By Vitor Gaspar and Ceyla Pazarbasioglu
With sovereign debt risks elevated, a cooperative global approach is needed to achieve an orderly resolution of debt issues and prevent defaults.
We live in dangerous times. The world faces renewed uncertainty, as war comes on top of a persistent and evolving pandemic, now in its third year. Moreover, pre-COVID-19 issues have not gone away. When policymakers return to Washington in the coming days for the IMF and World Bank spring meetings, one of the central topics will be the world’s growing debt vulnerabilities.
The debt was already very high before the first confinements linked to the coronavirus. When the pandemic hit, unprecedented peacetime economic support stabilized financial markets and gradually eased liquidity and credit conditions around the world. In many countries, fiscal policy has been able to protect people and businesses during the pandemic. It also supported monetary policy by strengthening aggregate demand and avoiding deflationary dynamics. All of this has contributed to financial and economic recovery.
Today, the war in Ukraine adds risks to unprecedented levels of public borrowing, while the pandemic continues to weigh on many government budgets. The situation highlights the urgent need for the authorities to undertake reforms, including governance reforms, to improve debt transparency and strengthen debt management policies and frameworks to reduce risks.
The Fund will continue to help address the root causes of unsecured debt through specific policy advice and capacity building activities. But, with high sovereign debt risks and notable fiscal and financial constraints, international cooperation to minimize tensions in the period ahead will be necessary. In cases where liquidity support alone is not enough, policymakers must adopt a cooperative approach to alleviate the debt burden of the most vulnerable countries, promote greater debt sustainability and balance the interests of debtors and creditors. .
During the pandemic, deficits grew and debt piled up much faster than in the early years of other recessions, including the most significant: the Great Depression and the global financial crisis. The scale is comparable only to the two world wars of the 20th century.
According to the IMF’s Global Debt Database, borrowing jumped 28 percentage points to 256% of gross domestic product in 2020. Government accounted for about half of that increase, with the rest coming from non-financial corporations and households. Public debt now represents nearly 40% of the global total, the highest in nearly six decades.
Emerging markets and developing countries (excluding China) accounted for a relatively small share of the increase. Although their public debt remains well below 1990s levels, the debt of these economies has steadily increased in recent years. This partly reflected their ability to tap into private markets, their increased creditworthiness, and the development of their domestic debt markets. Maintenance costs have also risen sharply. About 60% of low-income countries are currently in distress or at risk of it.
Risks related to rising inflation
Until recently, low debt-servicing costs eased concerns about record high public debt in advanced economies. There were two elements. First, nominal interest rates were very low. In fact, they have been close to zero or even negative all along the yield curve in countries such as Germany, Japan and Switzerland. Second, neutral real interest rates were on a clear downward trend in many economies, including the United States, the euro area and Japan, as well as in a number of emerging markets.
This, combined with real interest rates below real growth rates, has helped to give the impression of a painless fiscal expansion. However, with heightened risk perception and an expected tightening of monetary policy, debt vulnerabilities are back in focus.
High public and private borrowing contributes to financial vulnerabilities, which are already of concern. The number of advanced economies with debt ratios larger than the size of their economy has increased dramatically. There is a risk that ever-higher debt levels will cause interest rate differentials to widen for countries with weaker fundamentals, making it more expensive for them to borrow. Moreover, while inflation surprises can reduce short-term debt-to-GDP ratios, persistent inflation – and inflation volatility – can ultimately increase the cost of borrowing. This process can happen quickly in countries with short-term debt.
In advanced economies, economic activity, the primary balance, spending and revenue are expected to return to near pre-pandemic projections by 2024. But the situation in developing countries is much more concerning. Emerging and low-income economies face persistent GDP and income losses. This implies that primary spending will be consistently lower due to the pandemic, which will further push countries back in achieving the Sustainable Development Goals. This is a matter of global concern.
Sharp increases in energy and food prices add to these pressures for the poorest and most vulnerable. Food accounts for up to 60% of household consumption in low-income countries. These countries face a unique confluence of factors: dire humanitarian needs intertwine with extremely tight financial constraints. For low-income countries that rely on imported fuel and food, the shock may require more subsidies and highly concessional financing to make ends meet while supporting households in need.
Global financial conditions are tightening as major central banks raise interest rates to contain inflation. In most emerging markets, sovereign spreads are already above pre-pandemic levels. The credit crisis is exacerbated by the drop in foreign loans from China, which is facing solvency problems in the real estate sector; expand lockdowns in Shanghai and other major cities; the transition to a new growth model; and problems with existing loans to developing countries.
A global cooperative approach
Debt restructurings are likely to become more frequent and will face more complex coordination challenges than in the past due to the increased diversity of the creditor landscape. The establishment of orderly restructuring mechanisms is in the interest of both creditors and debtors.
For low-income countries, the Debt Service Suspension Initiative expired at the end of 2021. And the Group of Twenty Common Framework for Debt Treatment Beyond the DSSI has not yet been implemented. Improvements are needed. Options should also be explored to assist the wider range of emerging and developing economies that are not eligible for the Common Framework but would likely benefit from a global cooperative approach in the period ahead. Getting by will magnify the costs and risks to debtors, creditors and, more broadly, global stability and prosperity. Ultimately, the impact will be felt hardest by households that can least afford it.
With elevated sovereign debt risks and financial constraints back on the political agenda, a globally cooperative approach is needed to achieve an orderly resolution of debt issues and avoid unnecessary defaults. The views and interests of debtors and creditors should be reflected in a balanced manner.