Resolving sovereign in the era of geopolitical tensions

Introduction

Financing conditions for Emerging and Developing Economies (EMDEs) in the 2010s were smooth as soon as the impact of the global financial crisis dissipated. Most countries were able to roll over maturing external debt at affordable interest rates and new borrowing to finance fiscal deficits was straightforward. There were no waves of funding stress or systemic sovereign defaults. Countries like Argentina, Ukraine and Venezuela did default on their debts in the 2010s, but they were idiosyncratic cases driven by economic mismanagement or war.

The outlook for EMDE financing worsened radically with the Covid crisis. Tax revenue collapsed under lockdowns, spending needs rose to cushion the impact of the pandemic on people’s livelihoods and, fearful of the unknown effects of the pandemic, market participants refused to take on credit risk by lending to EMDEs. Just as the Covid shock was fading, Russia’s invasion of Ukraine put EMDEs under stress again, especially those that imported commodities.

This paper discusses funding stress and defaults in EMDEs since 2020, focusing on how China’s growing role in global finance has shaped debt distress situations and made EMDE financing a contentious issue in the broader context of strained relationships between China and the West.

The initial phase of the crisis and global responses

Measured by the number of instances where EMDEs defaulted on or restructured debts to the official and public sectors, the last three years have been a major wave of global stress (chart 1).

Chart 1. Number of sovereign default/restructuring events since 1970

Source: Horner et al. (2022), BoC-BoE (2023), Rossi and Kraemer (2024)

The surge in the number of credit rating downgrades by ratings agency S&P in 2020 shows that the covid crisis had a severe impact on the creditworthiness of developing countries (chart 2).

Chart 2. Number of S&P rating downgrades by quarter

Source: Bloomberg

EMDEs in distress had to deal with payments to four main groups of creditors: i) domestic lenders in local currency; ii) international institutions like the IMF (multilateral creditors); iii) other governments (bilateral creditors); iv) holders of external bonds. As is often the case, bilateral and multilateral creditors led a reasonably coordinated response.

Early in the pandemic, the international community secured temporary debt relief for low-income countries (not the entire EMDE universe). In April 2020, the G20 agreed the Debt Service Suspension Initiative (DSSI) to help 73 eligible countries concentrate their resources on fighting the pandemic. All bilateral creditors suspended their claims on eligible countries until the end of 2020. The DSSI was subsequently extended to end-2021. 48 countries participated in the DSSI, suspending $12.9 billion in debt-service payments.

The DSSI marked a departure from the usual means of granting official debt relief to low-income countries. Since the 1950s, official debt relief was discussed and implemented via the Paris Club, an informal group of mostly rich countries largely aligned with the G7. The DSSI was the first formal multilateral agreement on debt relief that also involved emerging nations like China, India, and Saudi Arabia.

Multilateral creditors lent at subsidized interest rates to many EMDEs that could not borrow elsewhere, acting as lenders of last resort. There was no debt forgiveness by multilateral creditors. Their role was lending when no one else would in exchange for not taking upfront losses. Episodes of multilateral forgiveness are few and far apart. The last major episode was in 1996 when the IMF and World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative.

By nature, bondholders played a smaller role. There are thousands of institutions holding EMDE external bonds and coordination is obviously more difficult than among the 20 member countries in the G-20. Before a default, bondholder coordination to act pre-emptively has usually been impossible. After a default, coordination to restructure defaulted bonds is a must but has been historically difficult. The adoption of super-majority voting rules in bond contracts since the early 2000s has improved coordination (Weidemaier and Gulati, 2013). If a majority of about 75% of bondholders agree a restructuring deal with the debtor, collective action clauses (CACs) can be used to overrule dissenters who would otherwise block the deal.

Zambia was the only country that defaulted on all its external debts in the acute phase of the covid crisis (in December 2020). The other restructuring events of 2020-21 were official debt suspensions that did not affect payments on external bonds and other commercial debt. As we will see below, all possible complications in debt restructuring materialized in Zambia, which is still to exit default as of May 2024.

The latter stages of the crisis and partial normalization

Russia’s invasion of Ukraine reignited stress in EMDEs at a time when global borrowing costs had already risen sharply due to tighter monetary policy in the US and Europe. Sri Lanka and Ghana defaulted on all their debts in April and December 2022. Belarus and Russia also entered default that year, although due to sanctions as opposed to fundamental inability to pay. Ethiopia defaulted in December 2023. Others like Pakistan narrowly averted default last year.

The official response progressively moved from the temporary liquidity relief provided by the DSSI to more structural support for low-income countries whose debt was unsustainable through the so-called Common Framework.

In essence, the Common Framework (CF) was a commitment by G20 countries to form creditor committees to restructure the debts of low-income countries that so request it. Middle-income countries were explicitly excluded, even if in debt distress. The CF mostly set out coordination and restructuring principles that had been used multiple times in the past. Formal structure was quite limited and included elements like the expectation of an eventual memorandum of understanding between the debtor and all its bilateral creditors.

The novelty of the CF was not its approach to debt restructuring but the participation of non-G7 countries in the context of the G20. The CF was almost exclusively about official debt. The framework required debtors to seek from private creditors a treatment at least as favourable as the one agreed in the memorandum of understanding with official creditors. However, as always in the history of debt restructuring there was no formal or statutory mechanism to enforce comparability of treatment across creditors.

Chad, Ethiopia, and Zambia were the initial users of the CF. Chad was the first to request debt treatment in January of 2021. Private debt in Chad was relatively small and bonds were absent, simplifying matters somewhat. Zambia applied shortly after Chad, but a creditor committee was not formed until June 2022. Ethiopia’s application followed Zambia’s in February of 2021, but full debt distress did not materialize until late 2023.

In several cases, a combination of multilateral loans and tighter policies stabilized the economic situation, avoiding default and debt restructuring. Ecuador, Egypt, and Pakistan are among prominent intense distress cases that eventually succeeded at relative stabilization.

More generally, the normalization of the world economy as the pandemic faded helped many EMDEs re-access borrowing. Similarly, as Europe and commodity markets learned to cope with protracted war in Ukraine, the degree of stress in commodity- and food-importing EMDEs receded.

However, we are far from being in a ‘normal’ world for EMDEs that issue external bonds. The share of countries that would pay more than 10% if they issued a bond now remains unusually high (chart 3). Typically, 10% is seen as a rough threshold above which bond issuance in substantial amounts is often impossible. Since 2010, only five countries have issued at more than 10% and two of them defaulted subsequently. This suggests that in practice, 10% is a prohibitive borrowing cost.

Chart 3. EMDEs whose dollar borrowing costs are above 10%

Source: Oxford Economics/Bloomberg

There are two reasons why external borrowing costs are historically high. The first is unrelated to EMDE vulnerabilities. It simply reflects the fact that even the safest sovereign borrowers like Germany and the US are paying high rates. Inflation in the post-covid world is stubbornly high and central banks have responded by rising interest rates markedly. The second is directly related to vulnerability in EMDEs. Several countries have to pay unusually high spreads over risk-free rates to borrow because their debts are much higher than before the pandemic.

A new wave of debt distress due to high borrowing costs appears unlikely in the near future. Investors seem happy to lend to risky sovereigns at high rates and expect inflation and risk-free rates to eventually fall. However, the combination of high borrowing costs and low economic growth many EMDEs face increases the odds of another systemic stress episode in a few years.

The role of China and ongoing restructurings

Despite the DSSI and CF, and overall improvement in EMDE funding conditions, discontent with the resolution of sovereign defaults runs high among stakeholders. The restructurings in Ghana and Sri Lanka, and especially Zambia, are proving challenging.

That sovereign defaults are hard to resolve is to be expected from a historical perspective. The average default spell since 1970 lasted 8 years and prior to 1900 it was common for countries to remain in default for 20 years (Graf von Luckner et al. 2023). In the recent past for example, Argentina’s default in 2019 took three years to settle. The novelty in the last few years is the presence of new players like China in the negotiations, which brings a new set of challenges to debt restructuring.

China’s role in funding EMDEs grew large in the 2010s, starting from negligible levels (chart 4). Lending has often been linked to the Belt and Road Initiative, a vast collection of investment and development projects launched by President Xi Jinping in 2013. In several developing countries, Chinese lenders now account for 20% or more of total external debt.

Chart 4. Net debt disbursements by China, in % recipient’s GDP, sample of 28 frontier markets

Source: World Bank

Expansion was aggressive but as domestic economic challenges increased (step devaluation and growth slowdown of 2015-16) and debtor-country distress grew, China retreated significantly, especially outside Asia. While less expansive than a decade ago, there is agreement in the field that China has become large enough in the lending arena to partially fulfil a lender-of-last resort function. Given its large exposure to developing countries, China uses tools such as PBoC swaps to rescue borrowers in distress (Horner et al. 2023).

A variety of Chinese institutions lent overseas, often blurring the line between official and private lending. China designated only the Export-Import Bank of China (Eximbank) and China International Development Cooperation Agency (CIDCA) as official creditors participating in the DSSI. Others like the China Development Bank (CBD) have implemented relief too, but the classification of Chinese lenders has been a source of friction with other creditors and a complication for the IMF’s efforts to obtain financing assurances from official lenders. Lack of transparency on overall Chinese lending to EMDEs and its financial terms has complicated the debate.

The sometimes geostrategic goals of China’s lending may have pushed aside credit-risk considerations in the expansionary phase of the lending cycle (Arco Escriche and Burguete, 2023). As we discuss in the last section, China’s quest of geopolitical influence via lending to developing countries has posed a challenge to the US- and Europe-centric mechanisms for debt restructuring.

In the DSSI stage of the crisis, China’s role was relatively uncontroversial. China contributed roughly 60% of debt suspensions (Brautingam and Huang 2023). However, friction arose over the potential participation of multilateral lenders like the IMF and the World Bank in the DSSI. Chinese officials encouraged multilaterals to participate in public speeches, something that Paris Club member countries hardly ever considered in the past.

Matters got more complicated in default cases where forgiveness beyond debt suspension was unavoidable. Extreme distress cases where default was averted like Pakistan were also challenging. In Zambia and Sri Lanka, Chinese debt accounts for a large share of the total (chart 5).

Chart 5. Composition of external debt, in % of total

Source: IMF, Ministries of Finance

Ghana and Zambia were eligible for the Common Framework but as a middle-income country Sri Lanka was not. At the time of writing, Zambia’s case is effectively resolved pending the finalization of a deal with non-bonded commercial creditors (bonds were exchanged in June 2024). The four years of negotiations laid bare the complications of restructuring debt outside the well-tested ‘Paris Club plus bondholders’ setup. Issues were manyfold: some Chinese lenders preferred maturity extensions without principal haircuts but other creditors thought this was insufficient; several stakeholders found information sharing deficient; the official creditor committee at times took issue with agreements between the government and bondholders. In the background, the debate between China and Paris Club members over whether multilaterals should bear losses in addition to lending into distress was unfolding.

Sri Lanka is a less contentious but slow-moving case. There is an agreement in principle with bondholders but the country is not out of default yet. The fundamental issues are similar to Zambia’s. Official lenders are still split along the Paris Club – China line, the classification of Chinese lenders into official and private has been an issue, and maturity extensions versus principal haircuts pit creditors against each other. The IMF and Paris Club members are pre-disposed to all bilateral creditors taking principal haircuts. Chinese lenders are a diverse bunch facing differing domestic incentives in a system that is very decentralized. For some, a minimal principal haircut seems to be harder to stomach than a long maturity extension.

In Ghana, China’s role is relatively modest. Negotiations are protracted owing to Ghana’s attempt at a deep restructuring that involves losses many creditors will not accept easily. At the time of writing, the government and bondholders appear close to an agreement.

The way forward

Sovereign risk and defaults will always be difficult to handle. Unlike domestic corporate insolvency, a global set of detailed rules and an international court enforcing them can’t be realistically agreed.

In the past, devices like bank committees were effective. The wave of Latin American debt crises in the 1980s brought to the table a relatively homogeneous set of creditors: large banks and governments led by the US. Each player had their own interests, but their numbers were low enough to raise awareness that individual free-riding could ruin a deal. The solution was articulated in the Brady Plan, which swapped bank loans for tradable bonds with some guarantees from the official sector.

The Brady Plan was a suitable solution for banks that could not be replicated again. It ushered in the era of bond issuance and a very large number of relatively small bondholders, complicating coordination in defaults. In the early 2000s, CACs addressed aspects of the problem quite successfully. Remarkably, these were solutions that eased coordination problems among a host of private lenders with their own profit-maximizing motives.

The way forward now will necessarily look very different because coordination issues among official lenders lie at the intersection of finance and geopolitics. Institutions like the Paris Club, IMF and World Bank were shaped by the West but newcomers like China have a different vision.

One partial solution is underway. China is retreating somewhat from the business of bilateral lending. Future restructurings where China’s claims are smaller may prove less conflictive.

On the narrow issue of allocating losses among official lenders no one is morally right or wrong. Upon default, it is optimal for creditors as a group to maximize future repayments by providing upfront relief to the debtor. However, who should forgive debt falls within the realm of the subjective concept of fairness.

It is also optimal to have lenders of last resort like the IMF who disburse when no one else does. It is therefore optimal to incentivize multilaterals to lend into crises by sparing them some of the losses from debt forgiveness. But the extreme of never asking multilaterals to forgive debt is a subjective choice.

Lack of transparency by China is hard to defend. Examples of opaque lending stoking the fire when a crisis erupts abound in the history of finance. China making major concessions on this front, especially on the role of state-owned banks lending overseas, appears essential. In particular, stronger understandings between China and the rest on what institutions are treated as official and private lenders would simplify matters.

Reconsideration of the role of multilaterals in debt forgiveness may be the signal China needs from the West to rethink transparency. The gradual emergence of China-centric multilaterals like the Asian Infrastructure Investment Bank (AIIB) could force the issue. If the international community wants truly global institutions as opposed to competing ‘regionalized lenders’, China’s preferences will have to be heard.

Regular involvement of multilaterals in debt forgiveness may be too much of a radical change for consensus building. An intermediate step could be a governance framework for multilaterals that contemplates the one-off initiatives of the past like the HIPC as something still unusual but built into the framework for responding to major global crises like the covid pandemic.

Understandings on the issue of maturity extensions versus principal haircuts could make a modest contribution to the overall solution. Economists have been moving away from debt sustainability assessments that rely too heavily on debt levels. In those old-school assessments, principal haircuts are the first best by construction. Continued emphasis by multilaterals on what kind of maturity extensions coupled with low interest rates are equivalent to principal haircuts could please China at a relatively low cost.

Further iterations on the CF could be a useful set of basic rules and high-level common understandings on the role of official creditors but hopes that a redefined CF is the main way forward appear misplaced. The high-level principles in the existing CF are valid and few stakeholders would question them. The issue is that the way China and traditional Paris Club members want to operationalize the CF is very different.

Sustainable Development Goals (SDGs) may be a useful cornerstone of negotiations, as most governments agree on the need to develop policies and growth strategies that are sustainable for the planet. Aspects such as the climate-resilience of developing-country debt are relevant parts of the debate. In this respect, some of the proposals at the UN Future Summit, held in September 2024, and the forthcoming Fourth International Conference on Financing for Development could be the source of specific steps forward articulated around SDGs that are agreeable both to China and the West.

Technocrats can propose solutions like the one I sketched out above that stick to a few economically optimal principles while allowing for negotiation between China and the West on subjective matters. Ultimately though, the feasibility of any solution depends on the degree of overall conflict between China and the West. If major issues like international trade or security in the Pacific are in extremely contentious phases, lending to EMDEs may well become a ‘subsidiary battlefield’ where agreement is impossible.

Sources

• Arco Escriche, I. and Burguete, V., 2023, “China y el Sur Global: viejos amigos, nuevas dinámicas”, Barcelona Center for International Affairs.
• Bank of Canada and Bank of England, 2023, “BoC–BoE Sovereign Default Database”.
• Brautingam, D. and Huang, Y., 2023, “Integrating China into Multilateral Debt Relief: Progress and Problems in the G20 DSSI”, China Africa Research Initiative Briefing.
• Graf von Luckner, C., Meyer, J., Reinhart, C., and Trebesch, C., 2023, “Sovereign debt: 200 years of creditor losses”, 24th Jacques Polak Annual Research Conference at the IMF.
• Horn, S., Bradley, C.P., Reinhart, C., and Trebesch, C., 2023, “China as an international lender of last resort”, NBER working paper 31105.
• Rossi, L., and Kraemer, N., S&P Global, 2024, “Default, Transition, and Recovery: 2023 Annual Global Sovereign Default And Rating Transition Study”.
• Weidemaier, W.M. and Gulati, Mitu, 2013, “A People’s History of Collective Action Clauses”, Virginia Journal of International Law, 1-95.

About the author

Sergi Lanau is Director of EM Strategy, Oxford Economics. He is an expert in emerging markets, currently managing the team in charge of emerging markets financial research at Oxford Economics, a leading firm in economic modelling and global forecasting. Sergi has more than 15 years of experience in the public and private sectors and spent many years at the International Monetary Fund working on sovereign debt crises.