Key findings on debt vulnerabilities
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- Authors: Ceyla Pazarbasioglu, CARMEN REINHART
- Published: March 1, 2022
Shining a Light on Debt
Key findings on debt vulnerabilities
- Emerging market and developing economies face weaker growth prospects, limited fiscal space, and higher refinancing risks due to the shorter maturity of public debt (IMF’s October 2021 Fiscal Monitor).
- Many countries are “debt intolerant” and have encountered crises at lower debt levels (Reinhart, Rogoff, and Savastano 2003).
- Public sector foreign currency debt remains a vulnerability; sustained exchange rate depreciation can force governments to assume contingent liabilities of state-owned enterprises, subnational governments, banks, or corporations.
- Emerging market sovereign spreads are, on average, close to their pre-pandemic levels even as public debt levels have risen and sovereign credit ratings have been marked down.
- Emerging markets’ external debt-servicing burden has been steadily climbing, with a sharp rise in 2020 as exports slumped, debt spiked, and borrowing terms deteriorated for many economies.
- Declining overseas lending by China and tighter monetary policies in advanced economies are set to deteriorate global financial conditions and raise default risks.
- The share of sovereign domestic debt in emerging market and developing economies has increased sharply in the past two decades (IMF 2021), increasing sovereign exposure within domestic banking systems and reinforcing the sovereign-bank nexus.
- Debt risks are likely to remain high for several years; gross financing needs of the public sector have increased on a sustained basis among emerging market and developing economies.
- Financing needs—and debt—“have a habit of coming in higher than expected.”
Opaque balance sheets and hidden debt
- A substantial share of debts contracted since the commodity-price boom (until about 2014) went unrecorded in major databases; borrowing from other governments, particularly China, increased beyond Paris Club creditors.
- External borrowing by state-owned or guaranteed enterprises increased and reporting standards are uneven.
- The boom in hidden debts has given way to a rise in unrecorded debt restructuring (Chart 3) and hidden defaults (Horn, Reinhart, and Trebesch, forthcoming).
- Many debt contracts lack disclosure of key features beyond maturity, interest rates, and currency—examples include collateral, cross-default, and secrecy clauses.
- Collateralized external public debt has risen in recent years, but accurate measures of its prevalence are limited; some evidence suggests many of China’s bilateral infrastructure loans are collateralized (Gelpern and others 2021).
- Pandemic-era accounting and regulatory forbearance and guarantees may have increased nonperforming loans that are not yet reflected on banks’ balance sheets, increasing opacity.
Financial-sector linkages and risks
- The increase in government debt held by emerging market domestic banks implies sovereign distress could transmit to banks, pension funds, households, and other parts of the domestic economy.
- The pandemic strengthened the “doom loop” between sovereigns and banks; banking and sovereign debt crises have often erupted in close succession (Reinhart and Rogoff 2011).
- Asset quality reviews and stress tests are needed to improve transparency of banks’ asset quality, including exposures to the sovereign and contingent liabilities.
Detection, transparency, and resolution—recommended actions
- Implement an encompassing strategy to increase transparency across public, financial, and corporate sectors to assess and address balance sheet risks.
- Clarify steps and timelines in the Common Framework for Debt Treatments and suspend debt-service payments until negotiations are completed; more than a year has passed since the Group of Twenty introduced the Common Framework and “to date, not a single country restructuring has been achieved.”
- Require disclosure of key contract features (collateral, cross-default, secrecy clauses) for debt instruments and broaden creditor and debtor disclosure.
- Multilaterals should expand data coverage, build more all-encompassing databases, and revise lending policies to enhance disclosure requirements.
- Conduct asset quality reviews and stress testing exercises to prepare contingency plans and enable accurate diagnoses for problem resolution and asset restructuring.
- Avoid “muddling through by evergreening—renewing loans indefinitely”; where credible recapitalization or restructuring is required, carry it out swiftly in ways that do not markedly worsen sovereign debt burdens.
- Support market-driven asset restructuring, accompanied by tighter regulation on loan-loss classification, provisioning, disclosure, and enhanced supervision to avoid “zombification.”
- Consider targeted government interventions where conditions require alleviating debt overhangs in household and commercial real estate sectors.
Institutional and policy responses
- The IMF and the World Bank will continue to support the transparency agenda through data dissemination, capacity building, and lending policies to assist with sovereign debt restructuring.
- In an ongoing review of IMF policies for lending to countries in arrears or undergoing restructuring, staff are proposing a new policy under which the IMF can lend only if countries share comprehensive information about their debt stock and debt terms (in the aggregate) with all creditors; such information sharing would be expected regardless of whether countries are already in arrears or seeking to avoid arrears.
- Debt coverage in the World Bank’s International Debt Statistics increased substantially in the most recent year: the latest edition identified and added almost $200 billion in previously unreported loans to past statistics, the single largest increase in debt coverage in the 50-year history of the World Bank’s debt report publications (Horn, Mihalyi, and Nickol 2022).
- About 60 percent of low-income countries are now at high risk of or already in debt distress, compared with fewer than 30 percent in 2015.
Shining a Light on Debt — Ceyla Pazarbasioglu and Carmen Reinhart, March 2022 (F&D Magazine).
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