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Blurred [sovereign debt restructuring] lines

Théo Maret is an associate at Global Sovereign Advisory and writes a sovereign debt newsletter. Umesh Moramudali is a lecturer at University of Colombo and Thilina Panduwawala is an economist at Frontier Research. Both Umesh and Thilina cover Chinese debt for Sri-Lanka based think-tank Arutha.

Despite the messy architecture for sovereign debt restructurings there was usually a pretty clear divide between official and commercial creditors. Stricken governments typically strike a deal with the Paris Club of western countries, before moving to commercial creditors and making a comparable deal. That’s now changing.

China is now turning this logic upside down, with unintended consequences on the broader sovereign debt restructuring process. Recent debt workouts — from Zambia to Sri Lanka and Ethiopia — show just how tortuous things can become.

Conventional wisdom is that an official lender is any government-controlled entity whose lending matches the policy objectives of said government — which can be political, geopolitical, financial, or related to development assistance. For members of the Paris Club, this is usually understood to encompass lending by governments themselves, national development banks, or export-credit agencies. Rates are usually below market rates or concessional.

At first glance, the China Development Bank (CDB) fits that definition. It’s fully owned by Chinese government entities and under direct supervision of the State Council. CDB has played a major role — alongside China EXIM — in China’s lending spree across emerging markets under the umbrella of the Belt and Road Initiative.

Sri Lanka probably provides the best example to date of the blurred lines in CDB’s lending to frontier economies, oscillating opaquely over time between political and commercial objectives as political and economic cycles move along.

The evolution of CDB’s lending to Sri Lanka

CDB’s engagement with Sri Lanka started only in 2010, almost a decade after China EXIM (the only bank China considers as an official lender) had become a major lender to the country. But by 2022 CDB had caught up, with an exposure of about $3bn compared to China EXIM’s $4bn.

CDB has three different types of lending in its Sri Lanka portfolio: project loans and Foreign Currency Term Financing Facilities (FCTFF) — often referred as term loans — to the government, and project loans to Sri Lankan state-owned enterprise that are guaranteed by the government.

Loans in $mn. Does not include accrued interest arrears. Others SOE loans are by ICBC and ChemChina © External Resources Department, Ministry of Finance, Sri Lanka.

When Sri Lanka compiled a comprehensive account of bilateral creditors in 2022, CDB lending was initially included in the bilateral debt stock, putting China at 52 per cent of the total. But in October 2022 the Ministry uploaded an updated version of its investor presentation, which reduced China’s share in bilateral debt to 40.1 per cent after CDB loans were reclassified as commercial.

Looking back, this change in classification can be observed in the process underpinning successive loans by CDB. Initial CDB project loans were disbursed and classified as bilateral debt by the Sri Lankan Ministry of Finance, but in October 2018 Sri Lanka obtained a term loan — following a competitive call for bids that was won by CDB. This latter loan was for general budgetary financing and was accordingly recorded as a commercial borrowing from the get-go.

The blurred lines are also very apparent when looking at the distribution of interest rates. The term loans and project loans that CDB provided were at variable interest rates, typically at Libor plus 200-350 basis points. That’s well into “commercial” interest rate territory. The effective interest rates on CDB debts have consistently been over 3 per cent during 2014-2021: lower than on Sri Lanka’s Eurobonds, but higher than the cost of loans from China EXIM, which receives direct subsidies from the Chinese government that enable it to extend loans on concessional terms.

Effective interest rates for CDB lower than ISBs but higher than ChEXIM © Authors’ calculations using External Resources Department data

Finally, the behaviour of CDB when Sri Lanka slid into debt distress from 2020 showed how policy priorities can trump commercial practices in tough times.

CDB provided $1.3bn in term loans in three tranches during March 2020, April 2021 and September 2021. During this period Sri Lanka had lost market access, went off the IMF reform pathway, and had its credit rating cut to CCC by late-2021. In fact, the March 2020 $500mn CDB term loan followed a failed attempt to raise a syndicated loan from foreign banks. The term loans made China the largest provider of external financing during 2020-2021 outside of the multilateral lenders like the IMF.

Net Flow of Chinese loans to Sri Lanka’s Central Government, $mn © Authors’ calculations using External Resources Department data

The CDB term loans were provided with plenty of official razzmatazz, with the Chinese ambassador to Sri Lanka and Sri Lanka’s prime minister present at the signing of the loan agreement in March 2020.

CDB also rapidly increased project lending to Sri Lanka’s water utility to support the government’s marquee “Water for All” initiative in 2020-2021. But the political importance of these “commercial” loans is best told by CDB employees themselves, in an article posted on WeChat:

China and Sri Lanka are traditionally friendly countries and friends who share weal and woe. In order to co-operate with the head office in promoting the implementation of new co-operation projects with Sri Lanka as soon as possible, the Party branch of the International Cooperation Department has done a good job in organising and mobilising overseas party members and employees.

One afternoon at the end of 2019, the International Cooperation Office, which was preparing to wrap up its business and welcome the new year, suddenly received an urgent notice from the head office to fully co-operate in promoting new co-operation projects with Sri Lanka.

(translation errors all our own)

The big picture impact of classifying CDB as a commercial creditor

Beyond Sri Lanka, China has in recent years made it very clear that CDB should be classified as commercial in all multilateral debt restructuring discussions.

This debate became especially acute during the Debt Service Suspension Initiative (DSSI) in 2020. As G20 countries led by example in providing much-needed debt relief, private creditor participation — which was not mandated — ended up being lacklustre. This lack of enforcement led China to push for a large share of its lending to be classified as commercial (namely CDB loans), arguably to avoid being forced into debt rescheduling.

However, the idea that China’s goal with this move was to escape restructurings altogether is misleading. For example, CDB subsequently provided debt relief under the DSSI on a voluntary basis to a select group of countries, namely Angola, which ended up representing the bulk of “commercial” creditor participation in the DSSI overall.

Similarly, CDB recently participated along broadly similar lines in the debt service suspension provided by official creditors to Ethiopia in 2023, showing the objective of the commercial classification appears to be more about keeping the ability to engage in restructuring discussions on its own terms.

An understandable reaction to all this would be to say “well, this official vs commercial divide has been around for a long time, perhaps it’s time to just move past it”. But the problem is that blurry lines create frictions at several steps of the restructuring process, and adds undue burden on to countries trying to extricate themselves from debt crises, for three reasons.

1) IMF policies. The IMF needs to satisfy specific requirements when approving loans for countries that need to restructure debt owed to official creditors, or have incurred arrears to them. This includes the provision by official creditors of “specific and credible” assurances to the IMF that they will provide debt relief in line with IMF program parameters, which Chinese institutions have been notoriously reluctant to provide. Debates around the classification of creditors therefore have a direct effect on the ability of the IMF to provide timely support to countries in need.

2) Coordination among official creditors. Blurred lines make it much harder to form cohesive official creditor committees, creating tensions with other lenders (namely in the Paris Club but also India in the case of Sri Lanka), and makes the whole negotiation process more uncertain.

3) ‘Comparability of treatment’. This provision traditionally protects official creditors, and ensures that no commercial creditor can extract better restructuring terms. The concept — which is complex enough by itself — hinges on the ability to define clearly who is an official creditor and who is not.

All these issues materialised to some extent in Zambia, as discussed in an earlier FT Alphaville post.

The struggle with obtaining financing assurances delayed the approval of an IMF loan by almost two years. Then, $1.7bn in claims of Chinese state-owned banks (including CDB) backed by China’s export credit agency had to be reclassified as commercial at the last minute before official creditors agreed on a deal in June 2023. Finally, China’s representatives in the Official Creditor Committee kiboshed an initial agreement between Zambia and its bondholders in part due to fears this would not leave enough room for a comparable deal with Chinese commercial creditors like CDB, which were yet to agree on their own restructuring deal.

In some sense, China’s choice to classify a large chunk of its lending as commercial is backfiring. CDB and other Chinese state-owned banks and entities cannot extract better terms, since comparability is now strongly enforced by official creditors (including China). Moreover, they end up as the residual debt service providers if bondholders move faster, with little choices on cash flow allocation and without being protected by the comparability requirement which only encompasses official creditors.

China therefore faces a trade-off: classifying claims as official comes with improved protection, but also with the need to be good citizens and abide by some common policies to avoid delaying support to countries in distress. China’s ability to abide by these policies will be mostly driven in coming years by the evolution of the institutional complex underpinning China’s overseas lending — including mechanisms to allocate political and financial losses during restructurings — or by reforms of the IMF’s financing assurances and arrears policies.

The IMF coincidently just made its move with a long-rumoured reform of these two policies. Reading the fine print, it seems it will enable the Fund to accelerate disbursements to countries undergoing a restructuring, even without the textbook consent and assurances from a major official creditor (cough China cough). This in turn reduces the hurdle for Chinese banks to join official creditor committees and abide by these very rules.

The ball is therefore now in China’s court. The next restructuring case will tell us if more of China’s official creditors are classified as such, and if China is able to develop a mechanism to allocate financial and political losses domestically.

An option — though remote for now — would be for China to create a bad bank tasked with managing and disposing of these bad sovereign loans. In the absence of such drastic action, we should just expect more muddling through for the next countries trying to restructure debt stacks where China is a big creditor.

The major danger is that this will translate in the multiplication of non-financial provisions in the restructuring agreements reached by countries with myriad creditor groups, each trying to ensure they are not subsidising payments to others. This in turn would increase the legal and political uncertainty, while hampering the economic recovery of countries in the wake of defaults.

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