The imperative of more sovereign debt relief

The Pope’s Easter message doesn’t usually wade into economics. But this year Pope Francis called for “debt reduction, if not forgiveness” for the world’s poorest countries that are being hit hardest by the pandemic. Pope Francis is right that countries need help in the face of this truly exogenous shock. In the short term, debt forbearance is absolutely necessary, and when the dust settles we should look into forgiveness.

The coronavirus crisis has been unprecedented in the scale and speed with which it has decimated global growth. Many governments have launched massive programmes to fund health and economic policy initiatives designed to protect the lives and livelihoods of their populations. It is too early to know how the world has been changed by coronavirus, but we know for sure it will involve a lot more sovereign debt. Governments are absolutely right to throw fiscal caution to the wind right now and in some cases to lean on their central banks for support, but not all countries are able to do this. Emerging and frontier economies in particular are already shouldering high debt burdens often denominated in ever dearer US dollars as they see record capital outflows that push borrowing costs up further.

In an increasingly go-it-alone environment, the rest of the world should still worry about this, and not just out of the kindness of their hearts. While the developing world has been hit by the financial and economic turmoil caused by coronavirus, much of it has not yet felt the full force of the virus itself. If governments in emerging and frontier markets funnel their money to debt servicing, they will be unable to address the imminent health challenge. If they cannot contain the virus in these regions, it will come back in subsequent waves to hit the rest of the world as well. Furthermore, developing economies account for roughly 60 per cent of global GDP and as such are an important source of demand for the rest of the world. If we want a quick economic recovery, the best way is to make it synchronised.

Thankfully, church and state seem to be aligned on this and some debt relief is coming for the poorest countries in the form of forbearance. Earlier this week, the IMF Executive Board approved debt relief for 25 low-income countries that are eligible for support from the Catastrophe Containment and Relief Trust for the next six months. The G20 also agreed to extend a moratorium on debt payments to the world’s poorest countries from 1^st May until the end of the year.

This forbearance from countries and the IMF can immediately free up resources for governments to devote to the immediate health and economic crisis and avoids developing countries borrowing just to recycle that money to other creditors. But we should go even further. First, six or seven months is not long enough and so forbearance should be extended to at least a year to give these countries a chance to plan once the economic quicksand has subsided and we know where the bottom is. Second, the 40 most highly indebted poor countries also owe around US$20bn to private sector creditors by the end of 2021. The G20 and the International Institute of Finance have urged private sector creditors to also offer forbearance, but so far this has not been forthcoming.

Private sector forbearance could bring some short-term problems. The credit ratings agencies technically view missed or delayed payments of contractually-obligated interest or principle as a default, even when countries have permission from their creditors. Private sector forbearance could therefore result in credit ratings downgrades, pushing borrowing costs up further. In a truly unique crisis in which everyone is tearing up their playbooks, the credit ratings agencies should find flexibility to avoid penalising developing nations benefiting from private sector debt relief.

Some developing countries will be disappointed with the debt relief measures announced, preferring debt forgiveness instead. Forgiveness should be provided when a country is insolvent or cannot meet its long-term financial commitments. Figuring out whether a country is insolvent or just illiquid (when it cannot meet its short-term obligations but should be able to meet them in the long-term) requires conducting a debt sustainability analysis (DSA) considering factors like a country’s growth projections, inflation, borrowing costs and fiscal position. DSAs are often more art than science at the best of times, but under the current, quickly-evolving circumstances they are near-impossible. According to a Bloomberg survey conducted between 3^rd and 8^th April, the range of professional forecasts for annualised US growth in the second quarter of this year is +0.4 per cent to -65 per cent. And that is for a country with some of the most readily available statistics.

There could be negative implications of immediate debt forgiveness as well. If a country has its debt written down now, losses will be crystallised for creditors and they may be unwilling to lend that country money, shutting it out of capital markets just as it badly needs to borrow. Furthermore debt forgiveness is a negotiated process between policymakers, creditors and lawyers and takes time that no countries have right now as they rush to address their health and economic crises.

Some might argue that helping countries out with their debt creates a moral hazard and sets up the wrong incentives for countries that have borrowed too much. Irresponsible countries are let off the hook for imprudent fiscal management—the argument goes—and learn that they get rescued when this happens so they can do it again. These arguments dominated debates about debt relief during the eurozone crisis. But they are completely inappropriate in this context. The coronavirus crisis and subsequent lockdowns have been the very definition of an exogenous shock, coming from outside the economic system. Many countries and companies that were perfectly prudent and healthy beforehand will fall into trouble and should be given bridge support until our economies reopen and they can get back on their feet.

Once the dust has settled and we have a better sense of the longer-term economic impact of coronavirus, we can conduct debt sustainability analyses and consider debt write downs. For now, when time is of the essence, forbearance should be part of a multi-pronged approach to provide immediate relief to those countries that most need it. The faster and more boldly we respond, the better we can stem the inevitable downturn we are all facing.