Jeffrey D. Sachs | December 3, 2021 | Project Syndicate
For low- and lower-middle-income countries to pursue their development goals and do their part in tackling problems like climate change, they need to be able to borrow reliably on decent market terms. Yet the current two-tiered global financial system extends this privilege almost exclusively to rich countries.
NEW YORK – At last month’s COP26 climate summit, hundreds of financial institutions declared that they would put trillions of dollars to work to finance solutions to climate change. Yet a major barrier stands in the way: The world’s financial system actually impedes the flow of finance to developing countries, creating a financial death trap for many.
Economic development depends on investments in three main kinds of capital: human capital (health and education), infrastructure (power, digital, transport, and urban), and businesses. Poorer countries have lower levels per person of each kind of capital, and therefore also have the potential to grow rapidly by investing in a balanced way across them. These days, that growth can and should be green and digital, avoiding the high-pollution growth of the past.
Global bond markets and banking systems should provide sufficient funds for the high-growth “catch-up” phase of sustainable development, yet this doesn’t happen. The flow of funds from global bond markets and banks to developing countries remains small, costly to the borrowers, and unstable. Developing-country borrowers pay interest charges that are often 5-10% higher per year than the borrowing costs paid by rich countries.
Developing country borrowers as a group are regarded as high risk. The bond rating agencies assign lower ratings by mechanical formula to countries just because they are poor. Yet these perceived high risks are exaggerated, and often become a self-fulfilling prophecy.
When a government floats bonds to finance public investments, it generally counts on the ability to refinance some or all of the bonds as they fall due, provided that the long-term trajectory of its debt relative to government revenues is acceptable. If the government suddenly finds itself unable to refinance the debts falling due, it likely will be pushed into default – not out of bad faith or because of long-term insolvency, but for lack of cash on hand.
This is what happens to far too many developing-country governments. International lenders (or rating agencies) come to believe, often for an arbitrary reason, that Country X has become uncreditworthy. This perception results in a “sudden stop” of new lending to the government. Without access to refinancing, the government is forced into a default, thus “justifying” the preceding fears. The government then usually turns to the International Monetary Fund for emergency financing. The restoration of the government’s global financial reputation typically takes years or even decades.
Rich-country governments that borrow internationally in their own currencies do not face the same risk of a sudden stop, because their own central banks act as lenders of last resort. Lending to the United States government is considered safe in no small part because the Federal Reserve can buy Treasury bonds in the open market, ensuring in effect that the government can roll over debts falling due.
The same is true for eurozone countries, assuming that the European Central Bank acts as the lender of last resort. When the ECB briefly failed to play that role in the immediate aftermath of the 2008 financial crisis, several eurozone countries (including Greece, Ireland, and Portugal) temporarily lost access to international capital markets. After that debacle – a near-death experience for the eurozone – the ECB stepped up its lender-of-last-resort function, engaged in quantitative easing through massive purchases of eurozone bonds, and thereby eased borrowing conditions for the affected countries.
Rich countries thus generally borrow in their own currencies, at low cost, and with little risk of illiquidity, except at moments of exceptional policy mismanagement (such as by the US government in 2008, and by the ECB soon thereafter). Low- and lower-middle-income countries, by contrast, borrow in foreign currencies (mainly dollars and euros), pay exceptionally high interest rates, and suffer sudden stops.
For example, Ghana’s debt-to-GDP ratio (83.5%) is far lower than Greece’s (206.7%) or Portugal’s (130.8%), yet Moody’s rates the creditworthiness of Ghana’s government bonds at B3, several notches below those of Greece (Ba3) and Portugal (Baa2). Ghana pays around 9% on ten-year borrowing, whereas Greece and Portugal pay just 1.3% and 0.4%, respectively.
The major credit-rating agencies (Fitch, Moody’s, and S&P Global) assign investment-grade ratings to most rich countries and to many upper-middle-income countries, but assign sub-investment-grade ratings to nearly all lower-middle-income countries and to all low-income countries. Moody’s, for example, currently assigns an investment grade to just two lower-middle-income countries (Indonesia and the Philippines).
Trillions of dollars in pension, insurance, bank, and other investment funds are channeled by law, regulation, or internal practice away from sub-investment-grade securities. Once lost, an investment-grade sovereign rating is extremely hard to recover unless the government enjoys the backing of a major central bank. During the 2010s, 20 governments – including Barbados, Brazil, Greece, Tunisia, and Turkey – were downgraded to below-investment grade. Out of the five that have since recovered their investment-grade rating, four are in the EU (Hungary, Ireland, Portugal, and Slovenia), and none are in Latin America, Africa, or Asia (the fifth is Russia).
An overhaul of the global financial system is therefore urgent and long overdue. Developing countries with good growth prospects and vital development needs should be able to borrow reliably on decent market terms. To this end, the G20 and the IMF should devise a new and improved credit-rating system that accounts for each country’s growth prospects and long-term debt sustainability. Banking regulations, such as those of the Bank for International Settlements, should then be revised according to the improved credit-rating system to facilitate more bank lending to developing countries.
To help end sudden stops, the G20 and the IMF should use their financial firepower to support a liquid secondary market in developing-country sovereign bonds. The Fed, ECB, and other key central banks should establish currency swap lines with central banks in low-income and lower-middle-income countries. The World Bank and other development finance institutions also should greatly increase their grants and concessional loans to developing countries, especially the poorest. Last but not least, if rich countries and regions, including several US states, stopped sponsoring money laundering and tax havens, developing countries would have more revenues to fund investments in sustainable development.