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The Coming Debt Crisis

If several larger emerging markets and low-income countries are simultaneously confronted with rising interest rates and an increasing reluctance by creditors to roll over their debts, a global debt crisis is likely to erupt. To avoid this scenario, an international agreement on how to support debt-distressed sovereigns is needed.

WASHINGTON, DC – In its latest World Economic Outlook, the International Monetary Fund reported that a rising share of countries – 56% of low-income countries and 25% of emerging markets – are “in or at high levels of debt distress.” While some of these countries are already working on reform programs that will make them eligible for IMF funding and offer good prospects for economic growth, many are not. A developing-world debt crisis is looming.

Extremely high levels of indebtedness are usually preceded by a period during which creditors roll over claims or extend new loans, with increasingly high interest rates. There is no simple way to determine when that debt becomes unsustainable. Analysts often use the debt-to-GDP ratio, but interest rates make a difference here. Low-income countries facing concessional interest rates might have lower ratios than emerging-market economies, for which interest rates are higher. The maturity structure of the debt also matters: if most of it will come due soon, the required rollovers (or renewals) will be much larger than for debts with a longer maturity.

Borrowing by poor countries is warranted if the loans finance activities that will yield a high rate of return for the borrower, whose own resources are already financing worthwhile activities. In such a scenario, debt-service can be self-financing (barring unforeseen shocks). The problem is that, in many countries, sovereign borrowing has largely been to finance expenditures with low or negative rates of return, such as sports stadiums or pre-election handouts.