A fork in the road to financing for development
By Daniel Cohen and Ishac Diwan/Paris
For more than a decade, the US Federal Reserve and European Central Bank, faced with below-target inflation, flooded the global economy with liquidity. But now, as they raise interest rates to bring inflation down, the flow of funds to low and lower-middle income countries has plummeted as others are squeezed out of the market. For at least 20 PFRs and PRITIs, the yield spread on foreign currency bonds, relative to US Treasuries, crossed the 10% threshold.
Meanwhile, the World Bank and International Monetary Fund have warned of a coming tsunami of debt crises, estimating that nearly 60% of the world’s poorest countries are in debt distress or at high risk. For many observers, such warnings are proof that the experiment of providing capital market access to fragile countries (those with debt ratings of BB or lower) is over. It was a one-time episode, reflecting a confluence of factors – including the Heavily Indebted Poor Countries Initiative, the commodity boom of the 2000s, the massive increase in Chinese lending and excess liquidity on the market – which are unlikely to recur.
According to this view, the current loss of market access is a return to the norm, and deep debt reduction makes sense. While this may discourage future lending, it may not matter, as private sector creditors are unlikely to return until perhaps the next decade. In the meantime, it will be up to public finance – grants, bilateral loans and concessional loans from multilateral development banks – to support the sustainable development agenda. Think of this scenario as Option A.
In option B, the problem would be solved rather than buried. This would require an acceleration of selective debt resolution processes and measures to encourage new credit flows. Most developing countries would naturally prefer this scenario. Sub-Saharan African countries have worked hard to cultivate market access and still want to pursue development strategies to move up the global value chain. This is why many chose not to participate in the G20 Debt Service Suspension Initiative or the more recent Common Framework initiative, even as they were driven out of the market.
It is well known that the global capital market does not work well for poor countries. It overestimates risk and overreacts to shocks. And because sub-Saharan Africa has both sovereign debt and commodity risks, it is particularly vulnerable to financial market volatility. Without an African Mario Draghi who can step in to reassure the market, option B is not going to be easy.
But difficult does not mean impossible, and there are a few more arguments in favor of this option. For starters, since 2019, sub-Saharan Africa’s average public debt-to-GDP ratio has only increased by five percentage points (to 55%), and its external debt has only increased by 1.5 points (to 37%). These levels seem too low to justify a general insolvency verdict. With few exceptions, most LRICs cannot be called “highly indebted”, at least in the context of “reasonable” interest rates.
The problem, of course, is that many of these countries are facing a well-known snowball effect in which high interest rates and growing debt feed into each other. But it is also well known that all a country needs to remain solvent is an interest rate lower than the growth rate of the economy. In the case of sub-Saharan Africa, a safe real interest rate would be around 4%. And if we are currently above this tipping point, it should not be too difficult, with the help of donors, to create new assets with returns below this threshold.
To this end, our Finance for Development Lab has proposed a lending instrument more suited to the risk profiles of Sub-Saharan African countries, combining Brady bond-style guarantees with new forms of hedging insurance against commodity shocks. . Together with these assets, funding commitments of around $50 billion would go a long way in providing African countries with reasonable protection.
Without such protection, most LMICs, unable to weather market-induced interest rate hikes, risk becoming insolvent as tighter financial conditions continue to generate capital flight and devaluations. Spikes in fuel, food and fertilizer prices have worsened the situation, increasing the risk of Sri Lankan-style social unrest. While market refinancing needs are already high, they will not peak until 2024. This means there is a narrowing window to clarify the choice between options A and B.
Like Option B, Option A also faces hurdles, as the Paris Club of major sovereign creditors can no longer resolve debt issues on its own. Moreover, China is unlikely to provide significant levels of new financing in the coming years.
Each option would have very different implications for the aging of public funds. Option A assumes that public debt will take priority over private debt, as it is ultimately the only resilient source of financing for development. Option B presupposes the opposite: if LMICs are to grow thanks to more robust markets, it follows that the improvement in the relative seniority of market debt will be useful. Public backstops can significantly reduce the cost of privately funded debt, but only if private debt is given priority.
The dominance of option A or option B will strongly depend on how the IMF decides to condition its debt restructuring programs in the coming months. Option B will only have a fighting chance if debt sustainability analysis is reformed to properly take into account the ability and willingness of countries to repay their public and private debts. Viable improvement mechanisms will then have been quickly created to manage slowdowns and reopen market access.
Both options involve unique challenges and long-term consequences. But indecision would be the worst choice of all. When G20 Heads of State and Government meet in November to review the performance of the Common Framework, they will also need to pay close attention to the alternative paths available to them. – Project union
* Daniel Cohen, co-founder and president of the Finance for Development Lab, is president of the Paris School of Economics. Ishac Diwan is research director at the Finance for Development Lab.