The New Debt Trap: COVID-19 and Global Development

Toolkit - Global Development

By Catherine Weaver and Rachel Rosenberg

As of October 30, 2020, the number of global COVID-19 cases was approaching 45 million.[1] Nearly 8.2 million of them were in the leading advanced industrial economy—the United States. Yet, the real and potential consequences of the pandemic are likely to be far more extensive, lethal, and long-term in emerging markets and developing economics (EMDEs) than in the U.S.

By many accounts, the COVID-19 pandemic may set back progress in alleviating global poverty[2] by at least 20 years. Numerous estimates published by the International Monetary Fund, United Nations, and World Bank predict GDP growth to contract anywhere from 3.8 to 7.6 percent under the rather hopeful assumption that a COVID vaccine is approved and ready for distribution by the end of 2020. In turn, the International Labour Organization[3] estimates that nearly half of the global workforce—close to 1.5 billion people—may become unemployed due to the "great lockdown."[4] Moreover, nearly 250 million people[5] could face severe food insecurity or famine[6] due to disruptions in global and domestic food supply chains and loss of income and livelihoods.[7] In East Africa alone, the World Food Program estimated that the number of acutely food insecure people could increase by 73 percent[8] this year. Moreover, in the first months of the COVID-19 pandemic, nearly 30 percent of the world's children[9] were unable to access schooling either in person or remotely. The lack of access to education poses the multiple risks of lost or delayed learning, increased hunger due to the absence of free school meals, and increased risk of forced child labor or early marriage.[10]

The COVID-19 pandemic may set back progress in alleviating global poverty by at least 20 years.

Overall, the threat to global development is severe: between 130 million[11] and 500 million people[12] worldwide may fall back into extreme poverty this year, defined as living on less than $1.90 per day.[13] As a result, numerous experts[14] predict that progress toward the 2030 Sustainable Development Goals is not only slowing, but may be moving in reverse.[15] Even in the most optimistic scenarios, COVID-19 will likely result in "lost decades of development."[16]

Here we focus on one of the most serious systemic threats related to the COVID-19 pandemic and global development: the looming debt crisis. Nearly half of emerging markets and developing economies (EMDEs) were already at high risk of debt crisis[17] before COVID-19 was declared a global pandemic by the World Health Organization in March 2020. Since then, the debt situation has only worsened. The IMF projects[18] that average 2021 debt ratios will rise by 7-10 percent of GDP in these countries.

While the debt-to-GDP ratio projection is even worse for advanced economies such as the U.S. (with projected increases near 20 percent), developing countries do not have the same capacity to carry additional debt. Their economic stress is exacerbated by private capital flight into "safe haven" economies, limited access to hard currencies that are necessary to service debt payments, and slowing economic growth due to declining commodity prices, falling remittance inflows, and disruptions in global trade and tourism.[19] In March 2020 alone, foreign investors withdrew more than $83 billion from low income countries (LICs) and lower middle income countries (LMICs), the largest capital flow ever recorded.[20]

One example of the looming debt crisis is Uganda. While the African country has a remarkably low number of reported COVID cases, it has suffered tremendously from the economic dislocations the pandemic unleashed. According to a study by Development Initiatives,[21] a U.K.-based think tank, Uganda's domestic job losses and declining remittances has resulted in significant loss of tax revenues. Without export earnings or domestic resources, it is difficult for the Ugandan government to address key gaps in its health infrastructure, much less enduring problems in poverty, education, and food insecurity. Scarce resources have been reallocated toward COVID prevention and treatment, but at the cost of reduced spending on malaria prevention and treatment. Public debt in Uganda is roughly equal to 41 percent of its GDP and debt service accounts for nearly 12 percent of the government's annual budget. Uganda's struggle with COVID-19 demonstrates that the pandemic is not simply a public health crisis, it is a threat to the long-term sustainable development of most low-income and lower and middle-income countries (LICs and LMICs).

Debt burdens in developing countries limit fiscal resources and the policy space needed to address immediate crises in their health care and other social policy systems, as shortfalls in inward investments and high debt payments curtail spending on other sectors. This is particularly debilitating in the least developed countries, where health care infrastructure was weak prior to the pandemic. The World Health Organization (WHO) estimated in 2014 that 83 countries[22] did not meet its basic threshold for health workers (23 skilled professionals per 10,000 people). More recently, the WHO calculated that an additional 9 million nurses and midwives will be needed globally by 2030.[23] As a result, these countries are not only at higher risk for COVID-related illness and death; they are also vulnerable to rapid increases in maternal and infant mortality, the spread of untreated diseases like malaria, and an inability to sustain critical vaccination campaigns against preventable diseases like polio and tuberculosis. Globally, weak health care systems are further threatened as political support wanes for institutions such as the WHO, from which President Trump announced his intent to withdraw U.S. membership in July 2020.

In October 2020, at the fall meetings of the IMF and World Bank, the United Nations' Director of Financing for Sustainable Development[24] warned G-20 finance ministers and central bank governors of "protracted fiscal paralysis" and the "worst global crisis since WWII" if developing countries do not receive significant debt relief. Yet debt-relief initiatives led by the G-20 so far have fallen short for three key reasons.

First, global aid[25] has fallen in the past several years, as official development assistance from many major donor countries (including the U.S.), has stagnated or declined in the face of domestic economic downturns and the rise of right-wing, ethnonationalist opposition to foreign aid. Multilateral financial institutions, including the IMF and World Bank, had promised to deliver on the estimated $2.5 trillion in financing[26] needed to combat COVID-19. Yet, as detailed by financial experts,[27] many of these institutions have been slow to tap all of their available resources and disbursement of funds has been painfully slow. By August, 2020, the IMF and multilateral development banks had approved just under $175 billion,[28] despite having the legal authority to mobilize and allocate nearly $1 trillion from existing resources. According to one of these reports,[29] as of September 2020, only about $90 billion had been disbursed—less than 12.6 percent of available multilateral and bilateral financing. This may largely be due to fundamental disagreements between major donors over the conditions placed on debt relief, debt suspensions, or debt restructuring. For example,[30] while China supported the expansion of IMF Special Drawing Rights in April 2020, the U.S. and India blocked this in the G20. Overall, while the G20 agreed just recently at the IMF and World Bank annual meetings to extend its Debt Services Suspension Initiative (DSSI), it has been very slow to come to an agreement on the terms of debt relief and to disburse needed funds. Moreover, the IMF and World Bank may be hesitant to overextend themselves on debt relief out of fear that they themselves might lose their "preferred creditor status"[31] and face a degradation of their own bond credit ratings.

More critically, other current programs such as the IMF's Catastrophe Containment and Relief Trust (CRRT), do not adequately address the structural problems of contemporary debt restructuring and relief initiatives. Instead, these initiatives repeat historical mistakes in placing the burden of adjustment more squarely on borrowers without redressing the moral hazards that perpetuate bad lending on the creditor's side. While the DSSI and previous debt relief programs have actively solicited creditor cooperation with innovative options such as green debt swaps and buyouts to encourage action on climate change, private creditors are rarely forced to realize the risks of their behavior. They are the first to be "bailed out" when countries receive debt relief, as Emerging Markets and Developing Economies (EMDEs) are eager to maintain critical credit ratings[32] and access international credit markets. As a result and not surprisingly, private sector cooperation in the DSSI and other debt relief programs has been slow and uneven and is only on a voluntary basis. This problem grows as the overall percentage of private sector debt grows relative to public sector debt offered via multilateral and bilateral sovereign channels. According to Gulati 2020,[33] in 2018 alone, EMDEs (excluding China) had a collective external debt of $5.9 trillion, of which $2.1 trillion was in private sector debt (e.g., loans from commercial banks) and $1.7 billion in public sector debt to private creditors (e.g., bond-holders). This indicates that debt relief or restructuring programs without full buy-in from private creditors are unlikely to succeed and may even exacerbate the crisis if debt relief stimulates developing countries' sales of new high-yield sovereign bonds to private creditors or worse, triggers a new round of private capital flight.

Moreover, unlike past debt crises, today's overwhelming balance of bilateral debt held by EMDEs is owed to China,[34] which has largely eschewed multilateral debt relief in favor of direct negotiations on bilateral debt agreements. In June 2020, China suspended some debt repayments[35] for 77 countries and President Xi pledged to provide $2 billion over the next two years to aid developing countries in responding to the COVID-19 crises within their borders. However, many critics point out that China primarily offers debt relief in the form cancellation of zero-interest loans[36] or loans that were already in default.[37] These loans only represent a small portion of China's aid. This inadequate form of debt relief leaves most developing countries (especially those participating in the Belt and Road Initiative) still on the hook for existing and new non-concessional loans—a form of "debt trap" diplomacy[38] that may exacerbate, rather than alleviate, the looming debt crisis.

In the long term, aid and global finance need to be reimagined to avoid the inevitable debt traps that we have seen repeatedly in history.

Overall, an effective global response to the COVID-19 pandemic will require a well-coordinated and ambitious effort by multilateral and private sector donors. These actors must quickly offer debt relief and suspension packages on conditions that do not undermine the ability of borrowing countries to service existing debt. More critically, debt programs must enable countries to attract new sources of capital which will allow them to reallocate financial resources to address the immediate public health crisis. In the long term, aid and global finance need to be reimagined to avoid the inevitable debt traps that we have seen repeatedly in history. Without such steps, the developing world is not just going to suffer from the lost decade of development. They are likely to be living with the consequence of the COVID crisis for decades to come.

Catherine Weaver is an LBJ School Associate Professor and Associate Dean for Students. She co-directs Innovations for Peace and Development (IPD), a UT Lab devoted to interdisciplinary applied research. Rachel Rosenberg is an MGPS candidate at the LBJ School and a research affiliate at IPD. She is interested in global development, with a specific focus on gender and development assistance.