The Emerging Global Debt Crisis and the Role of International Aid

Commentary by Rafael Romeu

Published April 18, 2024

The world's poorest countries are facing a growing debt crisis. The International Monetary Fund (IMF) reported last fall that more than half of low-income developing countries are in or at high risk of debt distress, and about one-fifth of emerging markets have sovereign bonds trading at distressed levels. Meanwhile, in many lower-middle-income countries, escalating debt vulnerabilities and overlapping crises-the Covid-19 pandemic, the war in Ukraine, and the increase in global interest rates and risk aversion-are forcing a growing number of countries to seek debt restructuring from external creditors.

This emerging debt crisis has roots going back nearly 30 years. The Heavily Indebted Poor Countries (HIPC) program, launched in 1996 by the World Bank and the IMF, was a landmark effort to reduce the unsustainable debt burdens of the world's poorest countries. The initiative succeeded in reducing debts by the mid-2000s for many eligible nations. Importantly, HIPC sought to provide comprehensive debt relief to facilitate poverty reduction and allow for increased spending on health, education, and other poverty-reduction efforts.

Key to the HIPC initiative's successful implementation was the role of the Paris Club, an informal group of creditor nations whose role was to find coordinated and sustainable solutions to the payment difficulties experienced by debtor countries. The Paris Club worked alongside the IMF and other multilateral organizations and creditors to restructure debt and provide relief under the HIPC framework, ensuring that efforts were harmonized and effective in reducing debt burdens. This collaboration was crucial for the initiative's success, involving the restructuring of bilateral debt and ensuring that multilateral and commercial debts were also addressed through various relief mechanisms.

As HIPC progressed, and many countries lowered their debt burdens, the global financial landscape shifted toward the zero interest rate policy (ZIRP) in response to the 2008 global financial crisis. ZIRP was a monetary policy intended to stimulate economic growth by keeping central bank short-term interest rates near zero. The prolonged period of low interest rates spurred a search for yield among global investors, who turned their attention to newly debt-free frontier markets, drawn by higher returns and the potential for strategic investments in HIPC initiative countries. This period saw a surge in lending by an array of creditors, including commercial creditors, Eurobond lenders, and the People's Republic of China (PRC) through its Belt and Road Initiative (BRI). The BRI funded infrastructure projects as part of a broader strategy to enhance global trade networks and increase the PRC's geopolitical influence. The BRI, coupled with the global search for yield during the ZIRP period, significantly altered the dynamics of international lending.

Challenges of Debt Relief and Restructuring

In response to rising debt pressures, the G20 and the IMF introduced the Common Framework for Debt Treatments in 2020, aiming to streamline debt restructuring for distressed low-income countries by coordinating debt relief among all public and private lenders, setting treatment standards, and ensuring equitable relief requirements and loss sharing across creditors. The framework's effectiveness has nonetheless been hindered by several challenges: it lacks clear rules for ensuring uniform debt relief among creditors; it excludes marginally better-off indebted countries; and it provides no effective guidelines for countries to manage their debt. There has also been disagreement over which loans to include and how to share losses, especially given China's unwillingness to follow the fact pattern of previous defaults set by the Paris Club and the IMF. This has led to very slow or stalled negotiations. Meanwhile, the collective debt of developing countries reached about $9 trillion in 2022, with approximately 60 percent of the world's 75 poorest countries in or near debt distress.

The New Bailouts

Against this backdrop, an important 2023 study revealed China's growing role in the global financial system, which includes a global swap line network put in place by the People's Bank of China (PBOC) as a financial rescue mechanism for low-income countries. "Swap agreements" allow central banks to exchange currencies in times of financial crisis-the PBOC provides distressed countries much-needed liquidity in yuan, while also supporting its broader goal of internationalizing the currency. The PRC has extended both swap facilities and direct loan support to BRI borrowers, amounting to $170 billion in PBOC swap agreements and another $70 billion in rescue loans from Chinese state-owned banks and enterprises. This assistance is noteworthy not only for its scale but also for its terms, which are markedly different from those offered by traditional lenders like the IMF. Chinese loans are less transparent, carry higher interest rates, and are almost exclusively targeted at debtors involved in the BRI.

The PRC's new model of financial support has been increasingly mobilized in BRI-borrowing countries facing financial and macroeconomic turmoil, particularly those with low reserve ratios and subpar credit ratings. A World Bank study indicated that among 17 nations utilizing PBOC swap lines, only four accessed these funds under normal economic conditions without evident distress. Drawing on PBOC swap lines appears to enhance a country's gross reserves, ostensibly to improve financial aesthetics-a concept referred to as "window dressing." Yet the precise use of these funds remains ambiguous, especially concerning their potential deployment to repay Chinese creditors as they mature. Although the PBOC's swap line network has emerged as a mechanism for managing international financial crises, China's financial support is often viewed as opaque, expensive, and motivated by geopolitical interests or internal strategic objectives, contrasting with the more transparent and regulated financial aid from institutions like the IMF.

However, there is an equivalent source of external funding that is largely unrecognized as a significant source of hard currency to low-income countries: U.S. government (USG) foreign assistance. These "non-debt-creating flows," which are akin to remittances, do not necessitate repayment and therefore do not impact the receiving country's balance sheet. The critical downside of this form of assistance is the lack of influence it carries in debt negotiation processes, where the aid agencies of donor countries find themselves without a seat at the creditor committees' table. Because foreign aid is functionally equivalent to sovereign loans with 100 percent debt forgiveness, offering immediate relief to countries in crisis without contributing to debt, these types of donors lack leverage in broader financial restructuring discussions, particularly against lenders resistant to offering debt concessions. Put otherwise, foreign aid agencies provide crucial dollar inflows to countries in debt distress but are systemically excluded from the very negotiations that leverage these inflows in calculations of debt forgiveness, future repayment, capacity to repay, fiscal measures, and so on.

To illustrate the parallels and differences between Chinese and U.S. assistance models, Figure 1 provides a comparative overview of financial support from the PRC and USG to various countries bailed out by China. It shows that China's rescue efforts, totaling $78.1 billion include maximum drawing rights and rescue loans. The USG's taxpayer-funded overseas development assistance grants amount to $75.1 billion, allocated across several sectors including peace and security; democracy and human rights; health, education, and social services; economic development; environmental assistance; humanitarian aid; and others (see Figure 2 for country-level figures).

Figure 1: Comparison of PRC Bailouts and USG Assistance for the Same Countries in the Same Years

Source: Reprinted with permission from DevTech.

Figure 2:PRC Financial Support and USG Assistance to the Same Countries in the Same Years

Source: Reprinted with permission from DevTech.

Although the scale of financial support from the PRC and USG is similar, the nature of their support varies significantly. China's assistance largely comes via loans to be repaid, allowing Beijing to maintain significant influence over how debt crises are resolved, including through the Common Framework, bilateral negotiations, and its dominant presence in creditor committees. Because USG assistance is offered primarily through development grants, which provide a significant source of hard-currency earnings for many of the most critical debt cases, USG aid agencies have no voice or vote in debt crisis resolution, despite the implications of this process for their mission, work, results, and return on investment.

Given current yields, heavily indebted countries-including some of the poorest in Africa-are facing unsustainable debt levels and inevitable fiscal adjustments. The figures presented here reveal an underappreciated risk of deploying USAID grant funding in these contexts-namely, the requirement by the Common Framework and "lenders of last resort" that countries in debt distress boost central bank reserves with "non-debt-creating flows" as a precondition for support, while excluding aid donors from the design of the debt workout that their grants will fund.

Invariably, the current institutional framework implies using USG grants-and remittances-to meet central bank reserve requirements rather than to subsidize development. Through policy tools including devaluation, inflation, and multiple exchange rate mechanisms, governments can convert foreign aid to rebuild reserves, debasing the aid's international purchasing power in the process. This undermines the intended impact of USAID grants, which are meant to be spent on goods and services for the needy but are instead leveraged for future debt repayments as countries undertake structural adjustment programs. Although the borrowing country's capacity to repay external creditors and rebuild reserves is subject to intense scrutiny, there is insufficient effort to ensure that fiscal adjustments do not simply create space and time to redirect central bank reserves to repay PRC lenders, commercial creditors, and local bondholders ahead of devaluations and reserve exhaustion. Because reserves that stem from aid flows are funded by American taxpayers, neglecting this reality could put critical foreign assistance budgets at risk.

Figure 3: Geographic Distribution of PRC Bailouts and USG Assistance, 2001-2021

Note: The figures show the PRC bailouts and swaps (left, orange) versus USG foreign assistance (right, blue) from 2001 to 2021.

Source: Reprinted with permission from DevTech.

It is well understood that the fragmented nature of sovereign debt-with bonds held by a diversity of creditors ranging from hedge funds to sovereign wealth funds-complicates consensus building within the Common Framework's voluntary structure. The challenge identified here is that the framework, as well as any debt restructuring workout, leverages aid dollars to help build reserves that ultimately liquidate lender positions following a default. Scarce resources are diverted from critical development needs to debt service, with potential implications for global migration and humanitarian crises.

The response from the USG should be to develop strategies to provide immediate relief and engage in long-term efforts to address systemic debt vulnerabilities and debt workouts. This includes identifying debt risks, predicting crises, and negotiating restructuring agreements, with a focus on aligning aid with the economic interests of recipient countries. This may also include developing aid instruments that allow for greater leverage during debt restructuring negotiations to defend the mission of its aid agencies from lenders. Monitoring and engaging with aid recipient countries' financial management practices are also critical to ensure that aid does not inadvertently service debt owed to commercial creditors. Collaborating closely with ministries of finance and other key institutions-including central banks, legislative advisory bodies, and fiscal authorities-to ensure debt sustainability is equally important. Transparent borrowing practices that avoid agency problems from connected domestic lenders and other governance issues are also essential in fortifying the economic resilience of partner countries.

The debt crisis threatening many developing countries necessitates coordinated international efforts and a commitment to principles of transparency, equity, and sustainable development. The challenges presented by the Common Framework and the role of creditors like the PRC underscore the need for a more flexible and inclusive approach to debt relief. As the international community navigates these treacherous financial waters, the experiences under the HIPC initiative and the strategic responses of entities like USAID will be critical in shaping the future economic stability and sovereignty of indebted nations.

Rafael Romeu is a senior associate (non-resident) with the Project on Prosperity and Development at the Center for Strategic and International Studies in Washington, D.C.

Programs & Projects