The Restructuring of Sovereign Debt

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Dan Crawford
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by Joseph Joyce

The Restructuring of Sovereign Debt

The economic repercussions of Russia’s invasion of Ukraine will be devastating for many countries that have yet to recover from the pandemic. Higher prices for commodities, particularly energy and food, will increase inflation rates and widen trade deficits for those nations that import those items. Increases in interest rates will raise the cost of debt financing and hamper the ability of borrowers to meet their obligations or refinance existing debt.

Carmen Reinhart, Chief Economist of the World Bank, warned that the pandemic had exacerbated existing financial weaknesses in her Mundell-Fleming Lecture, “From Health Crisis to Financial Distress,” which has been published in the IMF Economic Review. She points out that economic and financial crises, including banking, currency, debt, etc., often occur together. The resulting “conglomerate crisis” can lead to a severe economic downturn. She warns that initial attempts to arrange a “shallow” restructuring of sovereign debt that does not reduce the intertemporal value of the debt may be followed by one or more subsequent restructurings, exacerbating the impact of the crisis.

Governments that need to restructure debt may be able to lessen the resulting impact if they act early. Tamon Asonuma, Marcos Chamon, Aitor Erce and Akira Sasahara have examined the consequences of debt restructurings in an IMF Working Paper, “Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel.” The authors looked at 179 restructurings of the sovereign debt held by private holders over the period of 1978-2010. They divided the sample into three categories: “strictly preemptive,” where no payments were missed; “weakly preemptive,” where some payments were missed but only temporarily and only after the start of negotiations with creditors; and “post-default,” which occurred when payments were missed and without agreement with the creditors.

They reported that banking crises and severe declines of credit and net capital inflow occurred more frequently following post-default restructurings. They also found that contractions of GDP and investment spending were substantial in post-default restructurings, less severe in weakly preemptive restructurings and did not occur in the case of strictly preemptive cases. Private credit and capital inflows remained below the pre-crisis levels and interest rates rose after post-default restructurings. Their results indicate that governments that can restructure without missing payments will avoid some of the costs associated with restructurings. The authors acknowledge that large shocks can force a halt in payments, but even in those cases collaboration with creditors is more advantageous than unilateral actions.

The IMF reviewed the institutional mechanisms that address sovereign debt restructurings in 2020 policy paper, The International Architecture for Resolving Sovereign Debt Involving Private-Sector Creditors—Recent Developments, Challenges, And Reform Options. The review found that recent restructurings of sovereign debt had been much smoother than those in previous periods. It attributed this change to several factors, including the increased use of collective action clauses which allow a majority of the creditors to override a minority that oppose a restructuring. The paper’s authors called for more contractual reforms as well as an increase in debt transparency, and also recommended that the international financial institutions support debt restructurings financially when appropriate. But the report  warned that the pandemic could engender a widespread crisis that could overwhelm existing procedures:

“Should a COVID-related systemic sovereign debt crisis requiring multiple deep restructurings materialize, the current resolution toolkit may not be adequate in addressing the crisis effectively and additional instruments may need to be activated at short notice.”

The IMF sought to establish new instruments in 2020 when it joined the Group of 20 nations to create an institutional mechanism for low-income countries with unsustainable debt loads called the “Common Framework” (see here). The initiative sought to bring together official creditors, including the traditional lenders such as the U.S. and France, with more recent lenders, such as China and India, to coordinate debt relief efforts. Private creditors were to use comparable terms in their negotiations.

But the Framework has not been widely adopted because of reluctance by some lenders and borrowers. Chinese lending has been funneled through several institutions, and they are not always willing to join other creditors. The governments of the nations with the debt loads have been reluctant to signal that they may need relief, in part because of a negative signaling effect. The IMF has called for reorganizing and expanding the Common Framework.

A wave of restructuring may be triggered by a Russian default on its dollar-denominated bonds. The credit rating agencies have downgraded the Russian bonds to junk bond status (“C” in the case of Fitch’s rating). President Putin has stated that the bond payments will be paid in rubles, but the Russian currency has lost its international value. A default would hasten the collapse of the Russian economy. It would also lead to a reassessment of the solvency of other governments and their ability to fulfill their debt obligations. Foreign bondholders could decide to cut their losses by selling the bonds of the emerging markets and developing economies. A wave of such selling that occurs at the same time as the Federal Reserve raises interest rates will almost certainly lead to a new debt crisis for many countries. The IMF and World Bank will be hard-pressed to coordinate relief efforts across so many borrowers and lenders.