In October 2020, Zambia, in the midst of an economic and financial crisis exacerbated by the pandemic, missed paying interest on its international bonds for the first time. Two and a half years later, the African nation is still in partial default on much of its $31.6 billion debt.

The fact that a poor and vulnerable country struggles unsuccessfully for such a long time to reach an agreement with creditors and overcome the crisis, is an example of the process of dealing with state bankruptcies. The implications could be severe for a number of countries that have recently defaulted on their debt, while this issue is high on the agenda of the spring meetings of the IMF and the World Bank this week in Washington..

In her opening remarks at these meetings, IMF Managing Director Kristalina Georgieva noted that approx. 15% of low-income countries are already in “debt distress” and nearly half are at risk of falling into it.

“This raised concerns about a potential wave of debt restructuring requests and how to deal with them at a time when ongoing restructuring cases are facing costly delays, most recently in Zambia,” he told attendees.

While the bankruptcy of companies and individuals is governed by domestic laws and court decisions, there is no international law for insolvent countries. There is only a chaotic, ad hoc process involving the crafting of a jumble of treaty clauses, tacit agreements, predatory negotiations, and geopolitical considerations.

This “fragile patchwork quilt” is now in danger of complete collapse due to the emergence of a new destructive, opaque and powerful force in the public debt sector: China.

Experts say Beijing’s lending to developing countries and its refusal to follow Western rules is the biggest obstacle to sovereign debt restructuring.

Yu Jie, senior China researcher at Chatham House think tank, said Beijing’s stance is “less about economic rationality and more about geopolitical competition. Multilateral financial institutions are primarily run by Americans and Europeans. China wants to shape the debt relief program, not dictate it to the West,” he says.

Jay Newman, a former Elliott fund manager who successfully sued Argentina for $2.4 billion after its debt was restructured in 2001, says China’s emergence as a major player has thrown the entire system into uncharted waters. “Now you have a major sovereign creditor with the power to dictate terms and the patience not to make a deal if it doesn’t suit him. It completely changed the game.”

new landscape

As a sign of the times, Alvarez & Marsal, one of the world’s largest corporate insolvency advisors, created a government department this year for the first time. In fact, he hired Reza Bakir, a former senior IMF official and Pakistan’s central bank governor, to lead the new division.

The latest IMF data for the end of February shows that nine poorer countries, such as Mozambique, Zambia and Grenada, are already in the so-called “debt problem”, while another 27 countries are in the “high risk” group. Another 26 are on the watch list. Bakir notes that these countries also have many troubled state-owned companies that will need help.

“The timing was right for A&M to set up a government advisory arm,” he says. “With more than 50 countries in various stages of debt distress, there is room for a more holistic approach.”

Decades ago, the Paris Club was created to coordinate the actions of public creditors, and the bankers created the London Club to restructure their debts. But the decline in bank lending and the growth of the bond market triggered a wave of sovereign defaults that began in the early 1990s. Creditor coordination has become more complex as claims are negotiated around the world by myriads of bondholders rather than a handful of banks.

Elliot’s “Ghost”

The default of $80 billion in Argentine bonds in 2001 led to years of disputes between Buenos Aires and investors such as Elliott, who refused to accept terms agreed with other creditors. At one point, a hedge fund hijacked an Argentine warship as it docked in Ghana. The publicity of the incident reached such proportions that bondholders sometimes used Elliott’s “ghost” to scare countries into default, while politicians used it as evidence of the weakness of the sovereign debt restructuring system.

After the Argentine default, the IMF responded by trying to create a kind of “bankruptcy court” for the countries. But the sovereign debt restructuring mechanism collapsed with little support from the IMF’s largest shareholders. Instead, the US has advocated the inclusion of “collective action clauses” in the bonds, which oblige uncompromising creditors to accept a majority-approved restructuring deal. Since the Greek debt restructuring in 2012, these provisions have been further strengthened.

However, many bonds still do not have these clauses. In addition, they can only facilitate the conclusion of a restructuring agreement after it has been concluded. Many experts point out that they are doing nothing to address the larger fundamental problem: countries are too slow to restructure their debt because they fear political humiliation if they default.

When they are eventually forced to restructure their debt, the bailout countries receive is often too little to ensure a sustainable recovery.

Chinese intervention

This imperfect process now it has been complicated by China’s massive program of lending to developing countries over the past decade. Many of these loans are not transparent in terms of size, terms, nature, and sometimes even their existence.

The total size of lending programs is difficult to estimate because China does not report on most of them to organizations such as the IMF, OECD or the Bank for International Settlements. But AidData, a development think tank based at the William & Mary Global Research Institute, Loans are estimated to be around US$843 billion.. China is not a member of the Paris Club and in most cases is notloans are provided by its myriad of state-owned or simply state-controlled banks, which further confuses the situation.

Zambian example

Zambia is a prime example. Of the approximately $20 billion in external debt fixed by the IMF when formulating its program for 2022, $2.7 billion came from international development banks, $1.3 billion from various Western governments. But the biggest chunk is almost $6 billion owed to China.

The IMF has reached a support agreement with Zambia on the condition that its debt burden becomes sustainable. But other bondholders don’t want any of the easing they’re offering to pay back China’s debt. Beijing agreed in principle to the haircut, but experts say it is aiming for a “dead end”.

Meanwhile, after the bankruptcy of Zambia, a debt of about $1.2 billion has accumulated. The IMF estimates that, including past due payments to domestic suppliers and creditors, the debt is actually almost $3 billion.

A senior adviser to the Chinese government commented that “there is no law giving priority to World Bank loans. The country (Zambia) was not happy with the practice that came at a time when Western countries were usually the only creditors. If we allow the World Bank to take precedence, we should have more say.”

Another increasingly common aspect of debt restructuring is what will happen to domestic bonds. Here Zambia is a good example.

Local currency bonds worth $3.3 billion held by foreigners were also excluded from the debt restructuring. Lusaka fears that a devaluation of the Kwacha bonds could destroy its banking sector. However, some holders of other international bonds argue that they should also be included in the restructuring.

China exception?

For the most part, experts say, China appears to be content with keeping its loans to third countries rather than restructuring them, sharing the news to ensure its domestic banks can be fully repaid. But she prefers to act alone, at her own pace, and doesn’t feel the need for transparency.

In a recent study by several economists, including Carmen Reinhart of Harvard University, Between 2000 and 2021, China is estimated to have provided 128 loans worth $240 billion to 20 distressed countries. About $185 billion has been awarded over the last five years of the study and over $100 billion in 2019-2021.

Reinhart says lending to China has been marked by a lack of transparency, but emphasizes that its overall behavior is not as unusual as some say. “China is playing a very tough game because it is a big creditor. US commercial banks also played tough in the 1980s,” he says. Bakir agrees, saying, “Regardless of the color or creed of the lender, lenders think like lenders.”

But whatever the root cause, most agree on the end result. “This fragmentation [των πιστωτών] it leads to paralysis,” says Sean Hagan, a former chief adviser to the IMF who now teaches international law at Georgetown University.

There are few solutions. In February, the IMF announced a new Global Public Debt Roundtable that will bring together all creditors and debtors and hopefully find ways to “facilitate debt resolution.” This is an initiative that few experts have high hopes for.

Seasoned lawyer Lee Buhite compares China’s presence in an already troubled debt restructuring system to a man who has a bad cold, which a doctor struggles to cure, and is then stabbed with a spear. “The cold has not gone away, but the doctor will likely focus more on the spear,” he says.