Debt and financial risks

Rise in SIDS’ external debt since 2000

Overall, SIDS’ external indebtedness is considerably higher than that of other developing countries. In 2019, SIDS’ external debtExternal debt is debt owed to nonresidents repayable in currency, goods, or services. -—
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—- defines it as outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy. accounted for 62 per cent of their GDPGross domestic product (GDP) (figure 1), compared with 29 per cent for all developing countries and economies in transition -—
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—-. This gap has widened substantially over the last decades. Between 2000 and 2019, the external debt-to-GDP ratio rose by 24 percentage points in SIDSsmall island developing States (SIDS) were recognized as a distinct group of developing countries at the Earth Summit in Rio de Janeiro in June 1992.
More information on UNCTAD official page. while dropping 6 percentage points in all developing countries. Most of the increase occurred in the aftermath of the 2008 global financial crisis, and has accelerated since 2013, the year of the taper tantrumTaper tantrum refers to the 2013 collective panic that triggered a spike in treasury yields in the United States of America, after investors learned of Federal Reserve’s plans to wind down the program, known as quantitative easing -—
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—-., which was then followed by a series of external shocks which in turn kept debt positions under strain¹.

Figure 1. External debt-to-GDP ratio in SIDS by main components

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—- and national sources.
Note: 2019 data are estimated by UNCTAD. Data on the use of IMFInternational Monetary Fund credit are provided by the IMF Treasurer’s Department. They are converted from special drawing rights into dollars using end-of-period exchange rates for stocks and average-over-the-period exchange rates for flows.

Large-scale borrowing from foreign creditors, both public or private, has opened new options for financing investment, recovering from natural disasters, and development in SIDS. However, this has come with greater exposure to the vagaries of international financial markets, including sudden changes in major exchange and interest rates, thereby raising concerns over sovereign risk.

The rise in SIDS’ external debt since 2000 has been mostly driven by long-term private debt along with short-term debtShort-term debt includes all debt having an original maturity of one year or less and interest in arrears on long-term debt., while long-term public debt, on which policy focus has traditionally concentrated, has remained rather steady. Long-term private debt represented 15.9 per cent of SIDS’ GDP in 2019, in stark contrast to 1.2 per cent in 2000. Over the same period, short-term debt increased from 6.6 per cent of SIDS’ GDP to 14 per cent. Resorting to these two components of external debt is a risky undertaking. In many developing countries, high levels of private debt have failed to deliver growth, structural transformationStructural transformation can be broadly defined as the reallocation of economic activity across three broad sectors, agriculture, manufacturing and services, which accompanies the process of economic growth. -—
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—- It usually refers to the transfer or shift of production factors — especially labour, capital and land — away from activities and sectors with low productivity to those with higher productivity, which are typically different in location, organization and technology -—
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—- or development, thereby compounding the threat that they pose to the sustainability of public finances in the medium to long run -—
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—-. A greater fraction of short-term debt renders developing countries more vulnerable to liquidity crises and in turn exacerbates sovereign risk, particularly if it did not go hand in hand with an adequate process of international reserves accumulation -—
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Several SIDS in debt distress

By virtue of their economic situations, typified by low diversification and the ever-present risks of natural disasters, SIDS are naturally exposed to public debt distress, which rises when a government struggles over time to honor some or all of its debt obligations. In this regard, it is useful to scrutinize ratios of public debt serviceDebt service refers to payments made to satisfy a debt obligation, including principal, interest and any late payment fees -—
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—-. to government revenues². There is a lot of variation among SIDS, ranging from 0.3 per cent in Timor-Leste to 21.6 per cent in Jamaica. However, these additionally need to be examined against total public debtTotal public debt refers to both public external debt (short-term and long-term alike) and public domestic debt. stocks and current accountCurrent account, within the balance of payments, displays the transactions between residents and non-residents of a reporting economy, involving economic values, namely the cross-national exchange of goods and services as well as cross-national transfers of primary and secondary income -—
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—-. balances. The former provides insights on whether the stress mirrored by debt service ratios is just temporary or likely to last, whereas the latter show in stark terms the capacity of the country to cope by mobilizing required financial resources from global trade³.

Figure 2. Total public debt, current account balanceCurrent account balance displays the flows of goods, services, primary income, and secondary income between residents and nonresidents of an economy. The current account balance measures, in general, the difference between current receipts and expenditures for internationally traded goods, services and income payments. At the same time, from a national perspective, the current account balance represents the gap between domestic saving and investment.-—
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—- and debt service to government revenues in SIDS, 2018

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Note: The x-axis refers to total public debt (percentage of GDP), the y-axis to the current account balance (percentage of GDP) and the size of the bubble to debt service to government revenues. Debt service data are not available for Antigua and Barbuda, Barbados, Marshall Islands and Tuvalu. The classification into the three groups of debt distress is made ex-post in light of the position of the countries in the three dimensions of the graph.

Once the vicious debt cycle is established, in which debt servicing burden, public debt stocks and current account deficit feed off each other, these three indicators are highly correlated. Figure 2 shows that this is the case for many SIDS: the further right the bubble is on the graph, the more public debt stocks a SIDS holds, the greater its current account deficit and its debt service ratio. When these three indicators are simultaneously high, the country is likely to experience debt distress.

SIDS perform on average less well than other developing countries against these three indicators, confirming, as mentioned above, that they intrinsically undergo higher debt distress . They yet show some degree of heterogeneity, so much so, they can be divided into three distinct subgroups.

SIDS located on the right-hand side of figure 2 have “very high” levels of public debt distress, including Barbados, which restructured its public debt for the first time in 2018 and 2019. Countries with “very high” public debt distress also include Cabo Verde, Jamaica, Antigua and Barbuda, Dominica, Sao Tome and Principe, Saint Vincent and the Grenadines, Maldives, Grenada and Bahamas. This category brings together countries with either very elevated public debt stocks, coupled with high debt service, or more moderate public debt stocks, but compounded by large current account deficits and heightened debt service. The economic impacts of the COVID-19Infectious disease caused by the strain of coronavirus SARS-CoV-2 discovered in December 2019. Coronaviruses are a large family of viruses which may cause illness in animals or humans. In humans, several coronaviruses are known to cause respiratory infections ranging from the common cold to more severe diseases such as Middle East Respiratory Syndrome (MERS) and Severe Acute Respiratory Syndrome (SARS). The most recently discovered coronavirus causes a coronavirus disease called COVID-19. pandemic may severely aggravate the debt positions of these countries, putting them at higher risk of defaulting -—
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—-. All of these SIDS with “very high” level of public debt distress, except Antigua and Barbuda, have availed of the IMF's -—
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—- COVID-19 financial assistance and debt service relief since March 2020. Moreover, five SIDS, namely Grenada, Cabo Verde, Dominica, Maldives and Sao Tome and Principe, have been so far eligible for the G20Group of Twenty (G20) COVID-19 Debt Suspension Initiative -—
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The second subgroup is displayed at the left-hand side of figure 2. It refers to SIDS with a “moderate” level of debt distress. This group comprises Comoros, Solomon Islands and Timor-Leste, as well as most of the least populated SIDS, such as the Federated States of Micronesia, Kiribati, Marshall Islands and Tuvalu. These states have relatively "low” levels of public debt, no or limited current account deficits and a small fraction of debt service to their government revenues. However, the least populated SIDS in this group face endemic issues, mostly related to climate change and their size, weighing on their debt positions, although their macroeconomic indicators, for instance GDP per capita, do not seem to be alarming -—
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The other SIDS coalesce into a more homogenous group, concentrated in the middle of the graph, and epitomized by intermediate debt stocks, debt servicing and current account deficits in comparison with the two previous groups, hinting at a “high” level of debt distress. The group includes Mauritius, Saint Lucia, Saint Kitts and Nevis, Nauru, Seychelles, Vanuatu, Samoa, Fiji, Trinidad and Tobago and Tonga. Among them, Saint Lucia, Seychelles, Samoa and Tonga have received IMF’s COVID-19 Financial Assistance and Debt Service Relief -—
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—- and Fiji, Samoa, Saint Lucia and Tonga were eligible for the G20 Debt Suspension Initiative -—
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—-⁴.

Debt vulnerability to external shocks and links to natural disasters

Owing to their smallness and their dependency on the global economy, SIDS are extremely vulnerable to external shocks. The terms of trade for merchandise trade and services and their need for steady supplies of imported goods are beyond the domestic control of SIDS. During the COVID-19 crisis, a significant drop in SIDS’ current account balance can be expected, from -2.7 per cent of GDP in 2019 to -12.1 per cent in 2020 and further to -12.3 per cent in 2021 -—
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Small domestic financial markets make SIDS dependent on external borrowing to finance investments and recovery from natural disasters. Stronger economic growth and export diversification can make SIDS more eligible for external borrowing and improve their capability to manage and repay debt. Regarding SIDS’ exposure to natural disasters (see Environment), Slany -—
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—- finds that, on average, a severe natural disaster cannot be directly linked with increases in external debt across SIDS, despite the devastating impact natural disasters have on output and export revenues.

The small effect of severe natural disasters on debt relates to the restrictions of already indebted countries to access additional funding. Moreover, climate change and the risk of a natural disaster may cause a downgrading of credit ratings making it even more difficult for SIDS to borrow money at reasonable terms, inflating their annual debt service payments.

Remittances important for many SIDS

Personal remittancesPersonal remittances comprise (1) compensation of employees, defined as the income of workers employed in an economy where they are not resident and of residents employed by non-resident employers; and (2) personal (current) transfers, defined as current transfers in kind or in cash, between resident and non-resident households -—
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—-. are a notable source of funding for several SIDS. In 2019, SIDS received, on average, remittances worth US$173 million. Two in three SIDS received less than US$100 million per year. The top recipient was Jamaica, with US$2.6 billion, while Palau received the least, US$2 million (see table 1).

Personal remittance receipts as a percentage of GDP illustrate the significance of remittances for SIDS’ economies. In 2019, the top recipient of remittances in relation to GDP was Tonga, with 34.6 per cent. This is one of the highest shares in the world, after Haiti (39.5), while a SIDS with the lowest receipts of remittances relative to GDP, the Maldives, received a share of just 0.1 per cent of GDP.

The significance of remittances as a percentage of GDP has decreased or stayed relatively stable in most SIDS over the years. Tuvalu has seen the biggest drop: from almost 23 per cent of GDP in 2005 to 9 per cent in 2019. In the top recipient country, Tonga, the share of remittances of GDP has on the contrary grown by 8.2 percentage points since 2005. For Sao Tome and Principe, data on remittances are available only from 2013, but since then the share has dropped from 8.8 per cent to 2.4 per cent in 2019.

Pacific SIDS especially dependent on ODA

ODAOfficial Development Assistance (ODA) are resource flows to countries and territories which are: (a) undertaken by the official sector; (b) with promotion of economic development and welfare as the main objective; (c) at concessional financial terms (implying a minimum grant element depending on the recipient country and the type of loan). In addition to financial flows, technical co-operation is also included -—
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—-., though it tends to be smaller than FDIForeign Direct Investment (FDI) is an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate) -—
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—-. or private flows, is another important financing source for SIDS. ODA frequently functions as “seed funding” or catalysers of additional resource mobilization in sectors or projects where other funding options are limited, or where investors are reluctant to participate. Furthermore, for some countries in vulnerable situations, official funds are frequently the only source of financing available. Figure 3 illustrates net ODA received by SIDS on average as a percentage of GDP.

Figure 3. Net ODA received, regional average

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Since 1990, Caribbean SIDS have received ODA equaling on average to 2.2 per cent of their GDP. The equivalent figures for Atlantic and Indian Ocean SIDS and Pacific SIDS, respectively, are 8.5 per cent and 25.3 per cent. Despite some year-to-year fluctuation, trends have been relatively stable over time, though ODA as a share of GDP in Atlantic and Indian Ocean SIDS has fallen from more than 10 per cent in 2010 to just more than 5 per cent in 2019. Pacific SIDS receive significantly more ODA relative to their GDP, likely a function of their less developed economies and more remote geography. Regional averages mask intra-regional variations, however. For instance, in 2019, Fiji received ODA equivalent to 2.5 per cent of its GDP, on par with most Caribbean SIDS. The figure for Tuvalu in the same year by contrast was 77 per cent.

Investment in SIDS increasing

FDI inflows to SIDS increased to US$4.1 billion in 2019, up 14 per cent from 2018 ⁵. In 2019, total FDI inflows to all SIDS were roughly on the same level as to individual countries, such as, Thailand, Norway and Cambodia. The main recipients among SIDS, Jamaica and the Bahamas, were just outside of the top-100 FDI recipient countries of the world in 2019.

FDI inflows to SIDS grew until the wake of the global financial crises in 2008-2009 at an average annual rate of 17.5 per cent (see figure 4). Portfolio investment is a relatively new source of financing for SIDS. It has started to play a greater role since 2008. However, as for developing countries in general, portfolio investment flows have been volatile, mostly due to external factors, including monetary policy decisions in developed economies. This poses a challenge to the stability of SIDS’ exchange rates and narrows their monetary and fiscal space. However, since 2016, net portfolio investment has been positive, with inflows outpacing outflows, and net flows have been rising for four consecutive years. Unfortunately, the pandemic which triggered substantial portfolio outflows, especially at its onset, from most developing countries, is likely to have reversed this trend in 2020.

Figure 4. FDI inflows, net portfolio investment and remittance inflows in SIDS

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Overall, Caribbean SIDS (US$66 billion in 2019) accounted for over 70 per cent of the total SIDS’ inward FDI stock which was US$90.5 billion in 2019 ⁵. As shown in figure 5, four of the SIDS with most inward FDI stock are Caribbean, followed by Mauritius from Atlantic and Indian ocean and Fiji from Pacific. Large inward FDI stocks are also held by Maldives, Seychelles and Cabo Verde in Atlantic and Indian Ocean.

Figure 5. Inward FDI stock by country in SIDS regions

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FDI inward stock as a percentage of GDP is notably high in several SIDS, with big differences across the countries. In 2019, the lowest figure was 8 per cent for Kiribati and the highest was 200 per cent for the Bahamas. A high amount of FDI stock as a percentage of GDP can be an indication of high interconnectedness of a country with the global economy through investment and multinational enterprises. It also provides indications of potential exposure to international tax avoidance and IFFsIllicit financial flows (IFFs) are defined as financial flows that are illicit in origin, transfer or use, that reflect an exchange of value and that cross country borders. The four main types of activities that can generate IFFs include: 1) tax and commercial activities; 2) illegal markets; 3) corruption; and 4) exploitation-type activities and financing of crime and terrorism -—
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The inward FDI stock relative to GDP is notably high in the SIDS group, reaching 71.9 per cent in 2019, compared to 33.9 for LDCsLeast developed countries (LDCs) are low-income countries confronting severe structural impediments to sustainable development. They are highly vulnerable to economic and environmental shocks and have low levels of human assets -—
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—-. ⁵. Globally, the British Virgin Islands and the Cayman Islands were the two countries with the highest FDI stock in GDP in 2019, at 55 042 and 8 885 per cent of GDP, respectively. These two countries have developed into offshore financial centers which attract financial capital disproportionate to their national economy.

The Bahamas ranks thirteenth globally with its inward FDI stock of 200 per cent of GDP. Seychelles, Saint Vincent and the Grenadines, and Saint Kitts and Nevis also make it into the global top-20 with their inward FDI stock relative to GDP, ranging from 170 to 187 per cent. Inward FDI stock also exceeds GDP in Palau, Barbados, Cabo Verde, Jamaica and Grenada.

SIDS are slightly less represented among the top countries for outward FDI stock as a percentage of GDP, with Barbados ranking 15th (72 per cent of GDP) and the Bahamas 22nd (56 per cent of GDP). Globally, the median FDI inward stock is 47 per cent of GDP, and the outward stock below 6 per cent.

Inward FDI stock as a percentage of GDP started growing visibly in the Caribbean SIDS in the 1990s, peaking for the first time in 2009 at 96 per cent of GDP. The rate exceeded 100 per cent in 2016 and came to 101 per cent in 2019. As of 2005, Pacific and Atlantic and Indian Ocean SIDS have joined the race, reaching nearly 65 per cent by 2019.

Figure 6. Inward FDI stock by SIDS regions and other LDCs

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Note: See note 5.