May 27, 2022
Rosa M. Lastra, Centre for Commercial Law Studies, Queen Mary University of London
In 2020, just as the world was recovering from the global financial crisis, the COVID-19 pandemic hit countries with such force that any hint of financial and monetary normalization quickly evaporated. Advanced Economies (AEs) embarked on gargantuan programs of monetary and fiscal support to confront the unprecedented public health crisis (both a demand shock and a supply shock), social disruption, and the ensuing contraction in economic activity following government-imposed lockdowns.[1] Both the global financial crisis and the COVID-19 pandemic remind us that, in the presence of crises, the resources of governments and the activities of central banks can become devoted to short-term crisis management, with the authorities often losing sight (and possibly control) of longer-term debt sustainability.
Emerging Market and Developing Economies (EMDEs), with much less room to maneuver through the COVID-19 crisis than their counterparts in AEs, experienced even greater challenges. Their lack of fiscal space and the sensitivity of their balance of payments to the exogenous shocks of COVID-19 (with the loss in tourism, remittances, tax revenues, and other inflows) exacerbated their economic problems, leading in the process to yet greater indebtedness and inability to meet their existing debt obligations.
Debt vulnerabilities in many of these countries predate COVID-19. The past decade has seen the largest, fastest, and broadest increase in debt in fifty years. The result is that many highly indebted countries face increased crisis containment costs with fewer resources and income prospects, and less capacity to act. Erupting sovereign debt crises in Sri Lanka and Zambia are cases in point. Russia’s invasion of Ukraine is acting as a new and potent amplifier of old vulnerabilities, pushing up food and fuel prices further when countries can least afford it. Higher interest rates in the United States and other developed countries intended to counter higher than expected inflation are a cause of great concern for EMDEs in general and for Low-Income Developing Countries (LIDCs) in particular, with capital inflows drying up and the cost of borrowing rising, adding to existing debt burdens.
If we are on the verge of a systemic sovereign debt crisis, having avoided one so far, the question arises: is our existing international debt architecture suitable to handle it?
The answer is NO. There is no institutional framework, no bankruptcy code, for sovereign debtors. The current international debt architecture is comprised of sovereign debt contracts (governed by national law and subject to the jurisdiction of national courts), institutions such as the International Monetary Fund (IMF) and the World Bank, groupings such as the Paris Club (fighting for relevance with the rise of non-Paris Club official creditors, notably China) and its would-be successor, the Common Framework for Debt Treatments beyond the DSSI (a more inclusive but still nascent, and at-best unproven platform), and ad hoc policy frameworks that support orderly debt restructuring across markets and instruments.
Treaty-based bankruptcy proposals had been floating around for years, and enjoyed a brief moment in the limelight in 2001–03, when governments and market participants debated the IMF’s proposal for a Sovereign Debt Restructuring Mechanism (SDRM). Since the SDRM was shelved in 2003, bankruptcy proposals are still just floating, while financial architecture debates have grown progressively incrementalist and unambitious.
Absent an international treaty, the solutions to the problems of sovereign debt are likely to remain based on contractual techniques (collective action clauses and others), possibly in conjunction with the adoption of soft law norms, a voluntary ‘code of conduct’ building on past efforts by the likes of INSOL International, the Council on Foreign Relations, the Institute of International Finance, UNCTAD, and others. Such norms can act as a helpful guide for debtors, creditors, and judges.
Statutory solutions, however, should not be dismissed. Though this might not be the time to resuscitate a full-blown international SDRM, an alternative and much more modest proposal would be a creative interpretation of Article VIII, section 2(a), of the IMF Articles of Agreement. One could also consider other options, such as amending sovereign immunity laws in the United Kingdom and the U.S. to permit judges to halt lawsuits against countries in which the IMF certifies that normal debt service is impossible in the light of dire economic circumstances, or having a UN Security Council Resolution akin to the resolution adopted in 2003 that shielded oil assets in Iraq (following the fall of the Saddam Hussein regime) from “all forms of judicial process” (as suggested by my colleagues Lee Buchheit and Sean Hagan).[2]
If statutory sovereign bankruptcy remains off the table despite the damaging legacy of COVID-19 for LIDCs and other EMDEs, a new Heavily Indebted Poor Countries (HIPC) initiative, a HIPC II, may be in order. We cannot ignore the plight of poverty. Such new HIPC initiative should take into account the lessons from the HIPC experience, especially the propensity to over-borrow by countries that benefit from debt relief (leading to a new build-up of unsustainable debt), the absence of sound debt management principles and weak governance, but also the underlying rationale: broad and comprehensive debt coverage. HIPC II should establish a better system of safeguards monitored by the IMF to achieve long-term debt sustainability and should prioritize debt relief through a new climate change agenda, developing green and blue (marine conservation) strategies, and raising greater awareness of the need to preserve, protect, and invest in nature.
[1] The extent to which quantitative easing (QE) in particular became a dangerous addiction, compromising the sustainability of public finances and financial stability and increasing wealth inequality, was questioned in the UK House of Lords Report on QE to which I acted as Specialist Adviser in 2021. The committee conducting the inquiry that led to the publication of the Report heard in oral evidence that if inflation rises (as it has since the report was published July 2021), independent central banks may come under political pressure not to raise interest rates to control it because the risk to public finances and debt sustainability would increase significantly. BACK TO POST
[2] Since UN Security Council Resolutions are not self-executing under U.S. law, the U.S. president enacted Executive Order No. 13,303 on the same day as UN Security Council Resolution No. 1483. BACK TO POST
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