Editor's note: This is the second of a two-part series exploring the politics and prospects of debt relief in financially distressed developing economies. The first part can be found here.
The IMF's Role in Debt Relief and Economic Adjustment
The International Monetary Fund (IMF) is a crucial player in debt relief when a country enters financial distress or falls into default. For a start, the IMF provides balance-of-payments financing conditional on economic adjustment, which is aimed at correcting imbalances and reestablishing macroeconomic stability. To this end, the IMF staff prepares a debt sustainability analysis. The analysis establishes the so-called resource envelope and the required financial relief a country needs to seek from its creditors in case the debt sustainability analysis shows that the debt burden is unsustainable. The IMF program and lending are conditional on the fund receiving financing assurances from the country's creditors in case its debt is deemed unsustainable or the country is in default.
The IMF itself is neutral in terms of how the costs of debt relief are allocated to a country's various creditors as long as the required debt reduction takes place. This is precisely why inter-creditor conflict is so prominent. Debt relief is a zero-sum game, and every creditor would like to minimize its losses and get others to provide debt relief. Historically, the problem of inter-creditor equity was managed reasonably well because the IMF was dominated by largely Western creditors, which were organized in the so-called Paris Club, a group coordinating the activities of the major bilateral creditors. In this context, the IMF received and accepted financing assurances from a ''representative standing forum,'' namely the 22 bilateral creditors of the Paris Club (and various observers and ad hoc members). The offer of bilateral debt relief was tied to the debtor country seeking equivalent debt relief from its private creditors. A commitment by the debtor to seek equivalent relief was typically enough for the IMF to lend to the debtor country, provided that it had received financing assurances from its bilateral creditors and was engaging in good-faith negotiations with its private creditors. In general, this enabled the IMF to approve a program and provide financing relatively quickly, typically a prerequisite for other multilateral and private financing.
Six principles underpinned the Paris Club: solidarity, consensus, information sharing, case-by-case approach, conditionality and comparability of treatment (accept no less favorable a restructuring). The club-like character enabled creditors to coordinate their policies and ensure inter-creditor equity. The ''comparability of treatment'' principle also helped ensure an equitable allocation of financial losses between bilateral creditors and private-sector creditors. Additionally, coordination between the Paris Club and the IMF was supported by the fact that the fund's major shareholders were members of the Paris Club.
The Problem of Inter-Creditor Disagreement
Sovereign debt restructuring has always been an ad hoc process, pitting creditors against debtors and creditors against creditors. However, this competition has escalated since the emergence of major non-Paris Club bilateral creditors, namely China, which does not accept the traditional Paris Club approach to restructuring. As a result, inter-creditor coordination has taken a dive, which is complicating the swift provision of financing assurances and the efficient restructuring of sovereign debt.
One major obstacle to the IMF's ability to help a struggling country is the fund's policy against providing credit to debtors who remain in arrears and have not received financial assurances from their creditors. As a result, any government that is a major creditor can refuse to provide financing assurances to the debtor, which prevents the IMF from offering credit. This means individual creditors effectively can veto an IMF program, providing them with enormous leverage.
To weaken this veto power, the IMF reformed its policy in 2015 by allowing itself to approve a program even if a country is in arrears on its official debt but has failed to receive financing assurances from an individual shareholder. However, the reform only applies if the official creditor consents and it does not jeopardize IMF financing. The reform sought to strengthen the incentives for bilateral lenders to collectively provide debt relief.
Despite this policy revision, China's importance as a creditor means that without Beijing's agreement to provide sufficient debt relief, lasting economic stabilization in a debtor country is impossible, as the country does not have access to IMF financing. China's role as a major lender is too important to enable other bilateral creditors to provide sufficient debt relief. Without Chinese participation, effective debt relief is impossible in many instances, given how important China is today as an international creditor. For example, across all countries that take part in the IMF's Debt Service Suspension Initiative, external debt owed to the Paris Club fell from 28% in 2006 to 11% in 2020; during that same time period, China's share increased from 2% to 18%, while eurobonds increased from 3% to 11%. Last but not least, debt owed to multilateral development banks fell from 55% to 48%.
Moreover, the West has accused China of using secret clauses and opaque lending practices, including ''hidden debts,'' raising concerns in the Paris Club about inter-creditor equity. Western creditors will therefore be even more reluctant to restructure their claims when they do not know how much the debtor owes to China and whether the debt owed to China is restructured on (roughly) the same terms, or at all. Otherwise, Western creditors risk incurring a disproportionate share of the financial losses. China has indeed preferred to deal with debt problems on a bilateral basis, which has weakened multilateral creditor coordination. A lack of transparency and trust is the main reason why financing assurances have been withheld and debt restructurings take so long.
Under traditional rules, loans from multilateral development banks are treated as preferential creditors whose debt is considered super-senior on account of its concessional character. However, China objects to the super-seniority of multilateral loans, which effectively forces all other creditors to take greater losses, as their claims are traditionally excluded from restructuring. As China is underrepresented in multilateral institutions, it incurs a disproportionate loss compared with Western creditors, given its relatively larger share of bilateral claims. China also objects to how the various types of lending should be classified for the purpose of debt restructuring. All of this has made the process of providing debt relief very choppy and unpredictable. Unless all lenders agree to a coordinated approach to debt restructuring, based on mutually shared principles, countries in distress and default will continue to suffer unduly against the backdrop of creditor fragmentation.
China's Wants to Minimize Its Losses
China and other creditors stand next to no chance of getting repaid in full in many cases of sovereign debt distress, with all creditors having to take a loss. Inter-creditor conflict is centered on how those financial losses are allocated. And as long as that conflict continues, providing debt relief quickly and efficiently along established or newly established lines will remain difficult.
Some observers have alleged that China is strategically withholding support for traditional debt restructuring because it wants to weaken the Western-dominated international financial architecture, hence why Beijing also prefers bilateral restructurings and disregards established multilateral norms.
However, China is more likely seeking to minimize its present and future financial losses. Additionally, Beijing may not yet have come to accept the inevitability of significant losses, as individual Chinese creditors — perhaps for bureaucratic rather than grand-strategic reasons — are certainly reluctant to acknowledge significant financial losses. China, for the most part, does behave like a commercial creditor keen to recover its money. Its interest-free loans come out of aid budgets and thus do not lead to any financial losses in accounting terms; Beijing has also been much more willing to restructure these claims, compared with loans by its public-sector or state-owned banks. In addition, bureaucratic interests and financial incentives may prevent a more sensible approach to debt restructuring that would benefit China and debtor countries.
Why Beijing Will Eventually Cooperate
There are good reasons to believe that China will largely, if reluctantly and incompletely, come around. After all, as long as Western creditors do not allow China to free-ride, China's bilateral restructuring approach will only go so far, as Beijing is unlikely to be able to impose adjustment policies on debtor countries. Moreover, providing refinancing to a sovereign that is essentially insolvent just leads to throwing good money after bad money, and simply kicks the can down the road before it hits a wall. Then China faces the choice between greater cooperation with Western creditors or not getting its money back.
Nevertheless, as long as the Paris Club and Beijing cannot agree, future debt restructuring will not become smoother. The West will not bail out China's lending to countries in financial distress. And China will not want to be blamed for holding up debt relief and economic stabilization in a situation where losses have become inevitable. But with financial losses inevitable and the geopolitical costs increasing for Beijing, China will be increasingly incentivized to accept a sovereign debt restructuring debt template that aligns, more or less, with traditional norms. After all, few countries will be willing to end their financial relationship with Western creditors by favoring China. It's thus difficult to see how China's bilateral approach will win out, which both Beijing and debtor countries are eventually going to realize.
Analysts have voiced concerns about the fragmentation of the international financial and development financial architecture. For decades, Paris Club creditors, who also dominated the IMF and the major multilateral development banks, were able to find agreement on the broad principles of sovereign debt restructurings. With the emergence of China as the major bilateral creditor, this long-standing consensus is being challenged. Continued dissent over how to allocate the losses of debt restructurings has been holding up debt restructuring and has prevented many attempts to seek debt relief. This has increased the economic and financial costs of distressed developing economies.
If Western bilateral creditors remain unwilling to substantially change their approach to debt restructuring but make the provision of debt relief conditional on China broadly agreeing to established principles, Beijing will likely be seen as the party responsible for holding up swifter resolutions. Moreover, the Paris Club is not going to accept solutions that fundamentally diverge from established principles, not least because it would require it to provide relatively greater debt relief and enable China to minimize its losses. If Beijing is seen as unduly holding up debt restructurings while the effective costs to the debtor and financial losses to the creditor increase due to the stalemate, the increasing geopolitical and reputational costs will eventually force China to accept the need to provide greater debt relief, more or less on the basis of traditional principles, than it has so far been willing to offer.
