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The developing world is facing a new debt crisis

The recently concluded COP27 in Sharm el-Sheikh had one important outcome for developing countries: the announcement of a loss and damage fund. This fund will help address climate injustice by helping low-income countries confront climate change disasters.

However, while the developed world finally faces the climate crisis in developing countries, we must recognize another interlinked crisis in the developing world: a debt crisis, the likes of which we have not seen since the 1980s.

Today, around 60% of the world’s poorest countries are in debt distress, or at high risk of it. Thirty years ago, developing economies owed most of their foreign debt to governments, nearly all of whom were Paris Club members, an informal group of official creditors who coordinated and found sustainable solutions to the debt problems of developing countries.

Not so today. At the end of 2020, low- and middle-income economies owed five times as much to commercial lenders as they did to bilateral official creditors. This year, of the nearly USD 53 billion that low-income countries need to make debt-service payments on their public and publicly guaranteed debt, only USD 5 billion will go to Paris Club creditors.

Why should we care about the debt of developing country governments? Sovereign debt defaults have catastrophic economic and social costs. Recent World Bank research shows that within three years of a debt default, affected countries lost 8% of GDP.

Headcount poverty rates increased 70% one year after the default. Infant mortality levels went up and life expectancy declined. This implies that debt defaults reverse years of progress and push the already poor citizens of low-income countries into further despair.

High debt levels and difficulties in debt servicing impacts lenders as well. During the period of low interest rates, many lenders sought yields by extending more credit to countries that previously had difficulty accessing loans. Borrowers were able to service their debts, but now in a new environment not all can.

As many central banks tighten monetary policy, interest rates have risen by an average of 5.7 percentage points for low-income countries compared with a 2 percentage point increase in the US. Why does this matter? A one dollar increase in interest payments to Western lenders is a dollar lost in crucial expenditures for developing countries. Obviously, some fiscal adjustment measures are needed in many countries in the new environment. For example, high energy prices made energy subsidies impossible in many countries. Slashing these subsidies makes sense when battling climate change.

Often, developing countries resort to using hard-earned tax revenues collected from their citizens to pay back lenders.

Luckily, we are beginning to see Western governments, China, and multilateral institutions realize that tangible actions are needed to lessen the debt burden of developing countries. A good example was the adoption of the Common Framework for Debt Treatments in 2020.

Within the framework, official bilateral creditors rescheduled USD 13 billion in principal repayments to give breathing room to low-income countries between May 2020 and December 2021. However, the limited participation of private lenders suggests that such initiatives are not likely to be as effective as is needed. Rapid progress on the Common Framework is necessary to continue to provide debt relief to the poorest countries during this new crisis.

Also, China’s role as a creditor increased in recent years. However, it has sometimes been difficult to determine China’s total lending and the conditions on those loans. Cooperation and information sharing among various lenders is crucial.

Fortunately, there are opportunities to address climate change with debt policy: so-called green and blue bonds can be used for a portion of a nation’s debt refinancing needs. Opportunities to mitigate climate change should serve as another strong motivator for lenders to support developing nations out of the debt crisis.

The developing world is facing an unprecedented set of interconnected crises in climate and debt, and urgent and decisive action is required to address these. These crises were compounded by the increase in the cost of living due to the Ukraine war. Like-minded development partners should join forces to mobilize resources for climate action and the achievement of the Sustainable Development Goals.

This article was originally published by Helsingin Sanomat and is reprinted here with permission. Click here to read the original article. Translated from Finnish by Annett Victorero.

Iikka Korhonen is Head of Research at the Bank of Finland Institute for Emerging Economies (BOFIT).

Kunal Sen is Director of UNU-WIDER and Professor of Development Economics at the Global Development Institute (GDI), University of Manchester.

The views expressed in this piece are those of the authors, and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.