How to prevent the next sovereign debt crisis

Por William “Bill” Dudley

This year could be very difficult for low-income and emerging market countries that have been big borrowers in the sovereign debt market. It is practically inevitable that a series of concentrated crises will be unleashed in these countries.

As the Federal Reserve begins to tighten monetary policy, funding costs will rise and credit will be less available as higher interest rates reduce the incentive for investors at the kind of yield these countries offer.

Fiscal space will also be limited because their economic recoveries are likely to lag behind advanced economies due to slower progress on COVID-19 vaccination campaigns. The end of the moratorium envisaged by the Debt Service Suspension Initiative—implemented by the G20 together with the International Monetary Fund and the World Bank—will raise debt service requirements and increase financial stress.

What can be done to mitigate the looming crisis? More support from official institutions and the G20 would help. But that might just postpone the “Time of truth” and further subordinate requests from private lenders. What is needed is not only more assistance from the official sector, but also far-reaching reform to make the sovereign debt regime more robust and resilient to adverse global economic events.

Achieving greater transparency in the sovereign debt market is an important starting point. Unfortunately, information on the obligations of sovereign borrowers is incomplete, especially for the private sector and for some large sovereign lenders, such as China.

In many cases, it is impossible to estimate how high the obligations are, when they will come due, their interest cost, and other terms and conditions, including collateral that may have been pledged to secure the loan.

The lack of transparency weakens the sovereign debt regime in several ways. First, because it is difficult to determine the aggregate of outstanding debt, its composition and maturity structure; it is also difficult to assess the creditworthiness of the sovereign debtor and its ability to service its debt when the economic environment worsens.

Second, it makes it difficult to restructure debt in a timely manner, that is, before the prospect of a default leads to a complete cessation of lending and capital flight. Not knowing what other obligations are outstanding and on what terms makes it impossible for lenders to define what kind of haircut and rescheduling will be needed to ensure the debt load can be sustained.

Third, lack of transparency increases credit risk. If a current or potential lender doesn’t know how much more debt is outstanding and on what terms, how can they reasonably determine whether a new loan is creditworthy? This leads to higher credit costs over time, as lenders factor in the risk that the debt load is substantially higher or on more onerous terms than its valuation.

In my view, there must be a sustained effort by the official and private sectors towards a transparency regime. This would include not only a detailed accounting of the terms and conditions of sovereign borrowers’ debt obligations, but also procedural transparency in which restructuring efforts would involve the private sector, at an early stage, working in conjunction with lending institutions. officers.

Support for greater transparency comes from both official institutions such as the IMF and the world Bank as well as interest groups associated with the private sector, such as the Institute of International Finance. And, with the support of both groups, the Organization for Economic Co-operation and Development is creating a repository of sovereign debt data.

While this is necessary, it is not enough and further reform is needed. In particular, the system needs to be changed so that both lenders and borrowers have a strong incentive to make the relevant disclosures.

Disclosure generally does not occur because it is not considered to be in the interest of the bank or the borrower. Although each bank would like to know where the others stand in assessing the borrower’s ability, that bank still has a financial incentive to continue to hide its cards from other potential lenders and competitors.

There are several ways to encourage a higher level of disclosures. For example, him IMF and the world Bank could make access to funding conditional on satisfactory disclosure. Or credit rating companies could explicitly factor disclosure and transparency into their decisions, with transparency leading to higher ratings.

A document released this week by the Bretton Woods Committee, which I chair —”Debt Transparency: The Essential Starting Point for Successful Reform” (Debt Transparency: An Essential Starting Point for Successful Reform)—explains in detail what needs to be done and how it can be achieved.

Another necessary change is greater procedural transparency on how the private sector is included in the debt restructuring process. This needs to happen at a much earlier stage and in a more transparent and comprehensive way. Historically, sovereign debt restructuring has been carried out primarily between official lenders and the sovereign borrower, presenting private lenders at the end of the process with a fait accompli as to what is expected of them and where they stand as creditors.

This not only creates mistrust and less commitment, but slows down the restructuring process and leads to inferior results. The point is that cooperative solutions can lead to better results than purely competitive ones. But to achieve this, the private sector must become more involved in the restructuring process.

Now is the time to implement a global transparency agenda before the next wave of defaults threatens another debt crisis.