Global bond markets and banking systems should provide sufficient funds for the high-growth ‘catch-up’ phase of sustainable development
At the COP26 climate summit last month, hundreds of financial institutions said they would put trillions of dollars to work to fund solutions to climate change. Yet a major obstacle stands in the way: the global financial system is in fact hindering the flow of finance to developing countries, creating a deadly financial trap for many.
Economic development depends on investments in three main types of capital: human capital (health and education), infrastructure (electricity, digital, transport and urban) and businesses. Poorer countries have lower per capita levels of each type of capital and therefore also have the potential to grow rapidly by investing in a balanced way among themselves. Nowadays, that growth can and should be green and digital, avoiding the highly polluting growth of the past.
Global bond markets and banking systems should provide sufficient funds for the high-growth “catch-up” phase of sustainable development, but this is not happening. The flow of funds from global bond markets and banks to developing countries remains low, costly for borrowers and volatile. Borrowers from developing countries pay interest charges which are often 5-10% higher per annum than the borrowing costs paid by rich countries.
Borrowers from developing countries as a group are considered high risk. Bond rating agencies mechanically assign lower ratings to countries simply because they are poor. Yet these high perceived risks are overstated and often become a self-fulfilling prophecy.
When a government issues bonds to finance public investments, it generally relies on the ability to refinance all or part of the bonds as they fall due, provided the long-term trajectory of its debt to government revenues is acceptable. If the government suddenly finds itself unable to refinance maturing debts, it will likely default – not through bad faith or long-term insolvency, but through lack of liquidity.
This is happening to far too many governments in developing countries. International lenders (or rating agencies) come to believe, often for some arbitrary reason, that country X has become insolvent. This perception leads to a “sudden stop” in new lending to the government. Without access to refinancing, the government is forced to default, “justifying” the above fears. The government then usually turns to the International Monetary Fund for emergency funding. Restoring the government’s global financial reputation typically takes years, if not decades.
Governments of rich countries that borrow internationally in their own currencies do not face the same risk of a crash because their own central banks act as lenders of last resort. Loans to the United States government are considered secure in large part because the Federal Reserve can buy treasury bills in the open market, in effect ensuring that the government can roll over debts as they fall due.
The same is true for euro area countries, assuming the European Central Bank acts as the lender of last resort. When the ECB briefly failed to play this role in the aftermath of the 2008 financial crisis, several euro area countries (including Greece, Ireland and Portugal) temporarily lost access to international capital markets. After this debacle – a near-death experience for the euro area – the ECB strengthened its function as lender of last resort, embarked on quantitative easing through massive purchases of euro area bonds, and thus relaxed borrowing conditions for affected countries.
Rich countries therefore generally borrow in their own currencies, at low cost and with little risk of illiquidity, except in times of exceptional political mismanagement (such as by the US government in 2008, and by the ECB soon after). Low- and lower-middle-income countries, on the other hand, borrow in foreign currencies (mostly dollars and euros), pay unusually high interest rates, and experience sudden stops.
For example, Ghana’s debt-to-GDP ratio (83.5%) is much lower than that of Greece (206.7%) or Portugal (130.8%), yet Moody’s assesses the creditworthiness of government bonds. Ghanaian at B3, several notches below those of Greece (Ba3) and Portugal (Baa2). Ghana pays around 9 percent on a 10-year loan, while Greece and Portugal pay only 1.3 percent and 0.4 percent, respectively.
Major rating agencies (Fitch, Moody’s and S&P Global) assign investment grade ratings to most rich countries and many upper middle income countries, but assign lower quality ratings to almost all middle income countries inferior. countries and all low-income countries. Moody’s, for example, currently only assigns an investment rating to two lower-middle-income countries (Indonesia and the Philippines).
Billions of dollars in pension, insurance, banking and other investment funds are diverted by law, regulation or internal practice from substandard securities. Once lost, an investment grade sovereign rating is extremely difficult to recover unless the government has the backing of a major central bank. During the 2010s, 20 governments – including Barbados, Brazil, Greece, Tunisia and Turkey – were demoted below the investment grade. Of the five that have since recovered their investment 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 conditions. To this end, the G20 and the IMF should design a new and improved credit rating system that takes into account 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 further facilitate bank lending to developing countries.
To help end sudden shutdowns, the G20 and 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 are expected to establish currency swap lines with central banks in low- and lower-middle-income countries. The World Bank and other development finance institutions should also significantly increase their grants and concessional loans to developing countries, especially the poorest. Last but not least, if rich countries and regions, including several American states, stopped sponsoring money laundering and tax havens, developing countries would have more income to finance investments in sustainable development. – Project union
Jeffrey D Sachs, University Professor at Columbia University, is Director of the Center for Sustainable Development at Columbia University and Chairman of the United Nations Sustainable Development Solutions Network.