I have previously written about how to evaluate and think about public debt in stable, developed countries. There, the overall message was that the dangers of debt were often (but not always) overhyped and cynically used by certain politicians. In a throwaway remark, I suggested the case was rather different for developing countries. This post unpacks that remark. It looks at why things go so poorly when developing countries take on debt and lays out a set of policies that I think could help developing countries that have high debt loads.
The very first difference in debt between developed and developing countries lies in the available terms of credit; developing countries get much worse terms. This makes sense, as they’re often much more likely to default on their debt. Interest scales with risk and it just is riskier to lend money to Zimbabwe than to Canada.
But interest payments aren’t the only way in which developing countries get worse terms. They are also given fewer options for the currency they take loans out in. And by fewer, I mean very few. I don’t think many developing countries are getting loans that aren’t denominated in US dollars, Euros, or, if dealing with China, Yuan. Contrast this with Canada, which has no problem taking out loans in its own currency.
When you own the currency of your debts, you can devalue it in response to high debt loads, making your debts cheaper to pay off in real terms (that is to say, your debt will be equivalent to fewer goods and services than it was before you caused inflation by devaluing your currency). This is bad for lenders. In the event of devaluation, they lose money. Depending on the severity of the inflation, it could be worse for them than a simple default would be, because they cannot even try and recover part of the loan in court proceedings.
(Devaluations don’t have to be large to be reduce debt costs; they can also take the form of slightly higher inflation, such that interest is essentially nil on any loans. This is still quite bad for lenders and savers, although less likely to be worse than an actual default. The real risk comes when a country with little economic sophistication tries to engineer slightly higher inflation. It seems likely that they could drastically overshoot, with all of the attendant consequences.)
Devaluations and inflation are also politically fraught. They are especially hard on pensioners and anyone living on a fixed income – which is exactly the population most likely to make their displeasure felt at the ballot box. Lenders know that many interest groups would oppose a Canadian devaluation, but these sorts of governance controls and civil society pressure groups often just doesn’t exist (or are easily ignored by authoritarian leaders) in the developing world, which means devaluations can be less politically difficult .
Having the option to devalue isn’t the only reason why you might want your debts denominated in your own currency (after all, it is rarely exercised). Having debts denominated in a foreign currency can be very disruptive to the domestic priorities of your country.
The Canadian dollar is primarily used by Canadians to buy stuff they want . The Canadian government naturally ends up with Canadian dollars when people pay their taxes. This makes the loan repayment process very simple. Canadians just need to do what they’d do anyway and as long as tax rates are sufficient, loans will be repaid.
When a developing country takes out a loan denominated in foreign currency, they need some way to turn domestic production into that foreign currency in order to make repayments. This is only possible insofar as their economy produces something that people using the loan currency (often USD) want. Notably, this could be very different than what the people in the country want.
For example, the people of a country could want to grow staple crops, like cassava or maize. Unfortunately, they won’t really be able to sell these staples for USD; there isn’t much market for either in the US. There very well could be room for the country to export bananas to the US, but this means that some of their farmland must be diverted away from growing staples for domestic consumption and towards growing cash crops for foreign consumption. The government will have an incentive to push people towards this type of agriculture, because they need commodities that can be sold for USD in order to make their loan payments .
As long as the need for foreign currency persists, countries can be locked into resource extraction and left unable to progress towards a more mature manufacturing- or knowledge-based economies.
This is bad enough, but there’s often greater economic damage when a country defaults on its foreign loans – and default many developing countries will, because they take on debt in a highly procyclical way .
A variable, indicator, or quantity is said to be procyclical if it is correlated with the overall health of an economy. We say that developing nation debt is procyclical because it tends to expand while economies are undergoing expansion. Specifically, new developing country debts seem to be correlated with many commodity prices. When commodity prices are high, it’s easier for developing countries that export them to take on debt.
It’s easy to see why this might be the case. Increasing commodity prices make the economies of developing countries look better. Exporting commodities can bring in a lot of money, which can have spillover effects that help the broader economy. As long as taxation isn’t too much a mess, export revenues make government revenues higher. All of this makes a country look like a safer bet, which makes credit cheaper, which makes a country more likely to take it on.
Unfortunately (for resource dependent countries; fortunately for consumes), most commodity price increases do not last forever. It is important to remember that prices are a signal – and that high prices are a giant flag that says “here be money”. Persistently high prices lead to increased production, which can eventually lead to a glut and falling prices. This most recently and spectacularly happened in 2014-2015, as American and Canadian unconventional oil and gas extraction led to a crash in the global price of oil .
When commodity prices crash, indebted, export-dependent countries are in big trouble. They are saddled with debt that is doubly difficult to pay back. First, their primary source of foreign cash for paying off their debts is gone with the crash in commodity prices (this will look like their currency plummeting in value). Second, their domestic tax base is much lower, starving them of revenue.
Even if a country wants to keep paying its debts, a commodity crash can leave them with no choice but a default. A dismal exchange rate and minuscule government revenues mean that the money to pay back dollar denominated debts just doesn’t exist.
Oddly enough, defaulting can offer some relief from problems; it often comes bundled with a restructuring, which results in lower debt payments. Unfortunately, this relief tends to be temporary. Unless it’s coupled with strict austerity, it tends to lead into another problem: devastating inflation.
Countries that end up defaulting on external debt are generally not living within their long-term means. Often, they’re providing a level of public services that are unsustainable without foreign borrowing, or they’re seeing so much government money diverted by corrupt officials that foreign debt is the only way to keep the lights on. One inevitable effect of a default is losing access to credit markets. Even when a restructuring can stem the short-term bleeding, there is often a budget hole left behind when the foreign cash dries up . Inflation occurs because many governments with weak institutions fill this budgetary void with the printing press.
There is nothing inherently wrong with printing money, just like there’s nothing inherently wrong with having a shot of whiskey. A shot of whiskey can give you the courage to ask out the cute person at the bar; it can get you nerved up to sing in front of your friends. Or it can lead to ten more shots and a crushing hangover. Printing money is like taking shots. In some circumstances, it can really improve your life, it’s fine in moderation, but if you overdue it you’re in for a bad time.
When developing countries turn to the printing press, they often do it like a sailor turning to whiskey after six weeks of enforced sobriety.
Teachers need to be paid? Print some money. Social assistance? Print more money. Roads need to be maintained? Print even more money.
The money supply should normally expand only slightly more quickly than economic growth . When it expands more quickly, prices begin to increase in lockstep. People are still paid, but the money is worth less. Savings disappear. Velocity (the speed with which money travels through the economy) increases as people try and spend money as quickly as possible, driving prices ever higher.
As the currency becomes less and less valuable, it becomes harder and harder to pay for imports. We’ve already talked about how you can only buy external goods in your own currency to the extent that people outside your country have a use for your currency. No one has a use for a rapidly inflating currency. This is why Venezuela is facing shortages of food and medicine – commodities it formerly imported but now cannot afford.
The terminal state of inflation is hyperinflation, where people need to put their currency in wheelbarrows to do anything with it. Anyone who has read about Germany in the 1930s knows that hyperinflation opens the door to demagogues and coups – to anything or anyone who can convince the people that the suffering can be stopped.
Taking into account all of this – the inflation, the banana plantations, the boom and bust cycles – it seems clear that it might be better if developing countries took on less debt. Why don’t they?
One possible explanation is the IMF (International Monetary Fund). The IMF often acts as a lender of last resort, giving countries bridging loans and negotiating new repayment terms when the prospect of default is raised. The measures that the IMF takes to help countries repay their debts have earned it many critics who rightly note that there can be a human cost to the budget cuts the IMF demands as a condition for aid . Unfortunately, this is not the only way the IMF might make sovereign defaults worse. It also seems likely that the IMF represents a significant moral hazard, one that encourages risky lending to countries that cannot sustain debt loads long-term .
A moral hazard is any situation in which someone takes risks knowing that they won’t have to pay the penalty if their bet goes sour. Within the context of international debt and the IMF, a moral hazard arises when lenders know that they will be able to count on an IMF bailout to help them recover their principle in the event of a default.
In a world without the IMF, it is very possible that borrowing costs would be higher for developing countries, which could serve as a deterrent to taking on debt.
(It’s also possible that countries with weak institutions and bad governance will always take on unsustainable levels of debt, absent some external force stopping them. It’s for this reason that I’d prefer some sort of qualified ban on loaning to developing countries that have debt above some small fraction of their GDP over any plan that relies on abolishing the IMF in the hopes of solving all problems related to developing country debt.)
Paired with a qualified ban on new debt , I think there are two good arguments for forgiving much of the debt currently held by many developing countries.
First and simplest are the humanitarian reasons. Freed of debt burdens, developing countries might be able to provide more services for their citizens, or invest in infrastructure so that they could grow more quickly. Debt forgiveness would have to be paired with institutional reform and increased transparency, so that newfound surpluses aren’t diverted into the pockets of kleptocrats, which means any forgiveness policy could have the added benefit of acting as a big stick to force much needed governance changes.
Second is the doctrine of odious debts. An odious debt is any debt incurred by a despotic leader for the purpose of enriching themself or their cronies, or repressing their citizens. Under the legal doctrine of odious debts, these debts should be treated as the personal debt of the despot and wiped out whenever there is a change in regime. The logic behind this doctrine is simple: by loaning to a despot and enabling their repression, the creditors committed a violent act against the people of the country. Those people should have no obligation (legal or moral) to pay back their aggressors.
The doctrine of odious debts wouldn’t apply to every indebted developing country, but serious arguments can be made that several countries (such as Venezuela) should expect at least some reduction in their debts should the local regime change and international legal scholars (and courts) recognize the odious debt principle.
Until international progress is made on a clear list of conditions under which countries cannot take on new debt and a comprehensive program of debt forgiveness, we’re going to see the same cycle repeat over and over again. Countries will take on debt when their commodities are expensive, locking them into an economy dependent on resource extraction. Then prices will fall, default will loom, and the IMF will protect investors. Countries are left gutted, lenders are left rich, taxpayers the world over hold the bag, and poverty and misery continue – until the cycle starts over once again.
A global economy without this cycle of boom, bust, and poverty might be one of our best chances of providing stable, sustainable growth to everyone in the world. I hope one day we get to see it.
 I so wanted to get through this post without any footnotes, but here we are.
There’s one other reason why e.g. Canada is a lower risk for devaluation than e.g. Venezuela: central bank independence. The Bank of Canada is staffed by expert economists and somewhat isolated from political interference. It is unclear just how much it would be willing to devalue the currency, even if that was the desire of the Government of Canada.
Monetary policy is one lever of power that almost no developed country is willing to trust directly to politicians, a safeguard that doesn’t exist in all developing countries. Without it, devaluation and inflation risk are much higher. ^
 Secondarily it’s used to speculatively bet on the health of the resource extraction portion of the global economy, but that’s not like, too major of a thing. ^
 It’s not that the government is directly selling the bananas for USD. It’s that the government collects taxes in the local currency and the local currency cannot be converted to USD unless the country has something that USD holders want. Exchange rates are determined based on how much people want to hold one currency vs. another. A decrease in the value of products produced by a country relative to other parts of the global economy means that people will be less interested in holding that country’s currency and its value will fall. This is what happened in 2015 to the Canadian dollar; oil prices fell (while other commodity prices held steady) and the value of the dollar dropped.
Countries that are heavily dependent on the export of only one or two commodities can see wild swings in their currencies as those underlying commodities change in value. The Russian ruble, for example, is very tightly linked to the price of oil; it lost half its value between 2014 and 2016, during the oil price slump. This is a much larger depreciation than the Canadian dollar (which also suffered, but was buoyed up by Canada’s greater economic diversity). ^
 This section is drawn from the research of Dr. Karmen Reinhart and Dr. Kenneth Rogoff, as reported in This Time Is Different, Chapter 5: Cycles of Default on External Debt. ^
 This is why peak oil theories ultimately fell apart. Proponents didn’t realize that consistently high oil prices would lead to the exploitation of unconventional hydrocarbons. The initial research and development of these new sources made sense only because of the sky-high oil prices of the day. In an efficient market, profits will always eventually return to 0. We don’t have a perfectly efficient market, but it’s efficient enough that commodity prices rarely stay too high for too long. ^
 Access to foreign cash is gone because no one lends money to countries that just defaulted on their debts. Access to external credit does often come back the next time there’s a commodity bubble, but that could be a decade in the future. ^
 In some downturns, a bit of extra inflation can help lower sticky wages in real terms and return a country to full employment. My reading suggests that commodity crashes are not one of those cases. ^
 I’m cynical enough to believe that there is enough graft in most of these cases that human costs could be largely averted, if only the leaders of the country were forced to see their graft dry up. I’m also pragmatic enough to believe that this will rarely happen. I do believe that one positive impact of the IMF getting involved is that its status as an international institution gives it more power with which to force transparency upon debtor nations and attempt to stop diversion of public money to well-connected insiders. ^
 A quick search found two papers that claimed there was a moral hazard associated with the IMF and one article hosted by the IMF (and as far as I can tell, later at least somewhat repudiated by the author in the book cited in ) that claims there is no moral hazard. Draw what conclusions from this you will. ^
 I’m not entirely sure what such a ban would look like, but I’m thinking some hard cap on amount loaned based on percent of GDP, with the percent able to rise in response to reforms that boost transparency, cut corruption, and establish modern safeguards on the central bank. ^