In early 2020, the “dash for cash” in the US Treasury market prompted the Fed to relaunch its dollar swap lines, which it did in mid-March of that year. In the aftermath of the 2008 Global Financial Crisis (GFC), the New York Fed had established permanent arrangements to supply dollars to five key foreign central banks. But as the emerging pandemic rattled global financial markets, dollar swaps were temporarily extended to nine more foreign central banks. Less privileged foreign central banks not extended such swap lines were instead given access to the Fed’s brand-new Foreign and International Monetary Authorities (FIMA) repurchase agreement facility, which allowed them to exchange their US Treasury securities for dollars as an alternative to dumping the securities for cash in the open market. The move was part of a concerted suite of measures undertaken by the Fed to stabilize dollar funding markets. (Compared to peak swap use of $449 billion, FIMA Repo use peaked at a relatively paltry $1 billion.) That spring, the Fed balance sheet mushroomed from $4 to $7 trillion. The Fed’s decisive actions quashed any doubt that the world’s most powerful central bank would hesitate to assume the mantle of monetary hegemony. As of the beginning of 2022, Fed assets stand close to $9 trillion.
The coronavirus crisis highlighted stark disparities in financing capacity across the globe. Monetary and fiscal relief amounted to one-fifth of GDP in advanced economies, only six or seven percent of output in smaller economies, and a mere two percent of GDP in the poorest of nations. The US macroeconomy’s rebound—steeper than that of any other rich economy—is an outcome of its $5-trillion-plus stimulus. In 2021, per capita growth in low-income economies was a tenth of that in advanced economies, foregrounding the starkly divergent paths of economic recovery. Increased government spending in response to the pandemic birthed deficits and debt in advanced economies that were twice the size of those in poorer economies. However, given the strictures placed on poorer nations by the international financial hierarchy, for some financially subordinated economies, public debt accumulation has brought sovereign debt default closer to the horizon.
Original sin, all over again
Crises catapult change but also entrench hierarchies. Countries granted swap lines saw their currencies stabilize faster than those that weren’t. The post-GFC period has been characterized by acute dollar dominance: global economic conditions are correlated to movements in the greenback. In the growth phase of the dollar cycle, associated with USD depreciation, the world economy is awash in liquidity—propelling credit, trade, and GDP growth. On the downside, dollar appreciation comes with credit tightening, and reduced trade and investment. Other key currency appreciations don’t have the same adverse effect on emerging market (EM) economies. EMs with large dollar-denominated debt exposure are at increased risk for banking crises. The dollar has knit the world economy into a tightly wound ecosystem.
In the aftermath of the European sovereign debt crises, non-European banks and non-bank financial institutions (NBFIs) ramped up their dollar liabilities. Credit growth is increasingly driven by bond markets and the dollar’s ambit has expanded. Dollar-denominated bond issuance is particularly large in developing economies. About a fifth of global dollar funding involves emerging markets. Foreign involvement in EM borrowing has grown. While equity investment in EMs doubled in the last decade, investment by bond funds in EMs quadrupled. In a bid to shrug off “original sin”—the inability of sovereign states to borrow in their own currency because of their subordinate monetary status—over the last two decades, developing economies have built up their domestic-currency-denominated debt markets. Ninety percent of the sovereign bond market in EMs is now in local currency (LC) bonds. Negative real yields in the Global North have made such bonds a desirable asset class for investors. Accordingly, foreign residents hold about one-fifth of outstanding local-currency EM sovereign bonds.
However, own-currency bond issuance has not absolved EMs of original sin. On the contrary, they now encounter “original sin redux”: the acute sensitivity of EM bond markets to the global dollar cycle, whereby dollar appreciation amplifies LC bond-market sell-off. The exodus of capital from developing countries in the spring of 2020 was driven by a loss of confidence in local-currency bonds. Foreign-currency-denominated EM bonds proved less flighty.
Advanced economies continue to be significant sources of funding across asset classes in emerging economies. As the major currency for borrowing and investment internationally, the dollar is a dominant vector for transmitting financial volatility to the Global South. The Fed’s monetary easing in 2020—the Broad Dollar Index fell by almost 7 percent that year—helped spur record levels of borrowing globally. In 2020, global debt surged to an unprecedented $226 trillion. More than half of the increase came from public sector borrowing. Sovereign debt issuance stood at $58 trillion, of which $44 trillion was issued by advanced economies and the rest by emerging markets. Pandemic-related healthcare and social expenditures have led debt issuance in low- and middle-income economies to increase by a third compared to pre-pandemic levels.
More recently, the Fed’s monetary tightening, via reductions in its asset purchases, has propelled sharp interest rate hikes in the Global South. In a context in which the issuance of foreign-law-governed, foreign-currency-denominated sovereign debt in EMs is at a record-high, this is particularly concerning. As of December 2021, outstanding international debt securities (IDS) were a $27.6 trillion market, almost half of which was dollar denominated. Known as eurobonds, or foreign bonds, IDS are typically issued outside the domestic market in order to attract foreign investment. Government bonds, including those issued subnationally, comprise about half of outstanding IDS in emerging markets. (By contrast, the public sector’s share of IDS in advanced economies is less than a fifth.) Interest rate hikes by EM central banks attempt to anchor inflation expectations and appease foreign investors. Lauded by investment funds seeking returns, higher bond yields make debt repayments more expensive. As the debt pile mushrooms, EM balance sheets—facing currency and maturity mismatch in an environment in which interest rates are often higher than growth—become increasingly prone to economic shocks. Not dissimilar to other countries on the precipice of sovereign default, Sri Lanka owes about a third of its debt to foreign creditors, has only $3 billion left in foreign reserves, and just repaid a $500 million bond. Meanwhile, its citizens are coping with government-mandated power cuts and double-digit inflation.
Launched in 2020, the IMF’s new integrated policy framework recommended that EMs withstand sharper and deeper currency devaluations to stave off balance of payments crises. A classic instrument in the EM tool kit, currency devaluation is, however, no longer as effective as it used to be. This is because dollar invoicing in global trade is enmeshed with dollar borrowing by firms in global supply chains. For many emerging markets exporters, both costs (of imports and loans) and revenues (export earnings) are in dollars. Fully ensnared in the web of dollar-dependence, they cannot benefit from local-currency devaluation as a competitive strategy. Moreover, relying on price- and exchange-rate changes as shock absorbers is Panglossian economics. Large and unexpected currency devaluations can catalyze into output shocks.
The debt restructuring impasse
The dollar’s role as the international reserve and vehicle currency is well known. Much less appreciated is the complex, multilayered configuration of dollar dominance today, structured as it is by the legal and financial apparatus of dollar-denominated debt, amplified by the global dollar cycle.
The flourishing of poorer nations is limited by their lack of fiscal and monetary autonomy, living as they are under the umbrage of the world dollar order. Efforts to restructure sovereign debt in the Global South have stalled with the Debt Service Suspension Initiative (DSSI), the G20’s pandemic-driven debt moratorium. At the close of the debt suspension period at the end of 2021, 60 percent of low-income countries remain at high risk or are already in debt distress. Ultimately, the success of the initiative has been limited. Fears that DSSI participation would negatively impact credit ratings on sovereign debt has meant that only forty-two of the seventy-three eligible nations have received relief. (Debt held by private creditors was exempted from the program’s remit.) The new G20 common framework for debt restructuring is even more narrow in scope: debt workouts are open only to countries facing sovereign debt default. The only participants thus far (Chad, Ethiopia, and Zambia) haven’t made much progress in restructuring.
Despite the unprecedented shock that this pandemic posed to the world economy—and in contrast to the dramatic actions of the central banks—the response of multilateral lenders such as the IMF has been remarkably tepid. It took until August 2021, more than fifteen months into the crisis, for the IMF to disperse more than a tenth of its monetary firepower. Of the $650 billion in last year’s IMF SDR issuance, only $21 billion has been directly allocated to low-income countries. To put this in some context, the sum that developing economy governments paid back bondholders in 2020 came to $194 billion.
More than half of the outstanding stock of international sovereign bonds is written into New York State law. Slightly less than half is governed by the law of England and Wales. More than 70 percent of EM sovereign debt is dollar denominated. More than 90 percent of sovereign bonds issued by countries that qualify under the DSSI are governed by English law. Debt haircuts issued by sovereign creditors will not be enough to stave EM defaults: bilateral creditors represent only one-third of upcoming payments owed by countries eligible for the DSSI. About a third of foreign-held EM sovereign bonds are owned by private creditors, including asset managers and hedge funds. A more sustainable global political economy would be one in which investor power is balanced by countervailing forces.
Mitigating waves of disorderly debt restructuring requires a global mechanism for sovereign debt restructuring. There is no bankruptcy code for sovereign debt. While, in theory, this might give sovereigns greater elasticity, in practice, it makes for highly asymmetric ad hoc negotiations in which private creditors from the Global North invariably have the upper hand. A slew of creative mechanisms for altering this imbalance have emerged from legal and economic research. Given the widespread macroeconomic instability that confronts the Global South, instead of time-consuming and costly bilateral debt renegotiations that financially strained economies can ill afford in this pandemic, now is the time for debt restructuring to employ the principle of “economic necessity” because of exogenous circumstances. Executive orders from the US Administration could protect sovereign assets housed within the US from usurpation by creditors. The UN Security Council has the capacity—employed in the past to protect oil assets in Iraq from seizure—to enact an immunity shield, legally binding on all member-states, which would exempt assets crucial to national sovereignty from use in debt repayment. In conjunction, debt moratoriums or cancellations could be enacted in UK and US courts, where the majority of sovereign asset seizures by foreign creditors will be fought.
As Katharina Pistor has argued, markets are carved out by legal doctrine, and resuscitating markets in times of crisis sometimes requires law’s suspension. The legal flexibility required to safeguard markets has been a preserve of the powerful. Stabilizing debt markets in emerging and developing economies can only occur by extending what Pistor calls the “elasticity” of law at the apex of the global legal-financial system to its periphery. Given the disproportionate impact of this crisis on poorer countries that lack the monetary and fiscal capacity of richer nations, it is also a moral imperative. In this era of multiple crises, governments should shape finance to forward the public interest. This requires both incentives and disciplining mechanisms. In light of the pandemic, laws that make private property rights inviolable at the expense of the maximum protection of human lives must be suspended.
This pertains not only to the neoliberal playbook governing debt restructuring, but also to the intellectual property protections embedded in trade agreements (TRIPS) that prevent poor countries from manufacturing Covid-19 vaccines. Just this week, COVAX, the WHO program created to deliver vaccines to Africa, Asia, and Latin America, revealed that it is fresh out of cash. It needs $5.2 billion to continue vaccine rollout in low-income countries that have received fewer total vaccine doses than richer economies’ residents have total booster jabs. Our crisis-prone system breeds instability whose effects fall unevenly. Unless our disordered world economy is reoriented toward protecting the interests of the majority, it may not withstand this catastrophe—let alone the next one.