to pre-pandemic growth rates.

With a few exceptions – Sri Lanka and Zambia, for example – most developing economies are not heavily indebted. Collectively, their average debt-to-GDP ratio has only increased by seven percentage points to 65% since the start of the pandemic, well below the 20 percentage point increase in advanced economies where debt combined sovereign now represents on average 122% of GDP. The flow of funds that developing economies receive from global bond markets and banks has remained woefully low. According to the most recent estimates from the Institute of International Finance, their combined sovereign liabilities represent less than 30% of global public debt.

Worse still, following post-pandemic credit downgrades, many low-income countries cannot access international capital markets and are now facing severe liquidity constraints that could turn into solvency crises. And because these countries’ below-investment-grade credit ratings have increased their borrowing costs, the fiscal impact of their sovereign liabilities has increased, and their governments’ reduced ability to roll them over to maturity has raised the specter of a developing country debt crisis.

SOVEREIGN BOND

Ghana, for example, planned to issue a bond to refinance its foreign currency-denominated debt earlier this year. But with a wave of ratings downgrades pushing up international bond yields, Ghana was effectively shut out of international financial markets and its ten-year sovereign bond yield soared above 22%. After resorting to painful internal adjustments – tax increases and discretionary spending cuts – during the pandemic, Ghana is now facing soaring food prices and its government is seeking IMF assistance.

Two other factors combine to increase the risk of liquidity stress in developing markets: the currency of lending and the shift to variable interest rates in an environment of increasingly complex lending structures and growing dependence on international capital markets.

Between 2000 and 2020, the number of low-income countries with variable-rate external debt rose sharply, from 13 to 31. And now that systemically important central banks are normalizing monetary policies to fight inflation, these countries will face significantly higher costs to service their debt. external debts.

While reliance on foreign-currency-denominated debt can reduce the risk of runaway inflation, it can also increase the risk of sovereign default, especially when a sharp depreciation of the exchange rate suddenly increases external debt servicing costs. . This is particularly the case during episodes of heightened global volatility and tighter financing conditions, which are often associated with massive capital outflows from emerging and developing economies.

Historically, sovereign defaults have been driven by markets’ reluctance to rollover existing debt or to do so only at prohibitively high interest rates. In emerging and developing economies, overstated risk premia, due to distorted perceptions, amplified the fiscal impact of sovereign debt and were a major driver of liquidity crises and default risk.

Advanced economies that have the “exorbitant privilege” of issuing reserve currencies generally do not face such risks. Because their currencies are seen as safe havens, they can sustainably attract foreign investment in Treasuries and bonds, continuously refinance debt at low cost, and run deficits without tears.

Take the example of the European Central Bank, the ECB, which recently adopted exceptional measures to reassure investors and stem bond market volatility in response to renewed concerns about the “risks of fragmentation” within the euro zone. As part of the “anti-fragmentation instrument” it adopted in March, the ECB “now reserves the right to deviate from the ratings of credit rating agencies in the future if justified, in accordance to its discretion in monetary policy”. The short-term impact of this decision was remarkable, with bond yields for the weakest members of the Eurozone falling sharply immediately afterwards.

DEVELOPING ECONOMIES

But systemically important central banks should be no less concerned about the disproportionate gaps between advanced and developing economies – what we might call the “risk of global fragmentation”. Tighter funding conditions by the US Federal Reserve and other major central banks have exacerbated macroeconomic management challenges in developing economies, increasing exchange rate volatility, increasing liquidity risks and widening spreads .

In the past, systemically important central banks have managed to extend some of the benefits conferred by their exorbitant privilege to other countries. At the height of the pandemic crisis, for example, the Fed strengthened its currency swap arrangements – first introduced during the 2008 financial crisis – and widened the geographical coverage of its support to include a few emerging economies.

This decision led to an appreciation of the currency, an improvement in credit default spreads and a decline in long-term interest rates in the beneficiary countries. And beyond mitigating liquidity risks, the extension of dollar-denominated swap lines has reassured investors, stemming capital outflows and strengthening the ability of these countries to refinance their debts.

Even though low-income countries do not pose systemic risk to the international financial system, a concerted effort to mitigate liquidity risks should be a high global priority, not least because debt restructuring has enormous costs.

According to the World Bank, this leads to lower output growth in the short term. For countries that lack the protection of systemically important central banks, induced default borrowing rates undermine macroeconomic stability and reduce the supply of medium- and long-term patient capital, without which developing economies cannot undergo the transformation necessary to break the negative correlation between growth and commodity price cycles.

In the long term, the most sustainable solution to recurring liquidity crises is to develop deep, efficient and well-regulated domestic capital markets in emerging and developing economies. Within an integrated financial market framework, a vibrant repo market will strengthen the link between money and bond markets, allowing the emergence of liquid capital markets. Taken together, these highly integrated markets will help construct appropriate yield curves to improve investment decisions.

The world already has effective and proven tools to prevent recurrent liquidity crises, a prerequisite for building these integrated markets. Democratizing the global financial system to maximize its positive impact on development is perhaps the most significant challenge on the road to international debt sustainability.

 Hippolyte Fofack is Chief Economist and Director of Research at the African Export-Import Bank.© Project Syndicate 2022www.project-syndicate.org