By Rodrigo Olivares-Caminal, Professor of Banking and Finance Law at the Centre for Commercial Law Studies, Queen Mary University of London, and Paola Subacchi, Professor of International Economics, Global Policy Institute, Queen Mary University of London
The financial response to the COVID-19 crisis has driven debt building at an unprecedented speed, which has increased the risk of debt distress and the odds of a new debt crisis cycle. Emerging markets and developing economies are most at risk. When the COVID-19 crisis began in February 2020, it demanded extraordinary policy measures to protect lives and provide support to those who had lost their livelihoods. The public debt vulnerabilities for many countries, especially the poorest ones, were already significant at that time, but the subsequent collapse of many economic activities exacerbated the situation. As of 30 April 2021, 29 countries were at high risk of debt distress, and 7 low-income countries had already succumbed to it. Somalia, for example, is currently in debt distress and needs to secure relief to restore debt sustainability.
Emerging markets and developing economies are most at risk because of their exposure to international capital flows and the fact that portions of their debt are issued in hard currencies, namely the US dollar. This leaves them vulnerable to changes in US monetary policy, and so to sudden outflows when risk aversion and international financial volatility are high. Some countries have learned lessons from previous debt crisis cycles – as is evident, for example, in the development of local-currency securities markets which mitigate the risk of foreign-currency borrowing – but such resilience is patchy and far from being systemic.
Peru and Uruguay, for instance, entered the crisis with balance sheets in good order (Peru’s average annual real GDP growth has been 5.4% over the past fifteen years, and Uruguay’s 4.7%) and so have been able to tap international capital markets. In November 2020, Peru issued dollar denominated bonds maturing in 2032, 2060 and 2121 – at historic low rates of 1.86%, 2.78% and 3.23% respectively – for a total amount of 4 billion dollars. This issuance adds to Peru’s April issuance of dollar denominated bonds maturing in 2026 and 2031, at rates of 2.39% and 2.78% respectively, for a total amount of 3 billion dollars. Similarly, in June 2020, Uruguay issued foreign currency denominated debt at a 2.48% and 3.75% rate, maturing in 2031 and 2040 respectively.
Argentina, on the other hand, saw its economy halt to a sudden stop and its debt service capability subsequently deteriorated – mainly because of the denomination in foreign currencies, short maturities of recent issuances and large external financing needs. In March 2020, the government announced its decision to restructure the debt – the nineth restructuring in its history. This followed the depreciation of the Argentine peso by over 40% against the US dollar – the largest in 2020 after Venezuela – the deterioration of Argentina’s sovereign risk after its presidential election in September 2019, and a larger than expected drop in real GDP – despite significant IMF disbursements. On the back of the announcement of debt restructuring, Argentina’s net international reserves took another plunge after approximately a 30% drop – from 67.7 to 43.3 billion dollars – in the months following the election. In August 2020, Argentina reached an agreement with its creditors to restructure 65 billion dollars of external debt which resulted in bondholders accepting a reduction of almost 40 billion dollars over the 2020-2024 period. However, after an exhausting seven-month negotiation with creditors, Argentina’s public debt to GDP ratio is now set to reach levels of around 110%, with almost no change in the share of public debt denominated in foreign currency (approximately 70%).
Debt restructuring, even when it is pursued in an orderly manner, is onerous because of the short-term costs of emergency measures and long-term reputational effects, such as the loss of credibility that a country suffers as a consequence. IMF research on the effects of sovereign credit history on a country’s sovereign interest yield found that the default premium rises with the number of years a sovereign stays out of the market after a default. Hence, a defaulter will experience a risk premium of 2% of GDP, with an extra difference of 1% of GDP remaining after five years. In the case of Argentina, the interest rates on debt issuances between 2016 and 2018 ranged between 6% and 8%, in contrast with other countries in the region that averaged between 3% and 4% over the same period.
Countries that default face a further burden in the legal and financial costs charged by professionals who assist in the process of restructuring, including lawyers, financial arrangers, and even the information agents who help administer the restructuring. Often the costs of litigation need to be added to legal and financial costs. In the 2020 Argentine restructuring, the government limited the commissions of the professionals involved to a maximum of 0.1% of the total amount to be restructured – almost 69 billion dollars.
Ex-post debt restructuring, as opposed to ex-ante measures to manage debt accumulation, are costly for the country involved and for international lenders, both in terms of negative impact on economic growth, hardship for people, stress for the banking system and capital losses. They have also become extremely complex due to different categories of creditors involved with non-Paris Club, non-concessional lenders such as China, large institutional players such as Blackrock, Fidelity and Pimco, and an increase in lending either through direct bilateral loans or through other vehicles such as publicly backed development funds and/or investment funds.
Despite the costs and complexity, ex-post intervention when a debt crisis is already under way seems to be the default option for many governments and multilateral institutions. The problem with this approach is that it only deals with problems as they occur and will not help to prevent further instances of debt distress. It is clear that the focus should rather be on preventative measures that assess whether there is a real need to incur new debt – i.e., whether, and under what conditions, countries should incur new debt obligations – and also improve transparency in sovereign borrowing.
The DSSI has provided countries with some relief; it has created breathing space by deferring payments so that resources can be re-directed to fight the pandemic, but clearly this is not enough. Although the Common Framework shows some improvements to broaden the stakeholders and bring China into the equation, it is still an ex-post partial solution to a broader problem. We need to shift focus before debt piles up – and not after. An ex-ante solution will pay careful attention to the intergenerational element of debt, as the money borrowed today will be paid by a different generation tomorrow. It will also uphold sound macroeconomic policies as the necessary condition for sound debt management, and good practices in the decision-making process related to borrowing. The focus should be on the ex-ante measures: greater transparency, debt management, and accountability. Although there are many frameworks in place that help stakeholders to improve their situations, such as debt ceilings, golden clauses, or detailed debt management policies, it is clear that these have not been properly or thoroughly applied given the debt accumulation context. This is the fault of both debtors and creditors.
Finally, enhanced transparency and greater accountability, supported by a well-functioning domestic legal system will facilitate accountability. As is expected, the rule of law plays an important role.
The authors would like to thank Guido Demarco for his research assistance. Any errors or omissions are purely attributable to the authors.