Unravelling the debt crisis: The 2020s dilemma for Africa, South Asia and beyond

From 2008 right through to 2021, high-income countries were running historically loose monetary policy – very low interest rates plus quantitative easing. This created a huge demand for the debts of lower-income and emerging countries, whose risks were very different (uncorrelated) from those in the high-income economies and where the returns were potentially more attractive.

Although many lower-income countries suffered a relatively mild impact from the 2008 Global Financial Crisis and continued to grow strongly through 2015 or even 2019, the sudden availability of much cheaper dollar financing, in addition to all the official finance and aid, was very tempting. It could be used to finance investment in infrastructure or in parastatal companies (e.g. Ethiopia), or to invest in human capital and/or simply to expand public consumption (e.g. Ghana).

Becoming unsustainable

There were always risks in running large deficits, partly financed by dollar-denominated debts, whilst economic performance was good and conditions were benign. What happens when conditions take a turn for the worse? Running large, foreign financed deficits in the good times is the very opposite of building ‘buffers’ to weather future storms.

The countries with weaker governance were not necessarily those that became the most indebted. The Democratic Republic of Congo, for example, was not able to raise non-concessional finance in the 2010s or even finance much of a deficit on the domestic market. As a result, it has a tiny stock of foreign debts and not really any debt related problems. Meanwhile, democracies like Ghana and Kenya were much more creditworthy and foreign financing was politically very tempting.

If income falls whilst public spending stays the same, then the ratio of debts to income increases, making countries less creditworthy, and the gap between and revenue and spending widens, because revenue falls alongside national income. If interest rates increase, the ratio of debt service to income and exports increases, making countries less creditworthy and more of the resources available for public spending are diverted to debt service. From 2020, both these things happened in many lower-income countries. Growth slowed and interest rates increased at the same time.

Amplifying the pain

Covid-19, and the public policy responses to it across the world, produced a recession that ended over 20 years of benign international conditions for poorer countries. Those with already high foreign debts were in a much worse position to borrow more. The reduction in creditworthiness came on quite fast – for example in 2016, the IMF said that Kenya was at low risk of external debt distress, by 2018 this had increased to moderate risk, by 2020 it had increased again to high risk of external debt distress.

Meanwhile, the higher-income economies that had locked down in 2020 and 2021 found that their massive fiscal support had caused inflation. By 2022 they switched out of the long period of ultra-loose monetary policy, raising interest rates right through 2023 in order to control demand and inflation. This blow was also most severe for the lower-income countries with high foreign debts.

What are the options?

However they got there, many lower-income countries started 2022/23 with high fiscal deficits and sluggish economies, diminished creditworthiness and much tighter financial markets depriving them of the easy finance they may have used in the previous decade. There was also the prospect of rapidly increasing foreign debt service: most non-concessional financing for lower-income countries is on a medium-term basis and needs to be rolled over every two to five years, so as bonds and loans mature, they need to be refinanced at much more expensive rates.

All these forces make it more difficult to finance the current account deficit (including the trade deficit) and this causes the currency to depreciate – one of the effects of this is to make foreign debt service even more expensive in local currency terms.

Solutions can include:

• Increasing revenue. This is difficult when the economy is weak. But in some cases, there are potential taxpayers who have been given a very soft ride and can pay more in the crisis: Kenya has reduced exemptions and mobilised more revenue. In Ghana, high oil prices and revenue measures have brought a very welcome boost to revenues. By contrast, in Ethiopia, where civil war exacerbated international pressures, revenue has fallen sharply from 12% of GDP in 2019/20 to 8% in 2021/22.
• Reducing waste. Again, the possibilities for reducing waste don’t emerge just because there is a crisis but the urgency of reducing waste increases. Perhaps the crisis can be ‘used’ as a reason for getting more serious about this.
• Cutting expenditures – cutting investment is easiest in the short term but hurts future growth – can the cuts be temporary? Was investment too high? Cutting current spending normally means making services worse. For example, Ethiopia has cut back spending drastically (from 18% to 11% of GDP in 6 years), with the cuts initially to the very high rates of public investment, but later on, starting to reduce real spending per capita on social services. In Ghana, public consumption ballooned in 2020 and has been cut back quite swiftly since then.
• Carefully managing the debt stock to minimise the future value of debt service and to avoid sudden changes in the level of debt service. Foreign financing is often lumpy – in 2024 Kenya will have to refinance a US$2bn Eurobond (about 2% of GDP) all on the same day: likely interest charges will increase by about 10% points. (In hindsight this was a poorly designed Eurobond).
• Reducing foreign debt service by refinancing maturing debts on the domestic market or on concessional terms. You need a good domestic market with some spare liquidity to pay down foreign debt in this way – Kenya may manage this as long as it reduces its deficit overall. This helps from a public finance perspective by reducing the debt service bill (probably), but it also reduces net foreign financing and squeezes the economy more (probably). Replacing Eurobonds with IFI debt is even more attractive and Ghana will do this using US$4bn of IFI advances in May 2023 – this is agreed as part of a wider restructuring in Ghana: see below.

More radical solutions for turning things around could include:

• Default. A national government can tell its creditors that it is unable and unwilling to service or repay its debts – a default. This is risky for the government – these creditors won’t lend it more money for years, whatever the needs. But if the government runs a primary surplus (borrows only for debt service), or even if it runs a primary deficit which can be wholly financed on the domestic market, it can default on foreign debts and still pay its other bills.
• Rescheduling, haircuts and debt relief. It is often in the interest of creditors and sovereign governments to avoid a default by negotiating what is effectively a partial default – a reduction in foreign debts. The more moderate way of doing this is a rescheduling, where debts are extended over a longer period without any face value reduction – this can be costly for foreign creditors who really need to increase interest charges and debt service rather than reduce it. A more extreme action is when private creditors agree to reduce the face value of debts they own by a certain proportion, a ‘haircut’. Creditors need to agree to share the cost of this is to work. And this may be accompanied by reductions (write-offs) in official debts and aid debts.

In practice, a default can be converted into a more sustainable form of debt relief after the event – this is happening in Ghana, Sri Lanka and Zambia, for example.

Debt relief can be in the interest of creditors (who get paid more compared to a default) and also generate a good humanitarian outcome by avoiding the most brutal public spending cuts which inevitably hit support for poor populations.

The elephant in the room

A challenge with debt relief in the 2020s is China. China and Chinese banks are, combined, quite a major creditor to many lower-income countries and they are not keen to participate in debt relief. The IMF, which normally brokers debt reductions and rescheduling has limited levers to force a country like China to cooperate. But this may reduce the willingness of other creditors to participate because China is free-riding. At the same time, it is difficult for small African countries to default on Chinese loans. Often they are secured on physical collateral. For example, Chinese creditors have acquired Sri Lanka’s main port in Colombo in lieu of its debts. East Africa’s largest port, the port of Mombasa, is effectively collateral on Chinese loans used to build the new Nairobi-Mombasa railway.

Stepping up

International donors can do more than just debt relief – being proximate to a debt crisis changes what is sensible in terms of foreign aid.

If governments are being forced to cut back so severely that what they and donors agree are ‘priority programmes’ are being hit, then it makes sense for donors to backfill those priority programmes. In 2020 and 2021, the IMF issued new special drawing rights (SDRs) and mobilised new balance of payments support to alleviate the squeeze on imports, and the World Bank frontloaded lending as budget support to help fill the deficits opened up by Covid impact. Bilateral donors did much less – most of them maintained the level of aid (not the UK) but did not switch from aid-funded projects to backfilling essential programmes.

This said, Technical Assistance for public finance management, revenue mobilisation, careful expenditure management and debt management still makes a lot of sense in the current conditions. Experience from Pakistan suggests that the point of crisis can be the time when reforms can make the most progress. For example, the Sub-National Governance II programme, an initiative funded by the UK Foreign and Commonwealth Office, used the financial crunch to nudge the government of Punjab towards dealing with some of its more intractable challenges, such as a burgeoning pension liability. The pension reform is expected to accrue savings of £1.89 billion over the next ten years and £10 billion over 30 years. Similarly, reforming an entrenched wheat subsidy has helped reduce the associated circular debt by 47%.

A call to action

The journey to understanding how we arrived at this point of the debt crisis has revealed the complex interplay of global monetary policies, shifting economic conditions and political temptations in developing nations. The consequences of unsustainable borrowing and the challenges faced by lower-income countries demand immediate attention and action.

The debt crisis presents us with an opportunity to come together as a global community, across borders and ideologies. Moreover, it is crucial for us to raise awareness of the debt crisis and its implications. Through sharing information and engaging with policymakers, we can amplify the call for decisive action and draw attention to the urgent need for support.

About the authors:

Linda Muruganandan is our Director of Consulting. Linda has twenty years of experience in the international development sector including in access to finance, trade, and investment across southern and eastern Africa and south Asia, and on global initiatives.

Stevan Lee is our Chief Economist. Stevan has extensive in-country advisory experience, including a nine-year residency in African countries and in the Middle East. Previously, Stevan worked for the Department for International Development and the World Bank