June 15, 2022
Aitor Erce, Universidad Pública de Navarra
As advanced economies start exiting from the extraordinarily accommodative fiscal and monetary policies that have characterized recent years, concerns about the ability of developing countries—from El Salvador to Sri Lanka passing by Tunisia—to continue servicing and rolling over accumulated public liabilities are coming to the fore. Against this background, the sovereign debt architecture remains unfit for purpose. Countries exiting default have historically been unable to transition to sustainable policies and achieve balanced long-run growth. Underlying these anemic paths out of crises is the “too little and too late” syndrome, the tendency of debt restructurings to under-deliver relief, leaving countries unable to finance their developmental needs in a sustainable manner.
To make things worse, forthcoming resolutions of debt overhang are further complicated by the growing diversity of lenders and a jockeying among them to gain priority. Major creditors now include newly emergent official players (most notably China) as well as bondholders, commodity traders and, often forgotten, domestic bondholders and lenders. As an example, in 2020, African sovereign debt securities issued abroad stood at $150 billion and sovereign bonds issued domestically at $500 billion. In parallel, sovereigns are increasingly relying on non-transparent, collateralized, and resource-backed borrowing from China and from commodity traders. Their presence complicates fair burden sharing and already has had a negative effect in recent debt restructuring negotiations.
In November 2020, the G20 endorsed the Common Framework for Debt Treatments beyond the DSSI. It is intended to support low-income countries struggling with their debt burdens. Relief under the Common Framework will, in principle, not be conducted using debt write-offs. As with the Paris Club, a comparability of treatment undertaking, pursuant to which the debtor is bound to seek comparable treatment from its other external creditors, guides the Common Framework. In theory, this ensures that adequate burden sharing emerges from the debt resolution process.
The Common Framework provides a unique opportunity to bring under the same umbrella all G20 official creditors and private creditors. However, it has (at least) two weaknesses that will render it insufficiently effective in meeting the financing challenges of developing countries. The first is the significant reluctance of the private sector to provide debt relief. This reluctance is based on the fear of private creditors that, because of uncertainty regarding the debt perimeter that accompanies the widening spectrum of creditors, they will be forced to provide unfairly large debt relief. The comparability of treatment undertaking places the burden to accomplish comparable participation of private creditors entirely on the debtor and provides no effective means of enforcing it. Private creditors may comply for their own reasons, but any commitment that they may make to participate is not legally binding. Thus, even if a large number of private creditors agree to participate in a debt restructuring, the potential for others to remain outside the agreement and claim full repayment is still high. This leaves debtors forced to face lawsuits by private creditors, potentially in multiple jurisdictions. This reluctance to provide relief also helps explain many countries’ fear that requesting relief from private creditors will taint their reputations and trigger litigation and credit rating downgrades. Chad, Ethiopia, and Zambia, who have already requested treatment under the Common Framework and are struggling to reach an agreement with their private creditors, testify to this.
The second is the weak analytical underpinnings guiding the determination of the need and depth of a debt operation. Currently, following a request to enter the Common Framework, the International Monetary Fund (IMF) conducts a Debt Sustainability Analysis (DSA) to determine the amount of debt relief needed. The DSA framework has no generally applied model of market access, nor does it include a systematic analysis of the impact of restructuring on growth. The DSA framework also lacks a structured way to link domestic sources of sovereign financing to economic growth. As debt stress keeps growing, domestic suppliers and non-financial creditors in some parts of the world are unwillingly becoming a source of public financing as governments accumulate payment arrears against them. While not paying suppliers (thus making them creditors) may help cover short-term borrowing needs, it also hinders economic production and delays economic recovery through multiple channels, including hurting the profitability of the private sector, stressing the banking sector, and, by undermining trust in government, reducing fiscal policy effectiveness. Instead, assumptions about growth and market access effects typically depend on judgement and rarely offset the lack of sharper analytical tools (this partly reflects the role of political pressures in the design of debt restructuring operations). The result is uncertainty about the capacity of DSAs to predict sovereign stress. In the case of the DSA used in countries with market access, the performance is dismal, failing to predict debt crises and providing false alarms over 60% of the time. This lack of effective modeling of the impact of debt operations, together with general forecasting uncertainty, effectively allows both debtors and creditors to insist on assuming improbably benign scenarios, thereby delaying and limiting debt relief while inflicting undue damage to the debtor country’s domestic economy.
These concerns call for three sets of reforms. First, the Common Framework needs to cover more countries and be given more teeth to promote earlier and broader involvement of private sector lenders. Comparability of treatment could be broadened to also imply that creditor governments are required to take steps to facilitate the operation with their private residents. Under this version of comparability of treatment, debtor countries would undertake to seek from private creditors a treatment on comparable terms, and creditor governments granting relief would undertake to seek that private creditors under their jurisdiction provide such relief. This could be achieved, for example, through the enactment of legislation preventing lawsuits against debtors that are under the umbrella of the Common Framework. If governments cannot use domestic legislation to force private sector participation, they could use alternative approaches to elicit it, including regulatory forbearance and tax incentives. To be most effective, comparability of treatment under the Common Framework should minimize potential free-riding by opportunistic creditors. For that, debt transparency must be enhanced across the board, including through the establishment of a detailed public registry system for sovereign liabilities, and stricter regulations for the disclosure of debt contracts and debt holdings by the private sector.
Second, there is a need to sharpen the analysis in which decisions to restructure debt are based. DSAs should be informed by a more thorough analysis of the potential consequences of debt restructuring on economic growth and market access. In particular, for countries that source the bulk of their market financing via domestic markets, the relevance of domestic sources of financing and their connection to internal demand and growth should be systematically embedded within the DSA framework. In addition to financial institutions, two sets of domestic actors merit further attention. National social security systems are often large holders of sovereign bonds and their involvement can have consequences for long-term growth through their impact on poverty and inequality. In addition, non-financial commercial creditors are often exposed to payments arrears, with dramatic consequences for domestic economic growth. The absence of these actors in the DSA framework likely reflects the notion of respecting domestic affairs that has led the IMF to have a policy for arrears to private creditors covering foreign residents but not domestic residents. Still, the fates of these local actors have first-order macroeconomic implications, and should inform the design of effective international debt policies.
A recent revision of the DSA framework for market access countries goes some way to addressing these concerns. It includes a module to analyze the governments’ ability to consistently meet given levels of financing needs. Instead, the role of domestic debt and its connection to economic growth remains ingrained within the DSA framework, at best, in an ad hoc manner. What is best for foreign bondholders need not promote balanced economic growth, and the DSA framework should do more to account for this.
Relatedly, and this is the third set of reforms, the Common Framework could be revamped to better align with globally agreed climate and development goals by promoting debt relief oriented towards a green and inclusive recovery. Similar to a recent operation in Belize and to various agreements signed by the Paris Club in the 1990s, the Common Framework could include provisions for debt reduction using debt for social, environmental, or investment activities swaps, through which creditors would cancel specific debts in exchange for a commitment from the debtor to undertake public investments in line with the 2030 Agenda for Sustainable Development.
Lower-income countries will continue to seek boosting growth through public investment that helps cover their substantial infrastructure needs. A sovereign debt architecture that is conducive to sustainable green growth requires financing for developing countries that is less crisis prone. For that, promoting state-contingent and countercyclical sources of funding would be key. GDP- or risk-linked debt instruments, designed to pay less when repayment capacity is lower, are straightforward tools to minimize risks of unsustainable debt dynamics. Unfortunately, aside from the countercyclical loan portfolio of the French Development Agency and the oil facility hosted by the Arab Monetary Fund, examples of this type of lending do not abound. Creditors have shied from offering these products due to concerns about novelty risk complexity risk, liquidity risk, and measurement risk (i.e., fear of manipulation of the metric for payments). According to The Commonwealth, opportunities for using this family of instruments are greatest in the case of privately-held restructured bonds and bilateral official bonds—precisely those falling under the Common Framework. The World Bank and regional multilateral development banks, as well as the IMF, could partner in this effort by promoting the necessary data quality and transparency required to foster broader use of these instruments by sovereigns.
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