Lending Into Official Arrears, a policy adrift?
In my last blog post, I looked at the Suriname 2021 IMF program to try and make the point that it was enabled by blurred lines between financing assurances and arrears policies. An eagle-eyed reader pointed me to a paragraph in the latest update of the Fund’s arrears policies which describes the theoretical interactions between the two and sheds an interesting light on the Suriname case.
In this blog post I explain what the IMF says explicitely about using the arrears policies to override the need for financing assurances, discuss whether these elements apply to Suriname in retrospect, and then try to draw historical parallels with previous evolutions of the policies to understand the way forward.
Overall, I argue that in cases where a debt treatment is needed, the ability of the IMF to override the requirement for debt restructuring assurances by applying the LIOA policy (i) risks underestimating the ability of creditors to obtain more favorable repayment terms and derail the IMF program, and (ii) can become an incentive for countries to fall into arrears, with adverse economic consequences.
On the other hand, the adherence to strict financing assurances guidelines in the presence of reluctant creditors might significantly undermine the ability of the IMF to support vulnerable countries. There is no easy way to reform of the LIOA and make it fit for current challenges, beyond temporary patches like relying on the strength of the Paris Club’s comparability of treatment principle.
Always read the footnotes and annexes!
The generic point I tried to make by browsing IMF reports on Suriname was actually hiding in “plain sight” – that is in paragraph 13, Annex I, deep into the latest update of the Fund’s arrears policies. It describes how the arrears policies and financing assurances interact, especially in the case of debt restructuring assurances:
Application of the arrears policies, which are underpinned by criteria designed to restore debt sustainability, may provide sufficient safeguards to negate the need for further assurances on debt sustainability. In particular, the application of the LIA or LIOA criteria, including the provision of consent by the creditor Executive Director, will generally act as a safeguard to assure the Fund that a restructuring deal will be forthcoming that will restore debt sustainability. […] Thus, staff could also assess that no assurances regarding the restoration of debt sustainability beyond the application of the arrears policies are required, depending on the member’s circumstances.
(The emphasis above is my own.)
The IMF writes clearly that the application of the Lending Into Official Arrears (LIOA) policy, more precisely the consent to IMF financing despite the arrears, can be used to override the need for a strict application of the financing assurances policy.
The idea that consent to financing despite the arrears can indicate that a restructuring deal is forthcoming seems counterintuitive at first, since the two policies are meant to serve distinct objectives. If a creditor wants to assure the IMF that it will restructure its claims, it can tautologically do so by providing financing assurances.
The intuition would therefore dictate the opposite: if a creditor refuses to provide financing assurances and barely consents to Fund financing, this should call for more scrutiny from the Fund on whether the claims will be restructured, not for an override of basic requirements – and at the very least in the case of creditors known historically for feet dragging when it comes to debt treatments.
How long has this interaction been in place?
Recently some people were surprised to hear Guillaume Chabert, Deputy Director in the IMF Strategy, Policy and Review Department, say at a conference that the Chad and Zambia processes were the first for which China formally provided financing assurances. The elements above could mean that in previous restructurings involving significant Chinese claims the IMF relied on the arrears policies to approve the programs.
A first question is hence to understand when this interaction between IMF policies first appeared, for instance by looking at previous IMF communications on the topic. The IMF 2015 paper on the creation of the LIOA policy does not indicate clearly – as far as I can tell – that consent is sufficient to override financing assurances, but it says that so long as official arrears are outstanding any disbursement will be subject to a review of financing assurances after program approval.
When it comes to the direct interaction between arrears and financing assurances, the 2015 paper points to another document from 2013, that is before the LIOA was even created. The 2013 article in question discusses developments in sovereign debt restructurings and provides useful insights. The IMF already hinted at that time to its reliance on the Paris Club’s comparability of treatment principle to deem away arrears to non-Paris Club creditors and make debt restructuring terms assumptions – which should in theory resquire financing assurances:
Arrears to non-Paris Club bilateral creditors are similarly deemed eliminated for Fund program purposes as the Fund has relied on the Paris Club’s comparability of treatment principle and assumed that these creditors will restructure the member’s debts on similar terms.
However, the IMF already acknowledged the shortfalls of this approach within a changing creditor landscape:
In the past, these conventions worked well because Paris Club debt constituted a large share of official bilateral claims. However, since the 1990s, the Paris Club's share of developing countries' debt and financing flows has been steadily declining and new non-Paris Club bilateral creditors are emerging.
This is especially interesting since in Suriname in 2021 the IMF indicated it relied on the comparability of treatment principle to have sufficient confidence that Chinese and Indian claims would be restructured, despite the fact that the Paris Club had negligible claims compared to the sum of these owed to China and India.
It appears that the IMF’s ability to override the need for specific and credible assurances when consent to financing has been provided was first explained transparently in the 2022 update of the policies. If this is correct, it might have been a major transparency improvement that was overlooked when discussing the update, compared to other changes like the classification of multilaterals within the arrears policies.
Further thoughts from Suriname
The elements above shed a new light on the Suriname situation, and raise the question of whether this mechanism provided ground for the IMF to approve the Suriname program in the first place – assuming of course this interaction between IMF policies already existed before 2022.
The short answer would be “probably not”, since another paragraph in the 2022 update of the arrears policies says the following:
However, in cases where there are significant uncertainties that the creditor(s) will restructure their claims (e.g., the debt is collateralized and/or there is a high legal risk that creditor action could severely undermine program implementation) and such restructuring is critical to achieving debt sustainability and medium-term viability, the Fund may still need to seek further assurances from the creditor(s) […] before approval of an arrangement or completion of a review to sufficiently establish safeguards for Fund resources.
As noted in the recent blog post on Suriname, the IMF learned during the first program review that China Exim had drawn balances from a so-called resource account between the program approval and the first review, using this collateral to clear part of the arrears and hereby threatening the comparability-of-treatment principle.
More than the use of collateral – which remains relatively small compared to the outstanding amount owed to China – one can argue that there are indeed “significant uncertainties that the creditor will restructure their claims”. A first one could be undisbursed balances for project loans, which can be used as a leverage by China to coerce Suriname into granting a more favorable treatment on disbursed claims.
To understand the leverage that China has if it wants to be paid back on more favorable terms than required by IMF program parameters and comparability of treatment, we need a broader scope than looking solely at its financial claims on Suriname. For instance, China appears to be a notable trade partner of the country, which imports c. 10% of its goods from China according to the UN Comtrade database. Hence the discussions on arrears between the Surinamese and Chinese governments are likely to fit within broader economic and geopolitical considerations and power plays.
An interesting parallel can be drawn with the debate about how sovereign restructuring procedures fail to capture the overall relationship between a debtor and its creditors, for instance in the different case of domestic creditors. This point was made by Anna Gelpern and Brad Setser in their seminal paper on the doomed quest for equal treatment between domestic and external claims:
Domestic firm or bank insolvency unfolds in the context of a social safety net-including, for example, unemployment and deposit insurance-to address the impact of economic failure on stakeholders whose interests in the failed enterprise are not adequately described by the instruments they hold.
They argue in essence that a sovereign bankruptcy regime akin to the 2004 proposal for a Sovereign Debt Restructuring Mechanism is not necessarily desirable, since it would probably not reflect the broader exposure of domestic creditors to their government – e.g. through the provision of security and healthcare.
This argument in reverse could well apply to the apparent failure of policies like the LIOA to account for wider forms of leverage that a bilateral official creditor can have in restructuring negotiations. It would as a result justify the need to maintain a high standard in terms of requirements before approving an IMF program when debt is not sustainable.
Creating an incentive to default
Taking a step back, the Suriname case illustrates a broader issue caused by the interaction between the LIOA policy and financing assurances. All other things equal, the mechanism lowers the bar for countries to access IMF financing once arrears have been incurred – a point I hinted at in the conclusion of the Suriname blog. This represents to some extent an incentive to run arrears, and the simplest way to do so is to default which entails unintended adverse consequences.
Say a country remains current on debt obligations, but faces liquidity issues and would need a rescheduling of upcoming official bilateral debt payments to ensure debt remains sustainable as per the IMF assessment. If non-Paris Club bilateral creditors representing a significant share of the debt stock are reluctant to commit to a debt treatment in line with IMF program parameters, the IMF cannot lend.
As happened in Suriname, negotiations will drag on for weeks or months, stumbling upon the requirement for “specific and credible” debt restructuring assurances. Then, if one day the country falls into arrears suddenly the IMF only has to require the creditors’ consent to IMF financing and the program can be approved without a commitment to debt treatment.
It can be understood from the point of view of the IMF that when a country stops paying, creditors will be more inclined to come to the negotiation table and restructure instead of not being paid at all. However, hard defaults and arrears are not a desirable way forward since they are associated with worse economic outcomes for countries in general. Again, Tamon Asonuma and Christoph Trebesch showed that preemptive restructurings “have lower haircuts, are quicker to negotiate, and see lower output losses”.
The idea is to find a way for the IMF policies to at the same time (i) prevent bilateral creditors from gaining undue leverage over IMF program approval, and (ii) incentivize stakeholders to opt for a premptive restructuring instead of falling into arrears.
A naive way to solve this would be for the IMF to seek a commitment from the debtor country that it will fall into arrears if no restructuring deal has been struck with the creditor before a set deadline. This could enable prompt IMF support without incentivizing the country to wait for a default, but this solution is not realistic. Indeed, no creditor would preemptively consent to IMF financing despite arrears as it would mean giving away significant leverage in subsequent restructuring negotiations.
Looking back to look ahead: a policy adrift?
The IMF arrears policies have gradually evolved to adapt to a changing creditor landscape, trying to gauge the leverage of new types of creditors over debtors and to strike the right balance in the level of assurance required before approving a program. To understand today’s debates, it is therefore worth looking at historical precedents and how they unfolded.
For instance, back in 2007, Lee Buchheit and Rosa Lastra wrote a piece entitled “Lending into Arrears—A Policy Adrift” to argue that the then recent implementation of the IMF’s Lending Into Arrears (LIA) policy – the one related to commercial creditors, since the LIOA did not exist at that point – risked making the Fund a referee in sovereign debt workouts, requiring it to have too much of a say on how negotiations with bondholders should be conducted.
Were their worries warranted? For a more recent take on the LIA, see this interesting piece by Gregory Makoff which concludes that the 2022 update does reduce the apparent willingness of the IMF to prescribe how the negotiation process with commercial creditors shall be conducted. Notably, the IMF removed from its policies the expectation that countries would engage with their creditors through a formal negotiating framework, something that drew the ire of Lee Buchheit and Rosa Lastra.
What is especially interesting is that their critic were along the lines of the IMF involving itself too much in how the negotiations should be conducted and their outcome. The problem today with the LIOA is quite the opposite: faced with an inability to steer bilateral restructurings in the right direction, the IMF appears to part way with the strict requirements for financing assurances, instead deferring to the Paris Club to convince reluctant creditors to provide debt treatment.
As a result the solutions that applied for the LIA – basically stop intervening in a process that already works rather well – are much easier than the potential modifications of the LIOA needed to help the IMF deal with reluctant bilateral official creditors. Furthermore, if the current policy toolkit does not work for creditors with significant leverage, and no feasible solution is in sight to reduce this leverage from the IMF’s standpoint, this might end up putting into question the role of the Fund in providing the bedrock for sovereign debt restructurings.
Arguably, the blurred lines between the LIOA policy and financing assurances might have helped the IMF provide badly needed support to vulnerable countries, especially during the COVID-19 pandemic. It appears however to have been not more than a temporary patch, something Kevin Carey likened elegantly to a “shadow DSSI”.
Recently in Zambia the IMF did obtain financing assurances from China, but we can infer from media reports that these assurances might have been too vague since some Chinese lenders are pushing back on DSA assumptions. Sri Lanka will be the next important test case in terms of financing assurances from China or India before program approval. However, the Zambia and Suriname precedents might entice major IMF shareholders to call for more specificity in the commitment by China or India to restructure their claims, in line with IMF program parameters and the comparability or treatment principle.
Hence comes the time of finding a lasting solution to the issue at stake: the inability of the IMF to rely on financing assurances and the comparability of treatment principle to ensure debt treatments are implemented and countries have the necessary capacity to repay the Fund. This stalemate is giving a de facto leverage for major bilateral creditors to make IMF programs go off track – at important economic and social costs – or block their approval in the first place.
Finally, even before thinking about possible reforms, more transparency about these policies and their interactions, including a look-back by the IMF on previous cases, would be extremely helpful. As Lee Buchheit and Rosa Lastra wrote in 2007:
Therein rests the problem. No one, the IMF least of all, seems prepared to articulate the definitive rationale and objective of the LIA policy. This makes a critical analysis of the policy, whether attempted by the IMF Executive Board, sovereign debtors, or private lenders, very difficult.
I am grateful to Sophie Borra for valuable comments.
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