Sri Lanka: who blinks next?
There have been major developments in recent weeks for Sri Lanka’s debt restructuring process and IMF program negotiations: India and the Paris Club provided financing assurances for the program to move to the IMF Board, while China Exim offered a two-year debt service moratorium falling short of IMF requirements and risking a protracted stalemate until one of the stakeholders blinks.
The situation puts China at odds with most other creditors. Assuming it does not comply with the IMF’s requirement for specific and credible financing assurances, there is a narrow path towards the approval of the program and associated disbursements. It would require the IMF to lend into arrears to China, and probably a loose interpretation of various policies including financing assurances or what constitutes a “representative” Paris Club agreement.
Sri Lanka is yet another illustration of how idiosyncratic sovereign restructurings get wound up in broader geopolitical tensions pertaining to the international financial architecture. The problem being that if none of the players yields, it will just mean more economic and social hardship for the debtor country stuck in the middle.
India building momentum on restructurings during its G20 presidency
India’s decision in Sri Lanka ought to be framed in a broader geopolitical context: India recently assumed the presidency of the G20 for the year 2023, a forum that gained a major role for sovereign debt issues in the wake of the COVID-19 pandemic by leading the implementation of the DSSI and the Common Framework for Debt Treatments.
The G20 is likely to be a key forum when it comes to sovereign debt in 2023 through the Sovereign Debt Roundtable, with its first gathering set to take place in Bengaluru at the end of February on the sidelines of the G20 Finance Ministers and Central Bank Governors meeting, chaired by India. This new forum was unveiled by the IMF Managing Director following a round of meetings in China, and will gather international financial institutions, bilateral and commercial creditors as well as debtor countries to try and improve the architecture for sovereign debt restructurings.
In parallel with global policy developments, it appears that India intends to build momentum on restructuring cases. While this mostly flew under the radar, India also agreed in January to restructure the debt of Suriname, according to declarations by the authorities reported in the local press. India’s claim in Suriname is arguably of modest size at USD 38m compared to 400-500m for China. However this is a notable development since both India and China had repeatedly refused to provide financing assurances to Suriname, forcing the IMF to make an unusual interpretation of its policies as discussed in an earlier blog. India’s decision to restructure hence isolates China as the sole holdout bilateral creditor.
Then came India’s letter to the IMF about Sri Lanka, which leaked on social media. This letter is interesting in several regards.
India was the first bilateral creditor to provide financing assurances, even before the Paris Club. This proactive attitude marks a change from previous cases, including Suriname, and is also interesting since India’s behavior in sovereign restructurings where it is a major creditor remains rather untested.
Not only does India commit to provide debt treatment to Sri Lanka, it commits to do so in line with the parameters of the IMF program targets which are precisely listed, e.g. a reduction of the public debt-to-GDP ratio to below 95% by 2032. This alignment is key for the IMF to consider the assurances as “specific and credible” per the textbook definition.
Additionally, India indicates its willingess to collaborate with the Paris Club on debt negotiations. India has been an observer at the Paris Club since 2019 but has never collaborated formally on a debt treatment outside of the G20 Common Framework. While it will be interesting to see how the coordination unfolds concretely, this move isolates China further by giving a sense of union among the rest of major bilateral creditors.
China wary of committing to a deep debt treatment
A few days after India’s letter was published, China Exim sent a letter to the Sri Lankan authorities. It offers a two-year debt service moratorium – for the payments due in 2022 and 2023 – and proposes to engage in further negotiations regarding a medium- and long-term debt treatment.
This letter looks rather underwhelming compared to the Indian equivalent, notably because the two-step approach gives no certainty to the IMF about the outcome of the negotiations. Additionally, while China Exim supports the IMF program, it does not commit that its debt treatment will be in line with the IMF’s assessment of debt sustainability or the fiscal targets of the IMF program.
As a result, it is highly unlikely that the IMF would consider these assurances as specific and credible. One can look at the Zambia precedent for guidance: the financing assurances statement signed by China did not specify clearly that the debt treatment provided would be in line with IMF program parameters. China subsequently pushed back against the IMF assumptions, causing a deadlock in restructuring negotiations unfolding after the approval of the program which now risks going off-track absent any progress.
It is worth noting that the letter to the Sri Lankan Ministry of Finance was sent not by Chinese authorities but by the management of China Exim, despite other policy banks like China Development Bank having major exposure to Sri Lanka. It could be explained by the fact that China Development Bank is classified as a commercial creditor, a category of creditors for which the IMF does not require affirmative financing assurances as flagged by Brad Setser.
However things are not that clear-cut, considering for instance that in Zambia China Exim is the leading negotiator for Chinese interests, representing other Chinese creditors – the precise list of which has not been disclosed.
The Paris Club chooses to move forward
On February 7, the Paris Club published a communiqué to provide financing assurances to Sri Lanka. The wording is especially interesting because it involves a wide range of non-Paris Club members – India, Hungary, Saudi Arabia, Kuwait – each with its own level of commitment, meaning that the group of countries changes from one paragraph to another.
For instance, while Kuwait participated in the Paris Club meeting, it is not mentioned in the following sentence, indicating limited political buy-in at this stage: “Paris Club members as well as Hungary, Saudi Arabia and India continue to look forward to working together along with all bilateral creditors and to engage with other key stakeholders in order to proceed with a comparable debt restructuring as soon as possible.”
Then, only the Paris Club and Hungary commit to a debt treatment in line with IMF program parameters. India had already done so through its letter to the IMF, while Saudi Arabia “expressed its support for the process and acknowledged the importance to offer financing assurances in the near future”.
The delay between the meeting on January 25 and the publication of the statement can indicate that the Paris Club left time for these countries to get domestic political buy-in, in order to maximize the impact and representativity of the agreement.
The “lending into arrears” puzzle
Now that all major stakeholders have played their cards, the scene is set for a final showdown. As of today it seems fair to assume that China will not provide textbook financing assurances, including because its reluctance is rooted in a deep disagreement on the foundations of the current mechanism for sovereign debt restructurings and the role of the IMF as umpire. China has notably advocated recently – in Sri Lanka or in Zambia and even in G20 communiqués – for a participation of multilateral institutions in restructurings, something other stakeholders think is at odds with their role as lenders of last resort.
This stalemate has led to discussions in policy circles about whether the IMF should lend into arrears to China. A first question is to see whether it is technically possible – the Lending Into Official Arrears policy details several ways for the IMF to move a program forward in the absence of an agreement paving the way for a clearance of arrears:
A representative Paris Club agreement enables the IMF to deem away arrears owed to other bilateral creditors, e.g. China in this case.
Bilateral creditors provide consent to financing despite the arrears, something China did in Suriname but which might be more difficult in the current context of heightened geopolitical tensions.
The debtor country is making a good faith effort to reach an agreement with the reluctant creditor, and “the decision to provide financing despite the arrears would not have an undue negative effect on the Fund’s ability to mobilize official financing packages in future cases.” This last option was designed to deal with the Ukraine & Russia situation after the Crimea invasion and it would be considered pretty much a hostile move for the IMF to use it with China.
Hence the most likely way forward without Chinese financing assurances or consent would be to deem away China’s arrears thanks to a representative Paris Club agreement. However, assessing the representativity of such an agreement is not straightforward, even more so since the IMF Executive Board has from time to time declined to set a numerical threshold determining representativeness.
First, China represents a major share of the bilateral debt stock: depending on the estimates – e.g. whether Sinosure-backed commercial claims are included in the bilateral stock – China can weigh 40 to 55% of bilateral claims. Whether any agreement without China can be considered as representative would clearly be a judgement call from the IMF.
Second the Paris Club stricto sensu would probably not be sufficient to reach that threshold and deem away Chinese arrears without the addition of other notable bilateral creditors including India, Saudi Arabia and Kuwait. Then it is unclear whether the IMF could consider such an ad hoc coalition as a representative forum. The latest update of the IMF arrears policies indicates notably that “Affording another representative standing forum similar status to the Paris Club under the LIOA policy would require an Executive Board decision”.
However, the IMF also notes that non-Paris Club claims within the Common Framework process can count towards determining representativeness, showing that some flexibility can be applied. India’s apparent willingness to collaborate with the Paris Club, together with the attitude of the Club trying to get as many bilateral creditors on board, seems to indicate that they are preparing for this option.
Additionally, solving the issue of Chinese arrears would not directly solve the related issue of financing assurances. Doing so would require the IMF to apply a caveat in its arrears policies discussed in an earlier blog, which negates the need for affirmative financing assurances when a country falls in arrears to a recalcitrant creditor. This would also not be straightforward since the IMF is supposed to still require these affirmative assurances when there is “significant uncertainties that the creditor(s) will restructure their claims” (arguably the case with China’s behavior in recent restructurings) and “such restructuring is critical to achieving debt sustainability” (arguably the case for China too due to the size of the claims).
Who will be the first to blink?
Despite these technical hurdles, it should be possible for the IMF to lend into arrears to China if the management and major shareholders want to politically – the real question being what happens next.
Deeming away Chinese arrears through a representative Paris Club agreement could be a major test for the enforceability of the Club’s comparability of treatment principle in a changing creditor landscape. The choice of the Paris Club when faced with a similar situation in Suriname was to provide a two-step deal and to reschedule debt service falling after the program period only if China had participated in the restructuring by that time. This approach is risky and akin to nuclear deterrence: it would be very difficult politically for the Paris Club to withdraw a debt treatment a few years from now and ask Suriname or Sri Lanka to resume higher debt service at the expense of, say, social expenditure.
Finally, the IMF arrears policy will put pressure on China and incentivize it to participate in the restructuring only if the IMF has some certainty that Chinese banks will actually not take money off the table in the short-term. Otherwise new money from the IMF and its partners would merely help repay Chinese creditors at the expense of restoring macroeconomic stability. Suriname again provides an interesting precedent: China Exim drew funds from an escrow account that the authorities failed to disclose to the IMF between the program approval and the first review.
More broadly, as noted by Mark Sobel, the current international financial architecture is ill-equiped to deal with a major recalcitrant creditor benefiting from outsized (geo)political leverage. While it remains illusional to insulate sovereign restructurings from geopolitical considerations, there is a risk that they would turn into a game of chicken between China on the one hand and the IMF and Paris Club on the other hand. The problem being that if none of the players yields, it will just mean more economic and social hardship for the debtor country stuck in the middle.
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