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.
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. Copyright: Project Syndicate, 2021
Jeffrey D. Sachs
is Director of the Center for Sustainable Development at Columbia University and President of the UN Sustainable Development Solutions Network
