Editor's note: This is the first of a two-part series exploring the politics and prospects of debt relief in financially distressed developing economies. Part two can be found here.
Many low- and lower-middle-income countries are in financial distress or in default. A combination of overborrowing and COVID-related higher fiscal spending has led many low-income countries to experience significant economic and financial distress. Increased debt levels and higher borrowing costs, in part due to global monetary tightening, have forced countries like Ghana, Sri Lanka and Zambia into default, while leaving many others teetering on the edge of a debt default and financial distress. In order to re-establish economic and financial stability, many of these countries will need to restructure their debt and pursue International Monetary Fund-led economic reforms. But this requires bilateral (government) creditors to provide debt relief.
The emergence of important new bilateral creditors, such as China, has made it difficult to find agreement on the provision of debt relief, which is holding up debt restructurings and is making developing economies reluctant to apply for debt relief in the first place. Unless traditional bilateral creditors converge on a common approach, developing economies will linger in economic and financial limbo longer than necessary. Ultimately, a greater consensus among bilateral creditors will emerge, if only slowly.
The Rise of Financial Instability
A large number of low-income and lower-middle-income countries are experiencing financial distress in the wake of COVID-19, the Ukraine war and high U.S. interest rates. Some countries have already defaulted on their debt, while others are on the verge of doing so.
Earlier this year, the international rating agency Fitch Ratings said that nine governments had defaulted since 2020, a notable uptick from the 19 that did so between 2000 and 2019. In addition, Fitch currently rates eight sovereigns at very high-risk levels of CCC+ and another nine at similarly high-risk levels of B-, meaning another 17 countries are at elevated to high risk of default. For reference, the cumulative five-year default probability of sovereigns rated in the C-CCC range is 40%. However, the actual number of countries in distress and at high risk of default is far higher, as Fitch does not rate all countries. The actual number of countries in, or at risk of, financial distress is far higher.
Markets take a similar view. The dollar debt of around two dozen countries, including Argentina and Pakistan, is currently trading at more than 1,000 basis points over risk-free U.S. treasuries, effectively shutting them out of international capital markets and increasing their risk of default. But not all countries issue international bonds. Credit ratings and market-based distress measures thus fail to capture the breadth of the financial challenges that developing countries are currently experiencing.
The International Monetary Fund (IMF) estimates that almost 60% of all low-income countries, or a total of over 40 countries, are either in default or at high risk of financial distress. In addition to low-income countries, several lower-middle-income countries are also in severe distress (including Egypt, Pakistan, Tunisia) or are already in default (including Ghana, Lebanon, Sri Lanka, Ukraine, Zambia). Even some upper-middle-income countries, like Argentina, are in deep distress or in default. Financial instability challenges are concentrated in low- and lower-middle-income economies, particularly in sub-Saharan Africa.
Delaying the Provision of Financing Assurances
Just as developing economies are experiencing peak financial distress, they are finding it harder to receive the financing assurances and the debt relief from official creditors needed to enact IMF programs.
As the lender-of-last-resort, the IMF will only extend loans to distressed and defaulted countries once it receives so-called financing assurances from those countries' creditors, which can either take the form of ''new funding'' or debt and debt flow relief. Without those assurances, the IMF cannot provide financial support to a country in distress and launch a supervised adjustment program to monitor that country's economic and financial policies. But in recent years, it's become increasingly difficult for governments to secure new funding or debt (flow) relief due to disputes between their bilateral creditors, which has left countries in economic and financial limbo for longer periods of time.
Disagreements between creditors — particularly China and those in the Paris Club (which represents largely Western official creditors/governments) — have led to significant delays to IMF rescue packages and private-sector debt restructurings in recent years. The resulting uncertainty surrounding debt relief and restructuring has also made debtor countries more reluctant to seek pre-emptive debt relief, which has led to an even greater build-up of financial imbalances. Pre-emptive debt relief, if successful, can help a country avoid a painful financial default while putting it on a path toward financial sustainability. Pre-emptive debt relief is therefore preferable to an alternative scenario where a country is forced into ''hard'' default due to the greater economic and financial costs it engenders. But the longer it takes to restructure the debt and attract new financing flows, the greater the economic costs to a country. So countries' reluctance to ask for pre-emptive debt relief for fear of triggering the very default they're seeking to avoid unduly complicates a relatively lower cost, pre-emptive debt restructuring.
What's Changed?
Admittedly, sovereign debt restructuring has always been an ad hoc and sometimes inefficient process. The prolonged economic crisis and financial malaise of many developing and emerging economies in Latin America in the 1980s is a case in point. Debt restructuring was pushed off for too long in the context of ultimately unsuccessful adjustment programs. The failure to restructure debt led to far greater economic pain and greater aggregate financial losses than if debtors and creditors had agreed to an early debt restructuring and economic adjustment. In Latin America, the 1980s are tellingly referred to as the lost decade. Economies were in near-continuous crisis and the macroeconomic adjustment programs had significant socio-economic costs, while ultimately failing to prevent a deep financial restructuring.
But while dealing efficiently with financial distress and sovereign debt restructuring has never been easy, it's become markedly more difficult in recent years. For example, it took Zambia more than 18 months to receive the financing assurances needed to unlock IMF funding after the country defaulted on its debt in 2020, becoming the first African nation to do so during the COVID-19 pandemic. It then took over another year for Zambia to restructure its debt with its private creditors. And the debt restructuring deal may still not provide enough relief for the southern African country to avoid future financial instability. Sri Lanka, which defaulted on its debt last year, is making better progress. However, the process of providing debt relief to the South Asian nation has proven far from efficient or quick.
In the old days, official sovereign debt restructurings were much swifter and thus did not leave countries in limbo for a very long time; debt relief was also often provided on a pre-emptive basis, as was the case for Pakistan in the late 1990s. This was due largely to the previous dominance of like-minded official creditors organized in the Paris Club. But today, other non-Western creditors and especially China, which are less aligned with Paris Club principles, also play an important role in the process, causing disputes among countries' creditors that have led to more contention and slower debt restructurings. China has emerged as the most important bilateral creditors in recent years, meaning that any sustainable debt restructuring requires Chinese cooperation and participation.
The Implications of Creditor Fragmentation
For the longest time, economists were concerned that the emergence of bond financing, rather than original loan financing, would make sovereign debt restructurings more inefficient. Bondholders were thought to have greater incentives not to participate in a debt restructuring and instead to pursue their financial claims through legal avenues. Bank creditors, who were the dominant creditors previously, by contrast, were seen as having greater incentives to restructure the debt and find it easier to reach an agreement, both among themselves and with the debtor, not least due to the pressure they face from their respective governments.
Indeed, up until recently, it was the restructuring of private sector debt that proved more difficult, which the lending into arrears policy on private sector debt, introduced in the last 1980s, sought to alleviate. But while the emergence of private bondholders since the 1990s as the often dominant private-sector creditor has created obstacles in debt restructuring, they're generally manageable (thanks to the increasing use of collective action clauses, which diminishes the power of holdout creditors).
The primary drag on sovereign debt restructurings today has instead turned out to be the increased division, distrust and disagreement among bilateral creditors. In recent years, China has emerged as the largest bilateral creditor due to its extensive lending to low-income countries in the context of Beijing's Belt and Road Initiative. China's status as a major international creditor to low-income countries and its reluctance to abide by the traditional norms guiding sovereign debt restructuring accounts for the present problems in recent cases where countries remained in default for an extended time, such as Zambia.
But Chinese lending is not the only reason for low-income countries' over-borrowing. Ultra-low interest rates following the 2008 global financial crisis led private investors to provide significant financing to so-called ''frontier economies,'' effectively low-income countries with little experience of borrowing on international capital markets.
In the initial wake of the COVID-19 pandemic, cooperation between China and traditional Paris Club creditors appeared likely. In early 2020, an agreement was reached on the so-called Debt Service Suspension Initiative (DSSI), which allowed eligible countries to suspend their external debt service in the context of the COVID-19 crisis. Shortly thereafter, a so-called Group of 20 (G-20) Common Framework was established with the aim of facilitating international debt restructuring for low-income countries by allowing Paris Club and non-Paris Club creditors to negotiate debt relief in a single committee. But only three countries - Chad, Ethiopia and Zambia — have applied for debt relief under the G-20 framework. And securing debt relief has proved an arduous process due to disagreements among creditors.
Unless China and Western creditors can agree to a common set of principles, debt distress and debt restructurings will remain prolonged affairs. Growing creditor fragmentation and the subsequent rise in uncertainty surrounding debt restructurings will also continue to deter countries from seeking pre-emptive debt relief. Zambia's experience, for example, sharply limits the incentives for other countries to apply for debt relief under the G-20 framework. This will, in turn, lead to an even greater build-up of financial imbalances as countries remain in distress and default for longer, preventing a timely return to economic and financial stability and imposing significant additional economic costs on those countries.
Next: The Politics of Developing Economy Debt Restructuring, Part 2
