August 15, 2020


Another Lost Decade?

Contrary to common beliefs on fiscal fundamentals, the current debt crisis in the global periphery demonstrates that the solvency of sovereign states is determined by their monetary power. Crucially, liquidity has a cyclical character in the periphery of global capitalism and a countercyclical character in the core.

During economic booms, when many contracts look safe, private actors are more prone to purchase assets denominated in peripheral currencies, which typically reward higher interest rates. But during busts, perceptions of asset safety can change quickly. Peripheral currency states are therefore vulnerable to rapid withdrawals from contracts denominated in their currency. Sensing risk, private investors seek the safest assets in the global economy, which, despite lower interest rates, guarantee low credit and market risks, high market liquidity, and limited inflation, exchange rate, and idiosyncratic risks.

The overwhelming majority of safe assets are denominated in the world’s top currency, the US dollar, or other core currencies in the international monetary system. Over half of these are composed of government debt issued by these core states, which is guaranteed by their governments or central banks. Peripheral currency states do not benefit from this stability. The least monetarily powerful states in the world are therefore more vulnerable to exchange rate fluctuations caused by international liquidity booms-and-busts, which subject them to a cyclicality of structural illiquidity and, therefore, sovereign insolvency crises.

Solvency in the global pandemic

Covid-19 has triggered what the International Monetary Fund has called the “worst economic downturn since the Great Depression.” Countries at the core of global capitalism have launched an unprecedented set of monetary and fiscal stimuli, allowing them to keep their economies afloat at very low interest rates. In stark contrast, the periphery has suffered major economic and financial crashes, leaving many countries struggling to pay for imports, service their foreign debts, and fund emergency health, food security, and economic recovery programs.

From January to April of this year, private capital stopped flowing into Developing and Emerging Economies (DEEs). Meanwhile, outflows reached 96 billion dollars, the highest levels in history, as foreign investors sought to shed risk by withdrawing their money from these markets. At the same time, the outbreak of the pandemic has led to a plunge in global trade, foreign direct investment, commodity prices, and tourism. The sharp drop in export earnings expected this year means that an increasing share of revenues in the global periphery is to be spent servicing core currency-denominated debt.

According to the United Nations Conference on Trade and Development, the funding needs of DEEs (excluding China) will amount to 2.5 trillion dollars this year, and could reach 3 trillion dollars over the next two years. Even if official financing remains constant, the expected public sector shortfall in these countries, including long and short-term debt, is expected to hit 735 billion dollars. While a small part of these funding needs was covered by the Federal Reserve through the extension of swap lines to central banks of emerging markets such as Brazil, Mexico, and South Korea, these arrangements excluded the vast majority of DEEs, which were left unprotected amid a dramatic run towards liquidity in US dollars. This demonstrates the global hierarchy of money in which the core—and sometimes a select group in the periphery—of the system is able to access nonconditional liquidity backstops (and in the case of core states, unlimited ones), while emergency liquidity for the periphery often takes the form of conditional IMF lending or official development assistance (ODA) grants.

The current situation in the global periphery can be described as a systemic liquidity crisis which is rapidly shifting into a solvency crisis. In this context, policy options are limited. Countries may give an extra pound of flesh by diverting resources to debt service, despite the fact that their economies require increased fiscal spending to address both the health emergency and the economic downfall. Alternatively, those that retain market access may kick the can down the road by resorting to additional borrowing. This may seem easier due to near-zero interest rates in developed economies (which are driving some investors to pile into risky assets in the periphery in a hunt for yield) but sooner than later this may result in a more severe debt crisis. Finally, states can turn to the global periphery’s lender of last resort—the IMF. It is no surprise, therefore, that 100 of the IMF’s 189 members, half of which are low-income countries, have already approached the organization for emergency liquidity assistance. Predictably, dozens of them are at risk of or have already announced sovereign defaults and restructurings. In the coming months, it is likely that even more states will face financial distress.

In order to resolve the background asymmetries that determine the ability of states to access liquidity, we need to reset the international monetary system. But in the absence of structural reforms, an immediate alternative to cope with the crisis is available through IMF Special Drawing Rights. The SDRs are international monetary assets issued by the IMF against local currency promises of each member country. They are part of a country’s foreign exchange reserves, and can be sold or used for payments to other central banks.

In 2009, the IMF issued 204 billion SDRs, amounting to 318 billion dollars, to mitigate the effects of the global financial crisis. According to most estimates, the current crisis calls for at least 500 billion dollars of new SDRs, which would give some flexibility to the states that have already applied for IMF loans and grants, as well as to those that at present do not qualify for loans, such as Argentina. Creating SDRs would swiftly introduce indiscriminate international liquidity into the global market, allowing DEEs to implement countercyclical fiscal policies and fight both the pandemic and the looming economic recession.

But political circumstances are hampering any movement on these fronts. The Spring Meeting of the IMF in April 2020 resulted in strikingly weak measures to mitigate the serious challenges experienced by the global periphery. The agreement on the expansion of SDRs was reportedly blocked by a Trump administration seeking to prevent its geopolitical rivals from gaining access to unconditional resources. Government officials reportedly suggested that a global liquidity boost is not currently required—yet no practical solutions were proposed for the majority of states in the world that need it. Accounting for almost 17 percent of voting powers in the IMF, the US has effective veto power over any agreement. The impasse on SDRs allocation is unlikely to be resolved.

Debt relief initiatives

In face of immense political obstacles to even modest reforms to the international monetary system, two significant initiatives have sought to relieve the debt burden of the poorest countries in the world. Firstly, the IMF approved a debt service relief to 27 of its member countries under the revamped Catastrophe Containment and Relief Trust. Secondly, the G20 launched the Debt Service Suspension Initiative (DSSI), which allows 76 International Development Association countries (IDAs) and least developed countries (LDCs) to request an eight month suspension of principal and interest payments on their official bilateral debts with Paris Club members from May 1 through the end of 2020.

These initiatives seek to allow low-income countries to reallocate the resources that they would otherwise spend in official or multilateral debt service this year to fight the pandemic. However, both of these schemes have considerable limitations. Firstly, by focusing on debt service, they exclude debt stock. Secondly, they rely on the political will of donor contributors to fund grants from existing aid budgets, thereby reducing the availability of concessional resources for other needs. Thirdly, they fall short of providing sufficient debt relief to eligible countries by excluding private debt.

Even though the G20 “called upon” private creditors to provide forbearance comparable to that offered by Paris Club official creditors, the private sector has declined to voluntarily join any suspension. All three major credit agencies have stressed that requesting private creditor participation on G20-comparable terms could lead to a downgrade of the requesting debtor state. And they have already begun to do it.

Another element adding complexity to the DSSI is China’s participation in the arrangement. China—the world’s largest official creditor and a non-member of the Paris Club—agreed to join the DSSI in June, although it did not make public the terms, beneficiaries, or amount of money involved. But Beijing does not seem prepared to include China’s development bank loans in the DSSI, possibly because it does not feel obligated to indirectly subsidize New York and London-based hedge funds by freeing up resources that poor countries are likely to use to repay private creditors. In the absence of political or legislative initiatives by core states to enforce the DSSI in their own jurisdictions, it seems unlikely that Chinese banks will join this initiative.

In any case, the DSSI will likely postpone the sovereign insolvency crisis of eligible states, rather than resolve it. The payments to official creditors frozen by the G20 will all come due between 2022 and 2024, along with the accrued interest. In the meantime, without private sector involvement, the G20’s standstill and multilateral funding may divert resources necessary for recovery to the repayment of private debt.

Finally, the global periphery debt crisis is not confined to countries included in the DSSI. The initiative only involves IDA-eligible countries and Angola, which the United Nations designates as one of the least developed countries. Thus, it leaves off a group of 50 low and middle-income emerging economies which have significantly more foreign debt—around 95 percent of all sovereign debt owed by the global periphery—and many of whom are experiencing severe economic strain. According to the IIF, these countries may find it hard to borrow large sums in international capital markets this year. In addition, they are likely to have to grapple with increasing fiscal burdens as the recession unfolds.

It is therefore not a question of whether, but when, further defaults and debt restructurings will occur. Without debt reduction, the prospect of global socioeconomic recovery in the aftermath of the ongoing crisis is seriously compromised.

Lessons from the 1980s debt crisis

The magnitude of the challenges posed by Covid-19 is reminiscent of the global periphery debt crisis of 1982. From the 1960s onwards, international commercial banks—mostly based in the United States—significantly expanded their loan portfolio to sovereigns in Latin America and Africa, which relied on petrodollars to finance their developmental enterprises. When Federal Reserve chairman Paul Volcker raised interest rates from about 11 percent in 1979 to 20 percent in 1981, countries were suddenly pushed into sovereign debt crises, while the United States banking system was put at risk.

The IMF acted as a creditor coordinator during the crisis, leading committees along with the United States government and the largest commercial creditors of each country. The Fund led a variety of programs in debtor states, mostly consisting of harsh austerity measures and structural adjustment programs, including the privatization of national public assets to foreign corporations. Debt relief would only come years later with the Brady Plan, through which countries were allowed to exchange their commercial bank loans for a lesser amount of face value in bonds backed by US Treasuries. However, the impact of the policies adopted to address the crisis on the productive capacity, employment, and social conditions of the countries concerned was so strong that the United Nations Economic Commission for Latin America and the Caribbean (ECLAC) characterized the following years as a “lost decade” for their economic and social development.

Despite the possible analogies, there are significant differences between the debt crises of 1982 and 2020. This time, the creditor base of sovereign debt is the most diversified in history. Along with Paris Club official creditors and commercial bank debt, today’s creditors consist mostly of non-Paris Club official creditors (China) and a multitude of bond funds.

This varied creditor base of sovereign debt includes many competing interests and few shared codes of conduct. It is now much trickier to coordinate behind closed doors through the sort of “gentlemen’s agreements“ which permitted restructuring in the past. Furthermore, the level of exposure of hedge funds to emerging market bonds indicates that holdout strategies may become more widespread than in previous crises and include not only high-risk hedge funds (also known as “vulture funds”) but also traditional ones. In this context, consensus is much harder to achieve than in the past.

The legal governance of sovereign debt

As a new era of sovereign debt crises arises in the international community, the legal governance of sovereign debt yet again takes center stage. Despite the number and frequency of sovereign debt crises and their harmful implications, the law has historically failed to address such problems in any systematic way. Since Bretton Woods—and despite the transformations in the international monetary and financial system over the past 70 years—sovereign debt has remained one of the least regulated areas of global finance.

Sovereign debt restructuring is currently based on ad hoc arrangements between the debtor state and its creditors, which can be either official, multilateral, commercial, or composed of bondholders. Private debt contracts are mostly governed by two core jurisdictions on sovereign debt—England and the State of New York. Renegotiations take place through transactional arrangements in which participation is only mandatory when binding contractual majorities are gathered for specific bond issuances. There is no such thing as an international sovereign bankruptcy body like the ones commonly found in domestic jurisdictions on corporate or personal bankruptcy.

This legal framework prevents effective, timely, and fair resolution to insolvency crises. It is riddled with collective action problems which often result in insufficient debt relief, delays, and asymmetries among stakeholders in the restructuring process—including the various types of creditors and the population of the debtor state. These complexities often make contract-based sovereign debt restructuring a time-consuming activity. Creditor coordination is difficult to achieve, and the process is often unable to facilitate recovery from insolvency for the debtor state.

When restructuring terms are unsuccessful in tackling unsustainable debt burdens, new sovereign debt crises may be around the corner. Since 1970, more than half of the restructuring episodes with private creditors were followed either by another restructuring or a default within 5 years. The insurmountable obstacles posed by transactional legal arrangements in insolvency scenarios show why every jurisdiction in the world relies on bankruptcy rules in dealing with private insolvency.

Numerous calls for statutory or contractual-based moratoriums and debt reduction for developing states have proliferated among UN agencies, NGOs, and academics during the pandemic. However, the collective action problems typically posed by any restructuring process are currently exacerbated by the dimension of the crisis (in which many countries are facing or will likely enter into insolvency) as well as the variety of interests involved. Political consensus on any of those terms is particularly hard to achieve if the objective is to ensure the debt reduction levels required for an effective recovery from the insolvency crisis.

The existing legal governance of sovereign debt restructuring places a disproportionate burden of risk on the debtor state. The Covid-19 crisis is therefore exacerbating the problems already posed by contractual restructuring technologies in times of normality: restructuring terms will likely be too little and too late, and inter-creditor coordination has become impossible despite the urgency of the present situation.

The plurality of creditors and the diversity of interests among them generates a distributive conflict over the appropriation of public funds which, by definition, are limited during a sovereign debt crisis. In this context, the most leveraged creditors will seek to transfer risk to others in an attempt to obtain full and timely repayment. Thus, official moratoriums alone can end up simply bailing out private bondholders.

Moreover, once debt restructurings are initiated, minority bondholders may seek to block restructuring arrangements at any time before the courts of the core jurisdictions on sovereign debt. At present, it is unclear whether these courts are equipped to deal with the large number of sovereign debt cases on the horizon. It is not unreasonable to expect that courts will be swamped and that the costs of litigation will rise.

The need for international sovereign bankruptcy rules

The economic downturn posed by Covid-19 is intensifying across the world’s most dispossessed territories as states struggle to meet their population’s basic health and nutritional needs. Extreme economic and human loss will be caused by the delay in tackling the global periphery debt crisis. A global deal is urgently needed to provide DEEs the levels of debt relief they need, which otherwise is likely to drag the vast majority of the planet into another decade of economic stagnation.

But it is also crucial to engage in a structural discussion on the need for adopting an international sovereign bankruptcy mechanism that prevents chaotic crises such as the one we are currently facing from happening again in the future.

As long as the international monetary system is structured on the basis of a global hierarchy of currencies, sovereign debt crises will not disappear. Rather than being the product of individual characteristics of peripheral states, they are inherent to the asymmetric character of global liquidity. In this sense, the wave of sovereign debt crises triggered by Covid-19 is just a reflection of how the international monetary system is structured.

An international sovereign bankruptcy mechanism is a crucial matter of global justice. Bankruptcy rules are needed that can distribute the costs of losses in an accountable, transparent, and hopefully fairer manner, creating justifiable legal hierarchies between all the stakeholders involved in sovereign insolvency. These include all types of sovereign creditors, but also the populations of debtor states.

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