Report Contents

October 28, 2020

Macro Series

Comment – Default Options

BY John Llewellyn, Soyon Park, Preston Llewellyn, Russell Jones

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  • The world’s poorer nations are confronted by sharp recessions that threaten to endure.
  • Poverty and inequality are rising rapidly, reversing earlier global income convergence.
  • Public finances are coming under growing duress, and debt distress is mounting.
  • The external liquidity support provided to date is looking increasingly inadequate.
  • Defaults threaten to multiply in the absence of a thorough rich nation-led response.
  • The difficulty may well be concentrating the minds of OECD policymakers on the issue.

Non-OECD economies will suffer big falls in output this year …

Tough times for the world’s poorer nations

The less developed economies have been hit hard, if sometimes belatedly, by the pandemic.[1] As a group, the emerging market (EM)s are forecast by the IMF to contract by some 3.3% this year, although this figure is inflated by China’s early and relatively robust recovery. Ex-China, the likely decline in real GDP is put at 5.7%, a similar figure to that for the advanced economies, with Latin America, and the Middle East and central Asia experiencing particularly large projected falls. There is unlikely to be a return to the 2019 level of output before 2022.

As for the low-income developing economies (LIDCs), they are expected to contract by a less dramatic headline figure of 1.2%, but rapid population growth, and a low starting point for incomes, mean that this is a more challenging outcome than it looks at first blush. The poorest groups in these societies in particular stand to suffer considerable misery.

These projections are necessarily tentative, and hide extensive country-by-country heterogeneity. For those still in the earlier stages of the pandemic, with hard-pressed health care systems, a heavy reliance on the most affected sectors, such as tourism, or with a dependence on external finance, including remittances, the outlook is particularly uncertain and fragile. With the recovery in many advanced economies now losing momentum, no herd immunity, no effective vaccine broadly available, and the threat of tighter financial conditions and further commodity price volatility, the risks to real activity are skewed to the downside.

Non-OECD economies will suffer big falls in output this year

The non-OECD economies could thus face extended recessions, stretching out several years. Moreover, there is the threat of enduring supply-side damage, given that bankruptcies escalate, labour force participation is reduced, and structural policy frameworks and resource reallocation mechanisms in these economies often leave much to be desired.

Poverty and various inequalities are set to rise significantly

The global income convergence of recent decades is rapidly reversing, and inequalities and poverty, particularly extreme poverty, will rise sharply. Women and the young stand to suffer disproportionately. But the position of daily wage labourers, those beyond formal social safety nets, and migrants cut adrift from support networks is especially precarious. The IMF has suggested that more than 100 million additional individuals are now confronted by acute deprivation.

Burgeoning public sector indebtedness

Their public finances stand to deteriorate sharply …

The real-economy traumas faced by many EM and low-income country economies have perforce led to large increases in budget deficits and surges in outstanding indebtedness, when public sector liabilities were already historically elevated. Furthermore, any prospective damage to output potential will act to shrink the tax base in the years to come.

By the end of 2021, the stock of government debt in the EM and middle income economies is likely to have risen by the equivalent of more than ten percentage points of GDP to some 60% of output, thereby exceeding the previous 1980s peak, taking their debt burden to an all-time high (Figure 1). For the LIDCs, which have latterly become more heavily reliant on commercial credit than on official financing, the average debt ratio is likely to end next year at close to 50%, also a new peak.

Moreover, given the potential for private sector balance sheet issues to encourage a steep rise in government contingent liabilities, and with large budgetary shortfalls unlikely rapidly to dissipate, there is little prospect of the debt burdens of either group falling significantly for some time. Indeed, they could continue to escalate throughout.

The ratio of debt service costs to tax revenues seems bound to rise therefore, and rapidly so in some economies. This means that less revenue will be available for other important areas of government, including the social spending that will be needed to alleviate increased poverty, inequality, and any pandemic-related damage to human capital.

… even though scope for fiscal activism has often been limited

The increase in budget deficits and debt ratios in the non-OECD world reflects both cyclical considerations and discretionary policy actions, although the leeway for the latter has been much more restricted than among the rich nations, and has varied considerably country-by-country (Figure 2). Lower-income countries have faced particularly severe financing constraints. Indeed, almost half have already had to cut existing spending programmes in real terms, and almost a third have pared back the capital projects that are so important to future growth.

Challenging financing conditions

Market conditions for the least developed remain onerous

Despite rock bottom rates in the advanced economies, and a rebound in risk appetite earlier on in the year, concerns about new debt supply and weak domestic fundamentals mean than demand for short-term local currency debt has been consistently soft, and proposed new issuance has often had to be delayed. Bond spreads for the lower rated EMs, and especially for frontier market economies (not least in Africa) jumped when the pandemic began, and despite some limited downward adjustment, have remained prohibitive.

That said, investment grade EMs have been able to issue large amounts of debt in foreign currencies. Indeed, first-half issuance of EM Eurobonds amounted to $140bn, against a total of $95bn in 2019. Moreover, EM bond spreads have moderated to more comfortable levels. However, these liabilities carry foreign exchange risk, and hence the risk of currency depreciation greatly increasing the burden of future debt service costs and principal repayments.

Eighteen EM central banks have resorted to public and private bond purchases to stabilise markets and ease financial conditions. A few – Ghana, Indonesia, and the Philippines – have gone so far as to buy bonds in the primary market. Expressed as a percentage of GDP, the amounts purchased have generally fallen well short of the asset purchase programmes employed by advanced-economy central banks. However, they have been deemed successful in that they have brought down yields (albeit sometimes with a lag), and not encouraged large depreciations. (Figure 3).

Central bank bond purchases have been employed as stabilisers

The concern, nevertheless, is that these interventions morph into excessive direct monetary financing of budget deficits, fiscal dominance, and an inflation surge. Clearly, transparency and clear communications around the objectives of these initiatives are vital to sustain central bank credibility, especially in countries with questionable institutional and governance frameworks.

Mounting debt distress

Solvency issues for the poorest nations are multiplying

Even before the pandemic, many low-income developing economies and frontier markets were considered to be in debt distress, or at least at high risk. Today, the IMF puts the proportion in these categories at well over one-half. Furthermore, the debt and debt service environment is complicated by these countries’ growing reliance on non-concessional liabilities.

Comment - Default Options 1

Over the long term, the EMs and other developing economies will have to enhance their debt sustainability through robust and transparent fiscal rules, better expenditure control, the reduction of inefficiently targeted subsidies, and a range of tax initiatives, including more progressive tax codes, the reduction of corporate tax breaks to expand the tax base, tighter caps on personal income tax deductions, the instituting of VATs, improved tax registration, and electronic tax filing.

Help wanted

In the short term, however, there is likely to be a requirement for much greater external assistance, and debt restructuring if a cascade of defaults is to be avoided.

The G-20’s Debt Service Suspension Initiative has already offered 73 countries help to deal with financial pressures by allowing them temporarily to suspend payments to official creditors for three years. However, more extensive action foundered on US and Chinese reticence. As of mid-October, 43 countries had applied for debt suspensions, delaying some $5.3bn of payments, although this was less than half of that available. Also, few private creditors have been willing to engage in comparable debt relief.

Existing liquidity assistance needs to be extended

The IMF has in addition provided around $31bn in emergency financing to 76 countries, including 47 low income countries, as well as debt service relief to a selection of the poorest countries.

These support mechanisms and concessionary financing initiatives will have to be extended in whole or in part well beyond 2020.

A case for new departures

If a debt crisis is to be avoided, there will be a need for more dramatic interventions from the world’s multilateral institutions and wealthier nations.

One useful initiative would be an allocation of new Special Drawing Rights (SDRs), the IMF’s proxy reserve asset. The IMF has the ability to provide general allocations of SDRs in proportion to members’ quotas, although there is nothing to stop those advanced economies that have no need for these assets from transferring their allocations to those that do. The problem is that to date the US has vetoed any such initiative, as it would provide financial support to many countries with whom it is politically at odds. Perhaps there will be a change of approach after November 3rd.

A fresh allocation of SDRs would also be of considerable value …

To address current problems, however, policymakers will have to go beyond liquidity provision to addressing solvency considerations.

First and foremost, where debt is unsustainable, it must be recognised as such at an early stage, and a comprehensive restructuring package put in place. Typically, the longer that a debt restructuring is delayed, the harder it is to complete, and the greater is the damage to GDP, investment, private sector credit and capital inflows.

Comment - Default Options 2

The process of debt restructuring could also be enhanced by improvements in the international debt architecture, extending to enhanced CACs (collective action clauses) in international bonds, greater transparency around what is owed and on what terms, especially as regards non-bonded, collateralised and quasi collateralised debt, and a common approach to restructuring bilateral debts that is acceptable to Paris Club and non-Paris Club members alike.[2] After all, most official claims are now held by the latter.

… in the context of an improved global debt architecture …

Potentially more important, would be a movement towards the adoption of contractual clauses that reduce, or automatically suspend, debt service in the context of natural catastrophes and large economic shocks – GDP-linked bonds.

… extending to GDP-linked bonds …

Best of all, perhaps, would be the development of a sort of Marshall Plan for the non-OECD world, under which extended financial support could be supplied in exchange for the delivery of comprehensive development strategies worked out by individual countries in conjunction with the IMF and World Bank.

… if not a 21st century Marshall Plan

The key to any comprehensive solution to the non-OECD world’s debt problems will be persuading the OECD nations to care sufficiently to take action. However, their own public finances are under duress as budget deficits and debt burdens reach unprecedented peacetime levels. Moreover, populism and nationalism remain ascendant in many countries.

Ultimately, as was the case during the 1980s Latin American debt crisis, the most likely catalyst for thoroughgoing change may prove to be self-interest in the form of negative feedback – interrupted commodity supplies, damage to important export industries, or financial sector distress.

Watch fors

  • Growing non-OECD-economy debt distress.
  • Increasing resort to monetary finance.
  • A series of increasingly high-profile sovereign defaults.
  • Negative feedback into OECD export markets and financial sectors.
  • An allocation of SDRs.
  • GDP-linked bonds.
  1. This note draws heavily on the recently published October 2020 IMF World Economic Outlook, Fiscal Monitor, and Global Financial Stability Report.
  2. The Paris Club was created in 1956. It is a group of major creditor countries whose role is to find co-ordinated and sustainable solutions to the payment difficulties experienced by debtor countries. As debtor countries undertake reforms to stabilize and restore their macroeconomic and financial situation, Paris Club creditors provide an appropriate debt treatment. The Paris Club treats public claims (that is to say, those due by governments of debtor countries and by the private sector), guaranteed by the public sector to Paris Club members. Membership extends to Australia, Austria, Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Japan, the Netherlands, Norway, the Russian Federation, South Korea, Spain, Sweden, Switzerland, the United Kingdom and the United States of America.

 

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