Over the last five years, several low-income countries, such as Rwanda and Honduras, have issued their first-ever bonds to private foreign investors in London and New York. Until recently, that might have been unthinkable, so the new borrowers’ initial bond issue should be viewed as a sign of great investor confidence. But it should also sound some familiar warning bells.
Some 20 “debut issues” have raised around $12 billion at interest rates that, on average, are just 4.5 percentage points above what the United States government pays at maturities of five or more years. This is small change in the grand scheme of global finance; but, given that many of these borrowers were in distress or default just a decade ago, and needed debt forgiveness, theirs is an especially impressive turnaround.
But low-income countries’ access to private lenders comes with risks that should be highlighted at the outset, before they grow into imminent threats.
For starters, there is rollover risk. The bonds have to be repaid in a foreign currency, usually US dollars, in a single “bullet” payment. These bullets can be big, especially when compared with past debt obligations or future export earnings.
World Bank data tracking the evolution of developing-country debt since the 1970s show that the probability of a country falling into debt distress increases nine-fold (to a one-in-five chance) if its repayments are equivalent to more than one-tenth of its exports – a situation that one in three of today’s new issuers could face when their bonds come due.
Whether poor borrowers can avoid such a financial squeeze will depend on several factors. One is whether they will be able to issue more bonds to pay off those coming due. Another is whether they invest the money prudently, thereby enabling prompt repayment. And it will also depend on whether countries with volatile incomes, especially those reliant on natural resources, put money aside when earnings are high.
A second, medium-term risk involves capital-flow reversals. Lenders’ appetite for low-income-country bonds has been fueled in large part by a combination of abundant liquidity and near-zero interest rates in developed economies since the 2008-2009 global financial crisis. With only paltry yields on offer at home, investors have looked to riskier, “frontier” markets for higher returns.
Sooner or later, however, developed economies will revert to tighter monetary policy, which will make developing-country bonds less attractive. Those borrowers with sound macroeconomic policies will probably retain some appeal for global financial markets; but less prudent governments might suddenly find themselves cut off.
Unfortunately, the quality of debt-management practices among the new bond issuers is uneven. Sensible debt strategies, a professional and independent debt office, and a clear legal framework for public borrowing have become more important than ever.
To be sure, there has been significant progress on this front over the past decade, much of it funded by rich-country assistance. But more can and should be done before this new borrowing wave becomes too large to manage, or spreads to state and municipal governments that suffer from weaker administrative capacity. It is worth noting the strong negative correlation between the quality of a country’s debt-management practices and its risk of debt distress, with 90% of low-risk countries demonstrating good practices.
A third risk is that future debt workouts will become harder to agree. Traditionally, low-income countries’ creditors were rich-world governments and multilateral organizations that found it politically unfeasible to call in debts if this meant that borrowers had to cut vital public services such as education or health. In a process that has already taken 15 years – and remains unfinished – the debts of 35 highly indebted poor countries (HIPCs) have been forgiven, at a cost of more than $100 billion.
Now, however, many former HIPCs are selling bonds in the global market to private investors, which has become significantly riskier in recent months, in the wake of court rulings in the United States that permit bondholders to reject debt workouts and sue for full payment. One must hope that the funds raised will be put to good use, and that repayments will not require major sacrifices, as there is currently no agreed mechanism to restructure, let alone cancel, the new debts.
One might ask why anyone but the private global investors taking the risk should care about roll-overs, reversals, debt management, and workouts. The reason is that public-debt distress most harms a country’s poorest citizens, who have little knowledge, and no choice, about issuing bonds. When a country defaults, the economic damage swells the number of poor people and worsens their living conditions. When Argentina defaulted in 2001, one in five citizens fell under the poverty line.
Sound debt management is, in effect, sound social policy – a lesson that borrowers and lenders alike should heed as they enter into debts that, if not properly managed, can turn out to be more complicated than first assumed and more troublesome than anyone expected.
Marcelo M. Giugale is Senior Director of the World Bank Group’s Global Practice for Macroeconomics and Fiscal Management.