Document prepared for the sixty-second session of the Trade and Development Board, to be held on 14 to 25 September 2015 in Geneva

The present document summarizes the main aspects of the analysis of the external debt situation of developing countries and countries with economies in transition, as presented in chapter V of the forthcoming Trade and Development Report 2015. It provides a brief overview of the core issues in the external debt of developing countries, and reviews the main trends in the evolution of external debt indicators and composition. It then analyses the underlying causes of the debt crises of developing countries in the world economy today, and discusses essential features and limitations of the current fragmented system of sovereign debt restructuring. Finally, it discusses different proposals to enhance sovereign debt restructuring mechanisms, in particular a multilaterally based statutory approach.

External debt: Main issues

The present document addresses a long-standing deficiency in the international monetary and financial system, namely the lack of an effective mechanism to help better manage external debt crises. It pays particular attention to sovereign debt since, even when financial crises originate in the private sector, as often occurs, they usually result in public overindebtedness and a prolonged period of economic and social distress. Estimates vary, though a recent paper by the International Monetary Fund (IMF) found that such a crisis had eliminated 5 to 10 percentage points from current growth figures and that after eight years, output was still lower than country trends by some 10 per cent. International awareness of the need to consider more effective approaches to sovereign debt resolution has grown in recent years, as evidenced by a series of United Nations conferences and resolutions.

In the last eight major crises in emerging economies (beginning with Mexico in 1994, followed by Thailand, Indonesia, the Republic of Korea, the Russian Federation, Brazil, Turkey and, finally, Argentina, in 2001), a significant proportion of the private debt, both domestic and external, was socialized through Government bailouts, often through a recapitalization of insolvent banks, which increased sovereign debt levels. Much the same pattern has been repeated in Ireland and Spain during the recent crisis in the eurozone.

External debt is not a problem in itself. Indeed, debt instruments are an important element of any financing strategy. Yet it can easily become a problem when foreign borrowing is unrelated to productive investment, or when a net debtor country is hit by a severe external shock that undermines its capacity to repay its debt. In such circumstances, the claims on a debtor can quickly exceed its ability to generate the required resources. If these claims are not matched by new credit inflows, servicing the external debt amounts to a transfer of resources to the rest of the world, which, if significant, will reduce domestic spending and growth in the debtor country. This, in turn, may eventually affect the country’s ability to make payments when they fall due.

High levels of external debt have diverse causes and dissimilar impacts in different groups of economies. In most low-income countries, they are the result of chronic current account deficits, primarily reflecting limited export capacities and a high degree of dependence on imports for both consumption and investment purposes. Most of the capital inflows that have had a direct debt-generating effect on these economies have come from official sources. By contrast, in several middle-income countries that are much more integrated into the international financial system, a core driver of the accumulation of large stocks of external debt has been their increasingly easy access to international financial markets and private creditors since the mid-1970s. A significant proportion of the private capital flows to these countries exceeded those required to finance current account deficits and ended up as residents’ private capital outflows or reserve accumulation by a central bank.

The sustainability of an external debt burden depends on the relationship between the growth of domestic income and export earnings, as well as on the average interest rate and maturity profile of the debt stock. Thus, to the extent that foreign capital inflows are used for expanding production capacities, they contribute to boosting domestic income and export earnings that are required to service the debt. However, where external debt primarily results from large surges in private capital inflows relative to a country’s gross domestic product and if those inflows are unrelated to current needs for the financing of trade and investment, they can lead to asset bubbles, currency overvaluation, superfluous imports and macroeconomic instability, thereby increasing the risk of default.

The sustainability of external debt also depends on its structure and composition. The commonly used definition of gross external debt (including in the present document) adopts the residence criterion, which refers to non-resident claims on the resources of the debtor economy. Other criteria used to distinguish between domestic and external debt are whether the debt is denominated in domestic or foreign currency and the jurisdiction under which the debt is issued. When most external debt consisted of loans, the criteria of residence, currency and jurisdiction tended to coincide (i.e. the lender was non-resident and the loan was issued in a foreign currency under foreign law). This has changed significantly since the early 1990s. Over the past two decades, increases in the stock of outstanding debt have been accompanied by a shift in debt instruments from syndicated bank loans to more liquid bond debt. Since bonds issued in a local currency and under local law may be held by foreign investors and, conversely, sovereign debt denominated in foreign currency may be held by residents, there is a share of debt that may be considered external under some criteria and domestic under others.

The amount of debt that has been issued in foreign currencies will significantly affect debt sustainability. This is because, in order to service such debt, a debtor must not only generate the required income but also obtain the corresponding foreign exchange. This depends on the state of a country’s balance of payments. However, it can also produce a significant policy dilemma, whereby domestic currency devaluations and tight macroeconomic policies, while intended to improve export performance, will also increase the real value of the foreign denominated debt and reduce the debtor’s income.

In mostly higher income developing countries, a recent trend has been a shift in the denomination of external debt from foreign currency to local currency. This has been made possible largely as a result of a strong expansion of global liquidity and concomitant surges of capital inflows into these economies, reflecting the willingness of lenders to assume the exchange rate risk. Yet the residence criterion remains relevant for debt sustainability, as investments in local bonds and securities by non-residents make domestic debt markets more liquid. Moreover, growing non-resident participation in these markets also means less stability in holdings relative to participation by domestic institutional investors, as the latter are usually subject to regulations that oblige them to hold a given percentage of their assets in local debt instruments. The decision by non-resident creditors to liquidate their local currency denominated debt and repatriate their earnings could weigh heavily on the host country’s balance of payments.

Finally, the jurisdiction of debt issuance affects debt sustainability, since it defines the rules under which any dispute between debtors and creditors will be negotiated, such as the extent to which non-cooperative creditors will be allowed to disrupt State-private creditor majority agreements on debt resolution. More generally, if the external debt of developing countries has mostly been issued under foreign jurisdictions as a supplementary guarantee for investors that are distrustful of the judicial system of the debtor country, this has the potential to complicate crisis situations, since the debtor economy may have to contend with multiple jurisdictions and legal frameworks.

Sovereign debt deserves special attention for a number of reasons. In some instances, Governments may encounter difficulties in servicing the external debts they have incurred to finance their public expenditures. In many other instances, however, the initial cause of a sovereign debt crisis is the imprudent behaviour of private agents, on the side of both borrowers and creditors. In principle, a private debtor’s defaults on its external debt fall under the insolvency law of the jurisdiction in which the debt was incurred. This legal framework typically provides for a certain degree of debtor protection and debt restructuring (with or without a partial debt write-off) or for a debtor’s bankruptcy and subsequent liquidation of its assets. Yet when a series of private defaults threatens to disrupt the financial system, the public sector often assumes private debt, especially that of large banks, and as a consequence becomes overindebted itself.

However, sovereign debt problems are not subject to the legislation that governs private defaults. They therefore necessitate specific treatment, not least because they often have significant social, economic and political impacts. This raises the question of how best to approach sovereign debt restructuring in an increasingly globalized economy, which is addressed in chapter IV of the present document