Reflections on Sovereign Debt Restructuring in Low-Income Countries and the ‘Shanghai Model’
Zhou Chengjun, Director of the Financial Research Institute of the People’s Bank of China, delivered a speech entitled “Building the Shanghai Model of Sovereign Debt Restructuring” at the fourth China International Finance 30 Forum held in Shanghai on May 29-30, 2021. His discussion centered on ideas for sovereign debt restructuring of low-income countries and noting, in particular, the “Brady Plan,” a package of debt restructuring plans initiated by the United States in the 1980s and 1990s in response to the sovereign debt crises of Latin American countries.
The “Brady Plan” was first launched in Mexico in 1989 and has since been implemented in many countries. The specific programs of each country are similar. Essentially, the debt principle formed by the original loan is “cut” (meaning a portion of the principal of debt is forgiven) or transformed into a bond (called a “Brady bond” in the market, after then-Secretary of the US Treasury, Nicholas Brady) with the possibility of a reduced interest rate. While debt was restructured, the financial instrument also attracted a wide range of international participation due to additional provisions in the new instruments, such as guarantees. Thus, the approach effectively diversified the financial risk. Overall, the Brady Plan can be relatively successful for the countries involved. It has not only solved the debt restructuring and sustainable repayment problems of heavily indebted countries and helped them get out of the debt quagmire, but also produced an unexpected benefit: it greatly promoted the prevalence of international dollar debt and effectively promoted the internationalization of the dollar.
Based on this experience, Director Zhou believes it is possible to consider building the “Shanghai Model” of international sovereign debt restructuring, suitable for the current characteristics of China’s sovereign lending. In addition to maximizing transparency, multilateralism, securitization and debt sustainability, the plan would be open, inclusive, shared and sustainable.
The biggest feature of the “Shanghai Model” is that it refers to the model of Brady bonds, through which the coordination mechanism (Director Zhou called it the “Shanghai Club”) restructures the debts owed to Chinese financial institutions by heavily indebted countries and issues them Brady-like bonds denominated in Chinese renminbi (RMB). Various forms and modifications of the original Brady bond could also be used in Brady-like RMB bonds, such as par bonds, discount bonds, recapture clauses (which require the borrower to apply excess cash flow (or some percentage of excess cash flow to reduce the outstanding debt balance) and others. The infrastructure required for various cross-border or off-shore RMB bond markets can also be gradually built through the development of Brady-like bonds. In addition, when conditions are ripe, Chinese sovereign government bonds, which may be used as collateral in the Brady-like bond transaction structure, can also be substituted by sovereign green or “climate change” bonds.
Director Zhou’s proposal is important and timely. The global COVID-19 pandemic continues to rock low-income economies, precipitating a need for sovereign debt restructuring. As one of the largest creditor countries, China has actively cooperated with various debtor countries to restructure its non-performing debts, which not only protects the interests of Chinese creditors to the greatest extent but also reflects China’s responsibility to developing countries.
Of course, one of the most important purposes of debt restructuring is to help debtor countries improve their debt sustainability and restore economic growth. From a debt sustainability perspective, debtor countries have experienced ups and downs in economic growth and debt crises in the past, in part due to debt mismatches, such as currency, maturity, interest, cash flow and others. Relatively speaking, RMB bonds would provide debtor countries with a more diversified basket of currencies in their liabilities, as well as longer-term debt options. If coupled with the instruments advocated by the International Monetary Fund, such as state-contingent debt instruments, RMB bonds could be extremely attractive to debtor countries.
Under normal circumstances, mature debt products that can be selected into an optimal debt portfolio in the international bond market include bonds in US dollars and other currencies (including RMB) and commodity price-linked bonds (CLBs). Commodity prices attached to CLBs are relatively less susceptible to statistical errors and moral hazard than other indicators attached to bonds. CLBs’ repayment terms depend on commodity export prices, and so they can incorporate the flexibility needed by developing countries, many of which are heavily dependent on primary commodity production and exports. For example, copper accounts for more than 70 percent of Zambia’s exports. Coffee, cocoa, bananas and others also dominate many countries’ key export lists. Due to its natural hedge, CLBs can be used as a countercyclical debt instrument for commodity-producing and exporting countries. As discussed in a recent Boston University Global Development Policy Center working paper, the optimal debt portfolio could then reduce the impact of exchange rates, commodity price and economic cycle fluctuations on the debt sustainability of debtor countries, and additionally, improve their credit ratings and further reduce the financing costs of debtor countries.
Previous research has pointed out that in a theoretical risk-minimizing debt portfolio for Sub-Saharan African (SSA) countries, general dollar debt should account for only about 30 percent of its debt and should be linked to the price of SSA’s most important commodity exports, including cocoa, coffee, cotton, copper and oil. This theoretical debt portfolio reduced debt volatility in SSA countries by about 90 percent. Another example is Papua New Guinea, where the use of an optimal debt mix, including CLBs and traditional debt denominated in different currencies, played an important role in the country’s risk management strategy. In this way, the “Shanghai Model” and the “Shanghai Club” could become an important part of the international sovereign debt market.
On the other hand, the current debt crisis of developing countries caused by the impact of the pandemic also provides a rare opportunity for the development of the international RMB offshore bond market. In the process of coordinating domestic financial institutions and international organizations to issue Brady-like bonds denominated in RMB, instead of converting all bad debt into RMB bonds, the first thing the “Shanghai Club” should consider is to help debtor countries establish their optimal debt portfolio, including RMB bonds. The Shanghai Club can also optimize the structure of “RMB-like Brady bond” transactions by including features of CLBs. The Shanghai Club could also provide guidance and support for the development of market infrastructure required for various offshore and cross-border RMB bond markets.
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