The politics of sovereign debt restructuring
By Pascaline della Faille, Country and sector risk manager, Credendo
By Raphaël Cecchi, Senior country risk analyst, Credendo
The analysis and opinion in this article is that of Credendo and its analysts and the views expressed are not necessarily those of WTW.
Over the past decade there has been a drastic shift in the composition of public debt. Creditors outside the Paris Club (e.g., China, India, Saudi Arabia), commercial private creditors, and a broader range of instruments – sometimes including non-transparent debt instruments – have come to play a larger role. The role of advantageous long-term low-interest concessionary debt has concomitantly become smaller. Hence coordination among creditors to address external public debt vulnerabilities has become more difficult, especially amid heightened geopolitical tensions. Efforts to remedy this issue, including the so-called Common Framework, and the Global Sovereign Debt Roundtable, have thus far not succeeded in addressing the underlying political challenges of sovereign debt restructuring.
Hence future sovereign debt restructuring processes are likely to remain lengthy and be dealt with bilaterally (mostly with China) or multilaterally on a case-by-case basis. Under these circumstances, several countries appear likely to turn to opaque bailout options requiring fewer conditionalities but imposing higher interest rates and potentially storing up greater risks for future debt crises.
After a decades-long steady increase, high global debt ratios have surged with the Covid-19 pandemic. Public debt is of a particular concern for low-income countries. According to the IMF, the majority were facing debt vulnerabilities as of August 2023, with 10 being in external debt distress and 26 at high risk of debt distress (see the accompanying essay, “Which countries are at high risk of debt distress?”). Even if global public debt (in relative terms) remains lower than it was prior to the HIPC global debt relief process in the mid-90s, its current level and the rising trend are worrying, as similar levels could be reached again in the future. Such a situation might be even worse than prior emerging market debt crises, in a complex environment of multiple types of creditors, high geopolitical tensions, elevated interest rates and rapidly worsening impacts of climate change.
Debt vulnerabilities can no longer be tackled in the same as way as in the past. This observation has to do with a drastic change in the composition of public debt that has occurred in the past decade. Firstly, domestic debt has become increasingly significant. Secondly, when it comes to the external share of public debt, the composition of external creditors has diversified sharply, with the rising weight of creditors outside the Paris Club (including China, India, Saudi Arabia, and the United Arab Emirates) and of commercial private creditors (bondholders and banks). The latter share has increased substantially, notably (but not only) in lower and upper middle-income countries, exposing them to a change in global financial conditions and investor risk perceptions.
Source: World Bank
In addition, the type of instruments has also evolved, with a rising share of bonds, syndicated loans, debt backed by collateral (e.g. commodity-linked loans from the private sector or through bilateral official lending and cash collateral), and sometimes more opaque instruments (e.g. hidden debt in Mozambique and Zambia, and the Chinese central bank’s swap lines). Moreover, after a continual decline since the early 2010s, concessional debt now accounts for a much lower share of the debt of lower middle-income countries, which implies that their public external debt has higher interest rates and shorter maturities.
In this new context, and taking into account the growing importance of China as a bilateral creditor, coordination among creditors to address external public debt vulnerabilities has become more complex, notably in a climate of strained international relations. This complexity is highlighted by the recent developments in the international debt restructuring process and the implications of the growing importance of China as a key player.
In 2020, the Covid-19 crisis exacerbated existing debt vulnerabilities, particularly in low-income countries, and pushed public debt levels to record new heights. Indeed, the pandemic amplified public spending needs to mitigate the health and economic effects of the crisis, while revenues declined due to lower economic activity and trade flows, which in turn increased debt burdens. Many countries, especially those with an already high debt burden before the crisis, had limited financing access or faced very high financing costs.
As a result, in 2020 several countries defaulted on their debt: Argentina, Ecuador, Lebanon, Suriname, Zambia and Belize (and again in 2021), followed by Sri Lanka, Ghana, Malawi and Ukraine in 2022. During that same year, Belarus and Russia also defaulted, but this was due to Western sanctions and not their inability to pay back their external public debt.
To help deal with abruptly heightened financial pressures, the G20 put in place the Debt Service Suspension Initiatives (DSSI) for 73 eligible* countries (broadly low-income countries). Among them, 48 benefited from the temporary suspension of debt service payments owed to their official bilateral creditors. However, the DSSI and the large emergency funds provided as a response to Covid-19 (by multilateral creditors and regional development banks) will not fix longer-term debt sustainability problems. Therefore, to prevent disorderly defaults, the G20 put in place the “Common Framework for debt treatments beyond DSSI” for DSSI-eligible countries. In 2020, Ethiopia, Chad and Zambia were the first to request debt restructuring under that framework. Ghana also joined last year, when the government announced it had ceased paying its public debt.
The first partial agreement was reached for Chad in early 2023, but this was mostly bilateral with commercial partners and did not include actual debt restructuring. Indeed, thanks to high oil prices, the country has no immediate financing gaps in its balance of payments. In the case of Zambia, an agreement was finally reached in June 2023, i.e. more than two years after it defaulted. Its official creditors (led by China) did not grant debt cancellation and instead opted for a restructuring consisting of grace periods and extended maturities. Moreover, a separate restructuring deal with private creditors is yet to be reached. Consequently, the Zambian restructuring case is incomplete, with important hurdles still to be overcome.
*Countries eligible to request Debt Service Suspension under the G20 DSSI were countries on the UN list of Least Developed Countries and countries eligible to borrow from the IDA at the time the initiative was endorsed in April 2020. To qualify for the DSSI, countries could not be in arrears with the IMF and/or the World Bank (ineligible IDA borrowers were Eritrea, Sudan, Syria and Zimbabwe).
The least one can say is that, almost three years after the process started, the Common Framework has been disappointing. It has not yet succeeded in reducing the complexity and length of the restructuring process for eligible countries, and has failed in getting the private sector involved, for three reasons. First, the entire process is thwarted by the fact that non-Paris Club creditors in particular – such as China and private bondholders – are the most exposed creditors, while the entire process is based on Paris Club practices. This creates a lot of technical discussions, especially in an environment of high geopolitical mistrust between the West and China.
Second, some countries that are eligible to participate in the Common Framework (e.g. Malawi and Djibouti, the latter of which is reported to have suspended its debt repayments to China and Laos) have not so far asked to restructure their debt under the Common Framework. Third, there is so far no multilateral mechanism – outside the Paris Club – for tackling a potential public debt crisis in non-DSSI-eligible countries (e.g. Sri Lanka and Suriname). Hence, an alternative and more efficient debt restructuring framework appears to be required.
In this context, the IMF has recently set up the Global Sovereign Debt Roundtable (GSDR). This is not a decision-making process but rather an information-sharing mechanism which aims to help multilateral agencies and private and public creditors to identify key impediments to restructurings, together with design standards and processes that can address them. This framework is chaired by the IMF, the World Bank and India (as G20 chair), and includes a broad group of participants, Paris Club and non-Paris Club bilateral creditors (including China), debtor countries and representatives from the private sector. The group aims to clarify key concepts to support predictability and the fairness of debt restructuring processes.
Looking ahead, the success of the GSDR will largely depend on creditors’ involvement and willingness to compromise. A fundamental obstacle remains China’s views on the privileged status of multilateral institutions. These institutions do not allow restructuring of debt owed to them because to do so would imperil their AAA ratings and thus their ability to fulfil their public mandates. China objects to this privileged status.
Given creditors’ different profiles and the variety of debt instruments, and taking into account the rising tensions between the West and China (which continues to insist on the participation of Multilateral Development Banks in debt restructuring and is itself reluctant to grant debt relief), it will be very challenging to put in place a new debt restructuring mechanism. Hence, future sovereign debt restructuring processes are likely to remain very complex and lengthy, dealt with bilaterally (mostly with China) or multilaterally according to a case-by-case approach, with negative consequences on debtor countries as well as on the recovery perspectives.
Public debt restructuring is no longer limited to external debt. As a matter of fact, a major dimension to address is also how to best handle the (rising) importance of domestic debt in total public debt. Indeed, restructuring of domestic debt is becoming a more frequent tool for restoring debt sustainability, as highlighted by the ongoing experience of Ghana and Sri Lanka (but not Zambia) and, in the past, Jamaica. However, such restructuring must be done carefully. The authorities must look at who owns the domestic debt (e.g. the banking sector, pension funds) and the implications of a restructuring on the financial system, economy and households, to avoid deepening existing structural problems (e.g. by hampering the banking sector).
China has become, by far, the number one bilateral official creditor for low-income countries. Hence, any external debt restructuring negotiation usually involves China, and this has wide-ranging implications.
Historically, China has limited experience with debt restructuring processes, so the learning process will take time to facilitate. This learning process will complicate debt restructuring talks, actual collective debt relief and the effort to find – if possible – a common level playing field. A constructive Chinese role is also made more difficult by the fragmented Chinese system and a lack of centralisation and coordination among the Chinese entities involved (notably China Development Bank, China Exim Bank and the People’s Bank of China). These institutions sometimes have differing goals and do not (necessarily) follow China’s official stance. Further internal and bureaucratic reforms within the Chinese system are thus necessary.
Meanwhile, China’s structural domestic hurdles will continue to slow down progress within the Common Framework.
Another problem lies in China’s different perceptions about assumed financial responsibilities and creditor involvement. Beijing was seemingly frustrated by the DSSI (which it eventually applied to, perhaps largely for international reputation reasons) because private and multilateral creditors were not involved. That frustration partly explains – together with debt issues related to the Belt and Road Initiative projects – why Chinese banks have been less constructive in the Common Framework talks in the recent past, and why the Chinese authorities have repeatedly been calling for fair burden-sharing among all creditors, including multilaterals, in the case of debt restructuring negotiations.
As a result, pressure from Beijing to end multilaterals’ preferred creditor status, potentially establishing a new collectively agreed common architecture with new rules is certainly going to increase in the coming months and years. This pressure might affect the IMF’s role in stabilising the international financial and monetary system as an international lender of last resort for low- and middle-income countries. Meanwhile, China appears likely to continue to favour its bilateral approach.
This is corroborated by a recent study (Horn S., Park. B., Reinhart C. and Trebesch C., 2023) which showed that a rising number of countries (e.g. Argentina, Pakistan) in need of liquidity support amid financial and macroeconomic distress have used swap lines from China’s central bank (PBC). Looking ahead, more countries could be incentivised to seek liquidity support and bailouts from China instead of the IMF, with fewer or no conditionalities
required but with higher interest rates. Such an evolution is made more likely by geopolitical tensions and the challenges of building up of a new world order and global governance system.
This trend of shifting international crisis management, with a big role for China as international lender of last resort for many developing countries, is underway and – as highlighted by the 2023 study – could “have implications for the international financial and monetary architecture, becoming more multipolar, less institutionalised and less transparent”. Therefore, debt sustainability risks could increase and be more difficult to assess.
