The New Politics of Emerging Markets Debt Relief (2022)

Intensifying financial distress in developing economies is increasing the risk of economic and political instability and creating more pressure for China to engage in debt relief negotiations.

Signs of financial distress are particularly pronounced in lower-income countries, such as Ghana, even though several middle-income countries, such as Sri Lanka, have also been affected. A large number of countries, including Bangladesh, Ghana, Pakistan and even Serbia, have in recent months requested financial assistance from the International Monetary Fund. Many lower-income countries do not have a sovereign debt rating, but among those that do, many are rated CCC or below by Fitch Ratings or Moody's Investors Service, indicating a high level of default risk. This group includes Argentina, Belarus, Cuba, the Democratic Republic of the Congo, Ecuador, El Salvador, Ethiopia, Ghana, Grenada, Laos, Lebanon, the Maldives, Mozambique, Puerto Rico, the Republic of the Congo, Russia, Sri Lanka, Suriname, Tunisia, Ukraine and Zambia. Another 30-odd countries are rated single B, indicating a lesser but very substantial default risk. The spreads on ten-year sovereign credit default swaps, a financial instrument investors use to insure against default, exceed 1,000 basis points in more than 25 mostly lower-income countries, similarly pointing to the risk of imminent financial distress.

This increase in financial risk is happening because many developing countries entered the current global monetary tightening cycle with high levels of debt. The risk of financial distress and debt defaults has increased due to deteriorating global economic and financial conditions. The COVID-19 pandemic forced many low- and middle-income countries to increase government expenditure against the backdrop of slower economic growth, contributing to higher government debt levels. Many countries also over-borrowed externally, leading to higher foreign debt levels. Last but not least, many countries also are faced with high food and energy prices, making it difficult for governments to adjust macroeconomic policies sufficiently to preserve financial stability. Markets expect U.S. short- and long-term interest rates to continue to rise, which means that financing conditions for developed economies are becoming more challenging, as their debt service and roll-over risk increase. The dollar has strengthened considerably in recent months. This increases the debt burden of developing countries in local-currency terms and contributes to a further tightening of financial conditions, not least via reduced capital inflows and/or capital outflows. The increasing risk of a global recession, combined with the efforts of the U.S. Federal Reserve and the European Central Bank to stamp out inflation, risks leading to a sharp downward adjustment of commodity prices. This will weigh on the economic and financial outlooks of low-income countries, most of which are commodity exporters.

Because of this growing economic and financial distress, many countries will be forced to request international financial assistance, as well as debt relief from their creditors. While many low- and middle-income countries will turn to the IMF, it will only provide financial support if it deems a country’s debt to be sustainable. If the IMF considers a country’s debt to be unsustainable, as it recently did in Ghana, it will require debt relief. Debt relief is a reduction in a country’s debt burden through a reduction in interest payments, a lengthening of maturities or a reduction in principal (or a combination of the above). If governments fail to secure debt relief, they may face the prospect of a disorderly debt default. Governments often procrastinate efforts to seek financial support from the IMF since the institution requires countries to implement macroeconomic adjustment policies that are often highly unpopular and increase the risk of political instability. These policies typically include raising taxes, reducing public expenditure, tightening monetary policy and implementing structural economic reform. However, when governments put off such economic reforms, they raise the risk of financial default. 

China’s position as the main creditor of many low- and middle-income countries will give Beijing a central role in future debt restructuring negotiations. Given that China is a major (often the single-largest) creditor of low-income countries, Beijing’s willingness to participate in debt relief will be crucial if a hard sovereign default and a prolonged financial crisis is to be avoided. But China, which has lent huge sums to countries in Africa and South Asia, has shown reluctance to engage in multilateral debt relief efforts. Compounding the issue, traditional lenders (such as the members of the Paris Club) and multilateral official lenders (such as the World Bank or regional development banks) are unlikely to grant debt relief or even provide financial assistance unless major creditors, including China, participate in the debt restructuring process. China's reluctance, therefore, raises the risk of protracted and costly debt relief and restructuring efforts, as well as of economically costly disorderly defaults and a prolonged economic and financial crisis. However, China is likely to eventually enter debt relief negotiations, given the reputational risk and diplomatic blowback it would suffer if it were seen as insisting on preferential treatment and thereby prolonging a country’s financial and economic crisis. Such creditor coordination will make the provision of debt relief less messy and less economically costly to the debtor country than it would otherwise be.China is not a member of the Paris Club of official creditors, Chinese lending is often opaque and Beijing prefers bilateral, preferential debt deals to multilateral ones. Beijing has committed to multilateral coordination under the 2020 Common Framework, and it has shown some willingness to provide debt relief, including under the Debt Service Suspension Initiative, as well on other occasions. In Zambia, China has already agreed to co-chair the creditor committee with France.

Foreign Direct Investment - Balancing Economic Benefits and Security Risks (2022)

Cross-border investment and trade give rise to both economic gains and economic vulnerabilities. Intensifying geopolitical competition is increasingly leading governments to resort to cross-border investment and trade restrictions. Trade and investment policies are ever more informed by a quest to limit security risks and to preserve (or gain) technological advantage rather than efficiency gains. 

o Germany’s outward FDI is concentrated in the European Union, the United States and the United Kingdom. China (7%) and Russia (1%) account for a relatively small overall share of German outward FDI. But the stock of FDI is only an imperfect indicator of associated supply chain vulnerabilities and technological leakage risks.

o The economic impact of German inward FDI screening and outward FDI promotion policies appears to be limited. Nevertheless, Germany should conduct a review of its FDI policies in the context of its new national security strategy and provide estimates of the economic costs associated with relevant FDI-related risk mitigation policies.

o A high level of European economic integration as well as the risk associated with US-Chinese geo-economic conflict make a more coordinated EU approach to regulating inward FDI highly desirable. A more integrated EU policy would help strengthen Europe’s position vis-à-vis third parties., whether pushing for a level playing field vis-à-vis China or coordinating FDI policies with the United States. 

WHAT IS FOREIGN DIRECT INVESTMENT?

Foreign direct investment (FDI) is defined as a non-resident natural or legal person controlling 10% or more of the equity of a company. FDI consists of equity capital, reinvested earnings and intra-company loans. Unlike portfolio equity investment, FDI leads to a lasting interest in and a significant degree of influence over a company. 

From a recipient country point of view, FDI provides benefits in the form of financing, the transfer of technology and managerial skills, as well as increased economic efficiency, all of which support economic growth, employment and productivity. From an investor or sender country point of view, FDI can be market-, asset-, efficiency- and/ or diversification-seeking. FDI is market-seeking when it seeks to gain access to another market by circumventing trade barriers. It is efficiency-seeking when it seeks to generate cost savings by, for example, gaining access to cheap labor in the recipient country. It is asset- and resource-seeking if its purpose is to acquire complementary resources and capabilities, such as technology and commodities. From a company as well as sender country perspective, FDI can also help diversify risks and create more resilient supply chains. 

German outward FDI amounts to roughly 50% of GDP and the bulk of it is located in the European Union, the United States and the United Kingdom. German FDI in China is significant, but amounts to less than 7 % of total outward FDI. German FDI in the United States is about four times as large. FDI in Russia accounts (accounted!) for less than 1% of the total. In euro terms, Germany’s primary FDI abroad amounts to a total of EUR 1.4 tr, of which EUR 700 bn is held in EU countries. Germany’s primary and secondary FDI amounts to EUR 1.3 tr, of which EUR 400 bn is located in other EU member-states (and EUR 350 in the US). [1]

Measured as share of GDP, Germany has seen large FDI outflows over the past decade, worth more than 2% of GDP annually. FDI inflows have been comparatively modest. While international financial integration allows Germany to reap substantial economic benefits, it also makes it vulnerable to potentially adversarial policies by host countries. Such policies have the potential to disrupt supply chains, force technology transfer, in addition to causing tangible financial losses to individual companies, particularly in extreme circumstances such as expropriation and nationalization.

FOREIGN DIRECT INVESTMENT POLICIES

FDI has both economic and security implications. The latter are generally disregarded by standard economic models. For example, foreign companies may acquire critical assets, such as commodities or technology, and ‘lock them up’ by engaging in non-market behavior. To what extent such concerns are valid is an empirical question. However, foreign companies that receive support from their home governments, and especially state-owned companies subject to direction from their governments, are more likely to pursue non-economic goals. This increases the risk of them engaging in uncompetitive, politically motivated behavior as well as related security risks. Similarly, outward foreign direct investment may expose a company to political interference by the host government, particularly, but not exclusively, if the host government is not fully committed to the rule of law and liberal economic governance, or if the host country government is an actual or potential geopolitical antagonist of the home country.

In this context, it is worth distinguishing between the financial costs faced by a company that suffers losses from, for example, expropriation of its overseas FDI holdings and the (non-market) technological leakage that can occur in case of expropriation or other types of political interference as well as systemic supply chain disruptions. From a national-level perspective, the risk of technological leakage and supply chain disruption generally bears more heavily than the financial losses of individual companies. This is not to say that financial losses can never be substantial, of course. Several large German companies would find themselves in significant trouble if, for example, their China investment and business were to disappear overnight. But the consequences of technological leakage – whether through inward or outward FDI – or supply chain disruption – in case of outward FDI – have generally a greater potential to cause disruption and damage than the financial losses incurred by companies.

National FDI policies affect both inflows and, outflows. The FDI regimes of advanced economies are relatively open, allowing residents to acquire foreign assets as well as giving non-residents relatively unfettered access to their market. In recent years, however, inward FDI regulation and screening have been tightened in many advanced economies due to concerns about national and economic security as well as technological competition. Some countries, like the United States, have even begun to consider outward FDI screening (see box).

Risks Related to Restricting Outbound FDI

Restrictions on outward FDI have historically been much more common in developing countries than in advanced economies, mainly due to balance-of-payments financing risks. But increasing concerns about technological leakage and supply chain risks have led governments in advanced economies to consider adopting a less laissez-faire approach to outward FDI. Washington is currently debating whether to introduce outbound FDI screening due to concerns about supply chain security, technology transfer, foreign government intervention and espionage. [2] In addition to export controls (including the foreign direct product rule), which targets Chinese technology companies, [3] the recently passed CHIPS and Science Act bars US semiconductor producers from producing advanced chips in China if they accept US government subsidies for the development and production of semiconductors. In October, the US government further tightened export controls targeting China. FDI and even non-FDI policies are becoming increasingly ‘securitized.’

The US inward screening regime, or the so-called Committee on Foreign Direct Investment in the United States (CFIUS), already indirectly allows the US government to extend inward FDI restrictions by forcing the dissolution of joint ventures between US companies and Chinese counterparts outside the United States.[4] It is not difficult to see how the reach of US policies could be extended by limiting, for example, the investment of German-owned companies with minority Chinese shareholders in the United States.

Restricting and Screening Inward FDI

The openness to inward FDI varies across countries and sectors. China, as an example of an emerging rather than an advanced economy, restricts investment in a significant number of sectors, and prohibits investment in others outright, while the US has outright restrictions in only five sectors and maintains generally minor conditions in a few others. Germany’s FDI regime is among the world’s most open, in spite of the recent introduction of an enhanced, national security screening mechanism.

Next to prohibiting FDI in certain sectors outright, restrictions of inward FDI flows typically include: limiting share of equity ownership in a specific sector that non-residents are allowed to hold, obligatory approval and screening procedures (ranging from pre-approval to post-notification), restricting foreign nationals from working in affiliates of foreign companies or mandate minimum nationals on board, and operational restrictions on branching, capital repatriation or land ownership. Moreover, informal barriers often exist that deter FDI, such as complicated cross-shareholding structures or simply onerous regulatory impediments.

Restricting and Promoting FDI

Inward FDI	Restricting	Prohibit or restrict non-residents from participation in specific sectors etc.
	Promoting	Provide economic and other incentives to attract FDI
Outward FDI	Restricting	Regulate/ restrict outward FDI in specific sectors or countries
	Promoting	Provide economic and financial support, including risk insurance, to outbound investment

Source: Author’s compilation

FDI policies in Germany, the EU and the United States

The regulation of inward investment remains under the purview of EU member states. Germany has tightened inward investment rules several times since 2016. Sensitive industries, such as defense and defense technologies among other sectors, are subject to a mandatory review. Investment in other sectors may only be scrutinized if the investor is based outside the EU.[5]

As a consequence of these recent changes, national-level FDI filings have more than tripled in 2017-21, reaching more than 300 last year. The authorities required ‘restrictive (remedial) measures’ in only 46 cases out of a total of 716 cases filed (or 6% of all cases) during that period. Not a single investment seems to have been prohibited outright. Naturally, it is impossible to say how many FDI M&A deals were deterred in the first place by the tightening of the screening mechanism.

At the European level, the EU Investment Screening Mechanism came into effect in in 2020. It is meant to streamline and coordinate EU member state policies towards FDI by third countries. The EU framework provides for the notification by EU member states of actions taken in the context of respective national investment screening mechanisms, and it establishes procedures for member states and the Commission to quickly react to FDI-related issues pertaining to third countries by exchanging information, raising concerns related to specific investments, issuing of an opinion by the Commission, and setting requirements for member states to adopt screening mechanisms at the national level to ensure “security and public order”.[6]

In 2020, the EU investigated 20% of all FDI notifications/ filings, meaning 80% of notifications did not lead to an investigation in the first place. And nearly 80% of the cases that were investigated were approved without conditions, 12% were approved with conditions, 2% were rejected and 7% were withdrawn. 

Like Germany, the United States has also tightened inward FDI regulations under the Foreign Investment Risk Review Modernization Act (FIRRMA) in 2016.[7] CFIUS is significantly more restrictive than Germany’s FDI screening mechanism Subsequent executive decree and Treasury regulations have broadened the scope of CFIUS reviews. It now includes any non-passive investment in critical industries or emerging technologies as well as transactions where a foreign government has a substantial direct or indirect interest. It also allows for discrimination among foreign investors based on a “country of special concern” label. In September, the Biden administration issued an executive decree further tightening inward investment rules, including tighter scrutiny of investment in artificial intelligence, quantum computing and biotechnology .[8]

Promoting Outbound FDI

Governments can also seek to promote outward FDI flows. Similar to the way that they provide export credit insurance to promote exports,[9]governments can provide insurance for outward foreign direct investment. [10] In addition, governments can provide ‘political’ support by negotiating improved market access and enhanced safeguards in the form of Bilateral Investment Treaties (BITs) or in the context of Free-Trade Agreements (FTAs). The EU-Chinese Comprehensive Agreement on Investment (or CAI) is an example of a BIT. 

Outbound FDI Promotion Policies

Government advocacy	Government-provided political risk insurance	International investment agreements
	-Currency & transfer risk
	-Confiscation, expropriation, nationalization
	-Political violence
	-Default on financial and legal obligations

Source: Author’s compilation

FDI Policies in Germany, the EU and the United States

The German Ministry of Economic Affairs and Climate Action provides political risk insurance for German companies acquiring overseas FDI assets. Political risk insurance typically covers nationalization and expropriation risk, war, convertibility and transfer risk, and sometimes breach of contract by the local authorities.

In 2021, the German government approved EUR 2.6 bn worth of investment guarantees, compared to EUR 0.9 bn in the previous year.[11] 12 out of 30 approved guarantees secured investments in China, amounting to EUR 2 bn (or nearly 80% of all guarantees). The stock of investment guarantees amounted to less EUR 30 bn last year. To put this into perspective, German GDP amounts to EUR 3,600 bn, annual FDI outflows to EUR 160 bn, and a German FDI stock in China worth EUR 90 bn. In quantitative terms, the FDI guarantees provided by the German government are not especially significant.

In the United States, various government agencies support outbound FDI, such as Overseas Private Investment Corporation (OPIC), which in 2019 was merged with Development Credit Authority (DCA), which is part of USAID, to form the US International Finance Development Corporation (DFC). Focused on promoting American investment in less developed economies (read: America’s answer to China’s Belt Road Initiative), the DFC provides political risk insurance, financing, equity and technical assistance. 

ISSUES TO CONSIDER IN FORMULATING NATIONAL AND EUROPEAN FDI POLICIES

Neither German inward FDI screening nor outward FDI promotion seems to be very consequential in quantitative, purely macroeconomic terms. Although FDI notifications have increased, the German authorities required ‘measures’ to be taken in only a small number of cases. True, it is impossible to say how much potential FDI was deterred by the enhanced screening procedures, and no data is available as to the size of the transactions that required remedial measures to be taken. But based on the available data, Germany’s FDI regime remains very open. Similarly, the share of German outward FDI that is supported by government insurance and investment guarantees is very small, economically speaking. 

None of this means, however, that German and EU FDI policies could not and should not be rethought, adjusted and ‘optimized’ –particularly in view of US-Chinese technological decoupling and the increasing securitization of investment (and trade) policies by both Beijing and Washington. Germany and the EU need to strengthen their geo-economic defenses. This needs to go beyond the EU’s trade defense and import diversification policies to include investment and especially FDI. After all, the economic and security risks associated with both inward and outward FDI may be more significant than quantitative measures imply. Here are some suggestions:

First, both inward and outward FDI policies should be formulated as an integral part of the new German national security strategy and address issues related to supply chain risks and technological leakage, not independently of it in or in ad hoc, reactive manner. 

Second, the government in cooperation with the private sector should conduct a thorough assessment of inward and outward FDI-related risks on sector-by-sector and technology-by-technology basis. It should also provide an assessment of the aggregate risks at the national level, which may differ from firm-level risks. The government also has a role to play in terms of collecting information and monitoring national-level risks against the backdrop a changing geopolitical environment.

Third, having assessed aggregate risks, the government needs to provide an estimate of the economic costs of individual and aggregate mitigation policies. It is this trade-off that should inform actual risk mitigation decisions. In this context, it should also be assessed to what extent domestic regulation might be effective in preventing technological leakage or non-market behavior of foreign-owned companies. If regulation is insufficient, enhanced inward screening and tighter regulation needs to be considered. A similar assessment should be provided as regards German outward FDI and technology leakage risks. If the risk of technology leakage in a specific geography is considered to be unacceptably high, government intervention may be warranted. (This is less egregious than it sounds in light of a long-standing export control policy.)

Fourth, the government should then propose mitigation policies. Nobody is better placed to manage risk at the company level than the companies themselves. But collective action problems, information asymmetries, and risks related to the behavior of complex systems, such as supply chains, and especially in the presence of systemic, un-diversifiable risk, warrants government involvement. In the case of outward FDI, without safeguards, companies may be tempted to trade short-term profits for future technological leadership (e.g. forced technology transfer). Private economic incentives and national security goals may not always be fully aligned. 

In terms of inward FDI, the present screening mechanism should be updated to allow for enhanced screening of and potentially tighter rules for investors from ‘countries of concern’ as well as companies with close ties to foreign governments. In terms of outward FDI, the government should put in place safeguards to prevent the forced transfer of critical technologies with respect to countries where this is a material concern. The same should also apply to foreign jurisdictions where the risk of government interference or espionage is particularly significant. 

The government may also consider using its investment guarantee policy to provide companies with incentives to diversify their foreign investment and supply chains and/ or guide them towards lower-risk jurisdictions (bearing in mind that risk can change). In practice, this means eliminating/ reducing/ raising the price of guarantees for investment in countries where risks are high and/ or where additional investment would add to concentration risk. Instead, guarantees could be provided, and potentially so on more favorable terms, where marginal investment helps improve aggregate diversification. (Again, information about aggregate supply chain vulnerabilities will be crucial.)

Fifth, Germany should support the further development of the EU’s ‘trade defence’ instruments.[12] This is not the place to evaluate the many tools currently under discussion in Brussels, which include anti-coercion, anti-subsidy, procurement tools etc.[13] But EU FDI policies, not just trade policies should be part of this broader strategy aimed at reducing EU vulnerability in light of the securitization and politicization of the foreign economic policies of Europe’s and especially Germany’s most important trade partners, China and the United States.

Last but not least, and as always, greater EU level coordination and integration of both inward and outward FDI policies are also desirable due to the greater leverage they provide in negotiations over FDI policies with third parties, whether in the context of creating more of a level FDI playing field vis-à-vis China, or FDI policy coordination (and supply chain risk mitigation) with the United States in the context of the EU-US Trade and Technology Council. In particular, the EU should seek to coordinate inward FDI policies with the United States in order to avoid conflict over the US inward FDI policies as well as possible, future outward FDI screening, which would inevitably affect European interests. American and European interests do not seem to differ fundamentally and should therefore be amenable to compromise. After all, supply chain security, technological leakage, the non-market behavior of foreign companies, and the political risk related to outward investment in high-risk or potentially antagonistic countries are all concerns that are shared on both sides of the Atlantic.

[1] FDI data is reported in a variety of ways. Data produced using the extended directional principle reports FDI on the basis of the ultimate beneficial owner. Data produced using the asset-liability principle reports data from the perspective of a country’s assets and liabilities. The Bundesbank also distinguishes between primary and secondary FDI. Secondary FDI takes into account assets held by dependent holdings companies, not just ‘persons’ directly holding the FDI asset. See also, OECD, Asset Liability Versus Directional Presentation, 2014: https://www.oecd.org/daf/inv/FDI-statistics-asset-liability-vs-directional-presentation.pdf (last accessed: September 17, 2022)

[2] White House, Building resilient supply chains, revitalizing American manufacturing, and fostering broad-based growth, June 2021:

[3] Congressional Research Service, The US Export Control System and the Export Control Reform Act of 2018, 2021: https://crsreports.congress.gov/product/pdf/R/R46814 (last accessed: September 17, 2022).

[4] Cleary & Gottlieb, CFIUS blocks joint venture outside the United States, 2020: https://www.clearytradewatch.com/2020/06/cfius-blocks-joint-venture-outside-the-united-states-releases-2018-2019-data-and-goes-electronic/ (last accessed: September 20, 2022)

[5] For more details, White & Case, Foreign Direct Investment Reviews 2021: Germany, 2021: https://www.whitecase.com/insight-our-thinking/foreign-direct-investment-reviews-2021-germany (last accessed: September 17, 2022)

[6] European Commission, Foreign Direct Investment EU Screening Framework, 2020: https://trade.ec.europa.eu/doclib/docs/2019/february/tradoc_157683.pdf(last accessed: September 20, 2022)

[7] Congressional Research Service, CFIUS Reform under FIRRMA, 2022: https://sgp.fas.org/crs/natsec/IF10952.pdf (last accessed: September 17, 2022)

[8] Financial Times, White House sounds alert on inbound Chinese investment, September 14, 2022

[9] OECD, Arrangement on Official Supported Exports Credits, 2021

[10] OECD, Investment Guarantees and Political Risk Insurance, Investment Policy Perspectives, 2008

[11] German Ministry of Economic Affairs and Climate Action, Investitionsgarantien – Jahresbericht 2021, 2022: https://www.bmwk.de/Redaktion/DE/Publikationen/Aussenwirtschaft/investitionsgarantien-jahresbericht-2021.pdf?__blob=publicationFile&v=4 (last accessed: September 20, 2022)

[12] EU has also proposed an ‘anti-subsidy tool’ that would allow the Commission to scrutinize and even prevent companies from third parties that receive subsidies from acquiring EU assets. European Commission, Trade Defence Instruments, 2018: https://trade.ec.europa.eu/doclib/docs/2018/may/tradoc_156892.pdf. (last accessed: September 17, 2022)

[13] Markus Jaeger, Designing Geo-Economic Policy for Europe, DGAP Policy Brief 7, 2022: https://dgap.org/sites/default/files/article_pdfs/dgap_policy_brief_no._7_march_2022_9_pp.pdf (last accessed: September 20, 2022)