Breaking the Debt Cycle in the Emerging World

Despite the global debt-to-GDP ratio decreasing in the last few years, it remains much higher than its pre-pandemic ratio. This enduring trend is especially concerning for developing countries, which are seeing public debt services take up a large portion of their spending capacity. 

Worldwide Debt Services

Debt Service as a Percentage of Expenditures

According to the 2024 report by the Norwegian Church Aid, while debt service represents on average 24.38% of revenue spending in high-income countries and 28.31% in upper-middle-income countries, the percentage of government revenue spending that must go into paying back debts in low-income and lower-middle-income countries is of 36.44% and 37.22% respectively. 

The region of the world the most affected by this debt crisis is Africa with 54.58% of debt service as a percentage of revenue spending. By comparison, in the United States, where the burden of debt is a major topic of public debate, debt service will account for 17% of total federal spending in 2024, according to U.S. Treasury Fiscal Data.

Debt Service as a Percentage of GDP

As a percentage of GDP, debt should ideally remain under 60% to ensure it does not take a toll on economic growth in developed economies, a number set in discussions by European governments in the 1990s. In developing countries, the debt-to-GDP ratio should be no higher than 40%, according to the United Nations. 

Comparing these prudential limits to current figures for debt-to-GDP is alarming for both high-income countries and low-income countries. The developing countries with the lowest credit ratings have on average a debt that represents 75% of their GDP at the end of 2023, a high ratio even for developed economies by the standards previously established. On the other hand, OECD countries’ government debt as a percentage of GDP averaged 121% in 2021. Global public debt to GDP has reached 92% by the end of 2023, coming down from the pandemic.

The amount spent by governments on the interest of the national debt is money that is not invested in the development of sectors essential for a country and its population to thrive. Health, welfare and education are often the first to suffer under debt distress. Cuts to these sectors undermine previous development efforts which are at the origin of why so many developing countries are currently in this level of debt, leaving developing countries in a vicious debt cycle. This blog post explores the story behind the rising public and private debt in the developing world, the impacts that this crisis is likely to leave without debt relief efforts, and what can be done about it.

How Did We Get Here?

Today’s debt crisis, which is affecting Africa more than any other region, is the worst to date. The Latin American countries affected by debt crises in the 1980s and 1990s were given some relief by the ongoing Heavily Indebted Poor Countries Initiative (HIPC), a International Monetary Fund (IMF) and World Bank initiative. Today, 31 of the 37 countries that entered the debt relief program are in Africa. 

The HIPC program was criticized for not being great enough in scope with eligibility criteria that are too narrow. Even Latin American countries are paying more now in debt service than they were before debt relief intervention.

A number of the countries suffering the most debt distress today, including Egypt, Ukraine, Sri Lanka, Tunisia and Kenya are not the ones who are receiving debt relief. Debt pressures are greater than ever. 

So, how did we get here?

Countries take on debt in order to fund projects of public interest. Planning for one’s country’s future is a necessary and vital part of state building.

The Tax Gap: Financing Challenges in Low-Income Countries

Another important means to fund these projects is taxation. According to the World Bank, a healthy tax-to-GDP ratio to ensure growth is 15%. The average tax-to-GDP ratio in countries that are members of the Organisation for Economic Co-operation and Development (OECD) is 34% in 2022, with France’s tax-to-GDP ratio being as high as 46.1%. 

Meanwhile, 86% of low-income countries and 43% of lower-middle-income countries have tax-to-GDP ratios below the crucial 15% threshold. 

High-income countries’ tax revenues are greater than low-income countries’ both in absolute terms and relative to their economic strength. Low-income countries, having more often than not experienced historical exploitation, have a large wealth and well-being gap to fill but also fewer means to invest in their development. These low-revenue tax systems have roots in the colonial history of the different countries of Africa. This was the era in which taxes were introduced, setting the conditions that would shape the current fiscal capacity building in Africa.

Since tax revenue is so low, the governments of these countries need to find other ways to fund their pressing development projects. While over 70% of the sovereign debts of high-income countries like Canada, China, the United States and the United Kingdom are owed to domestic creditors such as banks and citizens, African countries owe on average over 50% of their public debts to international creditors who use the US dollar (USD). 

This makes African countries especially vulnerable to exchange rate risk as industrialized countries have the luxury of borrowing in their own currencies. The difference is striking; over 98% of the public debt in industrialized countries is in their local currency whereas in Africa, 70% of total public external debt is in USD.

Private Sector Credits in African Countries

In recent years, African countries have increasingly turned to private sector creditors for loans, but this has come at a high cost. As of 2021, over one-third (40.4%) of Africa’s public external debt was owed to private lenders. 

The trend started following the 2008 financial crisis as private sector lenders sought higher returns in Africa, where interest rates were more attractive compared to the low rates in the Global North. These private sector loans come with much higher interest rates than those from official creditors, driven by financial motivations rather than development goals. 

Many African governments preferred this private credit to reduce their dependence on aid or loans with stringent policy conditions from official creditors. However, borrowing from the private sector is significantly influenced by Western rating agencies known as the Big 3; Fitch, Moody’s, and Standard & Poor’s. The firms have been criticized for overstating the risk of lending to African nations, which results in higher borrowing costs.

The Impacts of a Global Debt Crisis on Emerging Economies

This debt crisis leaves already vulnerable countries with fewer funds to invest in sustainable development projects, countervailing decades of poverty reduction efforts. This crisis is likely to persist into the 2030s with lasting impacts on the developing world if nothing is done.

Already, we are seeing high food prices, a shortage of goods, financial market dysfunction and a political crisis in North Africa, with the debt crisis exacerbated by geopolitical conflicts and the 2020 pandemic. According to the UN Development Program (UNDP), the population of heavily indebted countries face a greater risk of infant mortality, disease, illiteracy and malnutrition compared to other developing countries. When governments are left with no choice but to cut on health and education spending in order to repay debts, the most vulnerable are hit first. The weakening of health and education affects long-term economic growth.

Growing debt also prevents resources from being allocated to the fight against climate change. For the countries already facing the effects of climate change in the form of droughts and floods, which are themselves a great pressure on economic growth, preparing for them is crucial. 

These challenges are accompanied by the fact that indebted countries risk either being cut off from international markets or having to pay more in interest rates due to bad credit ratings, further indebting them.

Solutions From Now to Tomorrow

It is possible to act now in order to curb the debt crisis and break the debt spiral. On one hand, the Norwegian Church Aid and the UN Trade and Development call for a robust debt restructuring platform and urgent reform of the G20 Common Framework. This includes expanding the current framework to include all types of creditors and increasing transparency and accountability. The Norwegian Church Aid suggests an amendment to the UN Convention Against Corruption that would protect debtors from predatory lending or debt restructuring, an issue which contributes greatly to the debt crisis.

On the other hand, strengthening the fiscal capacity of the countries at risk, and in turn, strengthening their institutions, is a sustainable way to ensure they emerge from this debt crisis with the tools in hand to grow while reducing their debt-to-GDP ratio.

This can be done with the improvement of existing institutions and the digitalization of revenue administrations, according to the IMF. A transparent legal framework for tax collection is essential to build trust between citizens and the government. This trust is crucial for ensuring tax compliance, which ultimately leads to increased tax revenue.

A 2020 study has shown that in low fiscal capacity areas of Uganda, text-message reminders to make tax payments combined with demonstrated investment in public goods and services have successfully reached people and encouraged payments. Successfully investing in areas like health and education could bring more potential taxpayers to comply, generating more revenue to invest in further development projects.

Strengthening domestic investors such as local banks or individuals is another way to ensure long-term economic growth that isn’t hurt by foreign exchange rate risks. Financial literacy is primordial in that respect. Promoting financial inclusion must be accompanied by financial education, with an emphasis on topics where there is a knowledge gap in Africa like interest rates, loan risks and requirements, budgeting and saving. Financial literacy, when it leads to financial empowerment, in the long-term, has a positive effect on a country’s economic growth.

Schools, banks and mobile money service providers have a role to play in the accessibility and affordability of financial knowledge with the cooperation of their respective governments, especially as the financial technology sector grows in Africa and other developing economies.

How Can EZO Increase Government Revenues?

Along with important policy reforms and investments in different institutions, the IMF recommends the use of digital infrastructure for services and processes to build tax capacity in the long term. With smartphone users in sub-Saharan Africa expected to rise to 67% of its population in the next few years, the digitalization of services will allow a growing amount of users to easily pay their taxes from their phones using the EZO financial solution app.

Government agencies can consult and verify against fraud, as EZO provides a reliable paper trail of transactions from income tax payments for individuals to employee salary contributions for businesses. The accessibility and simplicity of EZO, combined with our in-house financial education resources, enable people who might not have previously had access to these conveniences to learn about how they can grow their finances and well-being, and in turn, help their country’s growth.

EZO Business will empower employers by allowing them to pay their employees directly through the EZO platform. This feature includes an option to automatically collect deductions at sources (DAS), ensuring that tax obligations are met seamlessly and accurately. By simplifying this process, EZO not only reduces the administrative burden on businesses but also ensures that governments receive timely tax contributions, which can significantly boost public revenue.

With the improvement of existing multilateral debt relief initiatives and the reinforcement of domestic institutions and individuals, the developing countries most hit by this debt crisis can come out of it strengthened.