The US and China, who are competing for influence over the developing world, are partnering to resolve a growing debt risk in emerging markets. Ironically, US politicians have accused China of laying debt traps in developing countries, where countries default on Chinese debt and are allegedly forced to yield assets to China.
In a speech to the Hudson Institute on October 4, 2018, then US vice president Mike Pence said, “In fact, China uses so-called “debt diplomacy” to expand its influence. Today [it] is offering hundreds of billions of dollars in infrastructure loans to governments from Asia to Africa to Europe and even Latin America. Yet the terms of those loans are opaque at best, and the benefits invariably flow overwhelmingly to Beijing. Just ask Sri Lanka, which took on massive debt to let Chinese state companies build a port of questionable commercial value. Two years ago, that country could no longer afford its payments, so Beijing pressured Sri Lanka to deliver the new port directly into Chinese hands.”
However, many disagree with such accusations.
“The “debt trap” accusation has always been a one-sided fallacy and part of the exaggerated “China Threat” narrative. According to UK-based Debt Justice, an independent NGO, the vast majority of developing countries’ debt is owned by Western commercial lenders,” Andrew Leung, a Hong Kong-based China strategist, told FinanceAsia.
And with higher for longer US interest rates, now the US is turning to China for help to avert a potential international debt crisis.
Last month on February 23, Bloomberg reported that the US and China are discussing new measures to prevent a wave of emerging market sovereign defaults. The talks were aimed at easing the $400 billion-plus annual debt service burden for poor countries and finding an alternative to the high borrowing rates those nations now face in the market.
At a Chinese foreign ministry press conference in Beijing on February 23, the ministry’s spokeswoman Mao Ning confirmed, “China and the US are in communication on debt issues via bilateral and multilateral channels.”
“China attaches great importance to developing countries’ sovereign debt issues …China stands ready to work with all parties to further contribute our effort in easing developing countries’ debt burden,” Mao said.
“If true, this will be a substantial breakthrough by way of mutual-trust building, auguring well for a G2 modus vivendi,” said Leung.
“Various emerging market economies are under severe strains due to US dollar exchange rate increases, massive interest rate hikes, repercussions of the Ukraine war, Red Sea Houthi disruptions, and segregation of the global supply and value chains by US-led “de-risking”. If not handled well, this may well trigger a global financial crisis,” Leung added.
“Debt relief for emerging market nations is a collective action problem that requires the cooperation of all major lenders. It is a very positive development that the US has agreed with work with China in addressing this problem. It is also in their self-interest since any defaults by highly indebted countries could result in financial contagion that will affect their economies,” Canadian senator Yuen Pau Woo told FA.
“While the size of these economies may not account for a large share of global output, the risk of contagion is real. Financial instability could spill over into countries that are not as indebted, but which are vulnerable to interest rate and currency volatility, as well as fickle investor sentiment,” Woo warned.
“My sense is that the US is very worried about a string of sovereign defaults in emerging and developing countries,” Alicia Garcia-Herrero, chief Asia Pacific economist at Natixis, told FA.
The collapse of some countries in terms of default on its sovereign debt could have systemic effects because of dollar rates which is key for their external debt, Garcia-Herrero explained. The contagion to Southeast Asia (SEA) is limited but the situation in South Asia is much harder, from Sri Lanka to Pakistan, she added.
“A silent debt crisis is engulfing developing economies with weak credit ratings,” said a World Bank blog on February 8.
“Yet 28 developing economies – those with the weakest credit ratings – remain stuck in a debt trap with no hope of escape anytime soon. Their average debt-to-GDP ratio was nearly 75% at the end of 2023 — 20 points greater than the typical developing economy. They account for a quarter of all developing economies with credit ratings and 16% of the global population. But their collective economic activity constitutes a mere 5% of global output, which makes it easy for the rest of the world to ignore their predicament. Their debt crisis, as a result, is silent—and it could intensify,” said the blog by Philip Kenworthy, a World Bank Group economist, M. Ayhan Kose, deputy chief economist of the World Bank Group and Nikita Perevalov, a senior World Bank economist.
These 28 developing economist with the weakest credit ratings include Sri Lanka, Laos, Pakistan and Maldives.
US and China cause emerging market debt problems
Over the past two years, real US interest rates increased at the fastest pace in four decades, said the World Bank blog. The cost of borrowing of the economies with weak credit ratings has increased sharply over the past two years, and they now face interest rates roughly 20 points above the global benchmark rate and more than nine times that for other developing economies, the World Bank blog explained.
“These economies, in short, have now been locked out of global capital markets for more than two years. They have issued almost no international bonds during that time, a barren spell of the kind not seen since the global financial crisis. Not surprisingly, 11 of them have defaulted since 2020, approaching the total of the previous two decades,” the World Bank blog said.
The slowdown in China’s property sector and downside risks to its GDP growth add to risks facing emerging market (EM) economies given the impact on global trade, commodity prices and financial market conditions, said a Fitch Ratings report on October 17, 2023. Moreover, a sudden stop in Chinese bank lending has reduced a critical source of financing for many EMs, while China’s different views from other creditors on debt restructuring is delaying reaching agreements, the report added.
Fitch estimates that the EM median general government interest/revenue ratio will increase to 10.3% in 2024 from 8.3% in 2022. Higher-for-longer US bond yields pose a risk of a greater and more persistent increase in funding costs, said the Fitch report. “Higher interest payments are adding to pressures on budget balances.”
“Nevertheless, EM economies are benefitting from the strongest growth differential above developed markets for many years, and ratings have somewhat greater headroom following a heavy weight of downgrades over 2020-2022. However, ratings of many lower-rated frontier markets remain under downward pressure,” the Fitch report added.
The prospects a developing country debt crisis have increased, said a US Federal Reserve blog on September 5, 2023. In the past few years, 11 countries have already defaulted, while another 48 or 54 are in or at high risk of debt distress, said the blog by Mark Wright, a Federal Reserve economist and Amy Smaldone, a Federal Reserve research associate.
“But viewed from the self-centered perspective of the US economy, the consequences of such a debt crisis for the US are likely to be far smaller,” said the Federal Reserve blog.
China, the US, other nations and their multilateral agencies need to coordinate their lending activities to developing countries because existing lending requirements to organisations like the IMF and World Bank can be violated if it takes on debt from other parties, a former World Bank officer told FA. “Without cooperative loan coordination, a country’s indebtedness will only worsen. Competing lenders only degrade lending standards and increase credit risk.”
However, not everyone is bullish on the US-China cooperation on emerging market debt.
“This just bails out private lenders while ensuring the crisis continues for years to come,” tweeted Tim Jones, head of policy at Debt Justice on February 23.
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