Record debt levels suggest we may be sleepwalking into the next global economic crisis

12 September 2018
Comment

Ten years on from the global financial crisis, several middle-income economies are facing a financial crunch and many low-income countries are reaching critical debt levels. Overall, debt levels are at a record high – and rising, both in dollar terms and compared to gross domestic product (GDP). Given that debt problems were one major underlying issue behind the global financial crisis, and it was American sub-prime mortgage debt that triggered the crash, does this mean the world economy is heading for another fall?

Global debt continues to rise

Graph: global debt continues to rise. Source: Bank for International Settlements, Annual Economic Report, June 2018, p xi

Global debt levels do not, on their own, spell disaster. As the UN’s mid-year global economic stocktake shows, on the surface, the global economy is faring well. Global growth rates are improving and unemployment is declining, including in low- and middle-income countries.

But while overall growth looks strong, the IMF argues that the ‘balance of risks has shifted further to the downside, including in the short term.’ High debt levels increase the risk of future crises because they make both public and private sectors vulnerable to changes in interest rates and to expectations about the future of the economy. One key risk is the impact of changing monetary policies in high-income economies.

Middle-income countries on the brink

Rich countries’ response to the last crisis was to keep interest rates at record lows, where they have stayed for most of the past decade, and to pump trillions of electronically created money into the financial sector through quantitative easing.

This created a constant supply of cheap money, fuelling the current debt build-up but also contributing to record levels of foreign investment in low- and middle-income countries, which peaked in 2015.

Now, however, governments are beginning to change course, with the United States leading the way by raising interest rates steadily in 2017 and 2018.

Middle-income countries have feared such a change for some time. The Bank for International Settlements (BIS, the club of central bankers) argues that emerging markets are currently the most at risk of crisis, because ‘the financial cycle has peaked, dollar debt is high, current account deficits are large and foreign exchange reserve buffers small.’

Several countries – notably Argentina and Turkey – are already experiencing crises partly caused by changes in monetary policy in the US and elsewhere and the rise in the value of the dollar, in which many of their debts are denominated, has led to major capital outflows and falls in the values of their currencies.

Given that emerging markets are now more than 60% of global GDP, a widespread crisis there could have global repercussions.

Sovereign debt crisis brewing in low-income countries

Many countries are facing a different kind of debt problem. In a growing number of the world’s poorest countries, government or ‘sovereign’ debt is the concern. Around two out of five low-income countries are now either already in sovereign debt distress, or at high risk of it.

Worryingly, this number has doubled since 2013, and now only one in five developing countries are deemed by the IMF to be at low risk. Seven countries are already in a debt crisis. Of these, six – Chad, Mozambique, São Tomé and Principe, South Sudan, Sudan and Zimbabwe – are in sub-Saharan Africa.  Of the 23 countries judged to be at high risk of distress, most are also in sub-Saharan Africa, which is why ODI’s upcoming event on Africa’s rising debt levels is so timely.

Borrowing to invest can be a sensible strategy for governments, as the boost to economic growth can help repay the debt. The dilemma facing low-income countries is that their domestic tax base is low. Given that international aid has been lower than promised and has been falling as a share of total aid for this group of countries, borrowing may be the only practical way to fill Sustainable Development Goal financing gaps. Borrowing is effectively plugging holes in essential public expenditure.

We have seen that many poorer countries remain vulnerable to external economic changes, such as the impact of monetary policies in high-income economies, and the value of the dollar. The fact that the majority of low-income country external debt is either short term or owed to private creditors increases this vulnerability. Many are also affected by changes in commodity prices, on which they depend for export revenue, and were hit hard by falling prices in 2015.

At the moment there is no effective mechanism for dealing with sovereign debt crises. The Heavily Indebted Poor Countries Initiative (HIPC), which eventually helped resolve the last widespread sovereign debt crisis, is not able to respond to this – it has already given 30 of the 36 eligible countries the full amount of debt relief available. The UN General Assembly agreed a set of Basic Principles on Sovereign Debt Restructuring Processes in 2015, but as yet there is no institution or mechanism for implementing these.

With the threat of a widespread sovereign debt crisis growing, and the poorest countries likely to be hit hardest, it is time for the international community to complete this work.