August 02, 2022
Stephen Nelson, Northwestern University
The sharp upward trend in many countries’ public debt levels in the wake of the global public health crisis continues to cast doubt over governments’ willingness and capacity to repay. Argentina, Ecuador, Lebanon, Sri Lanka, and Zambia, among others, have already missed debt payments, sought to restructure, or both, but—as Ugo Panizza’s contribution to this roundtable shows—markets still seem largely untroubled by the COVID-age debt buildup. It is, of course, possible that prognosticators anticipating waves of defaults from the tsunami of pandemic-related debt are wrong. Heightened but manageable debt levels could even become the new normal for countries across the national income spectrum.
Maybe. But persistent uncertainties, including the two below and many more, make this scenario unlikely.
First, policy uncertainty makes financial markets skittish, and skittishness can trigger liquidity crunches that turn into debt crises. We entered an age of heightened policy uncertainty even before the pandemic; COVID-19 exacerbated it, and Russia’s brutal war in Ukraine further amplifies it. Figure 1 tracks the global level of the Economic Policy Uncertainty Index from 1997 to the first two months of 2022. The year of Donald Trump’s election and the Brexit referendum is the inflection point for global policy uncertainty: the index average jumps from 101 before to 221 after 2015.[1]
Figure 1. Annual Economic Policy Uncertainty Index
Uncertainty makes debt markets particularly alert to monetary policy signals from the U.S. Federal Reserve and the European Central Bank in the face of mounting price inflation. Further policy shocks seem likely to push some teetering countries into full-blown debt crisis territory.
Second, the worldwide surge in commodity prices may help some developing country exporters, but does not augur well for broad-based sustainability, at least if history serves as any guide. Figure 2, which tracks a set of price indices from the World Bank, shows a rapid and synchronized upswing in the world prices of energy products (coal, oil, and natural gas), non-energy commodities (namely, food and raw materials), fertilizers, and non-precious metals and minerals.
Figure 2. Commodity Price Indices
For commodity importers, higher costs can rapidly sap reserves and trigger political instability, as we have seen in Sri Lanka. For exporters that may benefit from the commodity price boom at the outset, it can seed new debt vulnerabilities. When the boom gives way to the inevitable bust, capital inflows slow to a trickle or reverse, currencies crash, and interest rates increase, producing a new wave of sovereign defaults. Commodity-exporting autocracies (of which there are plenty) are more likely to end up in trouble in a commodity price bust, because they tend to sink windfalls into government consumption rather than liability management.
If these and other pressures produce the long-expected sovereign debt storm among developing and emerging economies, what options do their governments have for seeking shelter when market conditions tighten?
International initiatives triggered by the COVID-19 emergency created new, but still limited, options for some vulnerable countries. Creditor forbearance under the Debt Service Suspension Initiative (DSSI), for instance, deferred $12.9 billion in official bilateral debt payments for the 48 countries that participated in the initiative before it expired at the end of December 2021. But debt relief provided by the DSSI was both short-lived and meager: by one early estimate, the temporary relief amounted to less than 2 percent of all debt payments owed by developing economies. Even with later extensions, this was a drop in the bucket. Limited debtor eligibility and creditor participation are part of the problem. Efforts to cajole private creditors to join the DSSI by-and-large failed. And as Aitor Erce suggests in his contribution to this roundtable, foot-dragging by private creditors seems likely to stymie the G20-endorsed Common Framework for Debt Treatments, as well.
So much, then, for resuscitating the debt standstill as a means of coping with the coming sovereign debt storm in 2022 and beyond. Initiatives launched at the International Monetary Fund, however, may offer more promising options for developing and emerging countries in distress. But the international political environment poses considerable challenges to the Fund’s initiatives.
Disbursements of the IMF’s reserve asset, Special Drawing Rights (SDRs), offers one potential means of coordinating international support for struggling countries. But this option suffers from design flaws. By the terms of the IMF charter, the record SDR allocation of $650 billion approved in August 2021 was mechanically linked to IMF members’ weighted voting rights. As a result, two-thirds of the new liquidity went to advanced and other economies least likely to need it. At the Carbis Bay summit in June 2021, the G7 countries committed to redirect $100 billion of the SDR allocation to the neediest countries. The SDR disbursement appears to have helped some low-income countries stabilize their economies in the face of the pandemic shock, making the case for additional issuances to augment other liquidity sources in the international financial system.[2] The G7 countries should, further, pre-commit to rules that ensure fairer allocations of SDRs.
Russia’s invasion of Ukraine, however, complicates the international politics of SDR allocations. As long as Russia remains a member of the IMF eligible to draw on its resources, it would also benefit from any additional SDR issuance. This would be a political poison pill for some member countries, and could undermine U.S. and EU efforts to isolate the Russian economy.
Another initiative launched in April 2022 could offer additional liquidity boosts—beyond the traditional IMF lending programs—for developing and emerging countries. The IMF’s new Resilience and Sustainability Trust (RST), funded through voluntary SDR contributions from less vulnerable advanced countries, promises longer-term financing at modest interest rates for eligible members. The IMF has been clear that the aim of the RST is not to help members weather post-COVID debt repayment difficulties. Rather, the RST’s resources are earmarked for longer-run upgrades in different policy domains (namely, adaptation to climate change and disaster preparedness). But RST funds are not strictly encumbered and, provided the authorities propose a credible medium- to long-run reform program, the resources can be used to support a country’s more immediate financial needs.
A large share of the IMF’s membership—143 countries—are eligible for the $50 billion in funding currently available via the RST. But answering the key questions surrounding the RST programs—who is approved, how much is disbursed, and on what terms?—requires an understanding of the political factors that shape variation in how the IMF treats it members. The Executive Directors of the IMF approved the RST proposal with the understanding that RST programs would be accompanied by concurrent traditional IMF programs laden with conditions.
Prior research on politically-motivated IMF financing suggests that terms of access to IMF resources may continue to be shaped by the strategic motives of the institution’s most powerful members and the affinities demonstrated by IMF officials for likeminded policymakers in borrowing countries. Vulnerable but disfavored members may be deterred from the IMF’s new options by extensive and problematic conditions.
If international initiatives fall short, emerging market countries still have some other means of shielding themselves from the worst of the storm. Some emerging countries were able to shift much of their international borrowing before March 2020 from foreign to local currencies. Some built large war chests of foreign reserves (total reserves for the major emerging markets, excepting China, topped $2.6 trillion in early 2020) and integrated into regional swap networks that could provide additional liquidity in the face of financial market turmoil.
If these safeguards proved insufficient, frontier and emerging countries had more policy scope to try to insulate their economies after the IMF’s about-face on the appropriateness of capital controls.
Capital outflow controls can give developing and emerging countries some breathing room in a debt crisis, but they can also be politically costly. Governments may want to impose controls in highly targeted fashion (for example, depositing payments to international creditors in a domestic account for non-residents, access to which is tightly restricted by outflow controls). But, as Benjamin Cohen observed a long time ago, the rate of expansion in the controls has to exceed the proliferation of sneaky ways people find to evade them. When the reach of capital controls expands to the point that the finances of people in the middle class are affected, the mood of the electorate can turn against electoral candidates blamed for the imposition of the controls. Evidence from Argentina’s experience with capital controls before and after the country’s 2015 presidential election suggests that some voters, unhappy with the impact of the controls on their ability to swap pesos for dollars, switched their support to Mauricio Macri, the candidate that promised to lift the controls. Governments facing tight elections are constrained by voters’ sentiments—and if the evidence from Argentina is any indication, some proportion of the electorate is likely to oppose capital controls and vote on that basis. In short, even if the international community is more amenable to capital controls as a safeguard, domestic political calculations will still shape the prevalence of their use.
The intensity of public opposition to capital controls at home is shaped, however, by the commonness of controls elsewhere. Evidence suggests voters grow more opposed to capital controls when other countries—especially economic partners and cultural peers—maintain open capital markets. If more and more peer countries ringfence their financial systems behind a wall of controls, amplifying the trend toward greater fragmentation in the global capital markets, the domestic political costs of tightening controls will fall. Self-help through the imposition of capital controls may well become a more frequent complement to the international options for sheltering when the storm finally hits.
Endnotes
[1] The pre- and post-2015 difference in the mean level of the Economic Policy Uncertainty Index is statistically significant (t = 26.05, p < 0.000).
[2] Partisan gridlock in the U.S. Congress all but ensures that any proposed SDR allocation over 100 percent of total IMF quotas (in the $660 billion range), which requires Congressional approval, will trigger a protracted political fight – hence the need for scheduling multiple, rather than one-off, SDR disbursements.
Return to Sovereign Debt Architecture, Suspended prompt.