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High levels of government debt in the Emerging Market and Developing Economies (EMDEs), as well as the increases in global interest rates over the past two years, currently heighten risks of debt default in EMDEs. However, past debt defaults were often unsuccessful in addressing debt-related risks: more than one-third of past sovereign debt defaults failed to lower government debt or borrowing costs in a lasting manner. Those that succeeded were accompanied by above-median debt restructuring and growth accelerations. Many EMDEs have turned to domestic debt, which lowers default risks. However, predominantly domestic government debt comes at the price of higher borrowing cost and lower bank credit to the private sector. The current challenging external environment requires policies to accelerate sustainable growth and shore up fiscal positions.
1. Most defaults have occurred under circumstances that resembled the current juncture.
The latest South Asia Development Update shows that past sovereign debt defaults were bunched around the end of U.S. Federal Reserve monetary policy tightening cycles and were most common when government debt was above the EMDE median and no fiscal rule was in place.
2. More than one-third of sovereign debt defaults have failed to lower debt or borrowing cost in a lasting manner.
Fewer than two-thirds of sovereign debt defaults were successful in reducing the government debt-to-GDP ratio or the effective interest rate on government debt five years later.
3. Steeper debt and borrowing cost reductions after default have been associated with more favorable global economic and financial conditions.
Government borrowing cost declined more steeply after defaults if global growth was stronger and global borrowing costs fell more. Government debt ratios declined most steeply when domestic output growth was stronger. More favorable global investor risk sentiment was associated with steeper declines in both borrowing costs and debt after default.
Predicted change in effective interest rate on government debt accompanying a change in correlates.
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Source: World Bank.
Note: Predicted change in effective interest rate on government debt is defined as 1 percentage point increase in the variable indicated on the horizontal axis (0.5 of a standard deviation decline in the case of global risk sentiment) during the sample period times the coefficient estimate from a panel regression estimation, controlling for selection bias. Yellow whiskers indicate 95 percent confidence intervals.
4. Domestic debt mitigates default risk but at a cost.
In the average EMDE, domestic debt accounted for just over half of government debt in 2021 and just under two-thirds of the debt accumulation between 2010 and 2021. In the past, government debt buildups that were mainly domestically financed were less often associated with default than those that were mainly externally financed. However, above-median shares of domestic debt in government debt have been associated with higher government borrowing cost, shorter debt maturities, and larger shares of domestic credit directed toward the central government.
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