The Covid-19 pandemic will have one immediate effect on the sovereign debt positions of developing countries and another that will become painfully apparent by the end of this year. The immediate consequence is the need of many countries to deploy their available financial resources toward Covid crisis alleviation measures. More than 100 countries have asked the IMF for emergency financial assistance to deal with the pandemic. But that funding will not be enough, in many cases not nearly enough, to cushion the impact of a deadly and easily transmissible disease on weak health care systems. Many developing countries will therefore have little choice but to redirect the money that had been earmarked for other government purposes, including external debt service, to defray Covid-related expenses.
The slightly longer-term effect of the Covid-19 pandemic will be visible in the debt burdens being carried by many developing countries, what in the economists’ jargon is called ‘debt sustainability’. Virtually all countries in both the developed and developing worlds entered this crisis with historically high levels of government debt. A handful of countries (Argentina, Lebanon, Venezuela, Ecuador) needed a full-scale restructuring of their sovereign debt when 2020 began. That list will be longer when 2020 ends.
The Debt Service Suspension Initiative
The immediate challenge, however, is to assist the countries most affected by the pandemic in paying for the costs associated with the crisis. In addition to emergency financial assistance from official sector sources, countries may need to suspend normal debt service payments for a temporary period and redeploy those funds for Covid-related expenses. The amounts that could be liberated in this manner are significant. For example, the debt service payments due on external debts owed to bilateral and commercial creditors for the balance of this year from the countries belonging to the International Development Association (IDA), i.e. the 76 poorest countries, equals approximately $19.6 billion.
The official sector — the IMF, the World Bank, the Paris Club and the G20 countries — have moved swiftly to assist the poorer countries most affected by the pandemic. Their efforts, under the banner of the Debt Service Suspension Initiative (DSSI), have had these milestones:
On 25 March 2020, the President of the World Bank Group and the Managing Director of the IMF released a Joint Statement calling on official bilateral creditors to suspend debt payments from IDA countries in order to allow those countries to devote their liquidity to tackle challenges posed by the coronavirus outbreak.
The initial response of the private sector to the World Bank/ IMF Call to Action seemed very promising. On 9 April, the Institute for International Finance (IIF), a Washington based trade association with 450 members, most of them financial institutions, sent an open letter to several official sector actors expressing its “grave concern to debt sustainability posed by the COVID-19 pandemic.” The letter volunteered that both bilateral and commercial creditors should commit to “forbear payment default” until the end of 2020 for the poorest, least developed countries significantly affected by Covid-19.
In response to the Call to Action, the G20 countries issued a communiqué on 15 April supporting a “time-bound” suspension of debt service payments for the poorest countries that request such forbearance on terms that are “NPV neutral” for the creditors. Apparently encouraged by the warm response of the IIF to the Call to Action, the G20 called upon private creditors, working through the IIF, to participate in the initiative on comparable terms.
There were several curious features of the G20’s communiqué. Why had the G20 limited itself to “calling upon” the private sector creditors of IDA countries to provide comparable debt relief instead of simply conditioning bilateral creditor forbearance on matching private sector participation? (An invariable feature of debt relief provided by bilateral creditors under the auspices of the Paris Club is a legal obligation on the part of the sovereign debtor to seek “comparable treatment” from its commercial creditors.) Why was debt relief intended to alleviate an acute humanitarian crisis to be provided on an “NPV neutral”, rather than a concessional, basis? And what did NPV neutrality mean in this context?
Having reflected on the matter for three weeks and after consultation with some of its members, the IIF wrote again to the official sector actors on 1 May. This second letter, while not openly disavowing the IIF’s prior commitment to support the DSSI, now felt the need to anticipate and preview for the official sector the many obstacles that the IIF could foresee in asking private sector creditors to participate in the initiative. This, the IIF warned, reflected a “complex landscape.” Among these obstacles are:
- Private sector participation must be “on a voluntary basis.”
- Each participating private sector creditor, the IIF stressed, will need to make its own assessment of NPV neutrality. Achieving NPV neutrality may “require different assumptions for accrual rates on suspended debt service or some form of credit enhancement.”
- Before agreeing to participate, each private sector creditor would need to assess whether such a step was consistent with its fiduciary duty; that is, “whether participation is the right thing to do for its clients [investors].”
- A lengthy contract-by-contract approach may be required to implement a standstill on private sector debt service.
- “Market participants are concerned that the Debt Service Suspension Initiative will trigger a wave of sovereign downgrades, defaults and cross-defaults…”.
- It is “imperative”, the IIF warned, that borrowing countries “be well-informed about the potential consequences for market access when requesting debt service suspension (especially from the private sector).”
Taken as a whole, the IIF’s 1 May letter sent three messages to the official sector and to the sovereign debtor community generally. First, rather than decline to participate in the DSSI, the commercial creditors would prefer not to be asked to participate. This explains the repeated alarms about credit rating downgrades, loss of market access and the imperative need for the debtor countries to be “well-informed” about the dire consequences of even asking the private sector for a suspension of debt service payments.
Second, if a debtor country does ask for a suspension of private sector debt service, it must understand that this is likely to be a lengthy creditor-by-creditor, perhaps instrument-by-instrument, process. In addition, the resulting deferment of debt service payments may be more expensive than the “NPV neutral” suspension of bilateral payments The implication here is that by the time a debt service suspension for a private creditor is negotiated, documented and executed, there may be very little of 2020 left in which the suspension will operate. A debtor country may thus suffer all of the negative consequences of having asked for a deferment of commercial debt service payments without in fact ever deferring many (or any) such payments.
Third, the IIF 1 May letter is not a guide for how to implement a standstill on commercial debt payments. It is rather a checklist of the potential reasons that individual commercial creditors may cite as a justification for their refusal to accept such a standstill. Among these are fiduciary duties to investors, contractual commitments, regulatory requirements and national laws, “among other considerations.”
Paris Club Memoranda of Understanding
By the middle of May, the Paris Club creditor countries had begun signing Memoranda of Understanding implementing the DSSI with participating IDA countries. These MOU require the beneficiary countries to commit to seek from all other bilateral creditors a debt service treatment that is “in line with” the terms set out in the MOU. No mention is made of commercial creditors.
IIF Terms of Reference
On 28 May, the IIF released a document captioned “Terms of Reference for Potential Private Sector Participation in the G20/Paris Club Debt Service Suspension Initiative.” The Terms of Reference flesh out the principles previewed in the IIF’s 1 May letter to the official sector — wholly voluntary private sector creditor participation in the DSSI, bespoke amendment or refinancing of existing legal instruments and NPV neutrality (to be determined creditor by creditor).
Elements of a debt service standstill
In its short two-month history, the DSSI has exposed the main challenges in coordinating sovereign debt relief among official sector actors and commercial creditors. If the latter are merely “called upon” to join in a debt relief initiative on a wholly voluntary basis, there will be no shortage of reasons why they may be reluctant to do so. The problem is not that the reasons referenced by the IIF, such as the fiduciary duties of asset managers to their investors, are implausible. The problem is that these reasons are both plausible and predictable.
They can be summarised in the propositions that commercial lenders would rather be paid than not paid; would rather reduce, not expand, risk in the face of sovereign debt distress; and, if they are to accept additional risk, would rather be fully compensated for doing so.
Therein lies the problem. If left entirely to their own preferences, commercial lenders will behave in a commercially predictable manner even if this means, as it probably will with the DSSI, being tagged with the mildly opprobrious title of free-rider. Some of the emergency financial assistance being provided to the poorest countries by multilateral financial institutions, and some of the debt relief resulting from debt payment suspensions granted by bilateral creditors, will end up being used by the debtor countries to service their commercial obligations. To this extent, the private sector will free ride on the public sector.
In normal times, commercial actors may be expected to behave like commercial actors. There are other times, however, when venality should be tempered by a sense of social responsibility. A pandemic that shuts down much of the world's economy is such a circumstance. Forcing governments in the middle of this pandemic to choose between their credit reputations and the lives of their citizens is, we believe, self-evidently wrong. The DSSI does not ask creditors to forgive debt service payments falling due during the balance of this year, only defer those amounts (with interest) to allow limited financial resources to be devoted to crisis amelioration. It therefore seeks restraint, not charity.
For their part, the credit rating agencies appear to have approached the DSSI in a particularly wooden manner. Sovereign credit downgrades may well be coming. If the effect of the pandemic on export markets, commodity prices, remittance flows, tax collections and exchange rates is even half as bad as the official sector fears it might be, the credit ratings of many countries will inevitably be negatively affected. To threaten a downgrade simply because a country seeks to defer a debt service payment in the middle of a pandemic, however, is both morally obtuse and economically short-sighted. By redeploying those funds toward crisis amelioration the country may succeed in limiting the damage to its population and economy. This should raise, not lower, its esteem in the eyes of the credit rating agencies.
We believe that a temporary standstill on debt service payments owed to commercial creditors must include these elements (for our proposal on the implementation of a standstill, see here):
The debtor countries are in the middle of the Covid-19 crisis. If financial assistance is to have any effect in ameliorating the severity of the crisis it must arrive soon. Any plan that calls for months of negotiations between the debtor and each of its creditors about the design, documentation and execution of a standstill for each existing debt instrument is pointless.
Hundreds of private sector creditors will be affected by this initiative. The debtor countries will have neither the time nor the resources to pursue bespoke negotiations with each of those institutions. Even if such an approach were practical, it would inevitably produce a welter of inconsistent financial and legal terms. Only a standardised, uniform approach to a temporary standstill will be feasible in these circumstances.
It is perfectly fair for creditors, bilateral and commercial, to insist that the burden of helping these countries should be shared equitably among all creditors. Indeed, in its 9 April letter the IIF opined that a sovereign debt crisis resolution requires that “[n]o creditor or creditor group should be excluded ex ante from participating in debt restructuring.” Once a decision is made at a collective level to support a temporary debt standstill, any holdouts from the initiative are in effect asking to be subsidised by the participants. The G20 communiqué of 15 April indicated that such a collective decision for a temporary standstill had been agreed by bilateral creditors; the 9 April letter of the IIF purported to confirm that a similar collective decision had been reached by commercial creditors.
“Voluntary” — in quotes
The word “voluntary” has always had an elastic meaning in the context of sovereign debt workouts. Without a formal bankruptcy code to compel creditor participation, all sovereign debt workouts are in one sense voluntary. But that has never been understood to mean that individual lenders are free to participate or not as they see fit. In the global sovereign debt crisis of the 1980s and early 1990s, the commercial bank lenders of that era “voluntarily” joined serial sovereign debt restructurings for more than a decade. If any bank began toying with the idea of not participating (and there were some), however, that bank became the subject of intense peer pressure from its colleagues in the international banking community. In the rare cases where peer pressure proved inadequate to bring a maverick bank back into the corral, a stern call from the bank’s regulator did the trick. In this century the voluntary participation of bondholders in sovereign debt workouts is coerced, when necessary, by the operation of collective action clauses — contractual provisions by which a decision of a supermajority of bondholders binds any dissenting minority.
Although the G20 DSSI is limited to IDA countries, it is naïve to think that some middle-income countries will not also need similar relief.
All of this said, the question of private sector creditor participation in the DSSI now seems sealed. The official sector will not insist upon it. Some commercial lenders, for reasons of reputation or on-going business relationships with the debtor countries, may elect to defer debt service payments for some portion of 2020. Whether the cost (in terms of legal and financial adviser fees), the financial aspects (in terms of the interest rate charged on deferred amounts or associated calls for collateral security or guarantees) or the practical effect (in terms of the time remaining in 2020 when the suspension would operate) will be attractive to the debtors remains to be seen. Some countries may be sufficiently alarmed by talk of credit rating downgrades and permanent damage to market reputation that they will not even request a debt service deferral from commercial lenders.
The DSSI experience may have significant lessons for the next phase of this process — the likely need in 2021 for full scale debt restructurings by a number of emerging market countries. Indeed, we may all look back with gratitude that the limits of a wholly voluntary coordination of private sector lenders in sovereign debt relief efforts were exposed in the DSSI when the amounts at stake are modest. In the coming sovereign debt workouts, as in all Paris Club debt restructurings of the past, the watchword will be some variation of “comparable treatment” of all affected creditor groups. Achieving this goal with commercial creditors will inevitably require more than a simple appeal to the better angels of their natures. The fate of the DSSI will have taught us that.
Bolton, P, L C Buchheit, P-O Gourinchas, M Gulati, C-T Hsieh, U Panizza and B Weder di Mauro (2020), “Born Out of Necessity: A Debt Standstill for Covid-19”, CEPR Policy Insight No. 103.