Simon Hinrichsen is a EM debt portfolio manager at Sampension, wrote his PhD thesis on sovereign debt restructuring, and briefly worked on FT Alphaville back in the day. He’s now also lecturing at the University of Copenhagen, so we asked him to write up his how-to restructuring guide for FTAV readers.
After almost two decades of relative tranquility, a violent rash of sovereign debt defaults looms on the horizon.
Mozambique, Lebanon, Ecuador, Sri Lanka, Suriname, Belize, Russia, Ukraine, and Zambia have all defaulted or restructured their debts in the past few years. Many other countries have already priced in a high risk of restructuring this year and next. It might therefore be a good time for a primer on how countries can restructure their debts.
The underlying assumption for almost all sovereign debt these days is that loans will not be repaid fully but rolled over. Nominal debt stocks tend to rise over time and bullet loans — the standard in sovereign borrowing — are replaced by new loans as they mature. A crisis can therefore happen quickly if it is impossible to borrow new money (for whatever reason).
Let’s skip the niceties and assume that a country is out of money but wants to remain a part of the global financial system (so no total repudiations of debt à la Russia 1918). The country needs to restructure its liabilities, and it might even already have defaulted by not paying a coupon (a contractual failure to pay). Even if it doesn’t default contractually, it will do so substantially by forcing a distressed debt exchange. The outcome will be classified as a sovereign debt default regardless of the type of default or severity of outcome.
A debt restructuring is fundamentally about allocating economic costs to someone. Countries want the burden of adjustment to fall on external creditors. Creditors want the burden to fall on taxpayers. The problem is one of resource allocation and identification of why the debt is unsustainable, and to what degree.
The first step in a debt workout is to figure out what the problem is: chronic low growth, falling commodity prices, no export sector, a bankrupt financial sector, the maturity structure of your debt, too large a debt stock, or hidden debt that wasn’t disclosed? Perhaps the debt was manageable at low interest rates, but now interest rates are high and servicing the loans is a budgetary problem? Citizens don’t like that, which makes it a political problem.
Sovereign defaults have occurred for all of the above reasons (some more often than others). Normally it’s a mix of factors, but understanding the root cause is a first step in a successful restructuring. If it is a liquidity problem caused by a pandemic, maybe the country just needs temporary help? Perhaps the problem is that the country has a debt stock that is several times its annual export earnings, in which case the problem is fundamental. The restructuring must address the problem.
The second step is to find out what type of debt the country has. Is the debt external? If yes, what kind of external debt — governed by foreign law, issued in foreign currency, or held by foreigners? What share of the debt is domestic? If the debt is governed by domestic law, it is easier to restructure legally, but if all the sovereign debt is owned by your financial system, maybe a restructuring will cause a domestic financial crisis that just makes everything worse.
Maybe most of the liabilities are not even directly on the government books but rather guaranteed state-owned enterprises that need to be part of a restructuring? Any initial analysis should answer these questions.
The restructuring process
The first issue is whether to go to the IMF or not. The IMF can come in and do a debt sustainability analysis (DSA) and lend credibility to the macroeconomic numbers. A DSA is a prerequisite for a restructuring at the Paris Club, but, more importantly, it sets out how much debt a country is likely to be able to pay “sustainably”.
The Fund does an analysis of the balance of payments and the debt stock among other things (see for example Zambia’s DSA from last week here), and the IMF can provide stop-gap financing if there is a credible way to make debt sustainable.
The downside is that IMF programs often come with strings attached, such as “reforms” that a country might not find very appealing. The reality is that any IMF programme is a political art, not science. The benefit is that the IMF has done many restructurings before, as have most of the lawyers and bankers involved on either side. A sovereign debt restructuring has no set process — but the players and the tools involved are usually the same.
The tools used to restructure debt are always the same, however. It involves an exchange of old claims for news claims, where the new claims have different characteristics: lower principal value, lower coupons, or longer maturity. It’s usually a mix, but the composition depends on what the problem is — and what you can get creditors to agree to.
If the debt stock is manageable, but all the debt is due in the next two months, maybe a “reprofiling” of the maturities is all that is needed. If the debt stock is too high, maybe principal haircuts are required, or maybe a lowering of the coupon until after any reforms are enacted and growth hopefully picks up. Once this analysis is done — usually behind closed doors together with the advisers and the IMF — the doors are opened and some sort of negotiation starts.
The DSA probably suggest what debt to restructure and what debt to exclude (and what debt to pay!) Generally, you’ll want to exclude some types of claims needed to keep the economy going, such as trade credits (to maintain and facility international trade) and Treasury bills (for short-term financing). But it depends on the problem and the debt stock. Trade credits and T-bills are usually excluded from restructurings, but not always — if 80 per cent of a country’s debt is T-bills then you can’t really exclude them.
The process from here depends on what type of debt the country has and on its creditors. It’s a good idea to start where you can get the best deal and have the most friends. Negotiations with bilateral creditors can happen between politicians or at a bureaucratic levels. Normally it’s done at the French finance ministry (the Paris Club), where most developed countries are members (but importantly not China).
There are generally two ways to go about dealing with commercial creditors: either a creditor consultation via an adviser, which will report back to the country/IMF, or a negotiation with creditor committees made up (usually) of the biggest lenders. Committees can verify a deal and might make others creditors comfortable that it’s the best deal on the table (after all, no creditor wants to give debt relief only to see someone else repaid in full).
First the borrower. A sovereign county is a unique debtor. It is very difficult to force a country to do anything. There’s no sovereign bankruptcy code, no way to work out defaulted debt, and seizing state assets is very difficult. Do you want to try to seize Russian assets?
What a state has is its reputation and a wish to be part of global society. Countries are supposed to pay their debts under the doctrine of state succession (one of the international laws that are generally adhered to), but states are political entities. The debtor responds to domestic political incentives. A judge in New York might tell a country to do one thing but getting a country to respond is a different thing. Countries are often not in a rush.
Then there are the creditors. Creditors are important because they lend money, but on the other hand they don’t vote. Because most sovereign debt restructurings start out with an IMF DSA, the creditors are already pitted against each other if one or more classes of debt are excluded from a potential restructuring. So it’s a zero-sum game. Oftentimes a creditor’s main opponent is not so much the debtor but rather other creditors.
The senior creditors are normally multilateral institutions (IMF, the World Bank, some development banks) which often have “preferred creditor status”. The IMF is paid before everyone else. Sometimes preferred creditor status is also given to some wannabe-multilaterals (EIB, ECB, KDB, etc), but if too many get it that’s not great for junior creditors.
Creditors can be bilateral lenders (other countries, which negotiate at the Paris Club or individually), banks or bondholders (which usually form committees), trade creditors (often on their own but with political backing), households, or state entities. Each will argue their case. Some creditors can be more of a pain than others, as some are litigious or prone not to accept a deal.
Each creditor tries to talk their way up the capital structure. If you cannot talk your way up the capital structure, you want to make sure that everyone else shares in the pain.
If you’re a local bondholder, you say the financial system will go belly-up if you are restructured. If you’re an international bondholder, you mutter that the country will never be able to borrow in global markets again if you’re restructured. In extremis you say that you will go bankrupt if there is a restructuring and lobby your own government to help you negotiate — as banks in Europe did with Greek sovereign debt. You argue it’s cheaper to extend credit to Greece so they can roll over their debt rather than having to recapitalise some French or German bank.
The legal aspects
A legal analysis is needed to figure out the tactical approach. International law is difficult to enforce, but legal analysis still plays a very important role in today’s sovereign debt world — mainly because most debt contracts are governed by New York or English law.
The first step is to figure out how much of your debt is domestic law, which is easier to deal with, and how much is foreign law. Then you figure out how many of your bonds have old pari passu clauses, what type of collective action clauses govern the bonds, if some loans have weird clauses, and if the overall debt stock invites litigation. Some countries, like Ukraine, have relatively recently-issued debt that is easier to aggregate and thus restructure, while others, such as Zambia, have older contracts which might provide creditors or debtors some legal upper hand.
As a creditor, you try to figure out if your bond can be aggregated. Should you accelerate if there is a default? Get a judgment? Can you hold out for a better deal while other creditors restructure? Maybe you have an old, non-performing loan. If you have written it down already, it’s surely better to be able to collect on a smaller loan. Of course, if you want to sue, it’s important to get your strategy right, but also to remember that lawyers are expensive.
We’ll see a lot of variations of sovereign debt restructurings in the coming years. Some restructurings will be smooth, others . . . not so much. Consider this a bit of free advice for debtors and creditors alike.
The Restructuring Process — Buchheit et al. (2019)
Government bonds since Waterloo — Meyer et al. (2021)
The aftermath of sovereign debt crises: a narrative approach — Esteves et al. (2021)
The seniority structure of sovereign debt — Schlegl (2019).