Private lenders to emerging markets face threat

The writer is president of Queens’ College, Cambridge university, and adviser to Allianz and Gramercy

It became clear last week that private lenders to some of the most vulnerable developing countries do not share the sense of urgency about the risk of sovereign debt traps that is felt in governments and multilateral institutions.

The spring meetings of the IMF and World Bank underlined official concern over how debt burdens compound an economic divergence between advanced and emerging economies. That has its roots in uneven progress in the battle against Covid-19 and different policy flexibility.

Private lenders, judging by resilient emerging market bonds, appear to have largely shrugged off the risk that this will lead to painful debt restructurings.

Complacency may be a factor, especially for some non-specialised lenders. But the divergence is also influenced by doubts about the official sector’s willingness to play hardball. This is a calculated bet that, if it backfires, would risk not just losses for these lenders but also the return of old-fashioned volatility to the emerging market asset class as a whole.

And it is only a matter of time until there is more policy interest in the extent to which private creditors have been “free riding” on public sector financial largesse.

The notion of a more formal approach by the international community to private-sector involvement in debt restructurings is not new.

Ad hoc involvement in the 1980s, including via the Brady plan for countries to restructure billions of dollars of illiquid claims into restructured tradeable bonds, evolved into an integral part of the international debt architecture in the early 2000s. This was followed by IMF work, later abandoned, on the sovereign debt restructuring mechanism, a global bankruptcy regime for over-indebted governments.

More recently, the G20 agreement on a common framework for debt relief for the world’s poorest countries last year seeks to hardwire greater burden sharing. It built on the debt service suspension initiative allowing stricken countries to defer debt repayments.

Five main factors beyond complacency are in play here that explain the relaxed attitude of private lenders.

One is experience. Repeatedly, the official sector has provided exceptional support to vulnerable developing countries without insisting on the private sector following suit. A second is hesitancy: debtor countries have been reluctant to press for private debt relief. They worry that this would limit both sovereign and corporate access to international capital markets.

Third, there are no easy mechanisms for co-ordinating a disperse set of creditors and debt instruments. Even within the official sector, there have been tensions between longstanding lenders and new ones, including China.

A fourth factor is that in several countries, the hump in debt principal payments does not occur until 2023-24. And the fifth is systemic risk: with emerging markets having attracted such a wide range of investors, a disruption in this asset class could spread elsewhere.

As understandable as these reasons are, a difficult reality faces some developing countries. Growth will be challenged for some time not just by internal Covid-19 issues but also a global economy that is less supportive of sources of foreign exchange earnings such as tourism and remittances.

Countries also struggle to impose domestic austerity to pay creditors when urgent relief for lives and livelihoods is needed, health and education are under enormous pressure, inequality has worsened and greater emphasis is being placed on digitalisation and green recovery.

The fact that the global economy avoided an explosion of developing country debt problems during this pandemic should not be an excuse for ignoring the risk of debt traps in the next few years.

The official sector needs to maintain existing liquidity support, expand debt maturity extensions and bolster the common framework by adding sticks to what has been a carrot-based approach to securing restructuring agreements.

Private creditors must better differentiate and actively manage their risk-taking in emerging markets lest a generalised and passive approach end up unnecessarily undermining the asset class as a whole.

Building back a stronger, fairer and more sustainable global economy requires more refined involvement from both public and private creditors.