The post-COVID Legacy of Debt and Debt Service in Developing Countries

Abstract

The post-COVID Legacy of Debt and Debt Service in Developing Countries Homi Kharas (bio) and Meagan Dooley (bio) The economic outlook for developing countries is grim in the wake of COVID-19. While gross domestic product (GDP) growth projections for 2021 look more optimistic with the rollout of mass vaccination campaigns, 150 countries are expected to have per capita incomes in 2021 below their levels in 2019.1 Commodity prices have been volatile, with swings in energy prices and increases in agricultural prices, creating winners and losers depending on a country's commodity dependence.2 Although fiscal support for developing countries has been far more modest than that of advanced economies, general government debt levels and foreign exchange debt levels have continued to rise in 2020, with prospects of further elevation in 2021. Sovereign debt levels are forecast to rise by 12 percentage points of GDP in emerging markets and 8 percentage points in low-income countries thanks to a combination of higher borrowing, falling GDP, and depreciating currencies.3 There is every expectation that debt restructuring will loom large on the international policy agenda in 2021 and 2022. Following a call from the African Ministers of Finance,4 G-20 leaders agreed to a Debt Service Suspension Initiative (DSSI) for all International Development Association (IDA) countries (GNI per capita below $1,875)5 and Angola,6 temporarily suspending debt service payments to bilateral creditors and allowing governments to spend more on COVID-19 response efforts.7 The initiative initially covered all bilateral debt service due between May 1 and the end of 2020 and has since been extended to year-end 2021.8 By May 2021, however, DSSI agreements have only covered $6 billion in debt service due.9 Doubtless this coverage will increase, but the agreement still falls well short of what developing countries owe: $350 billion in debt service on public and publicly guaranteed debt due in 2021 and another $334 billion in 2022. This debt service limits the fiscal space countries have to respond to the pandemic, including needed vaccine procurement and contact tracing measures. Countries will likely need to continue to borrow to finance these measures, yet many developing countries face limited market access and high interest spreads. Thus, getting debt dynamics back on track is a crucial element of COVID-19 response efforts. Policymakers must decide what to do. The lessons from past debt episodes are that interventions that are too little, too late result in inefficiencies and significant social and financial costs linked with large scale debt overhang problems and repeated restructurings.10 Conversely, too rapid and too large an intervention generates a moral hazard, potentially throws more money at a bad investment, and can seriously affect countries' future access to capital markets. This paper provides a framework and quantitative evidence for how to differentiate among developing countries based on their debt dynamics [End Page 262] and then prescribe an optimal tailored solution for each country. The main message is simple: public debt servicing problems go far beyond the DSSI in terms of the number of affected countries. While some countries require proper debt workouts, the larger problem is one of liquidity—the ability to roll over principal repayments at affordable rates in a context where market confidence is low and where collective action is desirable. The international community faces the challenge of solving this problem, while at the same time providing additional external financing for the investments needed to transform economies through sustainable development. Context To figure out how much debt service is really at risk, we disaggregate the public external debt service obligations by country income category in Figure 1 below (World Bank classification). The figure shows that the majority (roughly 70 percent) of debt service falling due is owed by upper-middle-income countries and most of the remainder is owed by lower-middle-income countries, while low-income countries, who are covered by the DSSI, owe a very small fraction of the debt service due. For each country category, we further divide up debt service obligations in terms of the credit rating of the public obligor. To give an example, Figure 1 shows that around $135 billion of...