This year is likely to prove very difficult for those low-income and emerging-market countries that have been heavy borrowers in the sovereign debt market. A series of crises concentrated in these countries seems virtually inevitable.
As the Federal Reserve begins to tighten monetary policy, financing costs will rise and credit will become less available as higher interest rates reduce the incentive for investors to stretch for the type of yield offered by these countries. Fiscal space will also be limited because their economic recoveries are likely to lag behind advanced economies due to slower progress in immunizing their populations against Covid-19. The end of the moratorium provided by the Debt Service Suspension Initiative — implemented by the Group of 20 along with the International Monetary Fund and World Bank — will drive up debt service requirements and increase financial stress.
What can be done to mitigate the coming crisis? More aid from official institutions and the G20 would help. But that might just postpone the day of reckoning and further subordinate the claims of private lenders. What's necessary is not only greater official sector assistance, but also far-reaching reform to make the sovereign debt regime more robust and resilient to adverse global economic developments.
Achieving greater transparency in the sovereign debt market is one important place to start. Information on the obligations of sovereign borrowers is woefully incomplete, especially to the private sector and to some large sovereign lenders, such as China. In many cases, it is impossible to judge how large the obligations are, when they will come due, their interest cost and other terms and conditions, including what collateral that may have been pledged to secure the borrowing.
The lack of transparency weakens the sovereign debt regime in a number of ways. First, because it is difficult to judge the aggregate level of outstanding debt, its composition and maturity structure, it's hard to assess the creditworthiness of the sovereign debtor and its ability to service its debt when the economic environment worsens.
Second, it makes it hard to restructure the debt in a timely way, that is before the prospect of default leads to a hard stop in lending and capital flight out of the country. Not knowing what other obligations are outstanding and on what terms makes it impossible for lenders to judge what type of "haircut" and rescheduling will be needed to ensure that the debt burdens can be sustained.
Third, the lack of transparency increases the riskiness of lending. If a current or prospective lender doesn't know how much other debt is outstanding and on what terms, how can it reasonably judge whether a new loan is creditworthy? This leads to higher credit costs over time as lenders price in the risk that the debt burden could be considerably higher or on terms more onerous than their assessment.
As I see it, there needs to be a sustained effort on the part of the official and private sector toward a regime of transparency. Not only would this include a detailed accounting of the terms and conditions of a sovereign borrowers' debt obligations, but also procedural transparency in which restructuring efforts would involve the private sector — at an early stage — working in concert with official lending institutions.
Support for greater transparency comes from both official institutions such as the IMF and World Bank and advocacy groups associated with the private sector, such as the Institute for International Finance. And, with the support of both groups, the Organization for Economic Cooperation and Development is creating a repository for sovereign debt data. Although this is necessary, it is not sufficient and more fundamental reform is necessary. In particular, the system must be changed so that both lenders and borrowers have a strong incentive to disclose in the first place.
Disclosure typically doesn't occur because it is not judged to be in the interest of the lender or borrower. Although each lender would like to know where others stand in order to judge the capacity of the borrower, that lender still has a financial incentive to keep its own cards hidden from other potential lenders and competitors.
There are a number of ways to encourage greater disclosure. For example, the IMF and World Bank could condition access to funding on satisfactory disclosure. Or the credit-rating firms could explicitly take disclosure and transparency into account in their decisions, with transparency leading to higher ratings. A paper published this week by the Bretton Woods Committee, which I chair — "Debt Transparency: The Essential Starting Point for Successful Reform" — explains, in detail, both what should be done and how this could be accomplished.
Another needed change is for greater procedural transparency in how the private sector is included in the debt restructuring process. This needs to occur at a much earlier stage and in a more transparent, comprehensive way. Historically, sovereign debt restructuring has mostly been conducted between official lenders and the sovereign borrower, with private lenders presented at the end of the process with a fait accompli about what is expected of them and where they stand as creditors. Not only does this lead to distrust and less engagement, but it slows the restructuring process and leads to inferior outcomes. The point is that cooperative solutions can lead to better outcomes than purely competitive ones. But to achieve that, the private sector needs to be more involved in the restructuring process.
Now is the time to implement a global transparency agenda before the next wave of disorderly defaults threatens another debt crisis
Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University's Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief US economist at Goldman Sachs.
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.