By Vitor Gaspar and Ceyla Pazarbasioglu
With sovereign debt at heightened risk, a global, collaborative approach is needed to achieve an orderly resolution of debt problems and prevent defaults.
We live in dangerous times. The world faces renewed uncertainty as war, now in its third year, joins an ever-changing and ongoing pandemic. In addition, problems that arose before COVID-19 have not gone away. When policymakers return to Washington for the spring meetings of the IMF and World Bank in the coming days, one of the key issues will be the world’s growing debt vulnerabilities.
Debt was already very high before the first corona lockdowns. As the pandemic hit, unprecedented peacetime economic support stabilized financial markets and gradually eased liquidity and credit conditions around the world. Fiscal policies in many countries have been able to protect people and businesses during the pandemic. It also supported monetary policy by increasing aggregate demand and avoiding deflationary dynamics. All this contributed to the financial and economic recovery.
Now the war in Ukraine is adding risk to unprecedented levels of public borrowing while the pandemic is still straining many government budgets. The situation underscores the urgent need for authorities to implement reforms, including governance reforms, to improve debt transparency and strengthen debt management policies and frameworks to reduce risk.
The fund will continue to help address the root causes of uncertain debt with granular policy advice and capacity-building activities. However, with heightened sovereign debt risks and significant fiscal and financial constraints, international cooperation to minimize stress will be required in the period ahead. In cases where liquidity support alone is not sufficient, policymakers must adopt a collaborative approach to reduce the debt burden of the most vulnerable countries, promote greater debt sustainability and balance debtor and creditor interests.
take on debt
During the pandemic, deficits widened and debt piled up much faster than in the early years of other recessions, including the biggest: the Great Depression and the global financial crisis. The extent is comparable only to the two world wars of the 20th century.
According to the IMF’s Global Debt Database, borrowing increased by 28 percentage points to 256 percent of gross domestic product in 2020. About half of this increase was accounted for by governments, with non-financial corporations and households accounting for the remainder. The national debt now accounts for nearly 40 percent of the world’s total debt, the highest in nearly six decades.
Emerging and developing countries (excluding China) accounted for a relatively small proportion of the increase. Although their public debt is well below where it was in the 1990s, debt levels in these economies have steadily increased in recent years. This reflected in part their ability to enter private markets, their creditworthiness and the development of their domestic bond markets. Maintenance costs have also risen sharply. About 60 percent of low-income countries are currently in distress or at risk of distress.
Risks from rising inflation
Until recently, low debt service costs allayed concerns about record levels of public debt in developed countries. There were two elements. First, nominal interest rates were very low. In fact, they have been close to zero or even negative along the entire yield curve in countries like Germany, Japan and Switzerland. Second, neutral real interest rates were on a significant downward trend in many economies, including the United States, the euro area and Japan, as well as a number of emerging markets.
This, together with real interest rates being below real growth rates, contributed to the impression of a painless fiscal expansion. However, given heightened risk perception and expected monetary tightening, debt vulnerabilities are coming back into focus.
High levels of public and private borrowing add to already worrying financial vulnerabilities. The number of advanced economies with debt ratios larger than the size of their economies has increased significantly. There is a risk that ever-increasing debt will cause interest rate spreads to widen for countries with weaker fundamentals, making them more expensive to borrow. Furthermore, while inflation surprises can lower debt-to-GDP ratios in the short term, they can ultimately lower persistent inflation – and inflation volatility can increase borrowing costs. This process can be quick in countries with short transit times.
In advanced economies, economic activity, the primary balance, spending and receipts are expected to return close to pre-pandemic forecasts by 2024. However, the situation in developing countries is much more worrying. Both emerging and low-income economies face sustained losses in GDP and revenue. This implies that primary spending will be permanently lower as a result of the pandemic, further pushing countries back from achieving the Sustainable Development Goals. This is a matter of global importance.
The sharp rise in energy and food prices increases this pressure on the poorest and most vulnerable. Food accounts for up to 60 percent of household consumption in low-income countries. These countries face a unique combination of factors: urgent humanitarian needs meet extremely tight financial constraints. For low-income countries that depend on imported fuel and food, the shock may require more grants and heavily discounted finance to make ends meet while supporting needy households.
Global financial conditions are tightening as major central banks hike interest rates to curb inflation. In most emerging markets, government bond spreads are already above pre-pandemic levels. Credit crunch is exacerbated by slowing foreign lending from China, which faces solvency concerns in real estate sector; Expanding lockdowns in Shanghai and other major cities; the transition to a new growth model; and problems related to existing loans to developing countries.
A global collaborative approach
Debt restructurings are likely to become more frequent and face more complex coordination challenges than in the past as the creditor landscape becomes more diverse. Mechanisms for an orderly restructuring are in the best interest of creditors and debtors alike.
For low-income countries, the debt service suspension initiative expired at the end of 2021. And the G20 common framework for debt treatments beyond the DSSI has yet to deliver. Improvements are needed. Options should also be explored to help the broader range of emerging and developing countries that are not eligible for the Common Framework but would likely benefit from a global collaborative approach in the coming period. Muddling through will increase costs and risks for debtors, creditors and, more broadly, for global stability and prosperity. Ultimately, the impact will be felt most strongly by the households least able to afford it.
As sovereign debt risks have risen and financial constraints are once again the focus of policy concerns, a global collaborative approach is needed to achieve an orderly resolution of debt problems and avoid needless defaults. The views and interests of debtors and creditors must be balanced.