Discussion Paper

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How to deal with the current debt crisis of developing countries?

Bonn: German Institute of Development and Sustainability (IDOS)

ISBN: 978-3-96021-256-0
DOI: https://doi.org/10.23661/idp11.2025
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Many countries are still struggling with high and rising debt levels. The economic impact of the pandemic, as well as some longer-term structural factors, explain this situation. The key problem is the high level of debt service relative to government revenues, which makes it difficult to address growing development, social and climate challenges. As this is a particular problem for low-income countries (LICs) and lower-middle-income countries (LMICs), the focus should be on these countries. But even within this group, the situation is not uniform. A differentiated approach with different components is therefore needed, depending on countries’ individual situations and their own priorities and choices. There have been many contributions to this debate and proposals on how to address the current problems. This paper builds on some of those contributions presenting a practical and coherent approach to address the current debt crisis which focuses as far as possible on incentives for debtor countries and private creditors. Importantly, a distinction should be made between countries with high debt levels that are at risk of debt distress and those with liquidity problems. Therefore, debt sustainability assessments (DSAs) are needed to decide which countries (a) are not in debt distress, (b) have an insolvency problem, and (c) have a liquidity problem. The International Monetary Fund (IMF) and World Bank should be asked to classify all LICs and LMICs accordingly, based on updated DSAs, using a prudent approach with conservative projections. These DSAs must emphasise debt service indicators. For countries with liquidity problems, they need to identify those countries where the problem is of a longer-term nature, with a risk that the liquidity squeeze will turn into acute debt distress. All LICs and LMICs facing insolvency or liquidity problems should be offered a moratorium similar to the Debt Service Suspension Initiative (DSSI) to give them breathing space (of 2-3 years). The expectation is that this would help countries with liquidity problems to maintain basic social and economic services until market conditions improve or debt relief is implemented. In cases where debt service remains high after the moratorium expires, the country would be expected to request debt relief. Countries at risk of default would be expected to use the period of the moratorium to engage promptly in restructuring discussions and to prepare negotiations with creditors on a debt relief programme. The IMF would make its resources conditional on a suspension of debt service payments. The question is whether private creditors, including sovereign bondholders, should be required to participate. It is suggested that a distinction be made between two categories of countries. For countries at risk of insolvency, including those with longer-term liquidity problems, the moratorium should be conditional on private participation on comparable terms, as their creditworthiness is likely to be affected anyway. In contrast, with countries facing short-term liquidity problems the approach should be more flexible. While pressure on private creditors to join a standstill should be maximised, this should be complemented by strong incentives.
Countries with unsustainable debt would request treatment under a reformed G20 Common Framework for Debt Treatment (CF) with the option of a more comprehensive debt relief arrangement (“CF+”), including the following enhanced or new components:
• At the beginning of the process, countries would have to present a “Just Green Transition Programme” (JGTP), monitored by the IMF and the World Bank.
• The CF+ would be accompanied by more comprehensive debt relief, thus creating more fiscal space to allow the country to finance transformational and social investments. Debt service after rescheduling should be based on DSAs, which pay greater attention to Sustainable Development Goal (SDG) investments and countries’ particular circumstances, leaving countries with substantial room to absorb shocks. The objective would be to limit the
debt burden to external creditors as a share of revenue after rescheduling to around 10-15 per cent.
• For those countries where a large part of the debt service will be due to multilateral creditors, the involvement of multilateral institutions should be considered. This should be the case for those multilateral creditors which are not willing, or able, to provide positive net flows at highly concessional terms.
• The issuance of “Brady-like” bonds could be considered for specific country cases. The issuance of Brady-like bonds could be an incentive to maximise private creditor participation in exchanging old debt for new bonds with a significant discount or “haircut”.

Dr Jürgen Karl Zattler is currently distinguished non-resident fellow at the Center for Global Development in Washington as well as non-resident research fellow at IDOS. Until October 2023, he was Director General at the German Ministry for Economic Co-operation and Development. Prior to that, he served as the Executive Director representing Germany at the World Bank.