incomes and government revenue, and yet governments will need to maintain spending to cope with the consequences of the pandemic and protect households and firms from further economic disruptions. Meanwhile, elevated levels of sovereign debt can also weaken the recovery, through their impact on the financial sector. Many governments have financed their COVID-19 response by issuing new domestic debt that is held predominantly by domestic financial institutions. While this helped governments mobilize resources for the crisis response, it exposes financial institutions to sovereign risk as the financial position of the government deteriorates. This, in turn, reduces the ability of the financial sector to issue new credit and support economic growth. High levels of sovereign debt, particularly in the relatively shallow domestic markets of many emerging economies, can also dampen economic activity by leading to higher interest rates and affecting the prices firms and households pay for financing. High levels of sovereign debt also affect the private sector directly, such as through the government’s inability to provide ongoing support in a prolonged recession or economic setbacks during the recovery. Governments that are near or in debt distress do not have room to provide even temporary fiscal support to firms and households. Moreover, an increase in the risk of debt distress typically leads to a downgrade in the sovereign credit rating, which sets off self-fulfilling dynamics because the downgrade itself deteriorates macroeconomic fundamentals and the access to capital by private firms.17 Finally, it is important to note that the COVID-19 pandemic is a “crisis within a crisis.” Countries may face additional pressure on government finances from other economic disruptions, some stemming from the risks posed by climate change. Policy makers will need to confront these risks by mobilizing fiscal resources to combat the effects of climate change.
The human costs of debt crises Managing and resolving elevated levels of sovereign debt are essential to ensuring an equitable recovery from the COVID-19 crisis. Long-lasting debt distress has far-reaching negative consequences for the economy and population. These consequences are typically borne disproportionately by vulnerable populations, low-income households, and small businesses, and tend to worsen pre-existing poverty and inequality. Sovereign debt crises affect human development in many ways because they rarely occur as an isolated event and often are only one component of a conglomerate crisis affecting multiple sectors of the economy.18 Debt distress or default often coincide with a myriad of economic problems that may include output collapses, financial crises, currency crashes, and high inflation, which disproportionately affect the poor. Though the initial crisis trigger and order of events may differ, conglomerate crises have larger economic and human costs than crises confined to one sector of an economy. Because the COVID-19 pandemic simultaneously weakened private sector, financial sector, and government balance sheets (and weakened the ability of governments to mitigate spillover risks), many countries are at risk of experiencing these types of mutually reinforcing crises in the aftermath of the pandemic. Evidence shows that sovereign debt crises are often associated with large output collapses that have significant human costs.19 Data on economic crises during the 1980s and 1990s, for example, indicate that the number of people living in poverty increased by as much as 25 percent during large contractions in output.20 Not surprisingly, aggregate economic shocks that weaken the government’s ability to provide public goods, such as health care and education, are also associated with a deterioration in human development and social indicators.21 On this point, there is significant heterogeneity between advanced and emerging economies. In advanced economies, where households can draw on insurance mechanisms that do not necessarily depend on current government spending, health and education outcomes are considerably less affected during crises. However, in emerging economies they deteriorate rapidly—for example,
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