Developing Countries Pay More Than Necessary for Borrowing
Isaac Diwan: Director of Research at the Finance for Development Lab.
Vera Songwe: Senior Fellow at the Brookings Institution, founding Chair of the Liquidity and Sustainability Facility, and Co-Chair of the Expert Review on Debt, Nature, and Climate.
Beirut/Yaunde – Why do low-income and lower-middle-income countries bear excessively high external borrowing costs? This issue has prominently emerged in global discussions this year. The Seville Commitment (a summary of the Fourth International Conference on Financing for Development in June) and the Jubilee Report (commissioned by the late Pope Francis) outline shared principles to address this issue. The pressing question now is whether South Africa’s Presidency of the G20 will effectively translate these principles into actionable agreements.
This issue is urgent as official development assistance is expected to decline sharply in 2025-2026. This is not just due to the U.S. decision to close the U.S. Agency for International Development, the world’s largest bilateral donor, but also due to numerous European countries reducing their aid budgets. Furthermore, these actions follow a significant tightening in traditional capital markets. Since 2022, developing countries have lost access to commercial financing, making debt refinancing extremely costly—or simply impossible.
Both the Seville Commitment and the Jubilee Report recommend expanding development banks, increasing access to private capital flows, imposing fairer rules for foreign investment regulation, enhancing the global financial safety net, and implementing global taxes to fund global public goods. They also advocate for a clearer approach (echoing the bridge proposal we had put forth) in the commonly encountered “gray area” cases where external debt is not high enough to render the country insolvent but significant enough to pressure developmental spending.
This effectively translates to implementing the “three-pillar approach” proposed by the World Bank and the International Monetary Fund, which recommends: local efforts to raise more revenue; increasing official financing for countries making determined structural adjustment efforts to attempt to grow sufficiently to exit debt distress; and critically, reducing debt service owed to commercial creditors during the adjustment period.
Not long ago, this first recommendation seemed unrealistic. However, experts increasingly recognize the need for developing countries to raise taxes, cut spending, or a mix of both. Many acknowledge the promise of the Ivory Coast model, where successful reforms lessen market disparities and help bring debt service burdens down to manageable levels. However, such reforms must be carefully planned, as raising taxes or cutting expenditures too quickly can lead to destabilizing protests, as recently seen in Kenya. When that happens, market risks ultimately increase.
The second pillar pertains to financing, which is crucial for any growth recovery. Unfortunately, the boom in countercyclical lending by the IMF, World Bank, and regional development banks during the pandemic has subsided. By 2023, net disbursements from these institutions and the Paris Club of sovereign creditors to low-income and lower-middle-income countries fell to around $30 billion—less than half of the $70 billion recorded in 2020—and net disbursements from the IMF turned negative. As financing dwindles, enhancing the financial capacity of these institutions, either through special drawing rights (reserve assets issued by the IMF) or new capital, has become an urgent priority.
The third pillar—reducing debt service owed to commercial creditors—is essential for establishing the other two pillars. Net disbursements to low-income and lower-middle-income countries are expected to remain negative in 2025 for the fifth consecutive year due to massive private capital withdrawals. If resources from international financial institutions continue to be directed toward repayments to commercial creditors instead of local investments, the risk of sovereign debt defaults will escalate.
The core issue lies in borrowing costs, which are so high that debtor countries struggle to refinance their commercial debts. While the IMF assumes, possibly optimistic, that markets can self-regulate, spreads for low-income and lower-middle-income countries remain high (the average has increased from 200 basis points in 2018 to 700 basis points in 2025), even as pricing normalizes for higher-income countries.
As noted in the Seville Commitment, without concerted efforts to prevent capital outflows, developing countries cannot alleviate their debt burdens. In fact, international financial institutions have become part of the problem. Our recent research concluded that a huge share of debt held by international financial institutions ultimately raises the cost of private sector financing. Given that loans from international financial institutions enjoy de facto preferred status, they diminish recovery value for other creditors in the event of default, prompting those investors to impose higher charges on new loans. Thus, lending from international financial institutions comes with an underappreciated opportunity cost. When they fail to assist countries in overcoming debt crises, they inadvertently worsen the situation by escalating overall borrowing costs.
The share of external debt owed by low-income and lower-middle-income countries to international financial institutions has risen from an average of 35% in 2018 to 45% in 2023. Worse yet, in about 20 countries, this share has exceeded 75%, and in 56 countries, it has surpassed 50%. Because inadequate support from international financial institutions is used to fund creditor bailouts rather than bolster economic recovery, it creates a deadly debt spiral that threatens not only the debtor countries but also the balance sheets of the international financial institutions themselves.
Addressing capital flight to private lenders requires collaborative efforts to improve transparency and cooperation among all creditors. Supporting the voluntary return of distressed developing countries to the market is necessary in some cases. However, in many other cases, it also requires renegotiating through discussions. It is understood that this is extremely challenging due to the stigma associated with debt restructuring. That is why we need clear guidelines rather than discretionary measures. The IMF already has tools in place to enforce restructuring when necessary, such as lending even in the event of arrears. While these tools are generally reserved for countries facing debt distress, they could also be applied to gray area cases.
Indeed, any rule to ensure proper burden sharing and discipline may resemble a proposal by legal scholar Sean Hagan to limit exceptional lending from the IMF by imposing a strict cap on all non-flexible (older) debts owed by countries in gray area circumstances. For instance, when non-flexible debts reach 60-65%, a Fund program may automatically trigger a renegotiation of commercial debts, thereby ensuring that sufficient funds remain within the debtor country to support growth recovery.
As South Africa’s G20 presidency will be followed by France hosting the G7, this presents a unique opportunity to form a coalition of willing partners comprising most G7 member states and China. However, if South Africa fails to mediate cooperation between the North and South, the current debt crisis may become lost for an entire generation. This may be our last opportunity to avert a debt disaster that could halt progress in development efforts and mitigate the impacts of climate change, while also jeopardizing the Bretton Woods system itself.
