In the last two years, the world economy has suffered multiple setbacks – from the COVID-19 epidemic to the war in Ukraine. But not all countries and peoples are affected in the same way. As highlighted “2022 Funding for Sustainable Development Reporting (FSDR), A financing split is drastically reducing the ability of many developing countries to cope and invest in recovery.
In the wake of the COVID-19 epidemic, developed countries can finance huge massive response packages (worth 18 percent of GDP) at very low interest rates, backstopped by their central banks. Developing countries were more limited. The poorest countries in particular were forced to cut spending on education and infrastructure, which contributed to a more protracted crisis. Even before the outcome of the war in Ukraine, per capita income levels in 1 of the 5 developing countries were projected to not reach 2019 by the end of 2023, investment rates were not expected to return to pre-epidemic levels for at least two years.
This compressed investment recovery widens the investment gap in the larger Climate and Sustainable Development Goals (SDGs). Yet, many countries are not in a position to finance the necessary investment push. At the beginning of 2022, 3 out of 5 poorest countries were at high risk or were already in debt crisis and 1 in 4 middle income countries was at high risk of financial crisis. Rising energy and food prices due to the war in Ukraine have put additional pressure on the financial and external balance of importers and the tightening of global financial conditions is increasing the risk of a systemic crisis. Debt sustainability concerns, which arise from lower levels of debt in developing countries, translate into higher risk premiums. Even in countries where debt is considered sustainable, the high cost of borrowing prevents the necessary investment.
Capital costs and conditions in developing countries
The average interest cost of external debt of developing countries is three times higher than that of developed countries (Figure 1). Over the past decade, developed countries have borrowed at an average interest rate of 1 percent in a low-interest environment. Least Developed Countries (LDCs), which have increasingly tapped into the international market in recent years, have borrowed more than 5 percent, with some countries repaying more than 8 percent. This draws on their average borrowing costs and translates into less financial space: LDCs dedicate an average of 14 percent of their domestic revenue to interest payments, compared to about 3.5 percent in developed countries, despite having much larger debt stocks later on (Figure 2).
Although this high cost of borrowing reflects a higher perceived risk, there is evidence of an additional premium associated with sovereign debt. Over the past 200 years, the average annual return on foreign currency loans to investors has been around 7 percent, even after calculating for losses from defaulters, the “risk-free” returns on US and UK bonds have averaged 4 percentage points. Since the beginning of the emerging market “bond finance era” in 1995, the total return of investors (net of losses from defaulters) has been much higher, averaging about 10 percent or about 6 percentage points risk-free rate – a historic high. *
Foreign currency bonds pose more risk to investors than compensation এমনকি even in the face of repeated financial instability in developing countries. Indeed, external sovereign bonds have outperformed other asset classes (such as equity or corporate bonds), the best performing asset class since 1995, even after adjusting for both default and risk (measured by market volatility). Although sovereign spreads and risk premiums may seem to have moved away from people’s lives, they have a direct impact on sovereign debt. Higher investor returns equate to higher borrowing costs for countries, removing government spending from government investment and social services.
A multifaceted policy response
On the right terms, debt financing enables countries to respond to emergencies and finance long-term investments. Productive investment increases growth and revenue potential, thus creating resources for sustainable lending. On the other hand, for countries with large debt overhangs, additional lending can be counterproductive and debt relief and further grant financing are essential. The challenge is to increase access to affordable long-term financing (and grants where appropriate) and to use the benefits productively. While there is no one-size-fits-all solution to increase countries’ financial space, measures to do so include national action, international public finance, and efforts to improve conditions and reduce the credit spread associated with commercial debt. 2022 funding for the Sustainable Development Report” Recommendations are made in four cases to bridge the “great financial divide”
First, countries need to reduce risks and ensure that all financing is consistent with SDGs and climate action. The efficiency of public investment is a key determinant of its growth and the impact of debt stability, and in many countries there is a gap in efficiency. Combining public investment decisions with a medium-term financial and budgetary framework and debt management strategies – for example, in terms of an integrated national financing structure – can reduce the volatility of financing for capital expenditure. But national action alone cannot solve the systemic challenge.
Second, access to extra long-term affordable international public finance is crucial. Promises of government development assistance must be met and lending to multilateral development banks (MDBs) must be expanded, including raising capital and restructuring unused special drawing rights. MDBs themselves can improve the terms of the loan, for example, through the systematic use of state-related clauses in ultra-long-term loans and their own loans. In addition, the whole “system of development banks” should be strengthened: MDBs can expand capacity building in national institutions and MDBs can benefit from the knowledge of national banks about the local market.
Third, the international community can take steps to improve the borrowing conditions in the markets of developing countries. Since global resources are a major driver of capital flow instability, it is essential to address leverage and volatility in the international financial system. Steps can also be taken to reduce the premium associated with the high cost of sovereign debt, such as strengthening the data ecosystem and prolonging the time horizon. Expanding the horizons of credit ratings (which is often only up to three years) and assessing the stability of the loan will provide insights for long-term based investors.
Fourth, the international community must immediately step up its efforts to resolve the volatile debt situation. A multilateral debt relief and restructuring initiative may become necessary as global interest rates and the risk of a systemic debt crisis increase. Systematic solutions should be followed now before the arrears of providing large loan services in 2023. They should be discussed in an inclusive forum that brings together lenders and lenders. The UN can provide such a platform.
* Note: Meyer, Josephine, and others. 2019. Sovereign Bond from Waterloo. Quarterly Journal of Economics (forthcoming).