Friday, October 20, 2023

The Political Economy of Sovereign Debt Restructuring in the Age of Sino-US Competition (2023)

Many low and lower-middle income countries are in financial distress or in default

A large number of low income and lower-middle income countries are experiencing financial distress in the wake of COVID-19, the Ukraine war and the U.S. interest rate shock. Some countries have already defaulted on their debt. Others are on the verge of doing so. 

Earlier this year, international rating agency Fitch said that nine governments had defaulted in 2020-23 compared to thirteen in 2000-19. In addition, Fitch currently rates eight sovereigns at CCC+ and another nine at B-, meaning another seventeen countries are at elevated to high risk of default. For reference, the cumulative five-year default probability of sovereigns rated into C-CCC range is 40%. The actual number of countries in distress and at high risk of default is however far higher, as Fitch does not rate all countries.

Markets take a similar view. The dollar debt of around two dozen countries is currently trading at more than a 1,000 basis, meaning that they are effectively shut out of international capital markets and at increasing risk of a default. But not all countries issue international bonds. Credit ratings and market-based distress measures therefore fail to capture the breadth of the financial challenges currently experienced by developing economies.

The IMF estimates that almost 60% of all low-income countries, or a total of more forty countries, are either in default or at high risk of financial distress. In addition to low-income countries and several lower-middle income countries are also in severe distress (Egypt, Pakistan, Tunisia) or are already in default (Ghana, Lebanon, Sri Lanka, Ukraine, Zambia). Even some upper-middle income countries are in deep distress or in default (Argentina, Russia). Financial instability challenges are concentrated in low- and lower-middle income economies, particularly in sub-Saharan Africa.



Any delay in providing financing assurances and debt relief has significant economic costs

Just as developing economies are experiencing peak financial distress, they are finding it harder to receive the financing assurances and the debt relief necessary to put in place IMF programs. This is leading to a further increase economic and financial costs in the context of prolonged distress and default. The lender-of-last-resort, the International Monetary Fund (IMF), will only extend loans to distressed and defaulted countries once it receives so-called financing assurances from a country’s creditors. 

But disagreement among creditors, particularly among the Paris Club and China, has led to significant delays to IMF rescue packages and debt restructurings. Increased creditor fragmentation prevents pre-emptive debt restructuring and leaves countries in distress and default for longer, thus preventing a timely return to economic and financial stability and imposing significant additional economic costs on distressed countries.

The uncertainty surrounding debt relief and restructuring has also has made debtor countries more reluctant to seek pre-emptive debt relief, which has led to an even greater build-up of financial imbalances. Moreover, the longer it takes to restructure the debt and attract new financing flows, the greater the economic costs to a country.


Sovereign debt restructuring has always been an ad hoc process

Admittedly, sovereign debt restructuring has always been an ad hoc process. And previous episodes of distress and default have not always been dealt with very efficiently. The prolonged economic crisis and financial malaise of many developing and emerging economies, particularly in Latin America in the 1980s is a case in point. Debt restructuring was pushed off for too long in the context of ultimately unsuccessful adjustment programs. The failure to restructure debt led to far greater economic pain and greater aggregate financial losses than if debtors and creditors had agreed to an early debt restructuring and economic adjustment. In Latin America, the 1980s are tellingly referred to as the lost decade. Economies were in near-continuous crisis and the macroeconomic adjustment programs had significant socio-economic costs, while ultimately failing to prevent a default.

In other words, dealing efficiently with financial distress and sovereign debt restructuring has never been easy. But things have deteriorated in the past few years, compared to the previous two decades. (There were exceptions, like Argentina in the mid-2000s.) Today debt restructuring has become more difficult. For example, it took two Zambia two years to receive the so-called financing assurances necessary for IMF financing to be unlocked. And it took another year for Zambia’s creditors to restructure its debt. And the debt restructuring deal currently on the table may not provide sufficient relief for Zambia to avoid future financial instability. Sri Lanka, which defaulted last year, is making better progress, but the process of providing debt relief has been far from efficient. 

For the longest time, economists were concerned that the emergence of bond rather than loan financing would undermine the prospect for efficient sovereign debt restructuring. Bondholders were thought to have greater incentives not to participate in a debt restructuring and instead to pursue their financial claims through legal avenues. By contrast, banks creditors were sees as having greater incentives to restructure the debt and find it easier to find to reach an agreement, amongst themselves and the debtor, not least due to the pressure they face from their respective governments. This is not to suggest that the emergence of private bondholders as often the dominant private-sector creditor does never create any obstacles. Argentina, for example, felt compelled to pay off hold-outs in 2016. But, in part thanks to collective action, which diminish the power of holdout creditors, they generally represent a manageable obstacle today.


Increased creditor fragmentation has further complicated the provision of debt relief

It turns out that it is the increased division, distrust and disagreement among bilateral creditors that represents a greater stumbling block to sovereign debt restructurings. In particular, China’s emergence as a major international creditor to low-income countries and its reluctance to abide by the traditional norms guiding sovereign debt restructuring accounts for the present problems. Unless traditional creditors, represented by the Paris Club, and China converge on a common set of principles, debt distress and debt restructurings will remain prolonged affairs. 

China has emerged as the largest bilateral creditors in recent years due to its extensive lending to low-income countries in the context of the Belt and Road Initiative. But Chinese lending is not the only reason for low-income countries’ over-borrowing. Ultra-low interest rates following the 2008 global financial crisis led private investors to provide significant financing to so-called “frontier economies”, effectively low-income countries with little experience of borrowing on international capital markets. However, private creditors represent much less of an obstacle to efficient debt restructuring than disagreement among bilateral creditors.

Initially, creditor cooperation looked likely. In early 2020, an agreement was reached on the so-called Debt Service Suspension Initiative (DSSI), which allowed eligible countries to suspend their external debt service in the context of the COVID-19 crisis. Shortly thereafter, a so-called G20 Common Framework was established with the aim of facilitating international debt restructuring for low-income countries by allowing Paris Club and non-Paris Club creditors to negotiate debt relief in a single committee. But only three countries, Chad, Ethiopia and Zambia, have applied for debt relief. And disagreement among creditors meant that creditors took a long time to provide debt relief. Zambia is a case in point and its experience sharply limits the incentives for other countries to apply for debt relief under the framework.


The IMF plays a critical role in delivering debt relief and economic adjustment

It is important to understand the role played by the IMF in the context of debt restructurings to understand why the provision of debt relief is not working properly. The IMF is a crucial player in case a country enters financial distress or falls into default. For a start, the IMF provides balance-of-payments financing conditional on economic adjustment, which is aimed at correcting imbalances and re-establishing macroeconomic stability. To this end, the IMF staff prepares a debt sustainability analysis with no input from creditors. The analysis establishes the so-called resource envelope and the required financial relief a country needs to seek from its creditors in case the debt sustainability analysis shows that the debt burden is unsustainable. The IMF program and IMF lending are conditional on the Fund receiving financing assurances from the country’s creditor.s Financing assurances are necessary for the economic adjustment to be successful and for the IMF to safeguard its financial resources.

The IMF itself is neutral in terms of how the costs of the debt relief are to be allocated to a country’s various creditors as long as the required debt reduction takes place. This is precisely why inter-creditor conflict is so prominent. Debt relief is a zero-sum game, and every creditor would like to minimize its losses and get others to provide debt relief. Historically, the problem of inter-creditor equity was managed reasonably well because the IMF was dominated by largely Western creditors, which were organized in the so-called Paris Club, a group coordinating the activities of the major bilateral creditors. In this context, the IMF received and accepted financing assurances from a “representative standing forum”, namely the 22 creditors of the Paris Club (and various observers and ad hoc members). In generally, this allowed the IMF then to approve a program and provide financing, typically a pre-requisite for other multilateral and private financing.

Six principles underpinned the Paris Club: solidarity, consensus, information sharing, case-by-case approach, conditionality (IMF program) and comparability of treatment (accept no less favorable a restructuring). The club-like character allowed creditors to coordinate their policies and ensure inter-creditor equity. The “comparability of treatment” principle also helped ensure an equitable allocation of financial losses between bilateral creditors and private-sector creditors. Coordination between the Paris Club and the IMF was also supported by the fact that the Fund’s major shareholders were members of the Paris Club.


Disagreement among bilateral creditors prevents IMF from supporting financially distressed countries

In principle, however, the Fund sticks to a non-toleration of arrears vis-a-vis official creditors, meaning that as long as a debtor country is in arrears on its debt to a bilateral creditor, the Fund cannot extend any credit to the debtor. Individual countries therefore effectively had a veto over IMF lending programs. The Fund accepted financing assurances from Paris Club members, often extended to non-Paris Club creditors as voiding arrears for the purpose of providing loans. But effectively, this gave individual Fund shareholders the right to veto an IMF program, therefore providing with enormous leverage, provided a debtor country was in arrears in its debt.

In 2015, a reform of the lending into arrears policies to official creditors (LIOA) in principle allowed the Fund to approve a program even if a country is in arrears, or has failed to receive financing assurances, form an individual shareholder, but only under specific circumstances: the official creditor consents and it does not jeopardize IMF financing. The reform sought to strengthen the incentives for collective action to provide for so-called official sector involvement (provision of debt relief by bilateral lenders) as long as the debtor was seen as engaging in good faith negotiations with its creditors. But given the importance of China as a bilateral creditor, the IMF under current rules is unlikely to approve an IMF program over China’s objections.

Effectively, China has a veto over the approval of an IMF program, and China needs to offer financing assurances for the IMF to be able to approve a program. By comparison, private creditors are in far weaker position, as the Fund allows for lending into arrears (LIA) to private creditors as long as debtor is negotiating with creditors in “good faith”. Private sector creditors do not have a veto over IMF programs. This policy was introduced in the late 1980s with the purpose of weakening private sector leverage which had allowed private sector creditors to block IMF lending indefinitely while nudging recalcitrant creditors to engage constructively with the debtor country.


Traditional bilateral creditors and China are struggling to find common ground

Sovereign debt restructuring has always been an ad hoc process, pitting creditors and debtors and creditors against creditors. The emergence of major non-Paris Club bilateral creditors, namely China, which does not accept the traditional Paris Club approach to restructuring, is undermining inter-creditor coordination and is complicating the swift provision of financing assurances and the efficient restructuring of sovereign. Not only has China the ability to block IMF programs. Its importance as a creditor, in many countries it is the most important bilateral creditors, means that without China agreeing to sufficient debt relief, lasting economic stabilization prove impossible, at least in the context of inter-creditor equity.

For example, across all DSSI countries, external debt owed to Paris Club feel to 11% in 2020 from 28% in 2006, while China ‘s share increased to form 2% to 18% and Eurobonds increased from 3% to 11%. Last but not least, debt owed to multilateral development banks fell form 55% to 48%. Under traditional rules, loans from MDBs loans are treated as preferential creditors whose debt is considered super-senior on account of its concessional character. If China did not participate in a restructuring, the Paris Club and private creditors would need to private disproportional debt relief, potentially making China whole.

Moreover, the West charges China with using secret clauses and opaque lending practices, including “hidden debts”. This also has Paris Club members concerned about inter-creditor equity. Western creditors will be reluctant to restructure their claims as long as they do not know how much the country owes to China and whether debt owed to China is restructured on (roughly) same terms as its own, or at all. Otherwise it risks incurring a disproportional share of the financial losses. China has indeed preferred to deal with debt problems on a bilateral basis, which has weakened multilateral creditor coordination. A lack of transparency and trust is main reason why financing assurances have been withheld and debt restructurings take so long.

China, on the other hand, objects to the super-seniority of multilateral loans, which effectively forces all other creditors to take greater losses, as their claims are traditionally excluded from restructuring. As China is underrepresented in multilateral institutions, it incurs a disproportional loss compared to Western creditors, given its relatively larger share of bilateral claims and its underrepresentation in multilateral development banks. China also objects to how the various types of lending should be classified for the purpose of debt restructuring. All of this has made the process of providing debt relief very choppy and unpredictable. Unless a coordinated approach to debt restructuring is agreed on, countries in distress and default will continue to suffer unduly against the backdrop of creditor fragmentation.


China wants to bend international norms to minimize its financial losses

China and other creditors stand next to no chance of getting repaid in full in many cases of sovereign debt distress. All creditors will have to take a loss. Inter-creditor conflict is about how the financial losses are allocated. As long as the conflict continues, providing debt relief quickly and efficiently along established or newly established lines will remain choppy.

Some observers have alleged that China is strategically withholding support for traditional debt restructuring because it wants to weaken the Western-dominated international financial architecture in the context of a Cold Financial War. This is why it prefers bilateral restructurings and disregards established multilateral norms. However, other China-dominated institutions like the Asian Infrastructure and Investment Bank (AIIB) are cooperating smoothly with established MDBs like World Bank along traditional lines. 

More likely, however, China simply seeks to minimize present and future financial losses. And China may not yet have come to accept the inevitability of losses. Certainly, individual creditors, perhaps for bureaucratic rather than grand-strategic reasons, are reluctant to acknowledge significant financial losses. China, for the most part, does behave like a commercial creditor keen to recover its money, which explains debt treatment and maturity extension rather than face value reductions and larger NPV reductions. China’s interest-free loans come out of aid budget and therefore do not lead to any financial losses in accounting terms. Bureaucratic interests and incentives may prevent a more sensible approach to debt restructuring that would benefit China and the debtor countries.


China will reluctantly, if incompletely accept the need for multilateral financial cooperation

There are good reasons to believe that China will largely, if reluctantly and incompletely come around. After all, as long as Western creditors do not allow China to free-ride, China’s bilateral restructuring approach will only go so far, as Beijing is unlikely to be able to impose adjustment policies on debtor countries. Moreover, providing refinancing to a sovereign that is essentially insolvent just leads to throwing good money after bad money and simply kicks the can down the road before it hits a wall. Then China faces the choice between greater cooperation with Western creditors or not getting its money back.

Nevertheless, as long as the Paris Club and Beijing cannot agree, future debt restructuring will not become smoother. China is in the end likely to come around, if reluctantly and gradually and incompletely, to accepting a sovereign debt restructuring debt template along traditional norms. The West will not bail out China. And China will not want to be blamed for holding up debt relief and economic stabilization in a situation where losses have become inevitable. 

But with financial losses inevitable and the political costs increasing, the incentives to converge largely if incompletely to the traditional debt restructuring template will strengthen relative to a scenario where recalcitrant Western creditors refuse to sign up to a restructuring that, from their point of view, unfairly advantages China. After all, few countries will be willing to end their financial relationship with Western creditors by choosing to treat China more favorably than Western creditors. In the meantime, it is countries in distress and default that will incur the cost of continued inter-creditor disagreement.