In the coming years, developing countries will need to increase borrowing to finance the investments required by the looming climate crisis and the Sustainable Development Goals.
The global financial system needs to prepare — and adapt — for this necessary increase in public debt.
A framework of sorts exists for dealing with sovereign debt distress, but the international financial community must change the way developing countries borrow in the first place, to make debt distress less likely.
It is especially urgent for lower rated countries with high borrowing costs.
Opposite interests
Sovereign debt crises can have multiple origins. More often than not, lax fiscal policy and excessive borrowing over years are the root of the problem, especially when growth flags and the country loses market access.
But sometimes exogenous shocks — a sudden deterioration in terms of trade, a slowdown in a major trading partner, sustained exchange rate depreciation or a natural disaster — can tip a borrower into payment difficulty.
This is the paradox at the heart of sovereign debt financing. A sovereign’s payment capacity is almost never fixed, whereas the repayment terms of its debts invariably are.
Calls for flexible repayment terms that adapt to a sovereign’s evolving capacity are nothing new. In recent years there has been growing interest in ‘counter-cyclical’ debt — GDP-linked bonds, or instruments with debt service varying according to prices for a country’s main exports.
The idea is simple: to give borrowers temporary buffers against unexpected deteriorations in payment capacity, while encouraging them to repay more quickly when times are good.
A move towards counter-cyclical financing is already under way in the form of ‘pause clauses’ — contractual terms that allow debt service deferrals if a sovereign borrower is struck by a predefined natural disaster.
Such proposals face difficulties, not least how to ensure that the variable chosen really does track the sovereign’s payment capacity.
However, the biggest obstacle such proposals have failed to overcome is that they run counter to what bond investors typically want. Unlike equity investors accustomed to providing buffers in a corporate balance sheet, debt providers are used to knowing precisely when they will get their money back.
Squaring the circle
One way to bridge this gap between the kind of debts developing countries need and those investors want to provide would be to create a new Global Financial Resilience Mechanism.
The GFRM would not be a lender or a development finance institution, but an intermediary and shock absorber.
Countries would have the option of issuing bonds via the GFRM, which in essence would be a passthrough structure. The sovereign would remain the borrower and investors would still be exposed to its credit risk.
In simplified terms, borrowers would accelerate repayments to the GFRM when their repayment capacity was strong, and reduce them when it was weak — all based on predefined parameters. Meanwhile, the GFRM would ensure investors received a fixed repayment stream.
The triggers for changes to repayment schedules would vary by country, but follow set templates for the sake of simplicity. Calibration points could include GDP growth, receipts from specific goods or services exports or climatic shocks.
Symmetry in the form of accelerated repayment when payment capacity is strong would be the quid pro quo for reduced payments when it is constrained, supporting responsible debt management by the sovereign.
To bolster financial resilience and further reduce risk, amortising structures would be prioritised throughout, rather than bullets.
To act as a shock absorber, the GFRM would build up a liquidity pool. Some of this could be prefunded by donors, but the rest would come from accelerated repayments from those countries experiencing enhanced payments capacity. If needed, the GFRM could top up by issuing its own bonds from time to time, using a preferred creditor status to obtain low pricing.
Just as the GFRM would not provide any form of credit enhancement or guarantee to bondholders, it would also not be a mechanism for debt relief or restructuring.
There will be several ways to deal with a debt instrument that benefits from GFRM support which becomes distressed and needs to be restructured, and the pros and cons of each can be considered further down the line.
Flexibility can take various forms
The primary purpose of the GFRM would be to strengthen the financial resilience of developing countries by making bond financing more adaptable to their evolving payment capacity. It could also be used to provide repayment flexibility on debts owed to official lenders.
A further step would be to remove predetermined triggers. There is no reason why a sovereign borrower cannot retain some choice as to how fast it repays, so long as there are clear drop-dead dates for final payments.
This could bridge another gap: that investors like bullet bonds, while amortising ones are better for countries that want to avoid large repayment spikes.
Later and separately, the GFRM could open up new possibilities for pooling borrowing and credit risk, helping small states whose scale of debt means they often have to overpay.
The GFRM will not consign sovereign debt distress to the past. But by recognising the fact that sovereign payment capacity is dynamic rather than fixed, it could make it less frequent.
J Sebastian Espinosa is managing director at White Oak Advisory
Picture by Katja Mali Fotografie