Debt restructuring: an increasingly complex puzzle for vulnerable countries

In recent years, several vulnerable countries have no longer been able to meet the interest and repayment obligations on their foreign debt. Debt restructuring is required to get out of the problems, but this is much more difficult than in the past. What is the cause of this?

A series of low- and middle-income countries have run into problems with their foreign debt in recent years. Spurred by previously low interest rates, high investment needs and a lack of domestic revenues, they borrowed much from foreign creditors in the past decade. Total external debt of the most vulnerable countries (those eligible for World Bank support) reached a record USD 1.1 trillion in 2022, more than double the level ten years earlier. There is no general debt crisis because many debtor countries can easily meet their debt obligations. However, the problems are serious for countries where this does not apply.

Increased interest rates

As a result of the Covid pandemic and the associated supply chain disruptions, global inflation rose sharply in 2021/2022, and the war in Ukraine and the resulting halt in gas supplies from Russia added significantly to this. Central banks worldwide increased their interest rates to combat inflation, bond yields rose along with it, and the debt burden for many countries increased sharply. The debt problems have now led to a series of sovereign debt defaults, the situation in which governments can no longer meet the interest and repayment obligations on their debts. The number of defaults is not yet very high, but many countries with a high risk of debt distress are in the danger zone.

Figure 1: Strong increase of countries with debt problems

(Source: IMF)    

During the Covid pandemic in 2020/2021, the Debt Service Suspension Initiative (DSSI) initiated by the G20 provided temporary relief to many vulnerable countries, but the subsequent Common Framework, which was supposed to lead to structural solutions, did not provide an adequate solution. For various reasons, only four countries signed up for this, and in most cases negotiations were (and are) difficult and take a long time before an agreement can be reached with all creditors. Country-specific causes play a role in this, but what is particularly complicating is that it proves difficult to get all parties involved on the same page.

New lenders take prominent role

This coordination problem, which also occurs in debt negotiations outside the Common Framework, is mainly related to the changed composition of the external debt by creditor. For example, China's share within the group of bilateral creditors has risen sharply, at the expense of that of the Paris Club, the body in which Western countries try to find joint solutions for countries that no longer meet their debt obligations. A second development is the sharply increased share of Eurobonds within the external debts of vulnerable countries. Unlike the Paris Club countries, China places a strong emphasis on creditor protection when tackling debt problems and requires debtor countries to keep the terms under which loans are granted, as well as the details of debt restructuring, confidential. In addition, China wants to solve its debt problems bilaterally as much as possible instead of participating in a multilateral approach. Debt negotiations with private creditors are often even more complex. If the many holders of the Eurobonds reach an agreement, the official creditors must also agree with it - if the negotiations take place under the Common Framework - and that has also often led to difficult negotiations.

Figure 2: Increasing share of Chinese loans and Eurobonds in DSSI countries’ debt portfolios (Source: World Bank)    

No solution in sight yet

Central banks in the US and Europe will likely start cutting their official interest rates in the not-too-distant future. If this leads to a decline in capital market interest rates, it will provide relief, but the favourable interest rate environment before the Covid pandemic will most likely not return. A new initiative is now the Global Sovereign Debt Roundtable, in which all parties involved try to agree on, among other things, information sharing and the role of multilateral development banks. The initiative goes to the heart of the problem, but given the major differences that exist, there is still a long way to go before a well-functioning coordination mechanism for debt restructuring of vulnerable countries is established again.

Read the full report by our economists Afke Zeilstra and Bert Burger here: