By Annie Babelle Odounlami
Developing and low-income countries have been exalted to borrow long term, internationally, in local currency in a bid to significantly reduce borrowing risks as well as the likelihood of debt crises.
This tend to be advantageous for the latter in that, long term international borrowing in local currency and provide an alternative to borrowing from domestic debt markets. This is most profitable in countries where domestic sovereign borrowing levels are high or domestic financial sectors are fragile.
Also, minimizing debt risks has been an important issue over the recent years and now a policy priority
as the COVID-19 escalates debt problems. The inability of multilateral financial institutions to accept currency risk is one of the main challenges and objections to expanding local-currency lending by international financial institutions.
Here, financial institutions provide non-concessional or market-rate loans by ensuring that lending in domestic currency is offset by an equivalent amount of domestic-currency risk, as any losses on one side of the portfolio (lending) are equivalent to gains on the other side and vice versa.
Moreover, political economy problems and debt-management capacity in borrowing countries is another objection. Borrowing in local- currency implies paying a currency premium aka ex ante, that incorrect the possibility a sharp devaluation in the future. While, moral hazard in its part leads to a lending increase in local-currency that could generate incentives to reduce the real value of debt by sticking inflation.
This is due to the fact that low-income countries were already facing damaging challenges and are now facing worsening debt sustainability, thus, a possibility of a widespread debt crisis because of the COVID-19 pandemic.
Going by a report titled, “reducing low-income country debt risks: the role of local currency-denominated loans from international institutions” these countries (developing) happen to be sensitive to external shocks partly because a large proportion of their debt is held in foreign currency. To this effect, widespread devaluation of their own currencies has made their debt situation much worse.
“The COVID-19 will have a massive effect on debt sustainability in developing countries. Higher healthcare costs, lower tax and export recent and frozen debt markets will limit government’s ability to recover existing expenditures and refinance their maturing debt,” read a segment of the report. Also, the large capital outflows, currency depreciation, fall in commodity prices and economic slump, associated with the COVID-19 crisis are likely to lead to numerous debt crisis.
According to the report, the problems in developing nations are not a result of policy failure but due to skyrocketing finance needs in advanced economies, elevated risks aversion among investors and the global economic downturn. Following the negative backdrops of the health crisis on developing and low-income countries, petitions from these most hit countries requesting widespread debt cancellation and the International Monetary Fund and the G20 group of industrialised nations have taken steps in this direction.
Since the crisis escalated to April 9, 2020, more than 90 countries around the world requested IMF’s support and 60% of these requests came from low-income countries. Currency depreciation however prompted by capital outflows have significant effects on low-income countries where external debt makes up a major share of the debts.
“Between mid-February and the end of March 2020, Emerging countries registered record portfolio outflows totalling more than $100 billion,” says art of the report. This implies that, a total portfolio outflows within three months following the global financial crisis were about US $20 billion. Thus, the latest outflows depreciation which have an average of 15% on a large sample. If developing countries. The reverse is true for emerging economies like Brazil, Mexico, Russia and South Africa where large depreciations will rather have negative implications for debt sustainability on countries with large foreign-currency debt.
Both developing and low-income countries however have a high proportion of debt denominated in external currency mainly in US dollars. An average of 74% of low-income country debt was denominated in a foreign currency in 2017 according to Penniza and Taddei. This is s the case though domestic debt levels ha e risen significantly in many low-income countries.
The report holds that the economic crisis caused by the COVID-19 pandemic is on a scale not seen before, but the extent of the external shock to low-income countries will be significant over the course if this year and beyond. This is due to the fact that public debt had become too expensive and volatile in low-income countries prior to the health crisis.
“As a result of increasing debt levels and the rising cost of debt, the number of low-income countries facing serious debt problems was already climbing rapidly and is likely to jump as a result of the COVID-19 crisis.” Due to this, the IMF and the World Bank debt sustainability exercise as being at high risk of or already in debt distress. To them, the figure has more than doubled since 2013.
However, the International community and multilateral financial institutions are called upon to prioritise finance ding ways to improving debt sustainability of low-income countries by mitigating the level of currency risk they face. Thus, the development of local currency-denominated loans by international institutions is one response that ought to be put back at the policy table.