The political economy of external debt within low-income countries in an age of asset management

Developing countries have become connected to the cycles of global market-based finance. This has important implications for external debt sustainability, debt relief, and the financing of development

In April 2020, the yields on Eurobonds issued by developing countries dramatically increased. While the steepening of borrowing costs may seem warranted from the creditors’ perspective given the economic challenges that COVID-19 brings, the shock to market yields was sudden and widespread across the developing world and presented new features compared to the past. While past crisis episodes in low-income developing countries (LIDC) which primarily includes countries from Sub-Saharan Africa), have arisen from a lack of foreign currency from exports which can be used to service high debts, this year’s shock originates from the sudden deterioration in global liquidity conditions. The ease of financing by borrowers depends on the liquidity conditions of financial markets. As LIDC debt is traded as a financial instrument by global asset managers, changes in global liquidity profoundly affect their debt sustainability.

This new financial channel of shock transmission is the result of the important changes in the external debt of LIDC. Historically, the dynamics of LIDC external debt was almost exclusively dominated by their borrowing from official creditors or multilateral creditors such as the IMF and the World Bank. These engagements were characterised by cycles of increasing indebtedness, repeated debt rescheduling and painful structural adjustment programmes. Since the turn of the millennium however there has been a structural shift in LIDC external debt, with official debt declining as a result of large multilateral debt relief initiatives, while private creditors increased in importance, particularly through an expansion of the bond markets. Over the past 10 years, there have been 57 international bond issuances by 16 LIDCs, for a total of $52 billion, so that just under a third of external debt is now owed to private creditors. For most of these countries this was the first time they enjoyed continual access to international bond markets. Take for example Senegal, a country that enjoyed substantial debt relief from multilateral creditors and had a total external public debt of about 18% of GDP at the end of 2007, over 99% of which was owed to official creditors. Just two years later, Senegal issued its first 5-year bond in 2009, followed by five more issuances over the course of the 2010s, for an outstanding total debt value as of the end of 2019 of 16.7% of its GDP.

As a result of these issuances, LIDCs are now increasingly connected to global finance. “Eurobonds” are, by definition, foreign currency issuances – mostly in US dollars, some in Euros – which are issued under foreign – most commonly English – law, and traded in foreign exchanges, such as Frankfurt or Ireland. Furthermore, these bonds are part of traded indices such as the Emerging Market Bond Index by JP Morgan, and thus are part of traded index funds such as the iShares J.P. Morgan USD Emerging Markets Bond ETF, which includes issuances from eight LIDCs.

This novel situation means that debt dynamics in LIDCs increasingly depends upon global liquidity conditions. The timing of the issuance of LIDC Eurobonds corresponded to periods where global financing conditions were “loose”, i.e. when global financial intermediaries had easy and cheap access to credit, and the yields on LIDC bonds issuance, as well as their evolution over time, follow the global financial cycle. As the figure below shows, there is a positive correlation between the average yield at issuance and the level of market uncertainty, represented by the VSTOXX index. For global asset managers and their ultimate asset holders, Eurobonds from LIDC represent a high-risk/high-return segment, a good investment when global liquidity is ample and the search for yields is on. But any negative shift in global liquidity conditions will induce a reversal of these investments, as investors strive for cash to meet their liability demands.

This situation has profound implications for the political economy of debt and its management. Firstly, given the growing importance of market-based financing for LIDC, it is hard to maintain that debt sustainability is exclusively or even primarily a question of a country’s trade or fiscal policy. Rather, it becomes a pro-cyclical function of global liquidity cycles: ample global liquidity means easier borrowing and refinancing conditions, but global market turbulence means increasing potential for debt distress. Therefore, international market access reinforces existing financial hierarchies, as LIDCs can only try to weather the storm with domestic policy, but do not have any way to influence global liquidity conditions, whose public and private drivers remain overwhelmingly concentrated in the global North.

Secondly, any action to meaningfully address debt repayment difficulties must include private creditors. If, as the current G20 Debt Service Suspension Initiative, only focus on official creditors, there is a clear risk that financing freed from suspending debt payments on bilateral debt or received from the IMF will simply be used to pay back private creditors rather than being used to counter the effects of the global COVID-19 recession. The voluntary call of the G20 or more recently by IMF director Kristalina Georgieva, is unable to compel private creditors to participate, which, as mentioned, now represent a significant component of LIDC external debt.   

Thirdly, it is important to reassess whether borrowing through Eurobond issuance is the best way forward for LIDC financing needs. While this has looked inexpensive compared to domestic borrowing, the average interest rate on these issuances remains high at 7%, and costs and accessibility remain contingent on abundant global liquidity. The development of local bond markets is often proposed as a solution to reduce these costs and risks. However, it might end reproducing similar vulnerabilities, if such markets are dominated by the global asset manager industry and their clients, as the recent experience of larger and more financial developed emerging economies shows. It is therefore paramount that the question of financing development looks outside the contours of the global market-based financial system. The establishment of a global authority to oversee comprehensive debt standstills and restructuring combined with a greater emphasis in using domestic public financing resources represent more fruitful avenues.