September 19, 2023
How the IMF can make sovereign debt restructuring more effective
This Econographic is part of our Next Gen Fellowship which aims to cultivate a new generation of young economists to rethink the pillars of economic global governance. These undergraduate Fellows researched governance of the international financial system with the Bretton Woods 2.0 Project in Summer 2023.
In the aftermath of the global financial crisis, a combination of low interest rates and abundant liquidity caused public debt in emerging market economies to almost triple from $215 billion in 2010 to $627 billion in 2021. But the Covid-19 pandemic dealt a heavy blow to sovereign financing. A sharp drop in investors’ risk appetite sucked capital from emerging markets, particularly from low-income countries, raising the “rollover” costs for governments carrying already high levels of debt. On top of soaring interest costs, governments issued more short-term debt as they needed additional cash to pay for vaccines and fiscal stimulus, which heightened refinancing risks. As low-income countries’ credit ratings were cut into junk territory, the G20 suspended their debt repayment for over a year and introduced the Common Framework to speed up restructurings. But a lasting solution to debt sustainability in low-income countries requires more dramatic action, in which the IMF will play a critical role.
Sovereign debt restructuring is essentially a zero-sum game of allocating the burden of a haircut among different creditor groups. Under the Common Framework, a debtor country would first request debt relief from official bilateral lenders before seeking treatment at least as favorable from its private creditors. While the Common Framework has looped non-Paris club countries like China (which has been resisting multilateral debt negotiations) into debt relief talks, it fails to help different creditors agree on what a fair burden sharing looks like.
One point of contention is the preferred creditor status of multilateral lenders. Notably, China has insisted that multilateral development banks (MDBs) take losses alongside bilateral and commercial creditors. Since the IMF cannot sign off on bail-outs unless all official creditors commit to writing down loans, China has tried to extract concessions from MDBs by delaying the installment of IMF financing. At the Global Sovereign Debt Roundtable in April, the IMF agreed to provide more grants to indebted countries in exchange for China softening its demand, although there was no guarantee from China that it would provide debt relief in line with other official creditors.
Then there is the matter of coordinating between official and private creditors. The Common Framework delays restructuring by forcing private creditors to wait for and follow the terms set by the official creditors’ committee. This would have worked in the days when official creditors dominated the lending market. But as the number of private creditors multiplied, official and private creditors often clashed over the terms of restructuring. For example, official creditors tend to prefer maturity extensions while private creditors favor haircuts in exchange for early cash flows. Moreover, credit rating agencies duly downgraded countries seeking debt rescheduling and debt relief, even though such treatments would improve countries’ debt sustainability from a development perspective. Consequently, many countries are reluctant to join the Common Framework for fear of losing access to private markets.
As lenders remain in a gridlock, the IMF can play a bigger role in accelerating restructurings and staving off future debt crises. To start, the uncertainty about borrowing countries’ true ability to repay and private creditors’ willingness to grant comparable relief have held up agreement on restructuring terms. Although the IMF does not directly take part in debt negotiations itself, it is the only organization with the political legitimacy to act as a neutral advisor to both debtors and creditors. It can, for example, build on top of the IIF-OECD Debt Transparency Initiative by reconciling the debt data it receives from sovereigns with information reported by private creditors. Collaboration with the World Bank, its sister institution, is equally important as the latter produces long-term growth forecasts that inform debt sustainability analyses. As the world’s crisis lender, the IMF can also design financial incentives that would encourage greater transparency, such as the disbursement of grants or concessional loans that are conditional on borrowing countries meeting a set of disclosure requirements. Greater debt transparency has two benefits. One is that it would encourage private creditor participation in granting debt relief by reducing official creditors’ monopoly on assessing compliance with the “comparability of treatment” principle. The second is that if sovereigns can make public the terms and arrangements that were previously hidden, this would hopefully restore investor confidence and improve their credit ratings.
Moreover, the IMF should make good use of its financial firepower. As a welcome first step, it has advocated the reallocation of covid-era discretionary special drawing rights (SDRs), which amounts to almost $650 billion, to low-income countries. Cash-strapped governments could then swap SDRs with currencies to shore up their reserves and support their economic recovery. At the Summit for a New Global Financing Pact in June, the IMF’s managing director announced that the IMF has successfully rechanneled 20 percent ($100 billion) of the SDRs into trusts that would issue concessional loans to low-income countries. But to achieve a more ambitious 40 percent reallocation, the IMF must convince non-participating countries that the global public goods that arise from more foreign assistance outweigh the domestic budgetary costs. Moreover, the IMF can mobilize external sources of financing. It should work with the OECD to earmark a portion of the revenue from the global minimum corporate tax for development purposes.
Lastly, the IMF should take advantage of the ongoing restructurings to introduce new financial instruments that better serve the needs of poor countries. Take state-contingent debt instruments, which reduce interest payment during recessions and increase payout in good times. Their popularization would not only help weak economies absorb commodity shocks but also avoid unnecessary credit downgrades due to short-term liquidity problems. Innovations often emerge out of crises. The IMF, with its extraordinary convening power, must take advantage of this opportunity to set up contractual standards that befit today’s increasingly complex debt landscape.
Bruce Shen is a former Next Gen Fellow with the GeoEconomics Center’s Bretton Woods 2.0 Project.
Euel Kebebew is a former Next Gen Fellow with the GeoEconomics Center’s Bretton Woods 2.0 Project.
At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.
Image: International Monetary Fund (IMF) Managing Director Kristalina Georgieva holds up a logo for the 2023 global policy agenda at the start of a news conference during the 2023 Spring Meetings of the World Bank Group and the International Monetary Fund in Washington, U.S., April 13, 2023. REUTERS/Elizabeth Frantz