For low- and lower-middle-income countries to pursue their development goals and do their part in tackling problems like climate change, they need to be able to borrow reliably on decent market terms. Yet the current two-tiered global financial system extends this privilege almost exclusively to rich countries.

NEW YORK – At last month’s COP26 climate summit, hundreds of financial institutions declared that they would put trillions of dollars to work to finance solutions to climate change. Yet a major barrier stands in the way: The world’s financial system actually impedes the flow of finance to developing countries, creating a financial death trap for many.

Economic development depends on investments in three main kinds of capital: human capital (health and education), infrastructure (power, digital, transport, and urban), and businesses. Poorer countries have lower levels per person of each kind of capital, and therefore also have the potential to grow rapidly by investing in a balanced way across them. These days, that growth can and should be green and digital, avoiding the high-pollution growth of the past.

Global bond markets and banking systems should provide sufficient funds for the high-growth “catch-up” phase of sustainable development, yet this doesn’t happen. The flow of funds from global bond markets and banks to developing countries remains small, costly to the borrowers, and unstable. Developing-country borrowers pay interest charges that are often 5-10% higher per year than the borrowing costs paid by rich countries.

Developing country borrowers as a group are regarded as high risk. The bond rating agencies assign lower ratings by mechanical formula to countries just because they are poor. Yet these perceived high risks are exaggerated, and often become a self-fulfilling prophecy.

When a government floats bonds to finance public investments, it generally counts on the ability to refinance some or all of the bonds as they fall due, provided that the long-term trajectory of its debt relative to government revenues is acceptable. If the government suddenly finds itself unable to refinance the debts falling due, it likely will be pushed into default – not out of bad faith or because of long-term insolvency, but for lack of cash on hand.

This is what happens to far too many developing-country governments. International lenders (or rating agencies) come to believe, often for an arbitrary reason, that Country X has become uncreditworthy. This perception results in a “sudden stop” of new lending to the government. Without access to refinancing, the government is forced into a default, thus “justifying” the preceding fears. The government then usually turns to the International Monetary Fund for emergency financing. The restoration of the government’s global financial reputation typically takes years or even decades.

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