Bridging the great finance divide

Over the last two years, the world economy has been rocked by multiple shocks—from the Covid-19 pandemic to the war in Ukraine. But not all countries and people have been impacted in the same way. As highlighted in the “2022 Financing for Sustainable Development Report” (FSDR), a financing divide is sharply curtailing the ability of many developing countries to respond to shocks and invest in recovery.

In the wake of the Covid-19 pandemic, developed countries could finance massive fiscal response packages (worth 18 percentage points of GDP) at very low interest rates, backstopped by their central banks. Developing countries were more constrained. The poorest countries in particular were forced to cut spending in areas such as education and infrastructure, contributing to a more protracted crisis. Even before the fallout from the war in Ukraine, 1 in 5 developing countries was projected not to reach 2019 per capita income levels by the end of 2023, with investment rates not expected to return to pre-pandemic levels for at least two years.

This subdued investment recovery further widens large climate and Sustainable Development Goal (SDG) investment gaps. Yet, many countries are in no position to finance the necessary investment push. At the beginning of 2022, 3 in 5 of the poorest countries were at high risk of or already in debt distress, and 1 in 4 middle-income countries were at high risk of fiscal crisis. Rising energy and food prices due to the war in Ukraine have put additional pressures on fiscal and external balances of commodity importers, and tightening global financial conditions are raising risks of a systemic crisis. Debt sustainability concerns, which tend to arise at lower levels of debt in developing countries, translate into higher risk premium. Even in countries where debt is considered sustainable, the high cost of borrowing precludes needed investment.

Developing countries’ average interest cost on external borrowing is three times higher than that of developed countries. In the low interest environment of the last decade, developed countries borrowed at an interest cost of an average of 1 percent. Least developed countries (LDCs), which have increasingly tapped international markets in recent years, borrowed at rates over 5 percent, with some countries paying over 8 percent.  This has dragged up their average borrowing cost and translated into less fiscal space: LDCs dedicate an average of 14 percent of their domestic revenue to interest payments, compared to only around 3.5 percent in developed countries, despite the latter’s much larger debt stocks (Figure 2).

While this high cost of borrowing reflects higher perceived risks, there is evidence of an additional premium associated with sovereign borrowing. Over the last 200 years, the average annual return of foreign currency debt to investors has been around 7 percent, even after accounting for losses from defaults, exceeding the “risk free” return on U.S. and U.K. bonds by an average of 4 percentage points. Since the start of the emerging market ”bond finance era” around 1995, total returns to investors (net of losses from defaults) have been even higher, averaging almost 10 percent or around 6 percentage points over the risk-free rate—a historical high.*

Foreign currency bonds more than compensate investors for the risks they face—even through periods of repeated financial turmoil in developing countries. Indeed, external sovereign bonds have been the best performing asset class since 1995, outperforming other asset classes (such as equities or corporate bonds) even after adjusting for both defaults and risk (measured by market volatility). While sovereign spreads and risk premium may seem removed from people’s lives, in the case of sovereign debt, they have a direct impact. High investor returns equate to high borrowing costs for countries, diverting government expenditures from public investment and social services.

The countries should reduce risks and ensure that all financing is aligned with the SDGs and climate action. The efficiency of public investment is a key determinant of its growth and debt sustainability impact, and efficiency gaps remain sizeable in many countries. Linking public investment decisions to a medium-term fiscal and budget framework and debt management strategy—for example, in the context of an integrated national financing framework—can reduce the volatility of financing for capital expenditure. But national actions alone cannot solve systemic challenges.

Second, access to additional long-term affordable international public finance is critical. Official development assistance commitments must be met and Multilateral development banks’ (MDBs) lending should be expanded, including through capital increases and rechanneling of unused special drawing rights.

brookings.edu