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Poor countries set to lose as rich nations start raising rates

Cheap money borrowed from abroad can turn out to be a bad bet

| Sri Lanka
Sri Lankan rupee note: Sri Lanka is by no means the only country staring bankruptcy in the face.   © Reuters

Rupa Subramanya is a researcher and commentator. She is a distinguished fellow of the Asia Pacific Foundation of Canada and the co-author of "Indianomix: Making Sense of Modern India."

In August 1982, Mexico's finance minister, Jesus Silva Herzog, notified the U.S. Federal Reserve, the U.S. Treasury and the International Monetary Fund that his country was no longer able to service obligations on its enormous sovereign debt, owed mostly to American commercial banks.

This was the opening salvo in the debt crisis, which spanned much of Latin America and resulted in the 1980s being called a lost decade for the continent. The debt crisis also spiraled into Asia and Eastern Europe, ultimately becoming the most severe set of sovereign debt crises in the developing and emerging world up until that point.

Could the world be again heading into a series of sovereign debt crises reminiscent of the 1980s?

According to the World Bank, the world's developing countries saw an increase in their aggregate external debt of 12% to a record level of $860 billion in 2020. When you consider low and middle-income countries, the total external debt had reached a staggering $8.7 trillion in 2020 and these numbers have only increased in the two years of the pandemic, which severely impacted the economies of developing countries.

In 2022, the world's poorest countries are expected to face $10.9 billion in debt repayments, which could potentially lead to a spate of sovereign defaults, very much like the 1980s. The situation is so serious that World Bank President David Malpass has warned that "the risk of disorderly defaults is growing."

World Bank President David Malpass has warned that "the risk of disorderly defaults is growing."   © Reuters

Speaking at a conference in Washington, D.C., Malpass also mused that Microsoft is spending $69 billion to buy a company that makes video games as against $24 billion in rich country aid to the world's poorest countries. "You have to wonder, is this the best allocation of capital?" Malpass asked.

A developing country that epitomizes the danger is Sri Lanka, which recently staved off bankruptcy by securing last-minute emergency financing from India to pay off a sovereign bond that was maturing. Sri Lanka is by no means the only country staring bankruptcy in the face. The pandemic saw a spike in debt being issued by developing countries' private companies as well as sovereigns. This debt, owed to the global bond markets, ballooned to $300 billion in 2021.

Much like in the 1980s, the burgeoning debt crisis in the developing world is taking place as advanced countries begin to raise interest rates to combat a growing inflation problem. In January, consumer price inflation in the U.S. hit 7%, the highest in 39 years. The Federal Reserve is set to meet next week and interest rate hikes are likely as the U.S. central bank tries to tamp down rising inflation.

Rising interest rates in the advanced world create two major problems for debt-laden developing countries. First, the interest cost on servicing future debt that is contracted at higher interest rates will rise, increasing the burden on their beleaguered coffers.

Second, rising interest rates in advanced countries send a signal to investors to pull out of riskier investments in the emerging world and pull their money back into safe havens like U.S. treasury securities and gold, which do not bear emerging market risk. This increases the downward pressure on emerging market exchange rates which further exacerbates the cost of debt servicing and can feed through higher domestic inflation such as the price of food, which most directly affects the poorest.

The impending debt crisis presents both a challenge and opportunity to China. Of developing country debt service payments coming due this year, fully 37% are owed to China. This could potentially increase Chinese leverage in the developing world, but it also poses a risk of a backlash.

There is growing anger in Sri Lanka at the extent to which the country is hock to China, leading to the very unusual situation of a ruling party official publicly criticizing the Chinese government, questioning their sincerity in lending to Sri Lanka and thereby putting the country's poorest at risk.

This is potentially an entree for India, at one point Sri Lanka's closest ally but long since edged out by a rival China as the country's most important lender and investor. Having said that, Sri Lanka's President Gotabaya Rajapaksa has reiterated that his country will continue to look to China for support, dismissing criticism of Chinese involvement in Sri Lanka as politically motivated.

What is beyond doubt is that a looming sovereign debt crisis in the developing world can only worsen the pandemic-induced push of millions more into poverty and widen existing gaps between rich and poor countries.

Relying on cheap money borrowed from abroad can turn out to be a bad bet as many developing countries like Sri Lanka are starting to discover as they painfully relearn the lessons of the 1980s.

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