Policy makers in both the OECD and developing countries should use this opportunity to improve the current framework for debt restructuring and crisis management
This article is part of the series—Raisina Edit 2023.
In 2023, many economies are affected by multiple crises. The legacy of the COVID-19 pandemic, the war in Ukraine, and the geopolitical conflict between China and the United States (US) have all had effects on individual economies as well as international trade and finance. The most serious issue, however, is the return of inflation and rising interest rates. For both highly indebted countries and individuals, the rapid rise of interest rates has created problems. But are they a matter for serious concern or are the potential negative effects overrated?
For well over a decade, interest rates in the Organisation for Economic Cooperation and Development (OECD)-countries had been extremely low, sometimes even negative. Inflation was not a reason for concern, but that changed in 2022. Inflation is back, and central banks have aggressively tightened monetary policy. That has had effects on developing countries too: 15 percent of low-income countries are already in debt distress and an additional 45 percent of low-income countries are at high risk of debt distress. In the wealthier group of emerging markets, 25 percent of countries are confronted with exceptionally high interest rates. Ghana, Sri Lanka, and Zambia have already defaulted. Some observers, for instance, Nouriel Roubini, an Iranian-American economist, have warned that a global debt crisis is unavoidable. Martin Wolf, from the Financial Times, has warned that the issue ought to be addressed before “it’s too late”. But is rising debt indeed such a problem?
< style="color: #0069a6;">For both highly indebted countries and individuals, the rapid rise of interest rates has created problems. But are they a matter for serious concern or are the potential negative effects overrated?
In the last two decades, total public- and private-sector debt as a percentage of gross domestic product has risen from 200 to 350 percent. In the US, the figure is 420 percent, which is higher than during the Great Depression and after World War II. Nouriel Roubini is so pessimistic that his best case scenario is a postponement of the crash. But Roubini, whose nickname is Dr Doom, may be too sceptical. At least four points warrant consideration. The first is real interest rates. Rising inflation has been very beneficial for debtors in the last months. Unanticipated inflation is the best that can happen to debtors, whether private or public. Creditors, many of whom had expected interest rates to be low for the time being, lost money. Debtors experienced an unexpected windfall: The real value of debt is declining in an inflationary environment. In addition, real interest rates continue to be negative. Even if monetary tightening will continue, it is currently difficult to envisage a return to (high) real interest rates. Borrowing will continue to be cheap, at least in OECD countries.
< style="color: #0069a6;">15 percent of low-income countries are already in debt distress and an additional 45 percent of low-income countries are at high risk of debt distress.
The second point is the now improved sustainability of monetary policy. An interest-free environment, again in particular in OECD countries, resulted in dangerous developments. The negative costs of borrowing resulted in an unprecedented asset-price inflation. Prices of shares, real estate, and other assets where supply is limited, for instance vintage cars, shot up. That trend, driven by the monetary policies of the major central banks, has resulted in social tensions. Those without assets were exposed to the negative consequences, in particular higher cost for housing, without benefitting from the low interest rates. The current return to a monetary policy with interest rates, if still negative in real terms, is thus, a welcome development. Quantitative easing has been an ill-designed policy, which was good for the asset-owning part of the population—the rich in plain English. The third aspect Is that, today, banks are much better prepared to weather a storm than they were in 2007 to 2009. Banks possess significantly higher levels of core capital, which should enhance their capability to write off bad loans. Banking regulators in most advanced economies have abandoned “light-touch regulation”, the approach praised by former British Chancellor of the Exchequer Gordon Brown before the 2007 crash began. Fourth, once the war in Ukraine is over, the sanctions against Russia will probably be lifted. Although no one knows how soon the fighting will end, for the world economy, this would result in a disinflationary shock. The current level of energy prices will probably come down further. The struggle of poor countries would probably ease, at least with regard to paying for their energy needs.
< style="color: #0069a6;">An interest-free environment, again in particular in OECD countries, resulted in dangerous developments.
Whilst there are some positive aspects of the current changes in monetary policy, there are certain drawbacks as well. The return of interest rates means that capital is flowing to OECD countries, and capital flows to developing countries are drying up. This is a difficult but unavoidable consequence of the normalisation of monetary policy in the OECD world. After a decade of risk without return, investors are flocking to the financial markets of developed economies. In particular, those developing countries that primarily have debt with short maturities are in trouble, partly because of their unwillingness or inability to borrow long term. In addition, many countries are being simultaneously hit by higher interest rates and an energy crisis. The expectation that the low-interest rate environment would be a perpetual feature had always contained an element of wishful thinking. But the energy crisis of 2022 has indeed been unexpected. Supply of oil and gas has been limited, and many developing countries have been negatively affected. But the crisis was no accident; rather it was a consequence of the sanctions imposed by a group of OECD countries against Russia.
< style="color: #0069a6;">The current return to a monetary policy with interest rates, if still negative in real terms, is thus, a welcome development.
The Western sanctions have both limited imports of Russian oil and gas—Western Europe, in particular, has been trying to end the consumption of Russian energy—and have distorted oil and gas supply elsewhere. Countries like Bangladesh, which depend on liquefied natural gas for their electricity generation, were suddenly confronted with competing purchasers for the commodity. Often, poor countries cannot afford to compete or have to pay much higher prices than budgeted. The Western sanctions alliance is, thus, responsible for at least part of the current debt crisis and should bear the consequences. It is often overlooked that the economic war against Russia is fought at the expense of the world’s poorest. An appropriate remedy would be the establishment of a fund to cover the additional cost for energy specifically for very poor economies. Countries like Bangladesh or Pakistan can neither be blamed for Russia’s invasion of Ukraine nor for the ill-conceived sanctions regime.
< style="color: #0069a6;">The Western sanctions alliance is, thus, responsible for at least part of the current debt crisis and should bear the consequences.
The International Monetary Fund’s Managing Director, Kristalina Georgieva, in January 2023, struck a cautious, but not pessimistic tone. She refrained from predicting a systemic debt crisis. However, she suggested that low-income countries are having a tough time. The unexpected return of inflation has resulted in reducing the weight of debt, if only once. Two policy options ought to be considered: First, the Western sanctions alliance should create a fund for low-income countries that have suffered from the rising prices of energy as well as the reduced availability of gas and oil. Second, the mechanisms for resolving a debt emergency in low-income countries should be improved. Today, it continues to be difficult to restructure debt if thousands of bondholders are the creditors. After years of relative calm in financial markets, turbulence is back. Policymakers in both OECD- and developing-countries should use this opportunity to improve the current framework for debt restructuring and crisis management.
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Heribert Dieter is Director of Policy Research and Visiting Professor at the Asia Global Institute The University of Hong Kong. Since 2001 he has been ...
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