Intensifying financial distress in developing economies is increasing the risk of economic and political instability and creating more pressure for China to engage in debt relief negotiations.
Signs of financial distress are particularly pronounced in lower-income countries, such as Ghana, even though several middle-income countries, such as Sri Lanka, have also been affected. A large number of countries, including Bangladesh, Ghana, Pakistan and even Serbia, have in recent months requested financial assistance from the International Monetary Fund. Many lower-income countries do not have a sovereign debt rating, but among those that do, many are rated CCC or below by Fitch Ratings or Moody's Investors Service, indicating a high level of default risk. This group includes Argentina, Belarus, Cuba, the Democratic Republic of the Congo, Ecuador, El Salvador, Ethiopia, Ghana, Grenada, Laos, Lebanon, the Maldives, Mozambique, Puerto Rico, the Republic of the Congo, Russia, Sri Lanka, Suriname, Tunisia, Ukraine and Zambia. Another 30-odd countries are rated single B, indicating a lesser but very substantial default risk. The spreads on ten-year sovereign credit default swaps, a financial instrument investors use to insure against default, exceed 1,000 basis points in more than 25 mostly lower-income countries, similarly pointing to the risk of imminent financial distress.
This increase in financial risk is happening because many developing countries entered the current global monetary tightening cycle with high levels of debt. The risk of financial distress and debt defaults has increased due to deteriorating global economic and financial conditions. The COVID-19 pandemic forced many low- and middle-income countries to increase government expenditure against the backdrop of slower economic growth, contributing to higher government debt levels. Many countries also over-borrowed externally, leading to higher foreign debt levels. Last but not least, many countries also are faced with high food and energy prices, making it difficult for governments to adjust macroeconomic policies sufficiently to preserve financial stability. Markets expect U.S. short- and long-term interest rates to continue to rise, which means that financing conditions for developed economies are becoming more challenging, as their debt service and roll-over risk increase. The dollar has strengthened considerably in recent months. This increases the debt burden of developing countries in local-currency terms and contributes to a further tightening of financial conditions, not least via reduced capital inflows and/or capital outflows. The increasing risk of a global recession, combined with the efforts of the U.S. Federal Reserve and the European Central Bank to stamp out inflation, risks leading to a sharp downward adjustment of commodity prices. This will weigh on the economic and financial outlooks of low-income countries, most of which are commodity exporters.
Because of this growing economic and financial distress, many countries will be forced to request international financial assistance, as well as debt relief from their creditors. While many low- and middle-income countries will turn to the IMF, it will only provide financial support if it deems a country’s debt to be sustainable. If the IMF considers a country’s debt to be unsustainable, as it recently did in Ghana, it will require debt relief. Debt relief is a reduction in a country’s debt burden through a reduction in interest payments, a lengthening of maturities or a reduction in principal (or a combination of the above). If governments fail to secure debt relief, they may face the prospect of a disorderly debt default. Governments often procrastinate efforts to seek financial support from the IMF since the institution requires countries to implement macroeconomic adjustment policies that are often highly unpopular and increase the risk of political instability. These policies typically include raising taxes, reducing public expenditure, tightening monetary policy and implementing structural economic reform. However, when governments put off such economic reforms, they raise the risk of financial default.
China’s position as the main creditor of many low- and middle-income countries will give Beijing a central role in future debt restructuring negotiations. Given that China is a major (often the single-largest) creditor of low-income countries, Beijing’s willingness to participate in debt relief will be crucial if a hard sovereign default and a prolonged financial crisis is to be avoided. But China, which has lent huge sums to countries in Africa and South Asia, has shown reluctance to engage in multilateral debt relief efforts. Compounding the issue, traditional lenders (such as the members of the Paris Club) and multilateral official lenders (such as the World Bank or regional development banks) are unlikely to grant debt relief or even provide financial assistance unless major creditors, including China, participate in the debt restructuring process. China's reluctance, therefore, raises the risk of protracted and costly debt relief and restructuring efforts, as well as of economically costly disorderly defaults and a prolonged economic and financial crisis. However, China is likely to eventually enter debt relief negotiations, given the reputational risk and diplomatic blowback it would suffer if it were seen as insisting on preferential treatment and thereby prolonging a country’s financial and economic crisis. Such creditor coordination will make the provision of debt relief less messy and less economically costly to the debtor country than it would otherwise be.China is not a member of the Paris Club of official creditors, Chinese lending is often opaque and Beijing prefers bilateral, preferential debt deals to multilateral ones. Beijing has committed to multilateral coordination under the 2020 Common Framework, and it has shown some willingness to provide debt relief, including under the Debt Service Suspension Initiative, as well on other occasions. In Zambia, China has already agreed to co-chair the creditor committee with France.