|
|
|
|---|
|
Lower-middle-income countries
|
Low-income countries
|
Lower-middle-income countries
|
Low-income countries
|
|---|
|
2019
|
11.8
|
6.8*
|
53.0
|
18.6**
|
|
2010
|
8.8
|
4.6
|
82.4
|
55.6
|
|
2000
|
17.4
|
8.7
|
23.6
|
8.7
|
|
1990
|
27.0
|
20.9
|
4.3
|
3.8
|
* 2016 figure. ** 2018 figure.
Source: World Bank International Debt Statistics, accessed via Haver Analytics.
Note: Lower-middle-income countries are defined as those with per capita gross national income (GNI) of between $1,036 and $4,045; low-income countries are those with per capita GNI below $1,036. Definitions at Serajuddin, U. and Hamadeh, N. (2020), ‘New World Bank country classifications by income level: 2020–2021’, World Bank Data Blog, 1 July 2020, https://blogs.worldbank.org/opendata/new-world-bank-country-classifications-income-level-2020-2021.
Table 1 illustrates these points. Low-income and lower-middle-income countries have indeed seen an increase in their net external debt, denominated in foreign exchange, and in their debt service ratios during the past 10 years. But understood in a longer historical context, these indicators of debt-carrying capacity are still quite healthy compared to 20 or 30 years ago when debt problems really were acute.
These facts should not encourage complacency, but should focus policymakers’ minds on limiting the further accumulation of net external debt, rather than leaping to debt restructuring as an immediate solution regardless of absolute need (given also the potential negative consequences of debt restructuring, which can affect a country’s ability to finance itself in the future). Before considering how limiting the build-up of debt could be achieved, it is worth outlining the ‘push’ and ‘pull’ factors that drive potentially unsustainable external debt accumulation.
‘Push’ factors
The overwhelmingly important ‘push’ factor that directs dollar-denominated debt capital to emerging and developing countries is US monetary policy. Historically, when policy is loose enough to turn inflation-adjusted interest rates in the US negative, this tends to provoke a ‘search for yield’ mentality among financial institutions, which makes lending to emerging economies attractive.
This kind of behaviour was emphatically behind the build-up to the developing-country debt crises of the 1980s, since the inflation shock of the 1970s pushed real interest rates in the US into negative territory for a considerable period. Simply put: developing countries’ accumulation of external debt during ‘good’ years (i.e. when borrowing costs are low) can mean that they subsequently find themselves with unpayable debts when an external shock materializes. In the early 1980s, this shock took the form of dramatic monetary tightening overseen by Paul Volcker, the chair of the US Federal Reserve, together with a global recession that eviscerated developing countries’ ability to earn foreign exchange by exporting. By the mid-1980s, the value of developing-country debt in default was equivalent to more than 2 per cent of global GDP.
A similar surge in capital inflows, for similar reasons, was evident in the early 1990s, and this was at least a proximate cause of Mexico’s late-1994 ‘Tequila Crisis’.
Real US interest rates, both short- and long-term, are currently negative and are likely to stay so for a considerable time. Although the US Fed has not formally adopted ‘yield curve control’, which would place explicit ceilings on US bond yields, it is tempting to argue that a de facto regime of yield curve control now exists in the US and will remain in place for some time, ensuring that the push factor for capital flows to emerging economies remains strong. One reason for this, above all, is to reduce the cost of servicing the now very large stock of US public debt. In 2020 the US government’s debt/GDP ratio will likely have exceeded 125 per cent, and will rise further in future years. With so much public debt, interest rate repression will be a necessary tool to avoid fears that US public debt dynamics could spiral out of control.
The inevitable arithmetic behind debt crises in emerging economies is that the probability of crisis grows when the increase in external liabilities outpaces that in external assets.
This push factor already helps to explain why international portfolio managers’ demand for dollar-denominated bonds issued by emerging-market borrowers has been so high. Gross bond issuance in emerging markets exceeded $800 billion in 2020, an increase of over 10 per cent on 2019. Similar trends are evident in early 2021. While it is true that most of these bonds were sold by relatively creditworthy borrowers, it is also the case that even sub-investment-grade borrowers have reasons to be optimistic about their ability to access international capital markets.
That optimism explains why so few low-income countries applied for debt service relief last year under the G20’s Debt Service Suspension Initiative (DSSI). If governments feared losing access to international capital markets, their incentive to seek relief through the DSSI – or its successor, the G20’s ‘Common Framework’ – would be high. But the opposite is currently true for most emerging economies, with the ‘push’ factor of negative real US interest rates giving many of them easy opportunities to borrow. The point is this: a debt crisis can’t happen so long as borrowers have access to financing. And emerging-market borrowers, by and large, have that access for now.
‘Pull’ factors
One of the main reasons for emerging economies’ continued access to financing is that their net dollar debt position these days is relatively healthy, a point also illustrated in Table 1. This is largely the legacy of the crisis decades of the 1980s and 1990s. Since fragile dollar balance sheets were the underlying cause of financial instability in that period, emerging and developing countries have, for the most part, made it a priority in the past two decades to ensure that their external liabilities didn’t rise disproportionately above their external assets (which for the most part consist of foreign-exchange reserves). That helps to explain why Table 1 shows a long-term rise in the ratio of reserves to total public and private external debt since the 1990s and 2000s – notwithstanding the past decade’s decline.
Another ‘pull’ factor that will make dollar borrowing attractive to policymakers in emerging economies is that servicing external debt hasn’t, in recent years, absorbed a disproportionate share of export revenues (again, see Table 1). This fact will give countries confidence that they have ‘space’ to increase their foreign-exchange borrowing. According to data from the rating agency Moody’s, the debt service ratio for relatively uncreditworthy countries in the single B rating category was 16.5 per cent in 2019, below the previous five years’ average rate of 19.8 per cent. For more creditworthy borrowers with higher ratings, the 2019 debt service ratio was only 14.8 per cent, roughly unchanged compared to the recent past.
This increased desire to borrow in dollars will be reinforced by two additional factors. The first is that a number of emerging economies seem to have a diminishing ability to borrow internationally in their own currencies. In recent years, countries such as Brazil, Mexico and South Africa have seen declines in the share of their governments’ local-currency bonds that are owned by foreign investors. Because the willingness of foreign investors to buy these bonds is likely to depend on perceptions of the issuers’ economic growth prospects, external demand for local-currency bonds in these countries may be weak for a considerable time.
Instead, the affected governments may well need to rely more on borrowing in foreign currencies, particularly in view of a second factor, which is that, at least for now, belt-tightening economic policies are infeasible for a combination of humanitarian and political reasons. In other words, the ‘pull’ factors encouraging rising levels of net external debt boil down to a combination of relatively strong dollar balance sheets and heavy public sector borrowing needs, the latter of which will be difficult to meet by relying purely on borrowing in domestic currency.
To sum up, then, emerging and developing countries will face growing risks of over-indebtedness in dollars. Policymakers, regulators, credit rating agencies and investors need to be aware of these risks now in order better to identify any worrying trends in borrowing. As the next section explores, one way of fostering this awareness would be to widen implementation of two current measures of external balance sheet risk: a policymaker’s ‘rule of thumb’ ratio originally formulated in response to emerging-market crises in the 1990s; and an IMF framework that has developed that rule into a more comprehensive indicator of foreign reserve adequacy.
The central role of reserves: the ‘Guidotti rule’ and the IMF’s reserve adequacy measure
By 1999, as emerging-market currency and debt crises had firmly established themselves as a phenomenon, Pablo Guidotti, then Argentina’s deputy finance minister, proposed a simple rule of thumb for policymakers in emerging markets. The rule, reiterated by US Fed Chair Alan Greenspan in a speech that spring, was that ‘countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year’. In other words, usable foreign-exchange reserves should exceed scheduled amortizations of foreign-currency debts during the following year on the conservative assumption that a country is simply unable to borrow abroad for that long.
Two features of the Greenspan-Guidotti rule, as it became known, are noteworthy. The first is that it shifted attention away from the idea that the adequacy of a country’s foreign-exchange reserves should be solely assessed by reference to how many months of imports they can cover. In a world of highly mobile capital, focusing instead on a country’s external balance sheet was a more sophisticated approach to the task of assessing a country’s reserve adequacy. The second feature of the Greenspan-Guidotti rule was its simplicity and intuitive appeal, which made it considerably more useful than it might have been had it been analytically complex.
The Greenspan-Guidotti rule was of immense importance in focusing policymakers’ attention on the need to keep net dollar liabilities at manageable levels.
In recent years, the IMF has developed an ARA framework that adds three variables to the original Greenspan-Guidotti ratio (which related short-term external debt to foreign-exchange reserves). These variables respectively consist of the level of foreign-exchange reserves relative to (a) the M2 measure of money supply, (b) exports, and (c) liquid foreign liabilities that aren’t captured in the stock of short-term foreign-exchange-denominated debt.
The IMF is to be commended for creating a more sophisticated framework for assessing the adequacy of countries’ reserves. The important task of the next few years, while debts accumulate in part as a result of the fiscal impact of the COVID-19 pandemic, should be to place that framework at the centre of financial stability assessments: not just those conducted by the IMF itself, but also those used by international bodies such as the Financial Stability Board (FSB).
Under the current framework, the IMF’s reserve adequacy assessment generates a ‘recommended’ level of foreign reserves for each country, and the Fund’s advice is that reserves at 100–150 per cent of this recommended level generally qualify as adequate. At the end of 2019, any countries that were relatively creditworthy satisfied this condition. For example, for countries rated between BB- and BB+ on the Standard & Poor’s rating scale, the median level of reserves was 114 per cent of the recommended threshold. Ensuring that the reserve metric stays above 100 per cent should be a central objective of policymaking in such countries, and multilateral institutions need to make very clear the importance of this principle for financial stability.
Less creditworthy borrowers, for example those rated below BB-, typically have more trouble meeting the reserve adequacy threshold. Among these countries, the median level of reserves in 2019 was only 84 per cent of the IMF’s recommended level. Their access to international borrowing on commercial terms will necessarily be heavily constrained, both by IMF advice and FSB assessments, and by the development of an analytical culture among market participants that hopefully places more emphasis on the essential role of strong dollar balance sheets in preventing future external debt crises.
The inevitable arithmetic behind debt crises in emerging economies is that the probability of crisis grows when the increase in external liabilities outpaces that in external assets. Limiting the rise in net external debt, therefore, should be the focus of policymakers and regulators.
