EXECUTIVE SUMMARY

• The Covid-19 pandemic and related global economic crisis triggered an unprecedented shift in public debt sustainability in the developing world. Emerging Markets (EMs) and Low-income Developing Countries (LDCs) have been hit harder by the post-Covid debt surge, reflecting their heavy debt-service burden compared to Advanced Economies (AEs). A decade ago, the share of government interest payments in fiscal revenues was nearly the same (on average around 6%) for the three country categories. Since then, the debt-service cost has fallen for AEs (to 4% in 2020), gradually increased for EMs (7.3%) and more than doubled for LDCs (13.7%).
• Despite the global economic recovery that is already underway (+5.5% in 2021, the fastest recovery in the past 40 years), we expect increased debt distress in EMs and especially in LDCs in the next two years and further sovereign downgrades as well as some defaults. Low-income countries will need a minimum of USD450bn in order to step up their spending response to Covid-19, to rebuild or preserve foreign exchange reserves and to offset the long-lasting scars of the crisis. In the absence of a comprehensive solution, heavy debt burdens may generate a permanent global divergence between rich and poor countries.
• Current debt restructuring initiatives will certainly continue to kick the can down the road and are likely to fall short of their objectives. The IMF’s new USD650bn SDR allocation is a step in the right direction but will be no game-changer. The G20/Paris Club Debt Service Suspension Initiative (DSSI) has the merit of including China, for the first time, into a coordinated debt relief initiative. Yet, it will bring only “temporary” relief (i.e. payment deferral without debt cancellation) in 2021 and covers a very small portion of the debt-service burden (excludes EM borrowers and private creditors, for example).
• The changing creditor landscape of public debt (Eurobond holders, China, India and some Middle Eastern countries) has created a “race to seniority” and increased debt sustainability risks. This shift from traditional (concessional) to private and commercial debt complicates debt restructuring and leaves less room for debt forgiveness. China’s collateralized lending with strategic assets gives it a more senior status, for instance in Angola and Zambia, compared to official international lenders (such as the IMF, World Bank). This creates a race to seniority that complicates debt-resolution negotiations in case of repayment difficulties. So far, when things have gone wrong and repayment difficulties arose, countries have bilaterally engaged in debt-restructuring talks with China behind closed doors (Sri Lanka, Ecuador, Angola, Zambia, Kenya), with barely any disclosure on agreed repayment deferrals (rather than write-offs).
• The IMF-coordinated “Common Framework” aims at offering the same restructuring terms for all creditors, including private creditors, by following a “case by case” approach. Coordination, transparency and acceptability will be the main challenges for reaching a satisfactory debt restructuring agreement with all stakeholders. Given the overwhelming share of Eurobond holders, official creditors are currently pushing for private sector involvement in debt restructuring to ensure “fair” burden sharing. Yet, some borrower countries are less inclined to incur losses on private creditors, with the fear of having their sovereign ratings downgraded, which would lead to losing market access. In addition, the success of the initiative hinges on transparent information sharing regarding the stock and conditionality of the debt with China. We believe that the political acceptability of these debt-relief initiatives could be jeopardized should China not take sufficient part in the process. The US and other bilateral creditors may not want to join the initiative if the provided debt relief is used to repay Chinese debt.
• Overall, we expect neither a fundamental blanket solution nor a tsunami of debt defaults in the near future. The international community is likely to step in to bring the needed liquidity relief in case of stress, without being able to offer an overarching solution. Debt forgiveness will bring only temporary financial relief to countries without tackling the root causes of unsustainable debt accumulation. In this sense, proposals like the “New Deal” for Africa from the Paris Summit would offer a viable solution through private-sector-led growth if countries manage to overcome their structural impediments (i.e. high exposure to commodity cycles, weak fiscal revenue collection, inefficient government spending, corruption and poor governance, low potential growth due to shortfalls in human capital, infrastructure and energy investment etc.).
• We identify pockets of sovereign debt stress vulnerability for the next two years. The top 20 riskiest EM countries include the heavyweights Egypt, South Africa, India and Brazil, as well as Pakistan. Our Public Debt Sustainability Risk Score (PDSRS) analyzes sovereign debt dynamics in 61 EMs and 40 LDCs. The countries that we flag as “most vulnerable” have high chances of being next to seek financial support from international lenders, to apply for debt relief/restructuring initiatives or to default on their sovereign debt (i.e. failure to reimburse principal or interest payments in due time). The top 20 riskiest countries include seven economies each from Latin America (Suriname, El Salvador, Costa Rica, Trinidad & Tobago, Panama, Brazil, Argentina) and Africa (Egypt, Zambia, Angola, Tunisia, Ghana, South Africa, Mozambique) and three each from the Middle East (Lebanon, Bahrain, Jordan) and Asia (Sri Lanka, Pakistan, India). However, there is no country from Emerging Europe. The top 20 also includes four of the five countries that defaulted in 2020 (Lebanon, Suriname, Zambia, Argentina).
• The traditional debt sustainability analysis toolbox may not catch all high-risk economies as some specific factors could suddenly trigger severe liquidity tensions followed by sovereign debt defaults, even if the overall debt metrics appear at acceptable levels (the example of Ecuador showed this in 2020). Therefore, we pay particular attention to EMs and LDCs with a high annual interest or amortization burden on sovereign debt and/or with a high level of foreign exchange-denominated public debt along with significant exchange rate vulnerability. This adds Bangladesh, the Dominican Republic, Guatemala, Iran, Kenya, Malawi, Nigeria, Uganda, Albania, Kazakhstan, Morocco, Congo DR, Kyrgyzstan, Tajikistan and Uzbekistan to our watch list for debt distress in the next two years.

The Covid-19 sanitary crisis triggered an unprecedented increase in public debt all around the world. Global public debt was already increasing before the Covid-19 crisis on the back of the commodity price slump in 2015 and weak growth momentum in most Advanced Economies (AEs, see Figure 1): The worldwide debt-to-GDP ratio rose from 60% in 2007 to 83% in 2019. Then, with Covid-19-related spending and the drying-up of international revenues adding to mounting debt pressures, the global debt-to-GDP ratio jumped to 96% in 2020. Comparing median public debt (as a share of GDP) among different country classes, we find that in 2020 Emerging Markets (EMs) nearly caught up with the 67% ratio of AEs. As for Low-income Developing Countries (LDCs) – which structurally have greater debt intolerance  – the median debt-to-GDP ratio climbed to 46% in 2020 (see Figure 2).

Figure 1: Government debt (USD trn)

Figure 2: Median government debt-to-GDP ratio (%)

Excess global liquidity did not bring lower borrowing costs to all. Despite accommodative financing conditions at the global level, all countries did not enjoy low borrowing costs. A comparison of the median effective interest rate (the average rate on the entire stock of a government’s debt) since 2015 reveals that the borrowing cost almost halved from 2.7% to 1.4% for AEs and fell from 4.8% to 3.6% for EMs. However, it rose from 2% to 2.9% for LDCs (see Figure 3). In fact, financing conditions have been less supportive for many EMs and especially LDCs because of their higher exposure to changing investor sentiment, exchange rate fluctuations and greater risk premiums. The interest rate differential between advanced and other economies is likely continue to widen further in the next two years, on the back of continued accommodative policies in AEs and higher inflationary pressures in the developing world.
There is a growing divide in the debt-service burden built up over the past decade between advanced and other economies. Even though debt volumes increased in AEs, historically low interest rates have enabled them to keep their debt-service burden constant since 2015. In contrast, higher interest rates and rapidly rising government debt levels in EMs and LDCs have fueled their interest-service costs. Figure 4 illustrates that a decade ago, the share of government interest payments in revenues was nearly the same, on average around 6%, for the three country categories. Since then, the debt-service cost has fallen for AEs (to 4% in 2020), gradually increased for EMs (7.3%) and more than doubled for LDCs (13.7%).
On top of this, Covid-19 added to already increasing interest burdens. The spread between AEs’ and LDCs’ debt-service costs widened in particular in 2020, to 9.5pp from 7.4pp in 2019, and is forecast to remain so in the next few years. The recent rise in the interest rate burden is particularly striking in debt-ridden African countries such as Zambia, Angola and Mozambique but also Senegal (see Figure 5).

Figure 3: Median effective interest rates on public debt (%)

Figure 4: Government interest payments (% of revenues)

Figure 5: Average cost of debt service per year in Africa (% of GDP)

Many emerging and low-income countries could  be trapped in a low-growth-high-debt loop after Covid-19. Because of limited fiscal space and a structurally weak revenue base, most developing countries could not engage in large-scale fiscal stimulus to spur post-Covid-19 growth and ensure debt sustainability down the road. In contrast, a growing debt-service burden, all-time high external funding gaps as well as weak export revenues and remittances have forced some countries to cut government spending while the sanitary crisis is still ongoing. Yet, this abrupt contraction of government spending in highly indebted countries may became counter-productive by putting a break on the economic recovery, feeding into social tensions and political instability, hence raising further their risk premiums.

The developing world could have more than USD450bn in financing needs in the medium run. The IMF estimates that low-income countries need around USD200bn to step up their spending response to Covid-19, including for vaccinations, and to rebuild or maintain foreign exchange reserves. An additional USD250-350bn would be required to accelerate convergence with AEs and offset the long-lasting scars of the crisis. In the absence of a comprehensive solution, heavy debt burdens may generate permanent global divergence between rich and poor countries. Moreover, a global recovery that leaves low-income countries behind could fuel humanitarian crises, increasing refugee flows and contributing to the rise of terrorism and violence. In addition, disorderly sovereign defaults in EMs and LDCs may create a domino effect that could destabilize financial stability across the globe.  

None of the initiatives currently on the table will bring sufficient support to cover the funding gaps of the developing world. In addition, it is still not clear how to include Eurobond holders and China into the restructuration talks.

The new USD650bn SDR allocation of the IMF will be no game-changer.  The new USD650bn allocation of the IMF currency, Special Drawing Rights (SDR), will bring limited oxygen to countries in need of liquidity. These new SDRs are good news as they will add to countries’ international reserves, hence improving liquidity positions and supporting credit worthiness. In addition, they can be exchanged for hard currency to finance imports or budget spending with the approval of the IMF. The new allocation will improve the international reserves of EMs such as Turkey, South Africa, Nigeria, Argentina, Pakistan and Sri Lanka by around 10-20%.

However, the country allocation of SDRs has followed the same rules since the 1970s, according to which the SDRs are distributed in proportion to members’ quotas. Needless to say, rich countries will receive the bulk of new SDR allocation (around 67%) while the USD650bn SDR allocation would provide only USD21bn in liquidity support to LDCs and USD212bn to other EMs (excluding China). The African continent will receive only USD34bn whereas its financing gap until 2023 is estimated at around USD300bn. For comparison, the IMF’s concessional lending provided about USD13 billion in emergency financing only in 2020.  

In the recent Paris Summit, French President Macron called for AEs to donate or lend their SDRs to other countries in need, namely USD65bn as SDRs for Africa. Nevertheless, at present, such mechanisms that would compel rich countries to transfer their SDRs to poorer countries free of cost do not exist. And amid the exit from the sanitary crisis and ahead of presidential elections (Germany and France), political priorities are likely to shift towards domestic issues. In view of the implementation complexities and diverging incentives of AEs, we believe this initiative has limited chances to provide a quick and significant solution to the continent’s looming liquidity needs.

The G20/Paris Club Debt Service Suspension Initiative (DSSI) covers a very small portion of the debt-service burden but at least has the merit of bringing China into the restructuring talks. The DSSI already provided USD6bn in debt-service relief for 45 countries (out of over 70 eligible countries) in 2020 and is expected to deliver up to USD7.3bn of additional debt-service suspension through June 2021. As the scope of the initiative was not extended to EMs, countries such as Tunisia or Gabon could not benefit. The expected USD7.3bn relief with official creditors covers a very small portion of the debt-service burden of intermediate income (over USD420bn) and eligible countries (USD42bn) in 2020 (estimations of the IMF and the World Bank). The main motivation of this initiative was to bring a “temporary” liquidity relief from debt payments to official creditors. It had the merit of bringing together, for the first time, China, G20 and Paris Club official creditors in a coordinated debt-relief initiative. However, as the participation of private creditors was only on a voluntary basis, none of them participated in the initiative.

A changing creditor landscape leaves little room for debt forgiveness

The Common Framework intends to bring a “case by case” solution for debt restructuring. Based on a case by case approach, the IMF-coordinated Common Framework aims at reaching debt re-profiling and restructuring agreements under the same conditions for all creditors. The initiative has the ambitious goal of extending the scope of relief beyond the limited debt deferral available under the DSSI to ensure "fair" burden-sharing across all creditors, including the private sector. The G20 launched the “Common Framework for Debt Treatments beyond the DSSI” in November 2020, with Chad becoming the first country to join in January 2021, followed by Zambia and Ethiopia.

The shift from traditional (concessional) to private and commercial debt complicates debt restructuring. The Common Framework aims at offering the same restructuring terms to all stakeholders. The main challenges for its successful implementation relate to coordination, transparency and acceptability. To ensure coordination of different stakeholders, the debt-negotiation talks would need to bring together (perhaps around the same table) official creditors (international organizations or state representatives), bondholders and new creditors from EMs. Importantly, the success of the initiative would require information sharing with full transparency on the stock and conditionality of the existing debt. It may be difficult to convince China and its creditors to disclose this kind of strategic information. Another complication relates to China’s collateralized lending with strategic assets: In these loans, China enjoys a more senior status compared to international organizations such as the IMF, the World Bank and other development banks. The collateralized debt creates a “race to seniority” of official stakeholders that complicates debt-resolution negotiations in case of a default or debt distress (for example Zambia and Ethiopia). Moreover, loans from private Chinese banks generally have cross-default clauses, which also make them difficult to restructure. The acceptability of these debt-relief initiatives in AEs could be jeopardized if China does not take a sufficient part in the process . Reaching a common debt-restructuring agreement with all creditors may also be challenging from the borrower’s viewpoint: Some bond issuers may not want to default on bonds or international banks’ loans as they would fear the negative impact on their sovereign ratings. On the other hand, official creditors would push for including private lenders into bailouts to ensure “fair” burden sharing.  

Market access fears: seeking debt relief is a double-edged sword for credit ratings. Despite the relief that debt restructuring brings for public finances, not all countries are eager to ask for it. The risk of credit rating downgrades and/or a deterioration in market reputation has prevented highly indebted countries like Kenya and Ghana  from joining the initiative to reschedule private sector liabilities. As expected, the initiatives to include private creditors into debt-relief schemes qualifies as a “selective default”, as seen in the example of Ethiopia. The country’s sovereign rating was downgraded to “substantial risk” by rating agencies following the announcement that it would seek debt relief under the new G20 Common Framework.

In the current international setting, we do not expect a comprehensive solution to be reached in 2021 to offer a way out for debt-ridden countries. Even so, debt forgiveness tend to bring only temporary relief while promoting private-sector-led growth could be the long-lasting solution. In the past, the IMF-World Bank Heavily Indebted Poor Countries (HIPC) Initiative and multiple Paris Club agreements have showed that debt forgiveness brings only temporary financial relief to countries, without tackling the underlying reasons of unsustainable debt accumulation, a trend that is echoed in the literature . Therefore, most sovereign debt default episodes have been preceded by on average two debt restructurings within the same decade.

Since 2012, the HIPC initiative has provided partial or full debt relief to 39 countries. However, most of these countries piled up new debt quickly thereafter. In most of Africa, the countries’ indebtedness tripled in just 13 years after the debt cancellation in 2006. The root causes of unsustainable debt accumulation in most developing countries arise from a long list of structural factors: high exposure to commodity cycles, weak fiscal revenue collection, inefficient government spending, corruption and poor governance, low potential growth due to shortfalls in human capital, infrastructure and energy investment and finally high borrowing and debt-servicing costs because of high risk premiums. In this sense, proposals like the “New Deal” for Africa from the Paris Summit would offer a viable solution to debt accumulation. The initiative aims at reallocating productive resources towards high-value added industrial sectors and setting the stage for a private-sector led growth model. Obviously, the successful implementation of this type of policy may take time and requires overcoming the structural obstacles listed above.

Overall, we expect neither a fundamental blanket solution nor domino debt defaults in the near future. The international community will step in to bring the needed liquidity in times of stress, without being able to offer an overarching solution to growing debt unsustainability. Despite the global economic recovery that is already underway (+5.5% in 2021, the fastest recovery in the past 40 years), we expect increased debt distress in EMs and especially in LDCs in the next two years and further sovereign downgrades as well as some defaults. Yet, we do not expect a continued strong wave of rating migrations going ahead (2020 registered record numbers of more than 30 sovereign downgrades by both Moody’s and Fitch). The debt relief and restructuring initiatives on the table (IMF, G20, Paris Club, China in some cases) – while being far from a comprehensive, far-reaching and sustainable solution – should help a number of countries to avoid default in the next few years. In the next sections, we will identify the main pockets of vulnerability.

Fiscal vulnerabilities depend on both the level and composition of government debt. We analyze the sustainability of sovereign debt in 101 countries – 61 EMs and 40 LDCs.  We calculate a Public Debt Sustainability Risk Score (PDSRS) for these markets in order to identify the most vulnerable ones that could be next in line to seek financial support and/or a debt restructuring or relief, or which may default on their sovereign debt. We apply a number of hard data combined with some forward-looking indicators based on our macroeconomic scenario.  

The top 20 countries with the least sustainable public debt according to our analysis include seven economies each from Latin America and Africa and three each from the Middle East and Asia, though none from Emerging Europe (see Figure 11 in the Appendix for the complete scoreboard of our analysis). The top 20 ranking also includes four of the five countries that defaulted in 2020 – Lebanon, Suriname, Zambia and Argentina..  

Importantly, the top 20 riskiest include the heavyweight EMs Egypt, South Africa, India and Brazil, as well as Pakistan, which are all included in the MSCI Emerging Market Index. India, Brazil and South Africa are expected to post large post-Covid-19 annual fiscal deficits that will certainly add to their already high public debt burdens. Yet, these heavyweights should be able to avoid default in the next two years as most of their debt is domestic and they enjoy manageable debt maturity structures. India should also experience solid nominal GDP growth in the medium term, which should help contain the debt-to-GDP ratio. However, Egypt’s debt metrics are a cause for serious concern, as they include a high level of foreign exchange denominated public debt (39% of the total) and maturing public debt accounting for 15% of GDP in 2021-2022 (among the highest in our country sample). Moreover, the country’s interest payments account for 40% of revenues, with an effective interest rate reaching 10%. Meanwhile, Pakistan continues to face strong debt distress: The country had an IMF Extended Fund Facility (EFF) program in place before Covid-19 that was disrupted by the pandemic and then paused for a year while it got support from the IMF’s Rapid Financing Instrument (RFI) and G20 debt suspension.

Sri Lanka is another Asian country with debt sustainability concerns. An IMF Extended Fund Facility (EFF) expired in 2020 and discussions on a RFI have not been completed to date due to disagreements over policy requirements from the IMF. To ease the liquidity tensions, the Sri Lankan authorities have concluded a USD1.5bn currency swap with China in the meantime...