The Coming Debt Crisis

Anne O. Krueger, a former World Bank chief economist and former first deputy managing director of the International Monetary Fund, is Senior Research Professor of International Economics at the Johns Hopkins University School of Advanced International Studies and Senior Fellow at the Center for International Development at Stanford University.

WASHINGTON, DC – In its latest World Economic Outlook, the International Monetary Fund reported that a rising share of countries – 56% of low-income countries and 25% of emerging markets – are “in or at high levels of debt distress.” While some of these countries are already working on reform programs that will make them eligible for IMF funding and offer good prospects for economic growth, many are not. A developing-world debt crisis is looming.

Extremely high levels of indebtedness are usually preceded by a period during which creditors roll over claims or extend new loans, with increasingly high interest rates. There is no simple way to determine when that debt becomes unsustainable. Analysts often use the debt-to-GDP ratio, but interest rates make a difference here. Low-income countries facing concessional interest rates might have lower ratios than emerging-market economies, for which interest rates are higher. The maturity structure of the debt also matters: if most of it will come due soon, the required rollovers (or renewals) will be much larger than for debts with a longer maturity.

Borrowing by poor countries is warranted if the loans finance activities that will yield a high rate of return for the borrower, whose own resources are already financing worthwhile activities. In such a scenario, debt-service can be self-financing (barring unforeseen shocks). The problem is that, in many countries, sovereign borrowing has largely been to finance expenditures with low or negative rates of return, such as sports stadiums or pre-election handouts.

Such spending – together with large debts and fiscal deficits – can make lenders wary, leaving countries struggling to borrow, especially in times of rising interest rates. When creditors start refusing to roll over outstanding debt coming due, or when the interest rate that would be charged on new or rolled-over debt is prohibitive, a debt crisis erupts.

To many, the solution to developing-country debt distress seems obvious: provide debt relief to countries that need it, so that debt-service payments can be reallocated toward expenditure on social services, such as health and education. But experience shows that such reallocation is far from always guaranteed. When the debt of the world’s poorest countries was forgiven under the IMF-World Bank Heavily Indebted Poor Countries Initiative, launched in 1996, adequate economic reforms did not follow. Many of these countries are again highly indebted.

Debt relief is certainly needed. But to lend, even on soft terms, to governments that cannot or will not pursue sound, realistic, and business-friendly economic policies is simply to increase their future debt-servicing obligations. That is why debt relief must be conditioned on such reforms.

This is not a new idea. From the mid-twentieth century, when sovereign creditors formed the informal Paris Club grouping to find solutions to countries’ debt-servicing difficulties, they relied on the IMF to assess debtors’ economic prospects and determine the policy adjustments needed to improve economic performance. The creditors recognized that, without reforms, debt would simply pile up again until another crisis erupted.

But some governments borrow so much that no reasonable policy adjustments would be sufficient to enable them to fulfill their debt-servicing obligations without imposing a “haircut” on creditors. In such cases, Paris Club members may allow for the rescheduling of debt service, thereby reducing the net present value of the debt to a sustainable level.

Once such an agreement is reached, an IMF loan enables the country to resume imports while economic reforms take effect, leading to higher growth. Obviously, most private-sector creditors also must agree to any restructuring; otherwise, the country would be left servicing debts to holdouts, reducing the amount available for those agreeing to restructuring.

In the 1990s, changes were implemented that accelerated the resolution of debt problems, although delays were frequent and, for debtor countries, costly. But by the end of the twentieth century, governments were increasingly borrowing from private sources. In 2010, low- and middle-income economies owed 46% of their long-term public and publicly guaranteed external debt to private creditors. By 2021, that share had risen to 61%.

Though the Paris Club’s share of debt declined, its procedures continued. When Turkey confronted debt-servicing difficulties in 2002, it undertook policy reforms and received an IMF loan, quickly restoring rapid GDP growth. Around the same time, Argentina became unable to meet its obligations, so its debt had to be restructured.

Today, however, there is another major sovereign creditor on the block – China – and it has refused to join the Paris Club. Other creditors are naturally reluctant to participate in debt restructuring if China does not, lest they end up effectively bankrolling full debt-service payments to China. Already, Sri Lanka and Zambia have faced long delays in receiving debt relief, because their Chinese creditors refuse to agree to the debt-restructuring terms agreed in the Paris Club, even though the IMF had backed the associated economic-reform programs.

Fortunately, neither country’s financial situation attracts headline news, and creditors did not withdraw lending from others. But some countries – including Egypt, Lebanon, Pakistan, Turkey, and many smaller economies – report high debt-to-exports and debt-service-to-GDP ratios. In Lebanon, external debt reached 603% of exports and 381% of gross national income in 2021.

If several of the larger emerging markets and low-income countries are simultaneously confronted with rising interest rates and an increasing reluctance by creditors to roll over their debts, a global debt crisis is likely to erupt. To avoid this scenario, the world needs an international agreement that establishes procedures for supporting debt-distressed sovereigns, thereby enabling the IMF to deliver loans faster. And all creditors must adhere to it.