The Covid-19 pandemic has propelled the issue of debt distress to the very forefront of the policy agenda. A series of debt defaults in developing countries occurred in 2020, and 2021 could see further defaults as an increasing number of poor and middle-income countries are running out of fiscal and monetary capacity while still confronting the health and economic challenges from the pandemic. These countries need more support to fight the health crisis they face – more investment, more sustainable projects, and infrastructure financing to combat climate change. Yet, debt sustainability issues represent a barrier to the flow of new financing towards value-creating investments.
The international community – including regional development banks (RDBs) ¬– has provided some financial support and debt relief. On 22 November 2020, the G20 agreed to extend a freeze on official debt service payments (DSSI) until mid-2021 and exhorted private sector actors to participate on equal terms. Coming after the debt service suspension initiative, the ‘Common Framework’ adopted by the G20 provides critical assistance to countries in debt distress.
The framework allows countries to benefit from comparable treatments in debt relief (mostly maturity extension and exceptionally debt cancellation) by official bilateral creditors in countries participating in the initiative. This includes China which has become a major bilateral creditor to developing countries, especially those in Africa. The framework also opens up the possibly of the private sector to provide similar debt relief on a participatory basis, but details regarding implementation are yet to be ironed out.
The narrow view and its consequences
Certain rating agencies have warned that the countries requesting assistance through the G20 Common Framework could face downgrades (Fitch Rating 2020). Their reasoning is that the framework will automatically bind private creditors to offer some debt relief. But this is far from a foregone conclusion.
As a result, countries in debt distress that are eligible for debt relief are reluctant to ask for debt relief through the G20 framework. Countries have traditionally not wanted to seek relief for fear of triggering a credit downgrade and cutting off access to international capital markets. But the experience with debt distress is that the longer countries wait, the more painful the restructuring will be and the harmful consequences for growth.
A cascade of defaults could trigger a downgrade of the balance sheets of regional development banks through their shareholding structure (G24 2015). Regional development banks, which typically have conservative management practices, rely on their ‘triple A’ credit ratings to raise funds from markets. Losing their trusted status would, in turn, limit the ability of development banks to lend a helping hand to the very member countries most in need of funding and investment.
The broader view and the imperative of coordination
The severity of the pandemic has led advanced economies to do whatever it takes in the form of unprecedented domestic fiscal and monetary interventions. Developing countries have not been able to follow suit because of their limited fiscal and monetary capacity. Preserving and expanding the financial capacity of international financial institutions, especially regional development banks – as was done in 2009 following the global crisis – is currently the only way of providing ‘lender of last resort’ support to developing countries fighting Covid-19. These institutions, which offer zero- or low-interest financing and long maturities and which provide necessary oversight in channeling funding to valuable projects, are best-equipped to help developing countries cope with the crisis.
The prospective credit rating downgrades of individual countries could cascade down into a downgrade of regional development banks and this will only hamper the ability of these institutions to perform their functions effectively. The international community should not tolerate such a scenario and should provide a strong backstop to development banks. Considering that the capital of regional development banks is paid in reserve currencies, major economies should offer that backstop. They should also consider doing so in the same way that their own economies are supported through the actions of their central banks.
The rationale for these extraordinary, coordinated actions to preserve and coordinate a systematic response to the crisis is in line with the imperative for global coordination to eradicate the virus. Previous experience in fighting smallpox suggests that the benefit-cost ratio for assisting its eradication exceeded 400-1 (Barrett 2007). Similarly, the cost of inaction, both economic and social, would be enormous. The payoff of an expanded and coordinated response by regional development banks is huge. Preserving and expanding the financial capacity of these institutions is a key pillar of the coordinated action to preserve the global economy.
Regional development banks can also help coordinate debtor countries’ efforts to obtain debt relief without collateral damage in the context of the G20 Common Framework. Indeed, the treatment of individual countries in isolation by rating agencies, and the failure to see the systemic nature of the crisis, should be balanced with the interests of debtor countries and the cost to the global economy. If countries individually become reluctant to use the Common Framework to obtain debt relief, they will be likely be subject to messy and prolonged debt restructuring episodes that would come too late and do too little to help reignite growth. These waves of defaults will also damage capital markets for a long time. Importantly, the network of development banks has an important role in channeling crisis response funding in a more efficient and coordinated way than is currently done through private capital markets (which alternate between sudden stops and search-for-yield highly risky speculative funding).
Evidence suggests that the debt relief provided during Covid-19 has helped lower the cost of borrowing (Lang et al. 2020). The Common Framework is too recent a creation to be assessed empirically but there is no reason why a framework aimed at alleviating the debt burden of debtor countries in distress would be harmful. While a maturity extension of debt will qualify as a technical default and cut the debtor country in distress off capital markets, one should not lose sight of the fact that the very debt relief also allows the country to put its financial house in order. The temporary loss of market access should not be seen as too detrimental and should be viewed as necessary to eliminate debt overhang and reignite growth. A coordinated approach by debtor countries led by regional development banks in the context of the Common Framework could go a long way in avoiding a downward spiral triggered by an avalanche of downgrades and defaults.
Overall, it is imperative that shareholders of regional development banks – especially from the major economies – provide the necessary backstop to avoid the cascading effect of downgrades from ratings of shareholders onto regional development banks. Further, it is essential that regional development banks coordinate debtor countries to form a coalition of interests in the context of the G20 Common Framework. Early efforts at coordination over these actions, as opposed to a laissez faire approach, will help limit the cost of rebuilding after the pandemic and will preserve international capital markets in the short and medium run.
Editors’ note: An earlier version of this column was published on the Brookings “Future of Development Blog”. Reproduced with permission.
Barrett, S (2017), “The smallpox eradiation game”, Public Choice 130: 179-207.
Bolton, P, M Gulati and U Panizza (2020), “Legal Air Cover”, CEPR Discussion Paper 15336.
G24 (2015), “Are Credit Rating Agencies Limiting the Operational Capacity of Multilateral Development Banks?”, 30 October.
Fitch Ratings (2021), “G20 Debt Deal Could Lead to Sovereign Default, Non Rating Action Commentary”, 16 February.
Lang, V, D Mihalyi and A Presbitero (2020), “Borrowing Costs After Debt Relief”, VoxEU.org, 29 October.