International support is needed to avoid a debt crisis in developing and emerging market countries

Posted by on 31 January 2009

Last week, Standard & Poor’s, the rating agency, downgraded Spain’s and Portugal’s long-term sovereign debt because of their deteriorating public finances. A week earlier S&P already downgraded Greece’s sovereign credit rating and issued a warning to Ireland that its rating is under threat too. The markets have already started to price in risk before the downgrades. In what appears to be a rediscovery of risk, the last months have seen bond yields widen sharply between Germany, the euro zone’s biggest economy and traditionally the benchmark for European bond markets, and the currency union’s weaker members Ireland, Italy, Greece, Portugal and Spain. While Germany continues to benefit from its safe haven status and its reputation for fiscal restraint, the risk premium that investors demand for 10-year bonds rose to historic highs even for Belgium and the Netherlands – two other euro member countries with a traditionally good standing in international capital markets. The price of credit default swaps which are used to insure bonds against default rose to all-time highs for Greece, Ireland, Netherlands, Portugal and Spain.

The rediscovery of risk is not limited to the euro area, and it does not end with the UK either. The era of easy credit came to an abrupt end last summer and has given way to a withdrawal of funds from almost all corners of the developing world. A flight to safety and liquidity – which essentially means a flight to US treasuries – has become the dominant strategy of investors all around the world. Bond yields of developing countries and emerging markets have widened significantly over US treasuries already since last summer. Since then, dozens of developing countries have been downgraded by rating agencies or received a negative outlook. The rollover of corporate and government debt has been severely disrupted by the seizing up of international capital markets, and the issuance of new debt has been almost impossible since September. In addition, domestic bond markets, which have gained in importance in many developing and emerging market countries over recent years, have suffered badly from the withdrawal of funds by international investors.

The Philippines successfully raised $1.5 billion in 10-year bonds recently in what was the first public offshore bond placement by a developing or emerging economy in the entire Asia-Pacific region since September. This might be interpreted as a glimmer of hope and an eventual unfreezing of credit markets. However, the thaw might not last very long.

In the months to come access to international finance might worsen rather than improve for many countries: given that the governments of virtually all major developed economies are preparing for large fiscal stimulus packages to counter recession, there is a clear danger that the issuance of debt by high-rated industrialised countries will crowd out demand for developing or emerging market country debt. The US government alone is expected to issue about $2 trillion in 2009; the other big developed countries might place another $1 trillion of government bonds. This implies that a large numbers of issuers will have to fight for a limited pool of capital, which threatens to curb developing and emerging economies’ access to the international credit markets.

And capital is desperately needed by many. Russia has to renew about $600 billion this year; Ukraine and Hungary, which already had to tap the IMF, have to rollover about $30 billion and $15 billion this year respectively. The Latin American Shadow Financial Regulatory Committee, a group of experts around Ricardo Hausmann, estimates that Latin American governments will have to rollover about $250 billion in 2009. India and China face external debt payments of $260 billion and $2,400 billion respectively. According to ING Wholesale Banking, emerging market governments and corporates need to repay $6,865 billion of debt in 2009, which includes bonds, loans, interest payments, and trade finance. All these sums mentioned do not include the debt that these countries would need to take on if they were to administer fiscal expansions like the industrialised countries do.

According to a new forecast presented this week by the Institute for International Finance, net private sector capital flows to emerging markets will amount to only $165 billion this year, less than half of the $466 billion that flew in 2008 and only a fifth of the peak value of 2007.

So far, only the Seychelles and Ecuador have defaulted on their sovereign debt since the start of the credit crisis in August 2007. But chances are rising that they will not remain the only ones in the coming year. Especially central and eastern European countries – who have accumulated large foreign debt while credit was cheap – are under increasing pressure to access fresh finance. Unlike the BRICs (Brazil, Russia, India and China) they have no comfortable foreign reserve pillows to fall on.

The re-pricing of risk and the shortage of liquidity in international capital markets has made it increasingly difficult for even well managed emerging markets to access external financing. To avoid the credit crisis from turning into a full-blown debt crisis, international support is warranted.

That is not to say that there’s been no international support up to now. The IMF has responded quickly and extended about $50 billion of emergency credit to Hungary, Ukraine, Iceland, Pakistan, and Hungary. Belarus, Serbia, Turkey and El Salvador are next in line. The Fund also created a new short-term liquidity facility for macroeconomically stable countries to obtain credit without hard conditionalities. With an additional $100 billion provided by the Japanese government, the IMF’s ammunition has increased considerably, but given the anticipated financing needs the $250 billion it now has at its disposal will not be enough.

Additional short-term liquidity has been provided by the Federal Reserve and the European Central Bank. The Fed has approved bilateral currency swap agreements with more than a dozen foreign central banks to ensure their dollar liquidity; the ECB has agreed on swap and repo arrangements with Hungary and Denmark. The World Bank has also provided crisis support and announced its readiness to disburse up to $100 billion over the next three years to developing countries. Furthermore, the World Bank’s International Finance Cooperation has created new facilities to help the private sector.

Yet more will be needed, especially if emerging and developing economies want to implement counter cyclical measures aimed at ensuring sustained economic growth and continue efforts to achieve the UN’s Millennium Development Goals, which include halving extreme poverty and halting the spread of HIV/AIDS by 2015.

The G-20 should hence start thinking about an idea that the Indonesian president presented at the “Bretton Woods II” summit in November in Washington. Back then, President Yudhoyono proposed the establishment of a temporary Global Expenditure Support Fund that would be used to support budget and project financing in countries that traditionally rely on market sources for their financing requirements but are facing harsh difficulties due to the breakdown and disruption of financial markets. According to this proposal, countries with a good track record on fiscal sustainability and a demonstrated commitment to a national development agenda would be eligible to access the funds as a transitional arrangement over the next two to three years. Another, similar, idea that was presented by the Latin American Shadow Financial Regulatory Committee is to establish an Emerging Markets Fund which would purchase assets from both governments and corporates of emerging and developing economies that have demonstrated good governance.

World Bank President Robert Zoellick picked up these proposals this week when he urged industrialised countries to use parts of the money they are now raising for their fiscal stimulus packages for a “vulnerability fund” to support poorer countries. Such a fund, however it might be called, need not be established as a totally new institution. It could utilise the facilities of the World Bank Group, the IMF and the regional development banks so that money can be channelled quickly to where it is needed to fill the void left by the credit crunch.

In their Washington declaration, the G-20 assured that they will “help emerging and developing economies gain access to finance in current difficult financial conditions, including through liquidity facilities and program support”. This is the time to let deeds follow words.

Ulrich Volz is a Senior Economist at the German Development Institute in Bonn.

This commentary draws on an article that was published in The Wall Street Journal on January 30, 2009 (“Sovereign Debt Risk Looms Large This Year”, http://online.wsj.com/article/SB123327870587231645.html).