The world is unprepared for a wave of sovereign debt defaults
The World Bank is not often inclined to make definite prophesies of doom instead of wringing its hands and talking vaguely about risk. So it’s something when that speak frankly of a “next round of debt crises” in emerging markets.
It is not very surprising that we are on the verge of a series of defaults. The end of a long period of extremely low global interest rates, the hit to growth caused by the pandemic, the enormous uncertainty caused by Russia’s invasion of Ukraine, in particular the shock to net importers of raw materials by soaring fuel and food prices, and the rise in the dollar quickly increased the burden of debt denominated in dollars.
It’s important to keep this in context and not start making it a morality piece about inept governments in developing countries. Pre-pandemic, emerging markets did not go on a mass borrowing spree. Nor is the flood a tsunami: the World Bank estimates that we will not see an episode comparable to the Latin American crisis of the 1980s or the phenomenon of heavily indebted poor countries (HIPC) of the 2000s.
Yet the vulnerable and those who have made policy mistakes are certainly affected. Besides Russia itself, Zambia and Sri Lanka, among others, have already defaulted, hit in their cases by high infrastructure costs and declining export earnings from copper and tourism, respectively. Others, particularly in sub-Saharan Africa, are following the same path.
When the wave hits, will lenders and institutions like the IMF be ready to address these issues in a constructive, growth-friendly way? One would think that after decades, if not centuries, of practice, creditor countries would have found a predictable and reasonable way to restructure sovereign bonds. You would have mattered had it not been for the changing nature of international capital flows and the disorganization of creditors. And this time there is a big new factor in the form of China.
There have been multiple attempts to regularize sovereign restructuring in order to achieve fair burden sharing among creditors. The “London Club” of commercial banks was created in 1976, when most sovereign borrowing was through bank loans, and was used extensively during the sovereign debt crises of the 1980s. really was relevant after the transfer of borrowing to the capital markets. For official creditors, the “Paris Club” was created in 1956 to deal with a debt crisis in — where else? — the Argentinian serial defaulter.
The Paris Club has played a key role in resolving episodes such as the HIPC debt relief initiative, but has always struggled to convince private sector creditors to also write down sovereign debt. Twenty years ago, the IMF tried heroically, but unsuccessfully, to set up a formal bankruptcy procedure (the sovereign debt restructuring mechanism) to bail out private investors.
Borrowers have increasingly added covenants to sovereign bond contracts to facilitate restructuring, but their coverage and effectiveness are imperfect. Sovereign bankruptcies with official bailouts and private creditors are still worked out ad hoc, sometimes with committees of rival creditors. Resolution can be particularly lengthy when struggling litigious investors are involved.
The EU has tried to put in place its own formal mechanism to include private creditors in the restructuring, Deauville proposal, in 2010 amid the eurozone debt crisis. But it was handled as chaotically as the official rescue process in general and was eventually scrapped. The G20 of major economies have created a common framework for dealing with debt during the pandemic in 2020, but it’s too vague to provide certainty.
So the new wave of defaults will be dealt with the usual framework of jury-rigged creditors even before adding the uncertainty of China’s emergence as a major official bilateral creditor. China is not a member of the Paris Club, due to its persistent reluctance to join groups led by wealthy countries. Its loans come from various state agencies with different approaches, including politically motivated infrastructure developments under the Belt and Road Initiative. He prefers to negotiate debt relief piecemeal, bilaterally and privately.
Debt crisis resolution is one of the political and institutional areas (the World Trade Organization being another) in which an increasingly powerful China is often accused of opacity, disregard for multilateral principles and a general refusal to play the game. This is often a reasonable criticism, but on the other hand, the rich countries can hardly take pride in the rules they have worked out on restructuring, in particular by addressing to private creditors, who generally hold chunks sovereign debt in more African countries than China.
Resolving the next emerging market debt crisis will likely be even slower and more painful than usual now that China is involved. This would be a good opportunity to develop a more systematic treatment that will bind all creditors, public and private. But China’s experience in other policy forums and weak efforts even before it became a major creditor suggest that’s not exactly the most likely outcome. Defaulters should be prepared for delicate negotiations ahead.
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