Cutting the Gordian EM restructuring knot

June 06, 2023 10:24
Photo: Reuters

In recent years, investors have become accustomed to a significant impasse facing emerging market sovereign debt restructurings. China’s role as a major creditor owes to its Belt-and-Road initiative (BRI) and its inability, or unwillingness, to sign on to the traditional bilateral creditor coordination mechanism (i.e., the Paris Club) when its BRI lending went bad. February’s G20 meetings failed to breach the deadlock, and secondary market prices for sovereign debt of restructuring candidates continue to trade at deeply distressed levels.

Although the recent approval of Sri Lanka's long-delayed program with the International Monetary Fund (IMF) seemingly clears the way for future progress, we doubt that the treatment of Sri Lanka’s debt to China is repeatable. However, as with the mythological Gordian knot, if there is a will, another resolution may exist under the IMF’s current policy mechanisms with modest changes to bond contracts. Our proposal not only addresses the current standstill, but it also improves participants’ incentive to maintain market access following a debt restructuring.

China is now the world’s largest bilateral creditor by far, more than double the size of all Paris Club creditors combined. Moreover, most Chinese creditors to the affected countries are policy- or state-owned commercial banks, and, in contrast to otherwise universally accepted practice, the Chinese authorities do not consider them sovereign. Thus, they are not subject to Paris Club treatment. Moreover, during prior opaque restructurings in countries as wide ranging as Venezuela and Djibouti, China appears to have “cherry picked” and claimed collateral in the form of commodities and port infrastructure, a practice normally eschewed by bilateral sovereign creditors.

Past attempts to solve the problem have largely fallen flat. On the heels of the March 2020 Debt Service Suspension Initiative, which was limited to payment suspensions to bilateral creditors, the IMF, World Bank, and G20 countries developed the so-called “Common Framework in 2021.” While not initially singling out China, the framework prescribes an approach where up-front debt treatment by bilateral creditors is a condition for IMF programs. Furthermore, the subsequent negotiation of comparable terms with private creditors is a condition to further disbursements. Initial optimism regarding the framework has proved fleeting: bilateral debt relief for Zambia—where China co-chairs the bilateral creditor committee—has not even been agreed upon. The IMF program subsequently stalled after Board approval.

The “solution” adopted in Sri Lanka’s IMF program merits scepticism. Sri Lanka’s program languished since last summer’s agreement on polices as key bilateral creditors, including China, demurred from extending financing assurances, which are essentially regarded as a commitment to abide to Paris-Club terms and IMF debt-sustainability targets. Approval was finally unblocked by splitting China’s bilateral debt in two: claims by China ExIm Bank were deemed sovereign (and received the equivalent of financing assurances), while those of China Development Bank (CBD) were lumped together with commercial debt (restructuring of which is a requirement for the second IMF disbursement envisaged in six months). However, the arrangement may leave both sides unhappy. As in Zambia, ExIm Bank could still renege on commitments, while the significant progress reportedly made in the commercial creditor committee risks being undone once CDB’s requests are presented. Thus, a repeat of the Zambia situation is a high-probability, if not a central, scenario.

The situation need not be deadlocked—there are tools in place to move ahead. With this background, it appears the Common Framework can now be safely laid to rest, and the creditor split in Sri Lanka’s situation can remain an isolated case. Instead, we propose that the IMF use another existing tool, the so-called “Lending Into Arrears To Official Bilateral Creditors (LIOA)” policy, more aggressively. The origin of that policy is telling.

In 2013, Russia was the sole buyer of a bond issued by Ukraine in the waning days of the latter’s Yanukovych government in an effort to move lending to Ukraine outside the scope of a future sovereign debt treatment. On the heels of Russia’s invasion and annexation of Crimea in 2015, a restructuring on Ukrainian debt was needed, and Russia balked at accepting bilateral terms on its “Eurobond,” which in turn put financing for the IMF program in peril. As a result, the IMF adopted LIOA, the Russian claim was not serviced, and the IMF disbursed funds to Ukraine. Moreover, the Fund has used LIOA as a threat in other cases to get some smaller bilateral creditors to deliver financing assurances.

From perceived bad faith to hiding behind private-creditor status, the parallels to the current situation are obvious. The IMF Board could advance stalled programs under LIOA with the condition that debt service to China is halted until requisite and comparable debt treatment with the country is agreed upon.

Potential “hold-out” gains for China and others are a theoretical problem under our proposal. If all other creditors agree to debt restructurings and China does not, then China would still have all of its original claims intact after full upon completion of the IMF program. This would be an unpalatable situation to say the least, especially if the other creditors provided meaningful debt relief. Moreover, the problem may be large enough that other creditors could balk at initial restructurings.

However, while looming large in theory, this problem may not be insurmountable for a couple of reasons. First, we doubt that China would enjoy the reputational cost of being the sovereign holdout creditor who gets paid in full, a role that only so-called vulture funds embrace on the private side. Second, even if one were not to put much stake in reputational concerns, another work-around exists.

In new, post-restructuring debt and bond contracts, a modest tweak can redress the hold-out problem. Introducing a so-called “Most-Favored Creditor Clause” (MFC) into the newly restructured debt would embed a substantial disincentive against favorable holdout settlements. In basic terms, this clause would require each restructured debt to benefit from a more favorable restructuring in the future. In extremis, if a holdout creditor was subsequently made whole, that would also be the requirement for prior restructured bonds. Thus, if China or any other holdout were to follow this route, all other restructured claims would “snap back,” and the original non-sustainable debt situation would reappear, including the need for another IMF program with LIOA. This could provide a powerful incentive against holdouts of any type.

Implementing polices along the lines proposed also could provide a jolt to needed international coordination. Advancing rules-based debt restructuring is an international common good that does not align with pro- or anti-Western narratives. India’s role chairing the G20 is particularly propitious. It already blazed a trail for other “non-traditional creditors” by agreeing to provide financing assurances to Sri Lanka. During its G20 presidency, it could further leverage its leadership and rising power to constructively mediate and implement a workable debt-restructuring along the lines proposed above. In turn, the G7 countries would also need to stand ready to step up with any “back-fill financing” if Chinese financing going forward falls short, preferably via boosting IMF resources. The G7’s fledging Partnership for Global Infrastructure and Investment initiative designed to offer an alternative to BRI would be a natural starting point. Of course, actual country examples will provide their own idiosyncratic challenges, and, as in the past, they are best dealt within multilateral organizations that would also benefit from a common G20 vision.

Our market-based proposal appears more timely and easier to implement than other recently suggested alternatives. Other recent proposals have centered on creating large sweeteners to creditors from cleverly leveraged multinational balance sheets. Of course, these funds have yet to be raised, and tighter strings make it unlikely that they will be in time for Zambia and Sri Lanka. Though, in the end, such proposals may be the easiest way to prompt an overdue boost in IMF resources. In contrast, our proposal relies on already existing IMF policies that just need a simple IMF Board decision to be applied. While we propose a new element in bond contracts, the MFC is hardly new ground as the last decades brought the wide-spread adoption of collective action clauses (CACs). We don’t see a reason why MFCs should not be similarly easy to adopt as part of the exchange bonds offered in a restructuring.

Turning crisis into catharsis. Our proposal to quickly resolve the current deadlock in sovereign debt restructurings harkens to the Greek legend of cutting the intractable Gordian knot. But our proposal could also help overcome the chronic shortcomings of the past—repeated sovereign restructurings for the same country, e.g., in Argentina, Ecuador, and Zambia. Similar to MFCs, the introduction of covenants into sovereign bonds could help. Covenants feature prominently in corporate bonds (e.g., prescribing leverage ratios), but they find little equivalent in the sovereign universe.

A covenant that would accelerate a prior (restructured) bond if the sovereign contracted new, non-concessional debt would be a powerful disincentive against new borrowing, which has been a past culprit in subsequent restructuring needs. Covenants would be equivalent to similar conditionality in IMF programs, but binding even if there is no program. Complete bond acceleration may not be needed and a preferable situation may be to allocate only two-thirds of new debt issuance to buying back prior restructured debt. This could offer a road into a new and so-far elusive finality in debt restructuring. Staying in Greek, more catharsis than crisis.

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Lead Economist – Asia, PGIM Fixed Income