By Zhicheng Zhong and Christoph Nedopil
Managing sovereign debt in emerging economies remains one of the core challenges for sustainable growth. Sovereign debt risks featured prominently not only during the latest Spring Meetings of the IMF and World Bank, but have caught headlines since COVID-19 dealt a double blow to government coffers through reduced GDP and higher fiscal spending.
So far, solutions to the debt issue have been scattered. This has led to a situation where the percentage of the 68 countries eligible for the (already expired) debt service suspension initiative (DSSI) that cannot fulfill their financial obligations in servicing their debt (e.g., through interest and principal payments) is at an all-time high of 14%, compared to 3% in 2016. In addition, countries with high risk of such debt distress remain at 43%, compared to 29% in 2016.
China, as a major bilateral creditor to many of those countries, plays a crucial role in addressing debt distress risks in emerging economies. According to data from China’s State Administration of Foreign Exchange (SAFE), China’s FDI debt instruments, loans and short-term trading credit have grown to a total of US$1.9 trillion in 2021.
Over the past years, China has participated in multilateral debt relief initiatives such as the DSSI, the G20 Common Framework for Debt Treatments and the repurposing of IMF Special Drawing Rights (SDR) for debt relief. China has also engaged in debt reorganization bilaterally and extended last-resort-lending through People’s Bank of China (PBOC) swap lines, complementary to the IMF’s SDR. However, the multilateral efforts have not yielded sufficient results. For example, only four debtor countries engaged in the Common Framework, likely due to the complexity of managing an increasing diversity of bilateral, multilateral creditors and the growth of sovereign bond holders.
To better understand the evolving role of China in overseas sovereign debt, the Green Finance & Development Center at Fudan University’s Fanhai International School of Finance has for the past three years analyzed relevant data from Chinese government sources, and official debt statistics provided by the IMF and the World Bank (see here for the report from 2021, and here for 2022).
This year our analysis shows that by the end of 2021, China’s debt exposure to DSSI countries decreased for the first time, an encouraging sign for global debt sustainability efforts (a list of the 68 DSSI-eligible countries can be found here). It also shows how sovereign debt markets have become more complicated over the past decade as a result of the growth of both new bilateral lenders, including China, Turkey, India and Russia, and private lenders, such as bond holders. Lastly, our analysis highlights how China’s involvement in debt relief is evolving, with strong positions on World Bank and IMF reform and possible interest in debt-for-nature swaps as part of debt restructuring negotiations.
China’s overseas debt exposure
By the end of 2021, total outstanding public external debt owed to China (as an official bilateral creditor) in the 68 DSSI eligible countries (57 of which are BRI partner countries) decreased from US$110 billion in 2020 to US$104 billion. This makes 2021 the first year to see a decrease in the debt exposure of China at least since 2016. While the World Bank’s outstanding lending to DSSI countries was higher than China’s (US$135 billion), China’s 2021 outstanding lending was larger than the combined debt of all other official bilateral creditors.
With 60 of the 68 DSSI eligible countries seeing their Gross National Income (GNI) increase or remain stable in 2021, 48 of those countries saw a reduction or no change in the ratio of outstanding debt to China to Gross National Income GNI in 2021. The countries with the largest relative decrease of Chinese debt were Congo Republic ( -3.9% of GNI), Maldives ( -3.5% of GNI) and Mozambique (-2.1% of GNI). Countries with the largest relative increase of Chinese debt in terms of GNI share were Tonga (+2.4% of GNI), Grenada (+2.1% of GNI) and Vanuatu (+2.1% of GNI).
In absolute terms, and despite China’s total DSSI outstanding lending decreasing in 2021, countries like Pakistan, Bangladesh, Cambodia, Nigeria and Cote d’Ivoire increased borrowing from China in 2021. In Pakistan’s case, outstanding debt owed to China increased 18.3% YoY to US$25 billion in 2021. Part of this can also be attributed to US$ 4.7 billion short-term swap lines extended by People’s Bank of China since 2013.
Debt outlook and debt service projections
An important determinant of debt distress risk is reflected in debt service projection, that is, how much interest and principal debtor countries are expected to pay. As much of the debt is paid in foreign currency (e.g., USD), debtor countries need to generate sufficient exports (often traded in foreign currencies) to service the debt. Accordingly, we look at the ratio of debt service projections to exports to understand debt service distress risks.
We find that in 2023, two countries are expected to spend more than 40% of their export revenue on debt service: Gambia (59%) – of which none will go to China – and Guinea Bissau (46%) where China is expected to receive 6.7% of export revenue. The other countries with a relatively high debt service-to-export ratio that arouses debt unsustainability concerns include Samoa (34%), Pakistan (32%), Cabo Verde (28%), Saint Vincent and the Grenadines (27%), Bhutan (27%), Dominica (26%), Kenya (25%), and Mozambique (25%).
While debt service-to-export ratios shed light on a country’s debt solvency relative to one source of its income, the debt service-to-GNI ratio reflects a country’s debt solvency relative to all sources of income earned by the people of the country. When we analyze debt service projections relative to each country’s GNI, Angola is expected to pay 11.7% of its GNI to repay its debt in 2023, of which 5.6% goes to China. Its debt service to China is largely to redeem principal. Therefore, China’s outstanding debt exposure in Angola is expected to continue down the descending path. Other countries that are expected to pay over 2% of their GNI to China include Lao PDR, Zambia, Republic of Congo, Maldives, Djibouti, Samoa and Tonga. However, their scale of debt repayment is relatively small compared to Angola.
An important trend making debt negotiations more challenging is the rise of bondholders in both the absolute amount and percentage of lending to the DSSI-eligible countries. In 2021, lending by bondholders to the 68 DSSI countries increased to US$87.9 billion, doubling from 2017 levels. These bondholders come mostly from the private sector. As private lenders play a more important role in the international sovereign debt market, credit rating impact and future access to bond markets become more important factors when it comes to debt relief.
Debt relief framework in a fragmented sovereign debt market
Dealing with sovereign debt in 2023 requires dealing with the fragmentation of the international sovereign debt market over the last decade. About a decade ago, Paris Club lenders accounted for more than 50% of lending to low-income countries. Today, apart from private bondholders mentioned earlier, many middle-income countries participate in the sovereign debt market as creditors. This has led to a situation where non-Paris Club bilateral lenders such as China, India, Russia and Turkey accounted for 68% of the official bilateral lending to International Development Association eligible countries in 2021.
In a more fragmented and complex sovereign debt landscape, new risks have emerged for debtor countries, such as lack of transparency in debt reporting due to the use of confidentiality clauses, foreign exchange risk, stricter terms demanded by private lenders and cross-default clauses.
Faced with unsustainable levels of accumulated debt, the international community has launched several debt relief campaigns aimed at relieving debt-ridden countries from debt distress. However, even though Heavily Indebted Poor Countries (HIPC), Multilateral Debt Relief Initiative (MDRI) and DSSI achieved some results through participation by Paris Club lenders and emerging country lenders such as China, they all failed to involve private lenders in the process. This created free-riding risks as private lenders seem incentivized to excessively lend in the hope that the debt would be bailed out by public lenders.
The G20 Common Framework for Debt Treatment was designed to address this very problem by introducing the comparability of treatment clause, by which public bilateral lenders, multilateral lenders and private lenders are treated on an equal basis. However, the slow progress of the Framework casts doubts on the effectiveness of the comparability clause. In the future, mechanisms that could guarantee debtor countries credit rating and future access to private lending in the case of debt relief might be needed to involve more private investors. Legislative solutions may also be required. Simultaneously, bilateral lenders would also need to find common ground and sometimes compromise on refraining from using confidentiality clauses, defining the role of multilateral lenders in debt relief, classifying debt based on terms or creditors’ legal status and defining default in softer terms in cross-default clauses to advance debt relief initiatives.
China’s stance on debt relief and a small opportunity through debt-for-nature swaps
China laid out three requirements for its participation in further debt relief efforts on April 14, which included first, the requirement for multilateral creditors, such as the World Bank, to participate in debt treatment as soon as possible; second, that the IMF would share information on debt sustainability assessments; and third, that all parties (including bondholders, bilateral and multilateral creditors) need to agree on the specific way to participate in debt reorganization in comparable terms.
Among the more challenging requirements was that multilateral lenders, such as the IMF and the World Bank, should participate in debt write-downs. This, however, is rejected by many players in the multilateral lenders, which see themselves as lenders of last resort with a requirement to have both seniority in debt repayment and the requirement to ensure highest credit worthiness to provide low-cost emergency loans and thus cannot participate in such haircuts.
During the recent Spring Meetings of the IMF and World Bank, China demonstrated a willingness to compromise on its stance that multilateral development banks need to take haircuts in debt restructuring agreements if the World Bank provides enough fresh concessional financing and grants to countries that defaulted. If a deal is reached on that matter, it would constitute significant progress for the Common Framework for Debt Treatment.
Other proposals to deal with overseas debt have also been partly discussed by China and implemented by other parties, including the use of debt for sustainability swaps, and in particular debt for nature swaps.
As many of the DSSI economies are not only in debt distress, but also highly vulnerable to climate change and biodiversity loss, and as the risks to the environment increases when economies try to grow their GDP at any price while public funding for nature conservation is being reduced, debt for climate and debt for nature swaps have seen growing attention. With growing experience in the application of debt for nature swaps, including using bilateral debt (see the Seychelles example), the IMF has indicated that the use of debt-for-nature swap can have an important role, particularly when the use of debt swaps involves a sufficiently large share of a country’s debt.
Chinese government-related institutions have also indicated an interest in debt for nature swaps. For example, the Chinese Academy of International Trade and Economic Cooperation under MOFCOM and the Green Finance Committee have both conducted research on debt for nature swap mechanisms.
A potential debtor country with which China may engage in debt-for-nature swap is Ecuador. For Ecuador’s debt relief during the Covid-19 pandemic, China rescheduled $900 million of Ecuador’s debt repayments. With the establishment of the US$233 million Kunming Biodiversity Fund at the biodiversity COP15, China may use it as an environmental trust fund that provides funding for retiring Ecuador’s debt at a discount. In return, Ecuador would agree to make regular payments to the environmental trust fund under restructured terms for preserving local biodiversity. In 2022, China showed willingness to renegotiate its debt with Ecuador by taking shared conservation goals into consideration.
In summary, while some trends in sovereign debt sustainability are encouraging, such as China’s decreasing overseas debt stock and a broad discussion of possible solutions as seen at the World Bank/IMF Spring Meetings, overall negotiations on dealing with the issue remain highly complex and progress seems haphazard.
Over the next months, it will be interesting to see whether multilateral solutions including the challenging involvement of bondholders can be agreed on and implemented, or whether bilateral creditors will carve out special deals advantageous for only a limited circle of creditors and debtors. The latter would risk undermining trust and transparency necessary for a more systematic solution. We remain hopeful that with more transparency on debt data and negotiation positions of the involved stakeholders, paired with the increasing urgency for action, a better common framework for debt reorganizations can be agreed upon. This would need to allow for negotiation of bespoke solutions for different debtor countries with their respective creditor compositions.
Zhicheng Zhong is a non-resident researcher at the Green Finance & Development Center at FISF Fudan University. He holds a Master in Finance from EDHEC Business School in France and a Bachelor of Financial Economics from Jinan University in Guangzhou, China. He has professional experience in derivatives trading, e-commerce data analysis and M&A. He currently works as a data analyst and business consultant at Battaglia Advisory Services, a consulting firm based in Rome and Shanghai that advises on cross-border transactions.
Dr. Christoph NEDOPIL WANG is the Founding Director of the Green Finance & Development Center and an Associate Professor at the Fanhai International School of Finance (FISF) at Fudan University in Shanghai, China.