Solving the low-income country debt crisis: four solutions

8 November 2019
Insight
 Money exchange along the streets of Afghanistan, 2011. Photo: Asian Development Bank CC BY-NC-ND 2.0

This is the second in an ODI series of blogs, briefing papers and reports examining whether a new debt or financial crisis is brewing that could threaten the Sustainable Development Goals – and what should be done to prevent it.

My previous blog highlighted the fact that public debt in low-income countries is rising and becoming more expensive, with an increasing number of countries in, or at high risk of a debt crisis. In this blog, based on a forthcoming report, I argue that there are four actions that need to be taken urgently if this brewing crisis in many low-income countries is to be resolved.

1. Boost alternatives to borrowing

Low-income countries face major public financing shortfalls to meet even basic public expenditure needs. For example, a recent ODI study documented how significant increases in tax and aid will be needed to ensure that all countries can afford the necessary investments in healthcare, education and social protection in order to end extreme poverty by 2030. 

Many low-income countries can do more to improve tax collection to reduce the need for borrowing, but this is often a difficult challenge as they tend to have a significantly lower tax potential than other countries. This is partly due to the structure of low-income country economies, which often have small manufacturing and formal sectors, and a less educated workforce.

But it is also due to failings in the international system. Tackling the use of offshore financial centres, intra-company operations within multinational corporations, and financial secrecy (which allows for tax avoidance and evasion) are on the international agenda, but far stronger action is needed if this discussion is to result in tangible improvements for low-income countries.

In addition, the international debate needs to go beyond tax avoidance and evasion and recognise that international competition over tax incentives and other ‘spillover’ effects means tax policies in developed countries can damage the tax base in many developing countries.

However, as our study showed, even if developing countries improved their tax collection to the maximum extent possible, 46 of them would still face public spending gaps to end extreme poverty. To meet these financing gaps that cannot be filled from domestic taxation, all donors must reach the 0.7% Overseas Development Assistance (ODA) target and direct half the money to the poorest category of countries.

2. Manage borrowing and lending better

Careful management of the opportunities, costs and risks of different sources of borrowing is crucial for low-income countries. Capacity for debt management remains weak in many low-income countries, and increased support to tackle this is important. But the underlying reasons for the limited improvement in debt management are linked to a lack of demand, accountability and political commitment. I’ll come to this point under proposal three.

Lenders should play a key role in improving the borrowing options available to low-income countries. Creditors could offer State Contingent Debt Instruments (SCDIs), where repayments are paused if the borrower faces repayment difficulties. They can also support changes to debt contracts to make restructuring easier, and endorse better contractual terms and conditions. This could entail supporting clauses that allow for restructuring by a majority of creditors, ‘standstills’ where repayments are halted during difficult periods, or supporting mediation and arbitration mechanisms.

3. Increase accountability to improve the behaviour of borrowers and lenders

There is considerable room for improvement in debt transparency at the country level, so that domestic citizens and parliaments can provide incentives for governments to improve debt contraction, use, and management. In addition, levels of ‘hidden debts’ such as contingent liabilities are high in many countries. Meaning, without greater transparency, the real debt risks that low-income countries face are obscured.  

Transparency is a theme that has only been taken up to a limited extent by international initiatives. Good proposals (PDF) include creating a mandatory public register of lending and requiring both multilateral actors and private sector creditors to use the register. The public disclosure of lending contracts would allow parliaments, journalists, and civil society organisations to examine them, and would also allow other lenders to have the full information before making further loans.

4. Introduce better ways of managing shocks and crises

Low-income countries are vulnerable to crises – especially those caused externally – for various reasons. A high proportion of their debt is in foreign currency and their economies are small and vulnerable to changes in the prices of commodities or in global financial markets, including the availability and cost of borrowing.

Ensuring debt is managed to deal with potential shocks is an important but difficult element of low-income countries’ debt management. Tools that they can use as part of their national development strategy include capital account management techniques, and the use of public development banks and other institutions to try to direct national savings towards longer term productive investment.

Nevertheless, there are limits to how much individual countries can be expected to insulate themselves from shocks, which is why the role of creditors and the international system is important. The evidence shows that restructuring is a common feature of sovereign debt markets and given that many countries are in or close to crisis, the focus should be on how to restructure unsustainable debt better.

The development of a permanent mechanism for resolving sovereign debt problems has long been on the international agenda and should be revived as the best solution. The key feature of such an institution is that it would be impartial and draw upon expertise, with a legal basis that would make its decisions binding. Fast-disbursing international finance to help developing countries deal with temporary shocks should also be promoted.

These four issues should be at the top of the international agenda. Crucially, preventing another widespread low-income country debt crisis is not solely the responsibility of borrowing countries: it will require serious changes on the part of creditors and the international system.

Authors

Head of Programme
Jesse is a specialist in development finance and the international development finance architecture [...]