Many developing countries are facing a renewed debt crisis. This is directly related to Covid-19, which is now sweeping across many poor countries in a new wave.
Between 2016 and 2020, debt service as a percentage of GDP rose from an average of 7.1% to 27.1% for South Asian countries, from 8.1% to 14.1% for Sub-Saharan African countries, from 13.1% to 42.3% for North African and Middle Eastern countries, and from 5.6% to 14.7% for East Asian and Pacific countries. These percentages are expected to climb again in 2021 by around 10% of GDP.
Incomes have fallen in developing countries with illness, lockdowns and business failures. This has been compounded by a fall in their exports as the world economy has contracted and by a 19% fall in aid in 2020. The fall in incomes has led to a decline in tax revenues and demands for increased government expenditure on healthcare and social support. Public-sector deficits have thus risen steeply.
And the problem is likely to get worse before it gets better. Vaccination roll-outs in most developing countries are slow, with only a tiny fraction of the population having received just one jab. With the economic damage already caused, growth is likely to be subdued for some time.
This has put developing countries in a ‘trilemma’, as the IMF calls it. Governments must balance the objectives of:
- meeting increased spending needs from the emergency and its aftermath;
- limiting the substantial increase in public debt;
- trying to contain rises in taxes.
Developing countries are faced with a difficult trade-off between these objectives, as addressing one objective is likely to come at the expense of the other two. For example, higher spending would require higher deficits and debt or higher taxes.
The poorest countries have little scope for increased domestic borrowing and have been forced to borrow on international markets. But such debt is costly. Although international interest rates are generally low, many developing countries have had to take on increasing levels of borrowing from private lenders at much higher rates of interest, substantially adding to the servicing costs of their debt.
International agencies and groups, such as the IMF, the World Bank, the United Nations and the G20, have all advocated increased help to tackle this debt crisis. The IMF has allocated $100bn in lending through the Rapid Financing Instrument (RFI) and the Rapid Credit Facility (RCF) and nearly $500m in debt service relief grants through the Catastrophe Containment and Relief Trust (CCRT). The World Bank is increasing operations to $160bn.
The IMF is also considering an increase in special drawing rights (SDRs) from the current level of 204.2bn ($293.3bn) to 452.6bn ($650bn) – a rise of 121.6%. This would be the first such expansion since 2009. It has received the support of both the G7 and the G20. SDRs are reserves created by the IMF whose value is a weighted average of five currencies – the US dollar (41.73%), the euro (30.93%), the Chinese yuan (10.92%), the Japanese yen (8.33%) and the pound sterling (8.09%).
Normally an increase in SDRs would be allocated to countries according their IMF quotas, which largely depend on the size of their GDP and their openness. Any new allocation under this formula would therefore go mainly to developed countries, with developing economies getting only around $60bn of the extra $357bn. It has thus been proposed that developed countries give much of their allocation to developing countries. These could then be used to cancel debts. This proposal has been backed by Janet Yellen, the US Secretary of the Treasury, who said she would “strongly encourage G20 members to channel excess SDRs in support of recovery efforts in low-income countries, alongside continued bilateral financing”.
The G20 countries, with the support of the IMF and World Bank, have committed to suspend debt service payments by eligible countries which request to participate in its Debt Service Suspension Initiative (DSSI). There are 73 eligible countries. The scheme, now extended to 31 December 2021, provides a suspension of debt-service payments owed to official bilateral creditors. In return, borrowers commit to use freed-up resources to increase social, health or economic spending in response to the crisis. As of April 2021, 45 countries had requested to participate, with savings totalling more than $10bn. The G20 has also called on private creditors to join the DSSI, but so far without success.
Despite these initiatives, the scale of debt relief (as opposed to extra or deferred lending) remains small in comparison to earlier initiatives. Under the Heavily Indebted Poor Countries initiative (HIPC, launched 1996) and the Multilateral Debt Relief Initiative (MDRI, launched 2005) more than $100bn of debt was cancelled.
Since the start of the pandemic, major developed countries have spent between $10 000 and $20 000 per head in stimulus and social support programmes. Sub-Saharan African countries on average are seeking only $365 per head in support.
Articles and blogs
- Imagine you are an economic advisor to a developing country attempting to rebuild the economy after the coronavirus pandemic. How would you advise it to proceed, given the ‘trilemma’ described above?
- How does the News24 article define ‘smart debt relief’. Do you agree with the definition and the means of achieving smart debt relief?
- To what extent is it in the interests of the developed world to provide additional debt relief to poor countries whose economies have been badly affected by the coronavirus pandemic?
- Research ‘debt-for-nature swaps’. To what extent can debt relief for countries affected by the coronavirus pandemic be linked to tackling climate change?
At its meeting on 6 May, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate at 0.1%. Due to the significant impact of COVID-19 and the measures put in place to try to contain the virus, the MPC voted unanimously to keep Bank Rate the same.
However, it decided not to launch a new stimulus programme, with the committee voting by a majority of 7-2 for the Bank to continue with the current programme of quantitative easing. This involves the purchase of £200 billion of government and sterling non-financial investment-grade corporate bonds, bringing the total stock of bonds held by the Bank to £645 billion.
The Bank forecast that the crisis will put the economy into its deepest recession in 300 years, with output plunging 30 per cent in the first half of the year.
Monetary policy and MPC
Monetary policy is the tool used by the UK’s central bank to influence how much money is in the economy and how much it costs to borrow. The Bank of England’s main monetary policy tools include setting the Bank Rate and quantitative easing (QE). Bank Rate is the interest rate charged to banks when they borrow money from the BoE. QE is the process of creating money digitally to buy corporate and government bonds.
The BoE’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target. Maintaining a low and stable inflation rate is good for the economy and it is the main monetary policy aim. However, the Bank also has to balance this target with the government’s other economic aims of sustaining growth and employment in the economy.
Actions taken by the MPC
It is challenging to respond to severe economic and financial disruption, with the UK economy looking unusually uncertain. Activity has fallen sharply since the beginning of the year and unemployment has risen markedly. The current rate of inflation, measured by the Consumer Price Index (CPI), declined to 1.5% in March and is likely to fall below 1% in the next few months. Household consumption has fallen by around 30% as consumer confidence has declined. Companies’ sales are expected to be around 45% lower than normal and business investment 50% lower.
In the current circumstances, and consistent with the MPC’s remit, monetary policy is aimed at supporting businesses and households through the crisis and limiting any lasting damage to the economy. The Bank has used both main monetary tools to fulfil its mandate and attempt to boost the economy amid the current lockdown. The Bank Rate was reduced to 0.1% in March, the lowest level in the Bank’s 325-year history and the current programme of QE was introduced in March.
What is next?
This extraordinary time has seen the outlook for the all global economies become uncertain. The long-term outcome will depend critically on the evolution of the pandemic, and how governments, households and businesses respond to it. The Bank of England has stated that businesses and households will need to borrow to get through this period and is encouraging banks and building societies to increase their lending. Britain’s banks are warned that if they try to stem losses by restricting lending, they will make the situation worse. The Bank believes that the banks are strong enough to keep lending, which will support the economy and limit losses to themselves.
In the short term, a bleak picture of the UK economy is suggested, with a halving in business investment, a near halving in business sales, a sharp rise in unemployment and households cutting their spending by a third. Despite its forecast that GDP could shrink by 14% for 2020, the Bank of England is forecasting a ‘V’ shaped recovery. In this scenario, the recovery in economic activity, once measures are softened, is predicted to be relatively rapid and inflation rises to around the 2 per cent target. However, this would be after a dip to 0.5% in 2021, before returning to the 2 per cent target the following year.
However, there are some suggestions that the Bank’s forecast for the long-term recovery is too optimistic. Yael Selfin, chief economist at KPMG UK, fears the UK economy could shrink even more sharply than the Bank of England has forecast.
Despite the stark numbers issued by the Bank of England today, additional pressure on the economy is likely. Some social distancing measures are likely to remain in place until we have a vaccine or an effective treatment for the virus, with people also remaining reluctant to socialise and spend. That means recovery is unlikely to start in earnest before sometime next year.
There are also additional factors that could dampen future productivity, such as the impact on supply chains, with ‘just-in-time’ operations potentially being a thing of the past.
There is also the ongoing issue of Brexit. This is a significant downside risk as the probability of a smooth transition to a comprehensive free-trade agreement with the EU in January is relatively small. This will only increase uncertainty for businesses along with the prospect of increased trade frictions next year.
The predictions from the Bank of England are based on many assumptions, one of which is that the economy will only be gradually released from lockdown. Its numbers contain the expectations that consumer and worker behaviour will change significantly, and continue for some time, with forms of voluntary social distancing. On the other hand, Mr Bailey expects the recovery to be much faster than seen with the financial crisis a decade ago. However, again this is based on the assumption that measures put in place from the public health side prevent a second wave of the virus.
It also assumes that the supply-side effects on the economy will be limited in the long run. Many economists disagree, arguing that the ‘scarring effects’ of the lockdown may be substantial. These include lower rates of investment, innovation and start ups and the deskilling effects on labour. They also include the businesses that have gone bankrupt and the dampening effect on consumer and business confidence. Finally, with a large increase in lending to tide firms over the crisis, many will face problems of debt, which will dampen investment.
The Bank of England does recognise these possible scarring effects. Specifically, it warns of the danger of a rise in equilibrium unemployment:
It is possible that the rise in unemployment could prove more persistent than embodied in the scenario, for example if companies are reluctant to hire until they are sure about the robustness of the recovery in demand. It is also possible that any rise in unemployment could lead to an increase in the long‑term equilibrium rate of unemployment. That might happen if the skills of the unemployed do not increase to the same extent as they would if they were working, for example, or even erode over time.
What is certain, however, is that the long-term picture will only become clearer when we start to come out of the crisis. Bailey implied that the Bank is taking a wait-and-see approach for now, waiting on the UK government to shed some light about easing of lockdown measures before taking any further action with regards to QE. The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target. Paul Dales, chief UK economist at Capital Economics, suggested that the central bank is signalling that ‘more QE is coming, if not in June, then in August’.
Bank of England publication
- How could the BoE use monetary policy to boost the economy?
- Explain how changes in interest rates affect aggregate demand.
- Define and explain quantitative easing (QE).
- How might QE help to stimulate economic growth?
- How is the pursuit of QE likely to affect the price of government bonds? Explain.
- Evaluate the extent to which monetary policy is able to stimulate the economy and achieve price stability.
One of the announcements in the recent UK Budget was the ending of the Private Finance Initiative (PFI), including its revised form, PF2. PFI was introduced by the Conservative government in 1992. Subsequently, it was to become central to the Labour government’s ‘Third-way’ approach of using the private sector to deliver public projects and services.
PFI involves a public–private partnership (PPP). The private sector builds and/or runs public projects, such as new schools, hospitals, roads, bridges, student accommodation, and so on. The public sector, in the form of government departments, NHS foundation trusts, local authorities, etc., then pays the private sector company a rent for the infrastructure or pays the company to provide services. The benefit of PFI is that it allows private-sector capital to be used for new projects and thus reduces the need for government to borrow; the disadvantage is that it commits the public-sector body to payments over the long-term to the company involved.
As the chart shows, PFI became an important means of funding public service provision during the 2000s. In the 10-year period up to financial year 2007/08, more than 50 new projects were being signed each year.
As the number of projects grew and with them the long-term financial commitments of the public sector, so criticisms mounted. These included:
- Quality and cost. It was claimed that PFI projects were resulting in poorer quality of provision and that cost control was often poor, resulting in a higher burden for the taxpayer in the long term.
- Credit availability. PFI projects are typically dependent on the private partner using debt finance to acquire the necessary funds. Therefore, credit conditions affect the ability of PFI to fund the delivery of public services. With the credit crunch of 2008/9, many firms operating PFI projects found it difficult to raise finance.
- The financial health of the private partner. What happens if the private company runs into financial difficulties. In 2005, the engineering company Jarvis only just managed to avoid bankruptcy by securing refinancing on all 14 of its PFI deals.
Recognising these problems, in 2011 the government set up a review of PFI. The result was a revised form of PFI, known as ‘PF2’. PF2 projects involved tighter financial control, with the government acting as a minority co-investor; more robust tendering processes, with bidders required to develop a long-term financing solution, where bank debt does not form the majority of the financing of the project; the removal of cleaning, catering and other ‘soft services’.
Despite the government’s intention that PPPs remain an important plank of its funding of public services, the number of new PFI/PF2 projects has nonetheless declined sharply during the 2010s as the chart shows. Of the 715 PPP projects as of 31 March 2017, 631 had been signed before May 2010. Indeed, in 2016/17 only 1 new project was signed.
The collapse of Carillion
Concerns over PPPs remained despite the reforms under PF2. These were brought dramatically into focus with the collapse of Carillion plc (see the blog, Outsourcing, PFI and the demise of Carillion). Carillion was a British company focused on construction and facilities management (i.e. support services for organisations). It was a significant private-sector partner in PPP projects. By 2014 it had won 60 PPP projects in the UK and Canada, including hospitals, schools, university buildings, prisons, roads and railways.
However, Carillion had increasing burdens of debt, caused, in part, by various major acquisitions, including McAlpine in 2008. Events came to a head when, on 15 January 2018, an application was made to the High Court for a compulsory liquidation of the company.
A subsequent report for the House of Commons Public Administration and Constitutional Affairs Committee in light of the collapse of Carillion found that procurement procedures were fundamentally flawed. It found that contracts were awarded based on cost rather than quality. This meant that some contracts were not sustainable. Between 2016 and the collapse of Carillion the government had been forced to renegotiate more than £120m of contracts so that public services could continue.
The ending of PPPs?
On 18 January 2018, the National Audit Office published an assessment of PFI and PF2. The report stated that there were 716 PFI and PF2 projects at the time, either under construction or in operation, with a total capital value of £59.4 billion. In recent years, however, ‘the government’s use of the PFI and PF2 models had slowed significantly, reducing from, on average, 55 deals each year in the five years to 2007/8 to only one in 2016/17.’
At its conference in September 2018, the Labour shadow chancellor, John McDonnell, said that, if elected, a Labour government would not award any new PFI/PF2 contracts. He claimed that PFI/PF2 contracts were set to cost the taxpayer £200bn over the coming decade. Labour policy would be to review all existing PFI/PF2 contracts and bring the bulk of them fully back into the public sector.
Then in the Budget of 29 October 2018, the Chancellor announced that no further PFI/PF2 projects would be awarded, although existing ones would continue.
I have never signed off a PFI contract as chancellor, and I can confirm today that I never will. I can announce that the government will abolish the use of PFI and PF2 for future projects.
We will honour existing contracts. But the days of the public sector being a pushover, must end. We will establish a centre of excellence to actively manage these contracts in the taxpayers’ interest, starting in the health sector.
But does this mean that there will be no more public-private partnerships, of which PFI is just one example? The answer is no. As the Chancellor stated:
And in financing public infrastructure, I remain committed to the use of public-private partnership where it delivers value for the taxpayer and genuinely transfers risk to the private sector.
But just what form future PPPs will take is unclear. Clearly, the government will want to get value for money, but that depends on the mechanisms used to ensure efficient and high-quality projects. What is more, there is still the danger that the companies involved could end up with unsustainable levels of debt if economic circumstances change and it will still involve a burden on the taxpayer for the future.
- Find out how PF2 differs from PFI and assess the extent to which it overcame the problems identified with PFI.
- The government is not bringing back existing PFI contracts into the public sector, whereas the Labour Party would do so – at least with some of them. Assess the arguments for and against bringing PFI contracts ‘in-house’.
- Find out why Carillion collapsed. To what extent was this due to its taking on PFI contracts?
- What were the main findings of the National Audit Office’s assessment of PFI and PF2?
- The government still supports the use of public-private partnerships (PPPs). What form could these take other than as PFI/PF2 contracts? Would the problems associated with PFI/PF2 also apply to PPPs in general?
We’ve considered Keynesian economics and policy in several blogs. For example, a year ago in the post, What would Keynes say?, we looked at two articles arguing for Keynesian expansionary polices. More recently, in the blogs, End of the era of liquidity traps? and A risky dose of Keynesianism at the heart of Trumponomics, we looked at whether Donald Trump’s proposed policies are more Keynesian than his predecessor’s and at the opportunities and risks of such policies.
The article below, Larry Elliott updates the story by asking what Keynes would recommend today if he were alive. It also links to two other articles which add to the story.
Elliott asks his imaginary Keynes, for his analysis of the financial crisis of 2008 and of what has happened since. Keynes, he argues, would explain the crisis in terms of excessive borrowing, both private and public, and asset price bubbles. The bubbles then burst and people cut back on spending to claw down their debts.
Keynes, says Elliott, would approve of the initial response to the crisis: expansionary monetary policy (both lower interest rates and then quantitative easing) backed up by expansionary fiscal policy in 2009. But expansionary fiscal policies were short lived. Instead, austerity fiscal policies were adopted in an attempt to reduce public-sector deficits and, ultimately, public-sector debt. This slowed down the recovery and meant that much of the monetary expansion went into inflating the prices of assets, such as housing and shares, rather than in financing higher investment.
He also asks his imaginary Keynes what he’d recommend as the way forward today. Keynes outlines three alternatives to the current austerity policies, each involving expansionary fiscal policy:
||Trump’s policies of tax cuts combined with some increase in infrastructure spending. The problems with this are that there would be too little of the public infrastructure spending that the US economy needs and that the stimulus would be poorly focused.
||Government taking advantage of exceptionally low interest rates to borrow to invest in infrastructure. “Governments could do this without alarming the markets, Keynes says, if they followed his teachings and borrowed solely to invest.”
||Use money created through quantitative easing to finance public-sector investment in infrastructure and housing. “Building homes with QE makes sense; inflating house prices with QE does not.” (See the blogs, A flawed model of monetary policy and Global warning).
Increased government spending on infrastructure has been recommended by international organisations, such as the OECD and the IMF (see OECD goes public and The world economic outlook – as seen by the IMF). With the rise in populism and worries about low economic growth throughout much of the developed world, perhaps Keynesian fiscal policy will become more popular with governments.
Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)
- What are the main factors determining a country’s long-term rate of economic growth?
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all countries rather than being the only country to pursue such a policy?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- What determines the size of the multiplier effect of such policies?
- What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
Some commentators have seen the victory of Donald Trump and, prior to that, the Brexit vote as symptoms of a crisis in capitalism. Much of the campaigning in the US election, both by Donald Trump on the right and Bernie Sanders on the left focused on the plight of the poor. Whether the blame was put on immigration, big government, international organisations, the banks, cheap imports undercutting jobs or a lack of social protection, the message was clear: capitalism is failing to improve the lot of the majority. A small elite is getting significantly richer while the majority sees little or no gain in their living standards and a rise in uncertainty.
The articles below look at this crisis. They examine the causes, which they agree go back many years as capitalism has evolved. The financial crash of 2008 and the slow recovery since are symptomatic of the underlying changes in capitalism.
The Friedman article focuses on the slowing growth in technological advance and the problem of aging populations. What technological progress there is is not raising incomes generally, but is benefiting a few entrepreneurs and financiers. General rises in income may eventually come, but it may take decades before robotics, biotechnological advances, e-commerce and other breakthrough technologies filter through to higher incomes for everyone. In the meantime, increased competition through globalisation is depressing the incomes of the poor and economically immobile.
All the articles look at the rise of the rich. The difference with the past is that the people who are gaining the most are not doing so from production but from financial dealing or rental income; they have gained while the real economy has stagnated.
The gains to the rich have come from the rise in the value of assets, such as equities (shares) and property, and from the growth in rental incomes. Only a small fraction of finance is used to fund business investment; the majority is used for lending against existing assets, which then inflates their prices and makes their owners richer. In other words, the capitalist system is moving from driving growth in production to driving the inflation of asset prices and rental incomes.
The process whereby financial markets grow and in turn drive up asset prices is known as ‘financialisation’. Not only is the process moving away from funding productive investment and towards speculative activity, it is leading to a growth in ‘short-termism’. The rewards of senior managers often depend on the price of their companies’ shares. This leads to a focus on short-term profit and a neglect of long-term growth and profitability – to a neglect of investment in R&D and physical capital.
The process of financialisation has been driven by deregulation, financial innovation, the growth in international financial flows and, more recently, by quantitative easing and low interest rates. It has led to a growth in private debt which, in turn, creates more financial instability. The finance industry has become so profitable that even manufacturing companies are moving into the business of finance themselves – often finding it more profitable than their core business. As the Foroohar article states, “the biggest unexplored reason for long-term slower growth is that the financial system has stopped serving the real economy and now serves mainly itself.”
So will the election of Donald Trump, and pressure from populism in other countries too, mean that governments will focus more on production, job creation and poverty reduction? Will there be a movement towards fiscal policy to drive infrastructure spending? Will there be a reining in of loose monetary policy and easy credit?
Or will addressing the problem of financialisation and the crisis of capitalism result in the rich continuing to get richer at the expense of the poor, but this time through more conventional channels, such as increased production and monopoly profits and tax cuts for the rich? Trump supporters from among the poor hope the answer is no. Those who supported Bernie Sanders in the Democratic primaries think the answer will be yes and that the solution to over financialisation requires more, not less, regulation, a rise in minimum wages and fiscal policies aimed specifically at the poor.
Can Global Capitalism Be Saved? Project Syndicate, Alexander Friedman (11/11/16)
American Capitalism’s Great Crisis Time, Rana Foroohar (12/5/16)
The Corruption of Capitalism by Guy Standing review – work matters less than what you own The Guardian, Katrina Forrester (26/10/16)
- Do you agree that capitalism is in crisis? Explain.
- What is meant by financialisation? Why has it grown?
- Will the policies espoused by Donald Trump help to address the problems caused by financialisation?
- What alternative policies are there to those of Trump for addressing the crisis of capitalism?
- Explain Schumpeter’s analysis of creative destruction.
- What technological innovations that are currently taking place could eventually benefit the poor as well as the rich?
- What disincentives are there for companies investing in R&D and new equipment?
- What are the arguments for and against a substantial rise in the minimum wage?