The vicious cycle of debt in the Global South

This article is published following the World Bank publication regarding rising debt in the Global South

A debt crisis threatens heavily indebted poor  countries such as Sudan, Afghanistan and Haiti,  already weakened by rising poverty, slower economic recovery than in industrialized economies and a shortage of vaccines, which makes them vulnerable to the spread of Covid-19. The pandemic and the war in Ukraine have increased their budget deficits. More than half of poor states are now over-indebted or at risk of being over-indebted, up from 30 percent in 2015. 

In this context, it is interesting to come back to the origins of this external debt as developing countries face certain specific challenges due to their macroeconomic characteristics.

External debt accumulation finds its origins in the 1970s where many developing countries contracted bank loans. The OPEC price shock led to a trade deficit for most less-developed oil importing nations, which destabilized their balance of payments. It is important to come back on this historical element as the accumulation of debt led to higher dependence towards other economies. These loans were “extended at market and variable rates of interest as risk was transferred to sovereign borrowers whose repayment obligations varied with the level of world inflation”. (Cypher) Hence, loans were highly risked and had extended periods for repayment that could exceed 30 years. External debt was used to fund current consumption and past debt obligations in certain countries, which impeded them from investing and outgrowing this vicious circle. 

This problem of indebtedness hinders sustainable human development as it obstructs governments from investing in their public services and the development and diversification of their economy. 

The Global South is subordinated to many pressures when interacting economically with Western powers and international institutions that are shaped by these global hierarchies. 

Moreover, fixing exchange rate regimes is inherently political. Governments can make various choices between fixed or floating regimes, monetary stability and flexibility, depreciated or appreciated levels and competitiveness or purchasing power. Every trade off comes with compromises and in developing countries the framing of currency policy illustrates dependency dynamics. 

Indeed, some countries choose to contract loans in dollars as it decreases the risk of inflation and instability. However, this dependency towards a foreign currency can also have its downfalls if there is an exchange-rate depreciation. This can increase a country’s external debt and render reimbursement processes difficult. Developing countries often have high levels of foreign currency-denominated debt and high levels of exchange-rate devaluation can result in an important debt crisis, generating inflation. 

Furthermore, several governments such as Djiboutian, Bolivian and Iraqi authorities have chosen to maintain a dollar peg, thus increasing their trade exchanges with the US. Pegging enables countries to fix their country’s currency to another one, avoiding high volatility of prices. This certainly highlights the predominance of the US dollar in the international financial markets. In addition, it is relevant to underline the relationship between the real exchange rate and net exports. Depreciating their currency enables countries to give a boost to their exports. This certainly shows that governments from the Global South can be incentivized to devalue their currency to gain competitiveness on the international trade arena. 

Policymakers are faced with the following dilemma: choosing to devalue their currency, which would support exports and trade but would fuel inflation or adopt the opposite approach on the exchange-rate market, reducing their competitiveness to stabilize prices. This policy approach would go hand in hand with raising interest rates. However, this would have the adverse effect of having a negative impact on growth and debt servicing. 

Once again, this discussion shows how the South’s policy decisions are made in relation to more powerful economies and currencies. They seem to be much more susceptible to high levels of inflation to the extent that they have a tendency of depreciating their domestic currency on international financial markets to adopt an export oriented economic strategy vis-à-vis Western States. 

This structural domestic factor is key: developing countries are susceptible to be contaminated by their trading partners’ levels of inflation. The globalization of the economy renders crises and inflation cycles contagious and developing countries certainly depend on other countries’ economic stability