How to reconcile debt and development

The COVID-19 pandemic is, we hope, only a temporary shock to economies around the world. The appropriate policy response to such a disruption is to borrow to cushion the impact on consumption and investment. But for many emerging markets and developing countries, borrowing could lead to debt service challenges that will require years of austerity to overcome. Yet if they don’t borrow, they will have to cut government spending, which could lead to major health crises, out-of-school children, job losses and a prolonged recession.

What to do? Borrow and risk a debt crisis, or choose austerity and risk a development crisis?

In 2020, countries took very different approaches, largely tied to their income. Governments of advanced economies have provided trillions of dollars in direct and indirect tax assistance, equivalent to 24% of GDP, while those of emerging and developing economies represented only 6% and 2% of GDP respectively.

As private capital markets are pro-cyclical, the risks of debt distress are significant and growing. Global foreign direct investment decreased by 40 percent in 2020 and is expected to decline by an additional $ 100 billion in 2021. Greenfield investment projects and cross-border mergers and acquisitions also fell by 50% last year.

What to do? Borrow and risk a debt crisis, or choose austerity and risk a development crisis?

Half of all low-income countries were over-indebted or at high risk before the pandemic, according to the International Monetary Fund, and six failed Last year. More, 36 developing countries saw their sovereign rating downgraded by one of the three main rating agencies, and 28 others saw their outlook downgraded. While many middle-income countries have returned to international bond markets since the start of the pandemic, only two countries in sub-Saharan Africa (Côte d’Ivoire and Benin) have entered the market.

The risks of widespread developmental distress are also increasing. IMF estimates that low-income countries need $ 450 billion by 2025 to respond to the pandemic and accelerate sustainable investments. Total investment in developing countries (excluding China) decreased by 10 percent in 2020, and is expected to remain below 2019 levels this year and next. And if growth slows, solvency will deteriorate, making over-indebtedness even more likely.

The debt dimension

To prevent this vicious cycle, policymakers will need to tackle two collective action problems that markets cannot solve on their own. First, they must ensure that the pro-cyclical behavior of private creditors does not trigger liquidity problems and debt crises. Most developing countries, especially middle-income countries, were growing fairly well before the pandemic, with stable long-term debt dynamics. If they can refinance their debt on reasonable terms, they should be able to avoid default. This will require additional funding from public and private creditors.

In May 2020, the G-20 suspended bilateral debt service payments by the World Bank’s International Development Association (IDA) countries as part of the Debt Service Suspension Initiative ( DSSI), which has been extended until the end of 2021. DSSI has so far deferred $ 6 billion in debt service payments – resources that developing countries have used to advance the economic recovery and purchase COVID-19 vaccines and personal protective equipment.

But given the continuing nature of the pandemic and the time required to roll out mass vaccination campaigns in developing countries, this is not enough. The G-20 should extend eligibility for DSSIs to all vulnerable countries, including small island developing states and tourism dependent economies. Middle-income countries account for the bulk of developing country debt service due in 2021-2022, but have had access to only limited budget support so far.

Since debt crises typically reflect poor government spending decisions, debt programs are often accompanied by a temporary lending pause. But this time it’s different, as most countries suffer from a short-term liquidity squeeze rather than a long-term solvency problem. The World Bank and IMF need to ensure that the macroeconomic framework and their own loans to ISD countries support large increases in short-term public investment.

Some called for larger-scale restructuring and debt relief efforts, including debt-for-investment swaps linked to achieving climate goals or sustainable development goals. The G-20 agreed to a common framework for debt processing, with three countries (Chad, Ethiopia and Zambia) requesting assistance to date. Such efforts should transparently link debt relief to additional investments in health, climate or SDG projects, in order to link the debt crisis to greater development finance needs.

Investment imperatives

This highlights the second challenge of collective action: providing developing countries with sufficient fiscal space to fight the pandemic and embark on the sustainable investments needed to build green, resilient and inclusive economies.

Even before COVID-19, the world was not on track to meet the SDGs and meet the targets set by the 2015 Paris climate agreement. In 2021, the international community must design a strong agenda for public investment, based on country specific needs and current spending levels, in order to relaunch stimulus efforts and enable longer-term progress on 2030 Agenda for Sustainable Development.

Several funding proposals are on the table. Developing countries have received $ 150 billion in COVID-19 specific funding from major multilateral development banks (MDBs) and an additional $ 100 billion in ongoing project funding. But more is needed. G-20 Finance Ministers Support a quick conclusion of the World Bank Replenishment IDA20, as well as a new allocation of $ 650 billion in Special Drawing Rights (SDRs, IMF reserve assets).

Since the new SDRs would be distributed on the basis of existing IMF quotas, which reflect the relative economic importance of countries, the bulk of them would go to advanced economies. There are therefore competing proposals for a reallocation mechanism so that countries with excess SDRs can lend them to others in need of additional liquidity. The IMF’s Poverty Reduction and Growth Trust (PRGT), which has already been used for this purpose, is a potential vehicle. But since only low-income countries are eligible for PRGT funds, further efforts would be needed to expand lending to middle-income countries.

Beyond one-off proposals designed to address immediate short-term funding challenges, policymakers need to establish an international funding system capable of supporting much higher levels of public investment in the medium term. MDBs are the natural vehicles for providing this financing, as they can offer better terms with longer maturities than other lenders, and they can combine loans with grants and technical assistance.

In addition, MDBs could increase loans from $ 750 billion to $ 1.3 trillion by using more callable capital and tolerating more risk. They could also do more to mobilize private capital, both by using their guarantee authority and by developing blended finance platforms in specific sectors. But these institutions need a strong push from the main shareholders to be more ambitious.

Developing countries need funding for public health spending, vaccine deployment and green investments. Much (except in the case of the poorest countries) will have to come in the form of debt, but it becomes more expensive for many. Given the need to avoid the debt-development trade-off, mobilizing additional financing for development, especially for middle-income economies, and linking it transparently to sustainable investments are therefore urgent challenges.

In 2020, policymakers focused on national stimulus efforts. In 2021, they must invest in global collective action to avoid a vicious cycle of debt and development difficulties.

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