Why developing economies are drowning in debt

Several developing countries are emerging from the pandemic-induced global recession with a massive debt overhang that is crippling their economies.

Low-income countries are particularly facing economic stress from soaring food and energy inflation, higher interest rates and a strengthening dollar.

On March 21, Ghana’s central bank announced its largest interest rate hike in a generation in a bid to slow rampant inflation that threatens to foster a debt crisis in one of the largest economies in West Africa. The Russia-Ukraine conflict is likely to make things worse, with Ghana importing almost a quarter of its wheat from Russia and nearly 60 percent of its iron ore from Ukraine.

In Sri Lanka, protests over a deepening economic crisis have forced Colombo to seek a bailout from the International Monetary Fund (IMF), just when it looked like it was about to default on repayments.

For months, Sri Lanka has faced mounting economic pain as its depleted foreign currency reserves triggered shortages of imports and fuel, blackouts and skyrocketing inflation. It has debt and interest repayments worth about $7 billion coming due this year against usable foreign currency reserves of $500 million.

About one-third of Sri Lanka’s debts are owed to international bondholders while other large creditors include countries like China and India. It is expected to finalise a $1 billion credit line with India.

Even with an IMF bailout, observers believe that Sri Lanka is en route to defaulting and ‘restructuring’ its debts with creditors. In doing so, it would join Belize, Ecuador, Suriname and Zambia as countries that have defaulted on their debts during the pandemic. Pakistan is also on the brink of default, with its Imran Khan-led government forced into calling elections.

Egypt too has sought support from the IMF, as the most populous nation in the Arab world struggles to weather the economic impact of the Russia-Ukraine conflict.

In 2020, Cairo received $8 billion to tackle the impact of the pandemic, making it the largest IMF borrower after Argentina. Foreign debt investors have also pulled billions of dollars out of Egypt in recent months, adding further pressure on its currency.

(Sub)merging market debt crisis

As both the IMF and World Bank have warned, many countries are emerging from the pandemic in a debt crisis that is on the verge of crippling their economies if both public and private creditors force them to repay.

Debt initiatives, which suspend payments on debts for a few years, have also come to an end.

Now, the Russia-Ukraine conflict is increasing the risk of defaults and economic recession for countries as inflation spirals, interest rates spike, and economic growth evaporates.

The irony is that poor countries are forced to raise even more debt in order to meet repayments and existing debt, much of which is denominated in US dollars. And as the greenback increased in value as a safe haven during the pandemic, the burden of repayment has only mounted.

Furthermore, capital investors and banks are less likely to invest in the stocks and bonds of the Global South – excluding China. In 2011, $1.3 trillion went into emerging markets from the Global North, while in 2020, that annual figure had fallen 30 percent to $900 billion (over half of which goes to just China).

As a result, private capital flows have dried up to fund existing debt.

Being starved of Western funds has forced governments in the Global South to turn to China, which has filled the role of a creditor to many developing countries desperate to cover existing debt and carry out infrastructure projects.

In South Asia, debt to China rose from $4.7 billion in 2011 to $36.3 billion in 2020, and Beijing has become the largest bilateral creditor to the Maldives, Pakistan and Sri Lanka.

Looming large over the entire debt question in developing economies is the amount of sovereign debt, which swelled during the pandemic as many middle- and low-income countries’ governments turned to international capital markets for help.

According to the World Bank, about 60 percent of all low-income countries need to restructure their debts or are at risk of needing to do so. More than 70 low-income nations are facing extra debt repayments of near $11 billion in 2022, an increase of 45 percent from 2020 after a sharp rise in borrowing last year.

Yet, the issue of extra debt repayments is only one strand of the problem. The other is the issue of “hidden” or nontransparent debt – such as faulty detection of financial risks like nonperforming loans – which is hitting access to financing for low-income households and small businesses.

Released in February, the World Bank’s latest report, “Finance For An Equitable Recovery,” argues that in addition to the challenge of mounting sovereign debt, unstable financing systems in developing economies make them more vulnerable to other issues like rising inflation and interest rates.

“The economic crisis of inflation and higher interest rates will spread due to financial fragility,” World Bank President David Malpass said in the report. “Tighter global financial conditions and shallow domestic debt markets in many developing countries are crowding out private investment and dampening the recovery.”

The report highlighted the risks small businesses and low-income households face if access to credit dries up.

According to the bank, 50 percent of households would struggle to maintain basic levels of consumption beyond three months, while the average business only has enough reserves to cover two months of expenses.