The writer is portfolio manager at Sampension and a visiting fellow at the London School of Economics.
Despite a recovery in the global economy from the pandemic, many developing countries are approaching a default on their debts. The lessons from history is that they should not delay a decision to default for too long.
The reasons why countries postpone a decision are understandable. Finance ministers fear for their jobs, bankers and lawyers talk about lost credibility, and surely markets will not forget the next time a country wants to borrow money. At least that seems to be conventional wisdom.
The cost of a sovereign default can be significant, but depends crucially on how and why it occurs. In a “hard” (or unilateral) debt default, where the country is unwilling or unable to pay, economic growth can, and often does, deteriorate. The risk of knock-on effects from the currency or banking system in these situations is high.
But many sovereign defaults are negotiated (so-called soft defaults), where the economic costs are often far smaller. Recently, Ecuador and Belize undertook successful sovereign debt restructurings, where market access was restored after a debt restructuring. The political consequence of a default can be significant, but it does no good to delay the inevitable. In fact, continued repayment of unsustainable debts has far bigger political risks.
If countries pretend that they will pay back their debt, a much more likely outcome is that they burn precious cash reserves which make an eventual restructuring harder. Such repayment favours certain creditors over others and makes it more difficult to reach an equitable agreement later. Fewer cash reserves inevitably mean creditors must accept a higher haircut on their claims, which leads to higher interest rates in subsequent years.
A serial defaulter, such as Argentina, has a harder time issuing new debt, but that is to a large extent because of its structural economic problems, failed bailouts and unwillingness to write down debt. The main problem is an inability to generate exports — a failing Argentina shares with many other countries, and something that is not addressed in the outline of its pending deal to restructure $44.5bn of IMF debts arising from a 2018 bailout.
Recent IMF programmes in Kenya, Sri Lanka, Pakistan and Ecuador all assume export growth that is way above historical trends. These optimistic assumptions have not materialised. If countries do not possess enough income from exports, it is difficult to service increasingly large debt burdens — burdens that are large enough to cause structural problems in many parts of the developing world.
The G20 Common Framework for debt treatments offered a way to pause payments and bring together official creditors and debtors, but lacked an enforcement mechanism to get private creditors on board. It was only a small step in the right direction.
The desire to keep up with interest payments in the hope of an economic miracle is powerful, but enforcing debt contracts is not without risk because money that goes to debt service cannot be used for productive domestic investments.
We see this in periods after wars. Victors have often imposed large war reparations on the losing country, which were repaid at high economic and political costs.
Many countries’ bonds trade at levels which indicate a high likelihood of a sovereign debt restructuring — Sri Lanka, Pakistan, Lebanon, Ethiopia, Zambia, El Salvador and Argentina are cases in point. All of these have had some form of contact with bondholders, bilateral creditors, or the IMF. Each country has its own economic problems, but they share a lack of hard currency exports that is commensurate to their debt burden. More countries are likely to join the list if the US Federal Reserve tightens monetary policy as expected, China slows down, or global trade contracts.
Much of the world needs capital to finance green investments. But the debt should be sustainable and not leave countries scrambling from one coupon payment to the next.
The restructuring of Belize’s sovereign debt showed that there is room for creativity and win-win deals. It boosted the debt sustainability of the country while creditors walked away with an acceptable deal with parts of the proceeds going to sustainable projects. It does no good for anyone to assume that everyone can export their way out of trouble. The current structural economic problems need to be addressed, but not by forcing repayment of clearly unsustainable debt burdens.