Covid-19 challenges IMF debt-restructuring framework

The International Monetary Fund’s current sovereign debt-restructuring framework needs adjusting to address new challenges associated with Covid-19 crisis, a former IMF official says.

The IMF’s current debt-sustainability criteria may not suit the highly uncertain nature of the Covid-19 crisis, Sean Hagen, former general counsel at the IMF, says in a recent report.

The fund should introduce a new “standstill” debt-restructuring agreement that would give countries a year or two of “breathing space” until there is greater clarity surrounding the economic consequences of the virus, he says.

The fund may also have to address the treatment of government creditors and consider building more robust measures to maximise creditor participation in debt-restructuring agreements, Hagen says.

The pandemic has brought with it a significant amount of uncertainty, not only in regard to the future path of the virus, but also the duration of economic downturns and projected paths for inflation, interest rates and commodity prices.

Several countries around the world are now facing in a second increase in Covid-19 cases, and lockdown measures are being reintroduced. Some government spending pledges are being extended and new fiscal packages are being agreed. 

As a result, “there may be a significant group of countries whose debt is neither clearly sustainable nor clearly unsustainable, a situation that would place the IMF in a difficult situation,” Hagen says.

A sovereign’s debt is typically considered unsustainable when the government’s debt-to-GDP ratio is so high that raising taxes becomes counterproductive and there is no fiscal policy that would prevent the debt from continuing to rise without relief.

The IMF plays a central role in making this judgement under the Debt Sustainability Analysis framework. Once a country’s debt is deemed unsustainable the fund enters into the debt-relief agreement process and commits to continue providing support under its “lending to arrears” policy. But under the current environment, the judgement is far more uncertain.

For example, if the IMF treats a country facing debt-servicing problems in the current environment based on its normal assumptions it might approve the need for debt restructuring. But this may turn out to be unnecessarily costly if the economic situation quickly improves.

On the other hand, there is a risk that if the fund treats the pandemic as a temporary event, the situation might continue to deteriorate. The risk of not acting early to find a debt-relief agreement would increase the costs of a debt restructuring in the future.

Hagen suggests when a country’s assessment of debt sustainability is uncertain, the IMF should make its resources available, conditional on a “standstill”. That is, “a debt restructuring that would give the country breathing space for perhaps one to two years, but would not involve a significant net present value reduction in creditor claims,” he writes.

“If the problem does indeed turn out to be temporary, an unnecessarily costly debt restructuring would have been avoided,” he says. “However, if problems persist to the point that the debt is clearly unsustainable, the standstill would ensure that there would continue to be claims of private creditors to absorb the needed debt relief.”

Treatment of official creditors

Once the IMF judges a country’s debt is unsustainable and the debt-relief agreement phase begins, the “lending into arrears” policy helps assure private creditors that the fund is prepared to continue providing funding even if no debt-relief agreement is reached and the government decides to default. This helps prevent private creditors holding out for a deal that is not consistent with the IMF’s view on debt sustainability, because it could trigger a full default.

Since 2015, the IMF has also had a lending into official arrears policy. Previously, the IMF was able to get prior approval of a debt-relief programme from the vast majority of official creditors because many of them were part of the Paris Club of major creditor nations.

However, over time, the number of official creditors outside the Paris Club grew. As a result, it became increasingly difficult to seek advanced consent on an agreement from official creditors.

“Given that this policy is relatively recent, it is not yet clear how it will be applied if a significant number of countries engage in the restructuring process because of the pandemic,” Hagen says, noting that because official creditors provide funds for IMF-supported programmes, it complicates the policy.

The fund may not be willing to lend into official arrears if it judges that doing so “would have an undue negative effect on the fund’s ability to mobilise official financing packages in future cases”, he writes, quoting the IMF’s policy.

The IMF has flexibility in analysing which countries it would and would not be willing to lend into arrears. “Going forward, a critical issue will be the extent to which this flexibility is used,” Hagen says.

Creditor participation

Hagan says a further challenge would be securing agreement among a diverse set of creditors, particularly if the pandemic leads to a large number of countries suffered debt-servicing issues.

This is not a new problem, and over the years there have been a number of proposals made to limit the leverage individual creditors can take on during the agreement process. This is because if a significant number of creditors do not approve of the debt-relief agreement, it will both limit the debt relief that is obtained and make it more difficult for other creditors to agree terms.

“If there is a significant wave of sovereign debt restructurings, consideration may need to be given to a temporary legal enhancement of a legislative nature that will limit the leverage of holdout creditors,” Hagen says.

Legislators in London and New York – those who govern the majority of international sovereign debt instruments – could modify some existing legislation so that it is applicable for the pandemic period. For example, in 2010, the UK parliament introduced a law which prevents creditors from suing sovereigns that participate in IMF and World Bank programmes for heavily-indebted poor countries.

“The UK could pass a similar law that extends the same protection to sovereigns that secured debt relief in the context of an IMF-supported programme during a defined period,” Hagen says, noting similar proposals exist for New York-based law.