Part of a series of proposals for the G20's* agenda on the COVID-19 pandemic.
COVID-19 is devastating low- and middle-income countries, adding to their debt burdens and threatening a far-reaching sovereign debt crisis. To help manage debt distress for the countries most exposed, the G20 should call for a temporary standstill on sovereign debt payments to official and private creditors. A standstill entails an agreement among creditors and the debtor for a temporary pause on debt payments. In some cases, contracts allow a majority of creditors to agree to a standstill over the objections of the minority. In addition, the G-20 should call for the establishment of a central coordination mechanism to assist in both implementing a standstill and developing a longer-term sovereign debt strategy to meet the pandemic challenge. It should make use of recent contractual and institutional reforms to maximize creditor participation in this effort.
Even before the COVID-19 pandemic, the International Monetary Fund (IMF) had projected that the gross public debt (both domestic and external) of low- and middle-income countries would on average reach a high of 55.7 percent of their GDP in 2020 (see figure). The pandemic has compounded the problem: Countries face staggering new healthcare costs; collapsing tax, nontax, and export revenues from the global recession; and capital flight and frozen debt markets, which leave governments unable to refinance maturing debt. The “sudden stop” in low- and middle-income countries is due in part to developments in high-income economies, where financing needs have skyrocketed overnight against the background of extreme risk aversion and a flight to safety among investors.
The debt problem is unprecedented in its magnitude. The Institute of International Finance estimated that in March alone, $83 billion had exited the emerging markets. On March 27, the IMF announced that the overall financial needs of emerging markets and developing countries in the face of the pandemic are about $2½ trillion. Managing Director Kristalina Georgieva stressed that this estimate may be on the lower end, and that countries’ own reserves and domestic resources are clearly insufficient for the task.
It is hardly surprising that the IMF has already received requests for financial support from more than 80 of its 189 members, some already experiencing debt distress. In past crises, the IMF has had to allay concerns about its financial capacity. New IMF borrowing arrangements recently approved by Congress mitigate such concerns for the moment, although it is too early to tell whether they are enough to meet the fast-growing needs. The most immediate question is how, as a policy matter, the Fund should respond to these requests, given the likely magnitude of the overall problem and continuing uncertainty about the precise effects of COVID-19 on individual countries.
Justification for a Temporary Debt Standstill
A temporary standstill endorsed by the G20 would enable the Fund to finance urgent crisis response policies for its most vulnerable members pending country-specific debt sustainability assessments. Without a standstill, IMF resources could simply pay off other creditors.
Under the Fund’s existing policy framework, both the design of the program and the level of Fund financial support must consider whether a member’s external debt is sustainable (i.e., whether any feasible set of economic and political policies can stop it from continuously rising). If the debt is judged sustainable, the Fund can support a program that enables the government to keep paying its external debt in full and on time, in the expectation that doing so would revive market confidence and catalyze funding from other sources. However, if the IMF determines that the member’s debt is clearly unsustainable, it would require the government to initiate a debt restructuring of sufficient depth to restore sustainability as a condition of its program.
Making judgments about sustainability is difficult even under the best of circumstances, in “normal” times. They entail long-term projections of a number of variables, including the country’s economic trends in the context of expectations of the path of the global economy, public and private debt dynamics in the country, its budget, and its balance of payments years hence. These assessments must take into account the political capacity of the government to deliver necessary economic reforms to ensure sustainability, a capacity that varies with each country’s domestic and external political circumstances.
COVID-19 has compounded the uncertainties around sustainability assessments. Additional factors include:
- the path of the pandemic, including within the territory of the member experiencing debt distress;
- the depth and length of the slump in global economic growth (especially the interplay of supply and demand shocks);
- the projected path of inflation, interest rates, commodity prices (especially for oil), primary fiscal balances, and exchange rates;
- the timing and extent of a return to some degree of normalcy in global financial markets, taking into account the level of financial distress in the creditor community;
- the ability and willingness of official bilateral donors and lenders to support developing countries financially; and
- the extent that resources could be mobilized domestically by the requesting country through taxation or borrowing to directly fight COVID-19 and meet other obligations; this will greatly depend on each country’s social and political conditions, which will be very fluid during the humanitarian crisis.
The IMF’s lending decisions now must take into account these extraordinary levels of uncertainty. A country whose debt looked clearly sustainable only several months ago may—or may not—move into unsustainable territory. The Fund faces a dilemma. On the one hand, making program approval conditional on a deep debt restructuring that involves significant reduction in the net present value of claims can generate considerable costs for the member, its creditors, and—through contagion—other countries. The mere expectation of debt restructuring can cause creditors to pull back. If the shock is short-lived, these costs would seem unnecessary in retrospect. On the other hand, treating the pandemic as a temporary liquidity problem poses significant risks both to the member and to the IMF: If other creditors’ claims are paid off and sustainability continues to deteriorate, by the time the government has to restructure, the pool of debt that could absorb necessary relief would shrink while the country’s senior debt to the IMF would have grown. Sustainability would require deeper debt reduction and further imperil the country’s future access to private markets.
In the current environment, there is a need for both urgency and patience: Urgency with respect to IMF support for effective policy adjustment, patience to allow for a more fully informed assessment as to whether the magnitude and duration of the current shock might render particular countries’ debts unsustainable. Programs that support a standstill on debt payments pending clarity on the longer-term impact of the crisis would satisfy both imperatives, and would be consistent with the logic of the IMF’s exceptional access policy.
The heads of the World Bank and the IMF took a first step toward putting such a standstill in place when they called for official creditors to suspend debt repayments from the very poor countries eligible for support from the World Bank Group’s International Development Association. Since then, it has become apparent that COVID-19 will deliver a debt shock for a broader set of countries, including emerging markets unable to refinance their debt in the frozen credit markets. If official creditors agree to pause debt payments from this broader set of countries, the second step requires a standstill on payments to private creditors. Government creditors are unlikely to exercise forbearance if borrowers and their private creditors could abuse their taxpayers’ generosity and pay off private creditors in full during this challenging time. Intercreditor equity concerns loom large in a systemic crisis of this magnitude.
While a standstill could apply to all countries experiencing debt distress, its implications would vary. Our focus is on countries whose debt appeared sustainable before the pandemic but is now more uncertain. For this subset, a standstill would give the IMF time to make a better-informed sustainability determination, while allowing for urgently needed IMF support. Where the IMF has already made a judgment that—irrespective of the depth and duration of the crisis—a country’s debt is unsustainable, governments could benefit from a standstill, but should in any event promptly engage in restructuring discussions to restore sustainability. Country-specific standstills could be reached without an IMF-supported program; however, external creditors and the country’s citizens would need an alternative means of ensuring that forbearance is not financing bad policies or preferential payments.
Operationalizing a Standstill
Implementing a standstill would require coordination among diverse private creditors as well as between official and private, bilateral and multilateral institutions, to give borrowing governments adequate relief in the aggregate and reassure creditors regarding intercreditor equity. These creditors have very different priorities and constraints. They hold a variety of legal claims on the borrowing governments, including some backed by valuable collateral. For corporate borrowers, the bankruptcy process goes a long way to ensure intercreditor equity and coordination. Sovereign borrowers, however, have no such option. The next section discusses the tools to make a standstill operational.
Existing Contractual Provisions
Sovereign bond contract reforms since 2003 can help support a more orderly debt restructuring, although they have important weaknesses. Tradable bonds account for more than three-quarters of the private external debt of middle-income countries and represent the fastest-growing share of this debt for low-income countries. Bonds also dominate near-term payment obligations and short-term debt in both groups. A standstill among private holders of sovereign bonds would involve a deferral of interest and principal payments falling due during the standstill period (perhaps 12 or 18 months). Deferring payments in a manner that would avoid a formal payment default is important, since default would trigger adverse effects for both the sovereign borrower and its creditors.
Full creditor participation in a standstill that would avoid a payment default could be facilitated through the contractual provisions widely adopted since 2003. Collective action clauses (CACs) allow for a qualified majority (typically 75 percent) of bondholders of a single bond issuance to bind all holders of the same issuance to a change in payment terms. The risk has always been—and would exist with a standstill—that a disruptive creditor would acquire a blocking position in a CAC vote, retain bonds with the original terms, and demand to be paid on the original schedule.
To address this problem, nearly half of all sovereign bonds governed by foreign law now have “aggregated” CACs that could allow creditor majorities voting together across multiple bond issues to modify interest and principal payments, thereby making it much more difficult for holdouts to obtain enough bonds to block an amendment. However, the most robust aggregation feature, which does not require a vote by individual bond series (“single limb” voting), may be used only when the bondholders affected by the amendments are offered amended instruments with identical new terms (the “uniformly applicable” condition).
Uniform applicability was introduced as a safeguard against discrimination among bond series in a broad-based restructuring, when the original maturities of the entire debt stock (or a significant portion of it) would be modified. While this would be the case with a definitive restructuring of unsustainable debt, it is not the case with a standstill, where the original maturities of debt falling due outside the standstill period would not be affected. Indeed, in the case of a standstill, the objective is to keep the maturity structure in place, except for any principal falling due during the standstill period. Although the “single limb” approach is not available, sovereign debtors would still be able to use bond-by-bond and aggregated voting mechanisms that require a vote by each bond series to achieve a standstill. these mechanisms are more cumbersome and more prone to holdouts.
In the event that CACs cannot prevent a default on certain instruments, the objective would be to prevent disruptive creditors from exercising the right of “acceleration,” which would result in the entire amount of the bond becoming due and payable. For many countries, such a step could clearly shift their debt stock into the territory of unsustainability. Most bond contracts have provisions that require a percentage (normally 25 percent) of the bondholders to vote in favor of an acceleration. CACs could be used to raise this threshold to 50 percent or more. Importantly, in the event of a default, the Fund would be able to continue to provide support to the member under its lending into arrears policy.
In sum, contractual provisions are potentially useful, but imperfect. Moreover, a significant portion of the debt stock in low- and middle-income countries is in bilateral and syndicated loans and does not have CACs: For low-income countries, loans still represent just over 80 percent of the stock of long-term public and publicly guaranteed debt held by private creditors. For middle-income countries, they account for a quarter of the debt held by private creditors (see table). Even if all the bonds were amended, sovereign debtors would get limited relief. And even the most cooperative bondholders would likely rebel if asked to sit on the sidelines while other creditors do not participate in the standstill.
The limitations of CACs and most other contractual approaches have prompted more radical initiatives, such as the IMF’s Sovereign Debt Restructuring Mechanism (SDRM) in 2002, which failed to garner adequate political support. Even if the current crisis catalyzed renewed interest in the SDRM, its implementation would require an amendment of the IMF’s Articles of Agreement, an international treaty. This is highly improbable within the crisis timeframe.
If the international community had the appetite for a more aggressive approach than CACs—which may indeed be needed given the systemic nature of the current crisis—it could consider more rapid alternatives that have been used in the past. In particular, consideration could be given to a UN Security Council Resolution under Chapter VII of the UN Charter, which was used in 2003 to temporary shield Iraq’s assets from creditors, bolstered by domestic legal measures in the United States and the United Kingdom (most international sovereign bonds are governed by English and New York state law).
A Sovereign Debt Coordination Group
To maximize the likelihood of a sustainable outcome and in light of the systemic nature of the crisis, a standstill requires
- a comprehensive creditor coordination mechanism, capable of reaching bilateral and syndicated bank loans;
- longer-term credit arrangements with nontraditional creditors, including commercial firms, sovereign wealth funds, and public-private hybrids; and
- trading partners extending credit in exchange for future deliveries of commodities.
At a minimum, such a mechanism would seek to dissuade creditors from exploiting differences in their claims on a sovereign to free-ride on concessions made by others, and from undermining the standstill by seizing assets or securing other forms of preferential treatment from the debtor.
To this end, the G20 should call for the establishment of a Sovereign Debt Coordination Group consisting of sovereign borrowers and representatives of the official and private creditor community. While such a group would not have any legal authority, it would have the capacity to convene creditors, collect and disseminate information, and facilitate negotiations among sovereign debtors and their creditors. It could also serve as a liaison with national financial regulators to monitor the impact of a standstill on the financial system and minimize the chances of systemic distress. Past sovereign debt and banking crises in the 1980s, and more recently in Europe a decade ago, used variants of this mechanism.
Although it is unlikely that the debt consequences of the growing pandemic will trigger a systemic banking crisis in advanced economies, its impact on the real economy and spillover effects in a wide range of countries warrant continuous monitoring and may require early intervention. Given the proposed coordinating group’s critical mandate and the changed composition of sovereign debt today, it is essential that the group have broad geographic and stakeholder representation.
The crisis has highlighted the need for broader and longer-term reform in this area. A particular priority should be debt transparency. The arrival of new and nontraditional creditors exposed flaws in the data collection and disclosure systems that has characterized the sovereign debt ecosystem for decades. Increasingly diverse debtor and creditor communities make flaws such as fragmentation, parochial and instrumental data collection, and unintelligible or inaccessible presentation more apparent and their impact more serious.
In addition, the pandemic crisis boosts the case for state-contingent sovereign debt. Had countries included standstill clauses in their debt contracts when these were actively discussed several years ago, they might have been able to secure binding standstills in many cases without the kinds of backstop measures we recommend in this blog. The international community could encourage the use of such instruments with technical assistance, exemptions or favorable treatment in the program context, and outright subsidies for the poorest countries. Restructuring precedent and a model term sheet produced by a Bank of England working group are a good place to start.
* The members of the G20 are Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, Japan, India, Indonesia, Italy, Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, and the United States.
1. When a member asks for financing above normal limits, the IMF must judge its debt to be “sustainable with high probability.” If the debt is judged sustainable but not with high probability, the program goes forward only with financing from non-IMF sources that improves sustainability and protects IMF resources.
2. A uniform extension of maturities of bond issuances falling due outside the standstill period would also not result in uniformly applicable terms (and therefore could not be achieved through single limb voting): A bond maturing in 2021 and another maturing in 2023, each extended by a year, would still mature two years apart. However, if a general reprofiling of maturities—even those outside the standstill period—was pursued, a sovereign debtor could use the single limb approach to amend different pools of bonds (“subaggregation”). To the extent that one could create pools of different bonds with sufficiently close maturities, it may be possible to offer these creditors a single amended instrument, which would satisfy the “uniformly applicable” requirement.