The surge in inflation that followed the recovery from the 2020 global recession has prompted monetary tightening in several advanced economies (AEs) and emerging market and developing economies (EMDEs), which exacerbates the challenges of sustainable development financing. Against this backdrop, debt situations in developing countries have continued deteriorating over the past decade. More than half of low-income countries (LICs) are already in debt distress or at high risk, with only 10% showing a low risk of debt distress (IMF, August 2022). Moreover, the risk of debt distress spreading to middle-income countries is increasing (Estevão and Essl, 2022).
Out of the 28 IsDB MCs classified among LICs, only two present a low risk of debt distress (Bangladesh and Uzbekistan). Four low-income MCs are in debt distress (Chad, Mozambique, Somalia, and Sudan), whilst 10 are at high risk of debt distress (Afghanistan, Cameroon, Comoros, Djibouti, Gambia, Guinea-Bissau, Maldives, Mauritania, Sierra-Leone, and Tajikistan). This means that half of the low-income MCs are at least at high risk of debt distress, risking a widespread debt crisis across all 57 MCs through contagion effects.
This topical issue paper explores recent monetary policy shifts to contain growing inflation, subsequent tightening in global financing conditions, and their potential implications on debt sustainability in IsDB MCs.
Across the world, inflation rates have been on the rise for the first time in years, making prices less stable compared to pre-pandemic years. In the United States (US), prices increased by 8.5% year-on-year in June 2022, while prices in countries with very high inflation, such as Türkiye and Argentina, increased by more than 50%. Nearly all AEs and the majority of EMDEs had surpassed central bank targets by early 2022, with inflation exceeding 5% in more than three-quarters of both AEs and EMDEs (Figure 1).
Figure 1. Global Consumer Price Inflation
Due to the fundamental dynamics of transitions from low to high inflation regimes, the dangers of wage-price spirals to develop cannot be understated. The risk that inflation expectations deviate from central bank inflation targets increases, leading policymakers to tighten monetary conditions more aggressively. A crucial concern on this policy choice is whether policymakers will be able to design a soft landing–that is, a tightening cycle that does not result in a recession.
Central banks across the world have begun to aggressively tighten monetary policy in reaction to skyrocketing inflation and to minimize financial market stress. As a result, yields on government bonds continue to grow in many of the world’s largest economies. Table 1 presents some recent changes to policy rates of central banks in AEs, EMDEs, and IsDB MCs.
Table 1. Changes in Interest Rates in Selected AEs and EMDEs, 2022
Due to the significance of the US dollar in the global economy, changes in US monetary policy affect not only their domestic financial conditions but also the financial conditions and investment sentiment in global economies and financial markets (Albagli et.al, 2019). In addition, financial conditions have tightened significantly in AEs, particularly in the Eurozone, and in the majority of EMDEs as a result of increasing interest rates to control inflation, higher external borrowing costs, currency depreciations, a retreat in equities markets, portfolio outflows, and wider risk premiums.
Inflationary pressures in major AEs and EMDEs prompted bond yields to rise globally. After the release of the December FOMC meeting minutes in early January, long-term rates increased in tandem across all AEs. In EMDEs, bond yields rose in tandem with inflation expectations, particularly in Latin America, where inflationary pressures were at their highest.
Since 2022, the US dollar has strengthened versus the currencies of non-commodity exporting countries that are less advanced in their tightening cycles. Rising interest rates might result in a large capital outflow from developing countries. Further capital outflows would raise the risk of debt rollover problems and local currency depreciation, particularly for economies with unsustainable debt levels and twin deficits.
Debt levels have been growing for over a decade, fuelled by a low-interest environment following the 2009 global recession that made it relatively cheaper to borrow money. The average public debt of AEs rose from 71% of GDP in 2007 to 104% of GDP in 2019 (Figure 2a). The public debt-to-GDP ratio increased significantly, from 36% in 2007 to 54% in 2019. In 2020, the debt-to-GDP ratios rose sharply to 123% and 64%, respectively, for AEs and EMDEs, reflecting both higher stock of debt and lower GDP, amid the pandemic-led global recession.
Similar trends are observed in IsDB MCs. The average public debt-to-GDP ratio for IsDB MCs rose from 31% in 2007 to 42% in 2019, before rising to 50% of GDP in 2020. However, it remains well below the EMDEs average. The relatively low public debt level in IsDB MCs mainly reflects the moderate sovereign debt exposure of fuel-exporting MCs. However, between 2014 and 2021, the public debt-to-GDP ratio of fuel-exporting MCs more than tripled, from about 13% to 42%, reflecting these economies’ difficult adjustment to lower oil prices.
Figure 2. Trends in the public and external debt levels
In terms of external debt, the average external debt (as a percent of GDP) of IsDB MCs, which has reached 47% of GDP in 2021, remains significantly above the EMDEs average of 31% (Figure 2b). The gap between the average external debt (as a percent of GDP) of IsDB MCs and EMDEs has widened since 2015, reaching a gap of 16 percentage points in 2021. The increase in IsDB MCs’ external debt was generally steep for all IsDB MC groupings, except for LDMCs, although the increase was steeper for fuel-exporting MCs. For fuel exporters, the external debt-to-GDP ratio has nearly doubled, from 25.6% to 50.1%, between 2014 and 2020. For non-fuel exporters, the ratio increased from 37% to 49%.
With the external public debt growing, mainly on non-concessional terms, the burden on fiscal and external accounts is also expected to increase, especially when global financial conditions tighten. This heightens the risk of macroeconomic imbalances, as well as a diversion of resources from priority social spending into debt service.
Debt levels in many EMDEs had followed an unsustainable path over the past decade in a global context of low interest rates, as indicated by the rising debt burdens and heightened risks of debt distress. Multiple adverse shocks since 2020, namely the Covid-19 pandemic and the East European crisis, have further squeezed the fiscal space and exacerbated debt vulnerabilities of EMDEs in general and IsDB MCs in particular. Consequently, several actors in the development landscape are calling for a renewed debt relief initiative to prevent a major debt crisis in EMDEs. This indicates that the temporary relief provided through the G20 Debt Service Suspension Initiative (DSSI) has only delayed the crisis and that more sustainable and robust solutions are required.
Due to the diversity of creditors, especially from the private sector, debt restructuring is more challenging than in the past. In this regard, the limited progress in rolling out the Common Framework for Debt Treatment, may necessitate an extension of the DSSI for a longer period and for a greater scope of eligible countries. Accordingly, many heavily indebted and debt vulnerable MCs will need fiscal consolidation in the medium-term. Better targeted fiscal spending and improved debt management policies are likewise critical for all, to foster resilience against a possible contagion from other EMDEs.
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