Local currency debt was supposed to be the solution for Developing Countries. Here’s a look at where it went wrong
Summary
Assuming understanding of basic economics (I just acquired this basic understanding in the past 2 hours)
Economic recessions due to world crisises inevitably worsen every countries economy, but it hits especially worse for developing countries. The focus is on ways to soften the impact of this economic crisis on developing countries who are heavily reliant on borrowed money.
In the 80s and 90s, developing countries borrowed from richer countries in US dollars, but this caused problems: it left them susceptible to volatile currency swings with respect to their local currency which led to defaults on repayment (summary: large USD investment into Latin America which was growing very quickly, but the oil crisis due to Middle East unrest halted their growth, worsened their local economy more significantly compared to the US, devaluing their local currency and making debt repayments more expensive = default). Foreign borrowing is more difficult to restructure and leaves developing countries at mercy of US monetary policies and international markets.
The latest approach is borrowing in local currency, as local currency debt issued by domestic banks should be easier to manage (such as restructuring due to less vulnerability to policies from the lending countries), and also give the government the ability to inflate the currency if required (print more money to make debt repayments). But amidst economic crisis, this is also not working due to the spiralling effects of the worsening economic climate and poor debt management.
Summary of spiralling effects: worsening global economy, inflation, lack of effective use of debt to build domestic economy = higher interest rates imposed by lending countries, foreign investors pull money from developing country = larger repayments, developing countries have less money in their economy as this borrowed debt accounts for significant portion of GDP = even worse local economy => debt default
More information:
Background of initial investment into developing countries local bonds
Foreigners were eager to invest due to the prospect of yield (profits from a developing countries’ growing economy) despite 0% interest. Initially proved very lucrative, and led to further influx of investment and eventually a massive amount of debt (investment) into the developing country. (Stat: By 2017, around 60% of Ghana’s medium-term domestic bonds were held by investors based outside the country, said Mensah. In Egypt, foreigners held nearly a third of local-currency debt, according to the IMF.)
Problems
Problems arose due to:
- Lack of systems, knowledge, information for local officials to manage these large complex investments
- Lack of focus of IMF and world bank on the risks of local borrowing. Basically, they prioritised ensuring safer foreign-currency borrowing as they believed there was more risk due to the past problems associated with currency fluctuations (explained earlier).
Domestic bank officials hence did not have access to sufficient data on their own bond values and yields, and lacked the skills to handle the debt effectively.
The negative impacts were exacerbated due to these problems stated above, and the debt in the country was not used effectively enough to improve the local economy, and instead funded a significant proportion of the GDP. This became even more prominent during the economic crisis (ukraine war related) that caused the local market to underperform; debt ended up being used to plug budget shortfalls on salaries and other expenses without building up sufficiently strong institutions to manage the debt.
Summary of Ukraine War effects: increase price of grain and hence food = increasing inflation = increased interest rates to cool inflation = increased bond debt repayments from all borrowers = harder for developing countries to repay debts = takes significant chunk out of local economy exacerbated by country’s reliance on debt = lower growth, lower value of the local bonds held by foreigners = more likely for foreign investors to pull out their investments = reduced amount of money in the local economy, spiral effect of worsening the local economy
Overall result was that poorly managed debt made the situation worse when the economic crisis hit and interest rates increased. Foreign investors were quicker to dump local-currency debt than dollar bonds (in anticipation of the local currency depreciating) when the Federal Reserve increased interest rates or the dollar increased in value. Vicious cycle: further depreciated the value of the local currency, driving up inflation and the cost of servicing both local-currency and foreign-currency debt as well for the domestic government.
The effect can be seen from the fact that Sri Lanka spends 40% of its revenue paying interest on its local-currency debt; the figure is 50% for Pakistan.
Original article: How a Plan to End Poor Countries’ Debt Crises Created a New One
Other sources for statistics and information:
Poor Countries Feel Sting of Local-Currency Debt
Wikipedia: Latin American debt crisis
Terms used:
Foreign currency borrowing: developing countries borrow money from richer countries like the US in USD = foreign currency debt
Local currency borrowing: developing countries borrow money from richer countries in local currency = local currency debt
Foreign investors: foreigners buying bonds in the developing country in the developing country’s currency
Debt, Bonds: money borrowed by developing countries from foreigners. this borrowed money constitutes debt, and it is issued through bonds (people pay cash to local bank to buy bonds)
Debt and bonds are basically used interchangeably, and the idea is that the countries use the money borrowed though this debt to improve the economy, hence these bonds are expected to grow in value and lead to returns for the foreign investors.
