Déjà Vu in Developing Economies? The Intertwined Story of Inflation, Interest Rates and Debt Burden

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glance at the history of the global economy reveals that certain critical junctures have been decisive for developing countries. And in keeping with the adage that history repeats itself, these critical junctures share some striking similarities: there are noticeable parallels between the historical period of 1971-1982 and today in terms of debt burden, which is a systemic challenge for developing countries and casts a shadow over their economic aspirations.

Let’s take a brief journey in history. In 1971, the U.S. left the Bretton Woods system, breaking the dollar’s link to gold. This bold move removed an important obstacle for the Fed, the U.S. central bank, enabling it to pursue a more inflationary monetary policy to finance the U.S. Treasury’s budget deficit.

After the collapse of the Bretton Woods system, money supply in the United States literally exploded. At the same time, the 1970s witnessed significant geopolitical upheavals, marked by the oil crisis caused by conflicts, wars, and political changes in the Middle East.

As oil-rich Middle Eastern nations restricted the flow of oil to the West, oil prices quadrupled in a short period of time. The surge in money supply and oil prices inevitably sparked inflation, which soared to double-digit levels. But, inflation was not the only problem as oil shortages also affected industrial production and transportation. Western countries faced both high inflation and sluggish economic activity—an economic stalemate known as stagflation.

The effects of stagflation reverberated throughout Western society and led to significant political changes. In 1979, Margaret Thatcher became the first female prime minister of the United Kingdom, while Ronald Reagan entered the White House shortly thereafter. These conservative leaders embraced bold economic policies based on neoliberal arguments. To tackle inflation head-on, they implemented fiscal austerity while giving central banks the green light to raise interest rates.

Up to this point, developing countries have not been major players in our story. However, that changed as global interest rates started to increase. In the 1970s, abundant liquidity and petrodollars provided developing countries with a promising opportunity to borrow. Particularly in Latin America, many countries took on significant debt burdens to finance their industrialization and development projects.

A significant portion of this debt was based on floating interest rates. In the 1970s, when liquidity was abundant and interest rates low, repaying this debt did not seem difficult. But things changed in the early 1980s and rising global interest rates made it harder to roll over debt.

The debt crisis that erupted in Mexico in 1982 spread first to Latin America and then to other developing countries around the world. Many countries turned to the IMF for help in overcoming their economic challenges, but the IMF’s support came with harsh conditions, namely the implementation of neoliberal policies that came to be known as the “Washington Consensus.” There was a sigh of relief for a while, but it did not last long.

As a result of the pandemic, supply chains experienced production bottlenecks, international transportation became more difficult, protectionist policies were put in place to discourage critical export items, and some countries stockpiled raw materials as a precaution. These events made the supply of intermediate goods very difficult and production costs began to rise. On top of all these developments came Russia’s invasion of Ukraine. With the outbreak of war, energy prices soared, fueling inflation.

The global economy faced the highest inflation in 40 years in 2022. Major central banks such as the Fed, the European Central Bank, and the Bank of England tightened monetary policy to fight inflation, and other central banks followed suit with global interest rates reaching 20–25-year highs. Debt repayment became a major headache due to, on the one hand, the increased need for borrowing due to the difficult economic conditions of the pandemic period and, on the other, the interest rate hikes due to post-pandemic inflation.

In the current global economic landscape, cumulative global debt exceeds an alarming $300 trillion, with developing countries accounting for a substantial share of about $100 trillion of this debt stock. Among the various components of this debt composition, it is evident that external debt is emerging as a prominent concern for developing countries.

The challenges posed by external debt arise not only from the escalation of interest rates, but also from the depreciation of local currencies, which exacerbates the complexity of debt repayment. External debt to gross national income ratio in low- and middle-income countries (excluding China) has increased from 25.6% in 2010 to 36.3% in 2021.

Rising global interest rates are making debt management more difficult, especially for poor countries. According to IMF calculations, eleven poor countries including Ghana, Mozambique, Sudan, Zambia, and Zimbabwe are in debt distress. Twenty-five countries, on the other hand, are in the high-risk debt category. It is important to underline that the aforementioned list does not encompass middle-income countries such as Sri Lanka and Lebanon, which grapple with significant debt burdens, as well as the prominent G20 member Argentina. Obviously, these countries also face formidable challenges in the debt rollover process.

The United Nations Conference on Trade and Development (UNCTAD) recently published a report with striking figures on the rising burden of interest and debt. The report exposed that 3.3 billion people live in countries that spend more on interest payments than on health or education. In the period 2019-2021, interest payments by developing countries will increase by 60.4% compared to the period 2010-2012. However, public spending on development-related areas such as health, investment, and education did not keep pace with interest payments. During this period, public spending on health, investment, and education increased by 54.7%, 41.1%, and 40.8%, respectively.

The money lost to interest payments shrinks public resources that could be channeled into development-friendly areas. As global liquidity tightens and interest rates rise, the gap in borrowing conditions between countries is widening. For example, countries in Africa can borrow on average at interest rates four times higher than the U.S. Borrowing costs in Latin America and the Caribbean are 2.5 times higher. Under these circumstances, it is very difficult for developing countries to catch up with advanced economies.

In a nutshell, the triangle of inflation, interest rates, and debt burdens shows that there are similarities between the 1971-1982 period and today. External shocks such as geopolitical tensions also reinforce this similarity. Inevitably, the question arises, “Could developing countries potentially face a debt crisis similar to that of the 1980s?”

As discussed above, there has been a discernible deterioration in debt burdens and debt rollovers in developing countries. However, it is important to note that the debt crisis is not all-encompassing. Although the debt ratios of major emerging economies such as China, Mexico, Brazil, Turkey, and South Africa have deteriorated, these countries are not experiencing significant difficulty in rolling over their debt despite rising interest rates.

Unlike in the 1980s, developing countries are more integrated into global trade, their economies are more diversified, and they have better macroeconomic governance. All these characteristics give emerging markets more foreign exchange earnings, flexibility, and experience in managing debt.

Nevertheless, there is little room for complacency. While upper middle-income countries may not face significant immediate challenges, it is clear in the current equation that debt has been increasingly becoming a vexing problem for low- and lower-middle-income countries.

As the cases of Sri Lanka and Lebanon illustrate, debt not only distorts key economic indicators but can also inflict significant social wounds. In addition, the growing fragility of the global economic and political landscape deserves due attention. Economic uncertainties and geopolitical risks remain high. Protectionist measures by developed countries are slowing the growth rate of global trade, which is vital for developing countries as it provides them with the foreign exchange inflows that are necessary for repaying their debt burdens.

Against this backdrop, developing countries need to be vigilant about their debt burdens, especially external debt. On the one hand, they need to embark on fiscal reforms to reduce their current debt ratios while, on the other, it is essential to accelerate the transition away from the debt-fueled growth model.