Seeking a way out of the debt maze

For the increasing number of countries weighed down by loan burdens, debt relief will free up much-needed fiscal space to pursue their development aspirations. However, current debt restructuring efforts are messy, difficult and woefully insufficient, necessitating a comprehensive mechanism for sovereign debt resolution.

Iolanda Fresnillo and Ilaria Crotti

---

SINCE states are not protected by bankruptcy or insolvency laws in national or international law, when a country’s sovereign debt becomes unsustainable and it can no longer repay its public debts it cannot simply declare bankruptcy as a private entity would. Before reaching that moment of debt distress, the country’s government has very few options to avoid default: keep borrowing – making the problem even bigger – raise taxes and mobilise other domestic resources to have more revenue to keep paying, or cut public spending to free up resources to pay back its creditors.

This last option comes at the expense of impacts on human rights, particularly women’s rights. All these alternatives generally end up delaying default, but not avoiding it. The country could also try a pre-emptive debt restructuring (to avoid default), but most countries avoid that option out of fear of rating downgrades by credit rating agencies and loss of market access.

Once default happens, the government needs to start a restructuring process, meaning renegotiating the contract terms of its debt with its creditors. According to the International Monetary Fund (IMF), between 1950 and 2010 there have been more than 600 cases of debt restructurings in 95 countries. These numbers show that it is often the case that a country that had recourse to debt restructuring is likely to do it again, with repeat defaulters representing up to 61%, exposing the inefficiency of the current system. On average, African debtor countries had to negotiate with the Paris Club seven times, with no debt sustainability achieved after just one negotiation.

What is sovereign debt restructuring?

Debt restructurings tend to be opaque processes with no commonly set rules nor universally accepted consensus on how they should work or unfold. A combination of political and strategic interests, normative considerations and even religious dimensions influences what, in theory, should be a legal process driven by economic and financial rationale, taking into account the impact on the well-being of the country’s citizens.

In summary, we refer to sovereign debt restructuring as a process, involving both a debtor government and its creditor(s), that changes the current terms for payment of outstanding sovereign debt instruments. The process is formally aimed at enabling the debtor government to address liquidity or solvency difficulties resulting from its current payment obligations and fiscal situation, and achieving debt sustainability in the medium term.

Today, a universal system that regulates the sovereign debt restructuring framework does not exist, to the extent that we can refer to the current situation as a ‘non-regime’. There are no common norms that regulate the level of debt cancellation or rescheduling for a country depending on specific criteria, nor a timeline for debt restructuring. A government cannot negotiate its total debt stock in one procedure and in one place, but has to submit to a series of fragmented negotiations with different non-coordinated creditors through ad hoc operations, which ultimately leaves room for significant risks, such as vulture funds. The outcomes of such negotiations are heavily dependent on the skills of the law firm representing the debtor country and the willingness of a government not to pay if an acceptable agreement is not reached. Additionally, there is no guarantee that an agreement will be reached.

How does it work?: Debt restructuring for the fictitious country of Debtlandia

Debtlandia is a low-income country that has been devastated by the pandemic, heavily impacted by climate change and is facing payment difficulties on its sovereign debts. Debtlandia tries to avoid default at any cost, out of fear of rating downgrades and losing market access. Borrowing costs continue to increase, however, and refinancing its debts with a new bond issuance is impossible. When a debt payment to bondholders arrives, and reserves are not sufficient, the country has no option but to hold the payments and enter into default.

As of 2020, Debtlandia is eligible, and has no other option but to apply for the G20 Common Framework (CF) (see box) to ask for a debt treatment. The first step to begin negotiating with its creditors is to ask the IMF for a programme, which the country has been trying to avoid given the harsh austerity conditions it will likely entail, along with the internal social and political tensions that can unfold as a result. However, without an IMF programme, even outside the CF, it is unlikely that the creditors will accept any debt restructuring. The IMF, together with the World Bank, will also provide an assessment of the country’s fiscal situation and indebtedness in their Debt Sustainability Analysis (DSA). The DSA includes a detailed examination of Debtlandia’s outstanding debt and fiscal situation. It is not normally made public until the IMF approves a loan and a programme. The DSA is the basis for determining not only the size of the IMF loan within the new programme, but is also used to indicate the amount by which debt should be reduced to reach sustainable levels.

For the IMF to give the greenlight to a new loan and programme, its Board has to make a decision based on ‘assurances’ that the creditors will participate in a debt restructuring process in good faith. Debtlandia knows that it can take months to get the assurances that the IMF needs, or for the IMF to accept the assurances that the country gets from its creditors. In the meantime, Debtlandia is still in default and accumulating arrears (unpaid interest and resulting fees). Once the IMF Board accepts the assurances and agrees on a loan and programme, the DSA will likely become public.

The IMF programme works as a guarantee for Debtlandia’s creditors, and it triggers the restructuring negotiations. Two committees are created, one with bilateral and another with private creditors. The back and forth of negotiations with one and the other starts. Debtlandia will probably agree on debt restructuring conditions with its bilateral creditors on the basis of the DSA, but it will maintain talks with the privates to see how much they are willing to accept. Once a deal is agreed with the bilaterals, the country needs to seek a similar deal with its private creditors, known as ‘comparability of treatment’. If it doesn’t, in theory, the bilateral creditors could step back and retire from the deal. In the history of the Paris Club, this has never happened.

The diverse creditor landscape is a complex knot that Debtlandia has to untangle. This has changed significantly in the past decades and neither group fully trusts the others. In an attempt to deal with this compound universe, some principles and instruments have been created, including the comparability-of-treatment principle. However, it is not a written rule but more of a gentlemen’s agreement. Another innovation to deal with this complexity is the inclusion of contractual collective action clauses (CACs) in bond contracts. These define how to initiate and conduct restructuring negotiations and allow a qualified majority of creditors to modify the conditions of a bond series, as well as binding all holders of these bonds to the decision. This means that if the country reaches an agreement with a certain percentage of creditors as indicated in the CACs, the remaining creditors are obliged to comply with that agreement.

In the meantime, and throughout the whole process, any form of communication about Debtlandia’s economic situation and any indiscretions about the debt restructuring negotiations need to be handled strategically, as ‘markets do not like uncertainties’. Depending on how it handles the process, Debtlandia fears a loss of market access (even though it has no access to financial markets while in default) and the reputational costs for future market access.

The potential for miscommunication is high. Debtlandia has to face several ambiguities throughout the process. For instance, the negotiations with the different creditors do not follow a precise timeline and can be extremely intricate and time- and resource-consuming. The legal context is ambiguous, too: several jurisdictions might be involved, each with different rules and perspectives. ‘It may not be clear which will prevail (and possibly none of them would prevail), and how the implicit bargaining among different countries’ judiciaries will be resolved.’  Private creditors might get nervous – or just fight for the biggest return possible, not willing to take any cut – and either threaten to or actually take Debtlandia to the New York or London courts (the two jurisdictions under which most international government debts are owed) over the unpaid debts.

After months or years of negotiations (the nine restructuring cases between 2014 and 2020 took an average of 1.2 years, with many cases going over two years of negotiations), Debtlandia will likely achieve an agreement with its bilateral and private creditors, which will most probably be ‘too little, too late’. Its debts to multilateral development banks (MDBs) and the IMF will remain untouched. As in most cases, Debtlandia will probably have to go through further rounds of debt treatment in the coming years, until creditors realise there is need for a substantial debt reduction for the country to achieve debt sustainability. Historically, debt default episodes have taken an average of seven years to be resolved, involving multiple restructurings. The IMF itself agrees that ‘debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way’.

Is an alternative to the maze possible?

The debt restructuring process is chaotic, costly, long and difficult to understand, particularly for ordinary citizens who suffer the consequences. Additionally, success is determined by the calibre of lawyers a country can afford to hire, as well as the willingness of a government to refuse to pay if creditors do not agree to an acceptable deal. Powerful creditor countries maintain the current lack of a system because it enhances their power, and that of their private companies, in debt negotiations. Furthermore, debtors today have to navigate new instruments, creditors, innovations and interests, which greatly complicate the restructuring process. As the then World Bank President David Malpass described it back in 2020, it is ‘the modern equivalent of debtor’s prison’.

In opposition to this chaos, we propose a systemic reform of the existing debt architecture. It is time to update the debt resolution frameworks to adapt to the new world we live in and, most importantly, to the needs of Global South countries and their people. We need a permanent rules-based multilateral debt resolution framework that provides fair, timely and comprehensive debt treatment from all lenders and for all countries according to their needs. We need a mechanism that does not rely on creditors’ will nor is defined solely by creditors. We propose a debt workout mechanism hosted under the auspices of the United Nations, since the UN is currently the only forum in which all countries have equal say and is neither a creditor nor a borrowing institution. This debt workout mechanism should respond to 10 essential principles:

1.   It should be a body independent from creditors and debtors to assure impartiality.

2.   The borrower has the right to choose to initiate the debt restructuring process in pre-default phase and an automatic standstill will apply to all external debt payments.

3.   The initiation of the process should trigger a stay on litigation by uncooperative creditors.

4.   The entirety of a country’s debt stock should be dealt with in a single process, reducing fragmentation and time.

5. Inclusive participation of all stakeholders, including civil society.

6.   Independent assessment of debt sustainability and validation of individual claims to assess the legality and legitimacy of debts through public debt audit.

7.   Focus on debt sustainability that puts the needs of the population before debt service, and that includes climate vulnerabilities and human rights and gender equality assessments.

8.   Respect for international human rights law and the realisation of international development commitments, such as the Sustainable Development Goals (SDGs).

9.   Transparency and accountability, as standard procedures for sovereign debt restructuring negotiations, must be established, and the negotiations and their outcomes must be made public.

10. Enforceability, meaning that all parties must respect the decision of the independent body.                             

The above is extracted from ‘The debt games: Is there a way out of the maze?’, a briefing paper (April 2023) published by Eurodad (European Network on Debt and Development). The full paper is available at https://www.eurodad.org/the_debt_games

*Third World Resurgence No. 356, 2023, pp 20-23