The House of Commons International Development Committee ("IDC") Inquiry: Debt Relief in Low-income Countries ("LICs"): Clifford Chance Submission

Background

There is no insolvency or bankruptcy regime applicable to sovereign debtors under which an orderly reorganisation of the financial claims of a sovereign debtor can be achieved. Consequently, other mechanisms have been developed and refined to address sovereign debt relief where this is necessary. Given the breadth of its roles with respect to its member states (comprising almost all countries) the IMF has been significantly involved in this field, including through its lending policies (including its lending into arrears policy here), monitoring the effectiveness of applicable mechanisms and making recommendations for improvement. Concerning official sector debt, the Paris Club plays a key role and its practices continue to evolve in response to developments. As to private sector debt, the implementation of debt relief arrangements is centred around the use of contractual mechanisms (e.g. the use of majority voting), engagement and voluntary participation. As with the IMF and the Paris Club, there has been a process of continued evolution for private sector debt relief, particularly by way of enhancements to contractual terms to facilitate debt relief where necessary.

Clifford Chance is one of the largest law firms in the world and we have an internationally recognised dedicated sovereign debt advisory and restructuring practice. We have dealt successfully with a number of the world's most high profile, novel and sensitive sovereign debt restructurings often during financial crises and we regularly provide sovereign debt advisory assistance, including representing and negotiating on behalf of sovereigns on the full debt life cycle ranging from debt issuance, refinancing, optimisation, reprofiling, liability management and restructuring as well as creditors.

We have worked with the IMF over many years. We regularly interface with the Paris Club, most recently on the Debt Service Suspension Initiative ("DSSI") and Common Framework for Debt Treatment (the "Common Framework") post-DSSI.

The re-worked version of the Institute of International Finance's ("IIF") Principles for Stable Capital Flows and Fair Debt Restructuring on which we assisted is an important reference point.

We have addressed each limb of the IDC's terms of reference below. Further information is available on request.

1.                   The current debt levels in low-income countries

1.1               The IMF and the OECD, among others, produce data on debt levels in LICs (available here and here). Such data appears to show that current debt levels in LICs are high and on an upward trajectory.

2.                   The impact on development of high levels of debt – including the ability of countries to respond to climate change and the pandemic

2.1               As a general proposition, high levels of debt would be expected to represent a constraint on development unless the debt was incurred and properly used for investment in development promoting activities (e.g. clean water or power projects) and the servicing costs of the debt incurred are lower than the expected overall return on that investment. Whilst this is the domain of development economists, allocation of funds to debt service can limit LICs' spending in other areas such as healthcare, education and social safety nets. Incurring debt and increasing spending can however support development in other areas, for example, the transition to cleaner energy sources, movement towards net zero and increased resilience to climate risk. The key factors are use of funds and the terms of borrowing. Examples of areas in which we have worked are described below.

2.2               Climate change:

(a)                Increased debt can support LICs' ability to respond to climate change, for example, through investment in renewable energy projects. Smaller projects might also be funded through debt-for-nature swaps, namely transactions which relieve a portion of a country's debt in exchange for local investment in environmental and conservation projects. See information on a well-known Seychelles debt-for-nature swap here.

(b)                There may be benefits associated with rolling over or refinancing sovereign debt owed to the private sector in a manner which is linked to environmental initiatives. This might be achieved through the creation of sovereign (i) use of proceeds bonds (green, blue, social or sustainability) or loans or (ii) sustainability linked bonds or loans. Appetite for debt with ESG features in the investor community is high. See here and here.

2.3               Covid-19: As is recorded elsewhere, in debt terms, the main impact of the Covid-19 pandemic has been a deterioration in the fiscal position of public finances (reduced economic activity led to lower receipts at a time when healthcare related, social safety net expenditure and other support mechanism expenditures were increased). Consequently many LICs currently face a fragile economic environment with reduced revenues and limited available resources having been redirected to health care spending and social safety nets. It seems clear that many LICs are a long way from recovering from the effects of Covid-19 and the consequences arising from the situation in Ukraine, including increasing inflation and changes in monetary policy, which are reflected in increased bond market volatility. LICs face increasing debt service challenges and will require additional financial support, not least to meet sustainable development goals.

3.                   An examination of where low-income debt is concentrated, and who holds the debt

3.1               The starting point for information concerning debt typically is the debtor country (Ministry of Finance or debt management office). There have been steps in public sector circles aimed at improving both data collection and consistency, including the IMF's Fiscal Transparency Code.

3.2               Regarding debt owed to private sector creditors, in the form of loans, most bank lenders employ risk mitigation techniques including guarantees, sub-participations, repackagings, insurance and derivatives. Information by the debtor country on lenders of record generally does not shed further light on where the ultimate credit risk resides.

3.3               Typically, internationally placed sovereign bonds are held in global form through the clearing systems (e.g. Euroclear, Clearstream, DTC). A significant investor may have a direct account with a clearing system; many end investors instead hold their instruments through a custodian or nominee. Sovereign bonds are often subject to risk mitigation, most typically through derivatives (e.g. credit default swaps). Therefore, information on the holdings of sovereign bonds through the clearing systems will also generally not shed full light on where the ultimate credit risk resides.

3.4               The result is that LIC sovereign credit risk is often held by a broader, more varied and dispersed group of economic creditors. There are many factors which encourage the use of these risk mitigation techniques, including bank regulatory capital rules and a desire to spread risk whilst maintaining client relationships. Generally, these techniques improve liquidity and tend to dampen price and so the debtor benefits from their use. A related issue is sovereign debt transparency.

3.5               Transparency:

(a)                Private sector: Increased debt transparency facilitates governance and accountability and, in arrangements designed to alter payment obligations, adds credibility. An important private sector initiative (in the first instance regarding Poverty Reduction and Growth Trust ("PRGT") eligible countries) has been the IIF's Voluntary Principles for Debt Transparency on which we advised, the accompanying Implementation Note and the OECD portal are relevant. There has been slow take-up among banks/providers of finance to submit relevant information pursuant to these Principles.

(b)                Official sector: The UK and Canada publish data on official bilateral debt arrangements; all G7 countries recently agreed to report quarterly on new lending arrangements (see here) and lending from the IMF and many multilateral development banks is subject to high levels of transparency; private sector participants nonetheless express concern that there is not complete official sector transparency (including by ECAs) and there would be public good benefits if other G20 creditors took a more active approach to transparency.

4.                   Lessons learned from previous debt-relief initiatives such as the Highly Indebted Poor Country (HIPC) Initiative, Multi-lateral Debt Relief Initiative (MDRI) and Debt Service Suspension Initiative (DSSI)

4.1               HIPC and MDRI: The IMF has pointed out that commercial creditor participation in the HIPC Initiative has been weak. See here (footnote 39, page 20) and table AIII16 in the Heavily Indebted Poor Countries ("HIPC") Initiative and Multilateral Debt Relief Initiative (MDRI) - Statistical Update here (see also paragraph 10.3).

4.2               DSSI: The DSSI represented a swift response by the G20 to the short-term consequences of the Covid-19 pandemic on government finances for the 73 eligible LICs, following the IMF and World Bank call to action. It was noteworthy for its co-ordination at the G20 level on debt matters and provided cash flow relief with few conditions (e.g. request for financing (emergency or otherwise) from the IMF). The April 2020 G20 Finance Ministers and Central Bank Governors Communiqué regarding DSSI also called on the private sector to participate "on comparable terms" to those set out for official sector bilateral creditors. While the production of Terms of Reference for Voluntary Private Sector participation in the G20/Paris Club DSSI and other documents to facilitate participation (see here, here, here and here on which we advised)  provided a framework for engagement, take-up was low, not least because of the hesitation of debtor countries to request it. The DSSI and Common Framework are discussed here (page 12) (including lessons learned).

4.3               Common Framework: While it was generally accepted that the DSSI was a timely response by official bilateral creditors to Covid-19, it was recognised that this did not address medium term debt distress. The end of the DSSI gave rise to the Common Framework (a more durable treatment for dealing with debt relief for DSSI-eligible countries). The Common Framework represents a return to the use of pre-existing financial architecture, save that the G20 co-ordination on debt matters will continue as the official sector will be represented not solely through the Paris Club but also through G20 official bilateral creditors that are not Paris Club members (e.g. China, India, Turkey and Saudi Arabia). A new official sector creditor committee is to be established in response to each request for debt treatment.

5.                   How the pandemic has impacted debt levels, and the implications of the Debt Service Suspension Initiative closing at the end of 2021

See paragraph 4. Information on debt levels and the replacement of the DSSI with the Common Framework is best sourced from those institutions with the broadest field of vision (e.g. the IMF and World Bank – see here and here).

6.                   The implementation of the Common Framework for Debt Treatment

6.1               Under the Common Framework, like the DSSI, the process must be initiated by the debtor country. However, unlike the DSSI, the debtor country must have an agreed IMF Programme (e.g. an Extended Credit Facility) and an IMF-World Bank Group debt sustainability analysis ("DSA") needs to be conducted, which in practice identifies the needed debt relief. See here (page 12).

6.2               Comparability of treatment is required under the Common Framework (but not the DSSI). This requires the debtor country to obtain from all other official bilateral and private creditors a debt treatment at least as favourable as that agreed under the Common Framework. See here.

6.3               There are concerns over the speed at which official sector countries form creditor committees and the need for relevant creditor countries to move swiftly to establish new norms and procedures. To make processes more efficient, (i) relevant issues need to be considered (for example the relevant co-chair, timeline, work plan and potential sharing with the private sector); (ii) transparency on the private sector side is required and (iii) discussions should move in parallel based on access to similar levels of data.

7.                   The relative merits of debt cancellations compared with debt relief

7.1               There is a place for both debt cancellation and debt relief. Broadly, in conducting a DSA, the IMF/World Bank would make a basic distinction between two cases, namely:

(a)                a solvency problem (generally requiring some debt reduction (cancellations)); and

(b)                a liquidity problem in which debt levels are sustainable but there is some bunching of payments which could be resolved through a re-profiling of debt claims without debt reduction (cancellation). See the IMF paper here.

8.                   The criteria used to determine eligibility for debt relief schemes, and whether this should be expanded to, for example, middle income countries ("MICs")

8.1               World Bank: Eligibility for IDA support depends on a country's relative poverty which is defined as gross national income ("GNI") per capita below an established threshold ($1,205 in the fiscal year 2022). See here.

8.2               IMF: The IMF's main vehicle for concessional lending is the PRGT which focusses on lending to LICs, but this could be expanded to support MICs. We believe some MICs will need financial support and there are circumstances where debt relief schemes and policy innovation could be expanded to such countries (depending on the specific relevant crisis and type of debt relief scheme).

8.3               OECD: Official development assistance eligible countries comprise all LICs and MICs based on GNI per capita as published by the World Bank, with the exception of G8 members, EU members, and countries with a firm date for entry into the EU. See here. At a time where many highly developed countries are themselves under financial strain, expanding existing schemes to a wider set of countries may raise sensitivities but this should be considered.

9.                   What role the UK Government could and should play in low-income debt relief – both through bilateral and multi-lateral initiatives

9.1               Over the past 18 months the UK Treasury has helped to fund the OECD's role as information host for the IIF/OECD Debt Transparency Initiative, but participation by the private sector is slow and could be further promoted. The UK has an important role within the IMF (HM Treasury takes the lead for the UK) and other IFIs. There would be public good benefits to using the UK's position to promote further support for LICs.

9.2               SDRs:

(a)                A significant measure introduced by the IMF in response to Covid-19 was the general allocation of special drawing rights ("SDRs") in August 2021, equivalent in value to $650 billion. Allocations of SDRs are distributed across the IMF membership in proportion to IMF quota shares, meaning wealthier countries have a higher allocation of SDRs as compared to LICs. Such allocation was significant and boosted liquidity and reserves around the world but it left the challenge of how to redirect SDRs to their greatest effect.

(b)                In October 2021, the Chancellor committed to rechannelling up to SDR 4 billion of such newly allocated SDRs to the poorest and most vulnerable countries, starting with an additional loan of SDR 1 billion to the IMF's PRGT (see here). The UK government might consider other opportunities to re-channel SDRs to LICs in need.

9.3               In seeking to identify improvements to the existing financial architecture for resolving sovereign debt, an IMF Staff Paper dated 23 September 2020 was released which identified areas for potential improvement, including (i) majority voting for payment term revisions in loan agreements and (ii) the issuance of new instruments with contractual features to protect the sovereign debtor from downside risk associated with natural disasters, e.g. hurricanes and pandemics. HM Treasury is leading working groups of private sector participants designed to address these issues.

10.               The role of the private sector in low-income debt relief, the role of the City of London and UK financial system, and how private debt holders can be incentivised to participate in debt relief programmes

10.1           Overview: English and New York law are the two most commonly used systems of law governing private sector sovereign debt contracts. Accordingly, English law and the English courts have an important role in LIC debt relief arrangements. As to active engagements, the working groups referred to in section 9.3 draw on input from City of London institutions. The output of such groups will benefit from promotion through the appropriate industry bodies, namely in the case of sovereign loans, the LMA, the APLMA and the LSTA and in the case of catastrophe resilient bonds, ICMA. The LMA and ICMA are based in London. As to actions taken in this field recently, the initiatives mentioned in 10.2 and 10.3 are worthy of mention. Additional measures are mentioned in 10.4 to 10.6.

10.2           Enhanced Aggregated Voting through collective action clauses in sovereign bonds ("CACs"): In a step toward strengthening the resilience of the debt relief system and enhancing financial architecture, most LIC internationally traded sovereign bonds now include enhanced CACs in their contractual terms. These clauses were finalised by a US Treasury convened expert group in which we participated and resulted in a new set of CACs, with aggregation features (so in certain circumstances, different series of bonds could be voted together in a single aggregated pool) governed by English and New York law. The enhanced CACs and pari passu language for use in sovereign bonds were endorsed by key institutions and promoted by ICMA. See here. The IMF reported on their take-up until they became the market norm (see here).

10.3           Legislation to limit HIPC/MDRI litigation: The Debt Relief (Developing Countries) Act 2010 (the "HIPC Act") was a UK statute designed to ensure that creditors could not use UK courts to seek to avoid providing their share of debt relief under the HIPC Initiative. This statute limited court enforced recoveries to the level dictated through HIPC Initiative. As demonstrated in table AIII16 in the HIPC and Multilateral Debt Relief Initiative statistical update, at the time of writing, there have been no commercial creditor lawsuits against HIPCs regarding in scope debt in any UK court, which suggests the HIPC Act has been effective. See here.

10.4           New York State legislation: New York lawmakers have proposed legislation to allow unsustainable sovereign and subnational debt to be restructured through new procedures. This would provide a limited bankruptcy type procedure for sovereign claims governed by New York law. See here. At the time of writing, it is unclear whether this will progress. As drafted, there could be unintended consequences.

10.5           Use of a United Nations Security Council Resolution ("UNSCR"): As noted on page 3 of the IMF Staff Paper (see 9.3 above), in the context of a possible Covid-19 related systemic sovereign debt crisis, it is possible to use international law to "limit creditor recovery or the timing of suits or immunise specified assets from attachment". In the context of sovereign debt claims, this approach was taken once in the case of Iraq in 2003, through UNSCR 1483 (22 May 2003) and later augmented by UNSCR 1546 (8 June 2004). The practical effect (under paragraph 22) was to shield Iraq from asset attachment or seizures in relation to oil and gas assets (and broadly the proceeds) and was designed to prevent disruption to global oil markets. Whilst UNSCRs need to be framed around the requirements of Chapter VII (UN Security Council powers to maintain peace and actions to restore international peace and security), this mechanism may be available in certain circumstances and the UK as a permanent Security Council member would have a role.

10.6           Use of IFI partial guarantees and mitigating FX risk: New debt claims arising through a restructuring could be credit enhanced through the use of partial guarantees from development institutions to incentivise participation. Greater use of such guarantees could be considered to increase private sector participation in new debt raising by LICs which might otherwise not be able to raise funding at sustainable levels. LICs would also benefit from foreign exchange risk mitigation techniques (see here).

Deborah Zandstra

Partner