Better ways to reduce the pain of debt crises for developing countries?

9 April 2024 | Guest comment

IMF Managing Director Kristalina Georgieva meets Zambian President, Hakainde Hichilema at UNGA77 in September 2022. Credit: IMF Photo/Kim Haughton

High interest rates and reduced access to global capital markets have made it harder for many developing countries to service and roll over significant portions of their maturing external debt, limiting their ability to make necessary investments to advance the Sustainable Development Goals (SDGs) and address climate change (see Observer Winter 2023, Autumn 2023). With a debt servicing crunch facing developing countries between now and 2026, there is a need for urgent intervention.

A recent study by the Finance for Development Lab (FDL) suggests that many of these countries face an illiquidity rather than an insolvency problem and advocates a response that incorporates preemptive debt reprofiling combined with scaled up international investment support to begin funding the green transition. But beyond the liquidity problem we also need to face a long-overdue, and more fundamental, reform of the international financial architecture and sovereign debt system.

The low global growth environment, higher debt costs and geopolitical conflicts already undermine developing countries’ efforts to advance their development agendas and begin to take on the climate challenge. However, in our search for things that can be done now, we must ensure that even partial solutions are consistent with our longer-term vision of a reformed, development-focused international financial system (see Observer Spring 2023).

Beyond the liquidity problem we also need to face a long-overdue, and more fundamental, reform of the international financial architecture and sovereign debt system.

When it comes to sovereign debt, the dividing line between illiquidity and insolvency depends largely on the “pain” that a country is willing to endure to avoid default (see Observer Winter 2023). And since the costs of default under the current international financial architecture are high, so are the “pain thresholds”. Faced with complex, protracted, and ineffective debt workout processes (see Observer Winter 2021, Winter 2020), countries are, instead, making the impossible choice to privilege debt servicing over investments in the SDGs. The FDL’s proposal to link liquidity relief with an International Monetary Fund (IMF) programme may not solve the problem given the time taken to negotiate and implement such arrangements (see Observer Spring 2024). The proposal has two key questions to answer: Will it be enough? and, will it deliver relief in time? Unless these questions can be more definitively answered, the process might only serve to worsen the situation of citizens down the line.

Private credit providers’ share of developing country debt increased significantly between 2010 and 2021 – they doubled for low-income countries (LICs) to 13 per cent and are now the dominant source of funding for lower-middle income countries (LMICs) – see figure V.1 from the Trade and Development Report 2023. By the end of 2023, they accounted for almost a quarter of the external exposure of the 36 Poverty Reduction and Growth Trust-eligible countries currently listed by the IMF as highly indebted or in debt distress. This is only slightly less than the exposure of those countries to bilateral creditors and serves to emphasise that without private sector participation, any developing country debt workout process is doomed to be too little and ineffective. In an environment where debts are being serviced, there is little incentive for the private sector to take seriously attempts to reprofile the debt of the country participating in the debt restructuring. Even if the private sector is persuaded to join, as the G20 Common Framework has shown, lack of comparability of treatment for different types of lenders creates prolonged and unproductive negotiations between different creditor groups with high costs to the country concerned. Much more needs to be put in place to secure the rapid restructuring of debt to limit long-term damage to the borrower.

Another way the sovereign liquidity problems of the kind identified by FDL could be addressed would be with a better-functioning global financial safety net. There are several improvements that could be made to the existing system, including the effective rechanneling of (more) unused Special Drawing Rights (see Briefing, Reconceptualising Special Drawing Rights as a tool for development finance); revised IMF quota limits that replace the existing skewed and outdated ones and help to recapitalize the IMF (see Observer Winter 2022); the abolition of tiered interest rates on the IMF’s Resilience and Sustainability Trust (RST) to support climate-related projects (see Observer Spring 2024), and the elimination of IMF surcharges.  The latter are a penalty charge that are expected to impose costs of $2.1 billion on 17 developing countries in 2024 alone (see Observer Autumn 2022, Spring 2022).

These improvements could be adopted relatively quickly and with limited cost.  Additionally, the IMF and World Bank should lead the way to the universal adoption of contingency clauses in new debt agreements that provide safeguards in the event of climate catastrophes, natural disasters, and other crises, increasing resilience of developing countries to external shocks. Then we will have made progress in adopting a more development-focused global financial system.