Government debt and wealth in the Global South

2 Why governments borrow

Borrowing is a behaviour common to many types of economic agents, in different historical contexts and in an enormous variety of situations. This means that from individuals to households, from firms to countries, there is always the need to stabilize some type of expenditure through time when faced with changing economic conditions that do not always match the timing of spending needs. In the case of governments, they may face significant short-term spending needs created by emergencies (such as the COVID-19 pandemic or natural disasters) but also volatile tax revenues or cyclical fiscal incomes that are generated by changing international economic conditions.

Most households need to incur debt at certain times in order to buy a house, a car, or expensive household appliances, usually due to the lack of financial resources to pay upfront. Or they may need to finance their children’s education and pay for medical treatments. In these situations, they may not have significant savings that they can draw on, and they want to be able to pay for these investments or emergency expenditures without dramatically sacrificing their standard of living. Usually, households that face these sorts of financial challenges try to adjust their day-to-day spending somewhat so they do not need to borrow as much, but they will still need to incur some debt to sustain a reasonable consumption pattern. This is especially the case for low- and lower-middle-income households that cannot realistically lower their spending patterns by much and are faced with a simple choice: either they take on debt to pay for whatever they need, or they do not get what they need.

Sometimes, lower-income households that have very low savings levels take on debt not because they must deal with an emergency or invest in appliances and education, but because they face significant income variation. For example, a household earner may lose their job and face a period of job searching with zero or reduced income, depending on whether they can access unemployment insurance. Again, the household will try to reduce spending and use whatever savings they have accumulated, but they may need to borrow just to keep food on the table, the kids clothed, and the lights and heating on.

government debt

The total amount that a state owes to others. These creditors can be private citizens or companies of the same country, foreign agents, other governments, international banks, and multilateral agencies such as the International Monetary Fund or the World Bank.

commodity exports

The exports of goods that are fully fungible in international markets, which means goods that have the same basic qualities independently of who produces them. This allows for the establishment of exchanges like the London Metal Exchange or the Chicago Mercantile Exchange where these products are traded as assets. Examples of commodities are oil, gas, copper, platinum, cotton, and wheat. Examples of products that are not a commodity, so that the origin matters, are products in which quality and variety are important attributes, such as shirts, cars, and computers.

Although there are significant differences between households and countries, at its most essential, the problems faced by countries that use government debt are not that different from those faced by households. Low- and middle-income countries, like lower-income households, sometimes face large spending requirements related to infrastructure or social investments in education and public health and cannot afford to cut other spending to accommodate these needs. This can become a crucial strategic bottleneck since some of these investments may be critical for the country’s development.

As well as large spending requirements, countries also face the problem of volatility of income. All governments finance a large proportion of their budget with the tax revenues they collect. Moreover, some governments directly own companies (usually known as state-owned enterprises or SOEs), some of which have the primary objective of earning income for the budget. These SOEs are common in countries across the Global South that export commodities. Whatever the source of income for the government, it will be subject to volatility. Sometimes the economy is booming and so are tax revenues, sometimes the economy is slowing and so are government incomes. In the case of many low- and middle-income countries across the Global South, government incomes are sharply dependent on commodity exports (such as oil, gas, copper, cocoa, and corn), which tend to have significantly volatile prices. If tax revenue or SOE incomes are highly dependent on commodity prices, then fiscal incomes may be very volatile and subject to pronounced cycles. A reasonable government would like to avoid transferring this volatility to social spending and would rather target a long-term, sustainable level of spending. If possible they would like to finance the cycles and volatility of income with savings but it mostly requires debt.

In addition, governments would like to avoid constantly moving the tax rate up and down to accommodate spending needs, for three reasons:

• Changing taxes is usually quite difficult from a political and institutional perspective. The political, legislative, and institutional processes it entails can be long and unpredictable, and a drain on political energy and resources. A government may end up spending precious time and political capital and getting nothing out of it. No elected official likes to raise taxes, because usually those affected by the raise do not like it and those benefitted by the resources raised usually don’t care very much how it is financed. A tax rise can be perilous for an elected official.
• Citizens rarely believe that transitory tax increases are transitory (and hence behave as if they are permanent).
• The effects of tax rates on the economy are not linear, which means that very sharp tax increases (even if people believe they are transitory), generate more than proportional costs in terms of reduced investment and tax evasion.

So, governments will avoid, whenever possible, adjusting taxes to accommodate short-term spending needs and will prefer debt.

In the CORE Insight Public debt: threat or opportunity?, Barry Eichengreen and Ugo Panizza discuss this question faced by governments around the world and explain how government debt can be a useful tool, but also a source of problems.

tax smoothing

A fiscal budgeting policy that consists of setting spending at a level consistent with long-term, structural, or ‘permanent’ tax revenues. Since tax collection is cyclical and affected by the fluctuations in the economy, this requires the government to save when it has especially high tax revenue and to use those savings and/or incur debt when tax revenues are especially low.

Economists call the use of debt by governments to stabilize spending tax smoothing, and this is a subject that is extensively studied by macroeconomists.

Why LMI governments borrow in foreign currency

One of the characteristics of public debt in the Global South is that it is usually denominated in foreign currency. A country such as Guatemala or Bangladesh will usually have most of its government debt in US dollars or euros rather than in local currencies (quetzals or takas, respectively). Some of the larger LMI countries, like Brazil or India, may have part of their government debt in the local currency of reals or rupees, but this is usually debt issued within their economy and held by local investors.

For an explanation of these two exchange rate regimes, read Unit 7 of The Economy 2.0: Macroeconomics.

Even large economies within the Global South, when faced with the need to tap into international capital markets, must denominate their debt in international currencies. This happens because international investors are usually not willing to take the risk involved in investing in the local currency and prefer currencies from countries that are perceived to be especially solvent and trustworthy because of political and historical factors (usually the USD, the euro, the pound sterling, the Swiss franc, the Japanese yen and the Chinese renminbi). The reason is that when an international bank or global investor (such as a pension fund) lends money to a government in the local currency they are, in fact, lending to an entity that can change the value of that debt through their own decisions (by devaluing their currency in a fixed exchange rate regime or prompting a depreciation of the exchange rate by loosening monetary policy in a flexible exchange rate regime). Investors usually feel that they are less informed than local political and economic actors about the determinants of these risks and prefer to protect themselves by lending in international currencies.

Read Section 5.14 of The Economy 2.0: Macroeconomics to learn more about exchange rates and how appreciation or depreciation affects the decisions of economic actors.

depreciation

The loss in value of a form of wealth that occurs either through use (wear and tear) or the passage of time (obsolescence).

exports (X)

Goods and services produced in a particular country and sold to households, firms and governments in other countries.

The problem this generates will be obvious to anyone that has had to exchange currencies when travelling, especially if you have travelled as a student on a tight budget. Your budget is usually a certain amount of money from the place where you live, but the place where you are travelling has its prices in its own currency. Suppose you live in the UK but are going to Thailand for some great beaches and spicy food, then you will be spending in baht. So, if the Thai baht loses value in comparison to the British pound, or as economists say the baht depreciates, you will be very happy. You will be able to buy more bahts for each pound in your budget and may be able to afford an extra serving of sticky rice with mango. But if it goes the other way and the pound depreciates, then you will be able to buy fewer baht with each pound and will have to trim your spending. The same principle applies to countries that have a budget in their own currency, but have to spend (or service their debt) in another currency.

Many low- and middle-income countries depend heavily on their exports, particularly commodities. Their economies and the general welfare of the population are significantly affected both by the prices of these products and fiscal revenues (through taxes on the wages and profits generated by the commodity-based part of the economy or directly from the SOEs’ profits). Prices can change quite dramatically depending on the ups and downs of commodity markets. For example, Chile has around 30% of world copper reserves, despite the fact that its economy is slightly less than 2% of world GDP. Naturally, copper exports are tremendously important in that economy. On average, if you look at a long period, around 20% of fiscal revenues in Chile come from mining in one way or another. But this can change dramatically in any particular year depending on copper prices. When prices are high, it can be as much as 35%; when prices are low, it can fall to as low as 10%. The country can go from a large fiscal surplus to a sharp fiscal deficit due only to the changes in copper prices. This is a reality that most LMI countries face. Moreover, a feature that many LMI commodity exporters are facing is the increase in volatility of agricultural products due to climate change that are making harvests more volatile and hence also prices and revenues generated by these products.

Commodity markets usually operate in US dollars. So, LMI countries that export commodities produce or extract their resources and sell their product in exchange for international currency. This means that a big chunk of their incomes is in the same currency as their US dollar debt. This is good, up to a point. The problem appears when, for example, commodity prices fall sharply, or the country faces some other shock that limits its capability to raise income in international currencies.

When this happens, international markets usually start dumping (selling) the currency of the country because they feel that the assets of the country have lost value and they don’t want to invest there anymore. So, the local currency loses value (depreciates) and the size of the foreign debt (in US dollars) compared to the size of the local economy or the fiscal budget (in local currency) grows fast. In fact, it can grow so much that it ends up occupying a big part of the budget and elbowing out social policies, infrastructure, or education spending. Instead of export revenue being used to finance imports from abroad, it is instead used to pay the interest payments on the debt. The country is poorer as a result. Living standards will have to go down and there will be conflict as different groups in society try to offload the burden onto others. The country is trapped in a situation where it cannot afford to do anything extra because most of its income is deployed in servicing a debt which has grown relative to its economy.

Comparing countries that can issue debt in their own currency with those that cannot

To learn more about how investors compare assets in different countries, read Section 7.8 of The Economy 2.0: Macroeconomics.

inflation targeting

Monetary policy regime where the central bank changes interest rates to influence aggregate demand in order to keep the economy close to an inflation target, which is normally specified by the government.

monetary policy

Central bank (or government) actions aimed at influencing economic activity through changing interest rates or the prices of financial assets.

Countries such as the United Kingdom that can issue debt in their own currencies have a way out of these sorts of situations: they can devalue their currency. They could do this by giving up their inflation target and loosening monetary policy. But the result would be higher inflation as well as a depreciated exchange rate. The burden of debt would be lower, but inflation would be higher, and it would become more difficult and costly for the British government to borrow in pounds sterling because investors would require compensation for the exchange rate risk. Even so, being able to borrow in the home country’s currency means the country cannot go bankrupt.

A low- or middle-income country that is forced to issue debt in dollars can become bankrupt and, in fact, many have. Unlike a country that can issue debt in its own currency, this is a situation in which a country is not that different from a household or a firm. When someone declares bankruptcy, they usually lose control over their own finances. They must accept conditions that the lenders impose in exchange for refinancing the debt. They must sell things, stop some types of spending, and be subject to other painful measures. When it is a country that is ‘going broke’, it can be a political disaster for the government and create a huge social and political crisis.

The problem of government debt and borrowing by low- and middle-income countries is not essentially different from the debt problems faced by any household, but it does have its complexities. This is a problem that has become more complicated in recent years, particularly after the COVID-19 pandemic.