At a recent private conference on sovereign debt restructuring, an old friend argued that, in addition to talking about what to do once a country has crossed a tipping point and needs to restructure its debt, efforts should also be made at prevention. It is, of course, a good point; one on which I have written in the past. His comment got me thinking about an idea I had a decade or so ago, in those halcyon days before the global crisis.
The concern then was that debt relief initiatives, which improved the debt-carrying capacity of many highly-indebted countries, created space for others to fill. Export credit agencies and private sector lenders, recognizing an opportunity to grow their balance sheets, rushed to lend to these countries, leading to widespread concerns that a number of countries whose longer-term growth prospects had been constrained by high levels of indebtedness prior to debt relief would, once again, take on too much debt and encounter debt-servicing problems when the global economy slows, interest rates rise, and commodity prices fall.
As things turned out, the global crisis of 2007-2010 didn’t play out the way many observers (including me) thought it would. The crisis was met with extraordinary counter-cyclical stimulus measures, with China leading the way. This stimulus kept the global commodity ‘super cycle’ going, fueling a quick recovery for developing countries. At the same time, the crisis led advanced country central banks to take equally extraordinary measures to prevent the global financial system seizing up. Global interest rates fell to (effectively) zero. All things considered, it was a good crisis for developing countries and emerging markets.
That being said, the policy issue I was pondering in the spring of 2006 was how to prevent export credit agencies (ECAs) from excessive lending that could impair future development. At the time, there were fears that some ECAs may have been pursuing non-economic (or "strategic") objectives, such as securing control of natural resources or market share. If other ECAs didn't play the game, the argument goes, they would lose access to key resources or find markets closed to them.
I wanted to address the collective action problem associated with lending to countries that had low levels of indebtedness owing to debt relief initiatives, but whose medium-term economic prospects remain uncertain. By taking on too much debt, the borrower increases the probability of default on all lenders. Moreover, because the return on previously issued fixed rate debt does not respond to this deterioration in the expected return, the borrower has an incentive to take on too much debt to invest in excessively risky projects. The collective action problem arises because, while lenders have a collective incentive to limit new lending, each has an individual incentive to lend as much as quickly as possible before other lenders do so. In this environment, the likelihood of a misallocation of investment resources must be judged to be high.
Of course, this problem is not new: it is encountered in virtually every lending situation. In the domestic context, legal arrangements have evolved to attempt to align incentives such that borrowers are penalized for taking on excessive debt loads. These include contractual provisions, such as parri passu and acceleration clauses, bond covenants restricting the range of investment projects financed by borrowing, and the enforcement of priority of claims. Such legal restrictions binding the interests of private lenders are reasonably successful domestically, though not without the threat of protracted legal disputes.
At the international level, however, contractual provisions are much less effective given the absence of a mutually agreeable process for the timely restructuring and adjudication of conflicting claims. The question is whether some form of ex ante government action.
One option to deal with this problem would be to secure agreement among ECAs on priorities of claim in the event of future debt-servicing difficulties. The idea would be to relax the "joint and several" rule that has governed past Paris Club restructurings by tying restructurings of particular ECAs to their relative contribution to the debt load. The earlier a credit is made, the greater the "protection" it would receive in any subsequent debt restructuring. Conceptually, the process is relatively straightforward. Paris Club members would agree on the extent of NPV reduction needed to restore sustainability (on the assumption that the country in question maintains a debt-servicing moratorium on non-Paris Club creditors). This quantum of debt relief to be provided by Paris Club creditors would then be distributed on a sliding scale that punishes creditors that came into the game late, pushing the country over the sustainable debt threshold.
This approach has a number of noteworthy features:
- First, it would tend to align incentives by forcing lenders to consider the potential consequences of their lending. This would hopefully result in a rising cost of capital schedule faced by potential borrowers. A higher cost of capital, meanwhile, would create incentives for the borrower to ration excessive debt accumulation and take actions to ensure that the funds are invested wisely.
- Second, it provide strong incentives for lenders to exercise due diligence in monitoring the use of borrowed funds-including adopting a probabilistic approach to loan evaluation (what is the probability that current high commodity prices will fall over the life of the loan, etc.).
- Third, it would create an incentive for borrowing countries to be more forthcoming in revealing their outstanding obligations.
- Fourth, it would provide an incentive for non-members of the Paris Club to cooperate with the international community (given the fact that Paris Club debt relief would be predicated on a continuing standstill on interest payments to non-members).
At the same time, however, the proposal could be criticized as not giving borrowers sufficiently strong incentives to observe the bonding role of debt. This is indeed the case. But it is also true of the status quo. The suggestion here, if successful, would at least result in a rising cost of capital to the borrower. Moreover, the proposed arrangements could be further strengthened by securing ex ante agreement among Paris Club members that any country that does seek debt relief from the Club automatically goes off cover for some specified period of time. Member countries could make loans (as at present) but they could not call on Paris Club "solidarity" in recovering amount owing when the country goes back on cover.
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The discussion here is obviously an abstraction, given its static nature. Debt-servicing capacity changes over time in response to both external (commodity price) shocks and domestic factors (policy frameworks, the nature of the investments made, etc.). Regardless, a very large stock of debt has been contracted over the past decade; some of it will not be repaid. How quickly and efficiently it is restructured will have an impact on the global economy. This fact underscores the ongoing efforts to improve the framework for restructuring sovereign debts. At that same time, it should also focus efforts on preventing the need for future sovereign debt restructuring going forward by better aligning incentives.
