Incentivizing Moral Hazard: Emerging Debt Restructuring Practices

Navigating international debt negotiations is a convoluted process. When a country finds itself unable to meet its financial obligations, it requires the involvement of IMF referees, teams of lawyers, and a tug-of-war between the country and its creditors. Everyone involved seeks a deal, but no one is willing to bear losses. Just when creditors agree on collaboration, disputes arise over the terms, leading to prolonged chaos. Unlike bankrupt companies, countries are never liquidated. Zambia’s President, Haikande Hichilema, described the process as a zig-zag journey but expressed satisfaction as the country finally struck a deal.

On June 22nd, at a summit in Paris, Zambia’s creditors from wealthy nations announced the long-awaited agreement: repayment on their loans would be pushed back by two decades, extending until 2043. The extension, accompanied by interest rate cuts, provides Zambia with some breathing space and the potential to alleviate its debt burden. This outcome is surprising, considering China is the country’s largest creditor, holding $4.2 billion of its total external debt of $6.3 billion to official creditors. China’s obstruction had contributed to the already chaotic restructuring process.

Beijing’s hesitance to write off loans and classify those from state-owned banks as official has resulted in standstill restructurings worldwide. Zambia found itself in a bind after its two-decade borrowing spree went awry. China’s refusal to reduce the face value of its loans and reluctance to acknowledge state-run banks’ loans as official had hindered progress. Since November 2020, when Zambia ran out of foreign currency reserves (dipping below $1 billion, equivalent to just over two months of imports), the country had been grappling with unpaid interest amounting to $1.8 billion.

International financiers were compelled to employ unconventional strategies. Before the recent deal, Zambia’s debt owed to official creditors had reduced from $8 billion to $6.3 billion. The borrowing was reclassified as private-sector loans, allowing it to be excluded from this part of the restructuring process, despite originating from one of China’s state-run banks and being guaranteed by Sinosure, a state-run insurer. China remained steadfast in its refusal to lower the loans’ face value.

The breakthrough also involved unique stipulations. Zambia will pay a reduced interest rate of 1% per year on the borrowed amount until 2025. If the IMF determines that Zambia’s economy is recovering, which is likely, the interest rate will rise to nearly 4%, thus erasing a significant portion of the debt relief. In this scenario, including Beijing, creditors will earn roughly the same returns they would have received by investing the funds in ten-year Treasuries. Paradoxically, the deal offers Zambia better terms when its economic performance worsens, creating a moral hazard.

Zambia’s case is not the only peculiar restructuring. In May, Suriname, which owes China $155 million (6% of its external debt), deviated from the norm by restructuring private-sector loans before reaching an agreement with China, an official creditor. Last year, Chad managed to strike a deal, albeit by rescheduling payments rather than reducing them. Under the agreement, the country can utilize commodities to pay its interest bills, with additional assistance contingent on economic indicators, such as the price of oil.

In wealthier countries, the stakes are higher. Sri Lanka’s debt-to-GDP ratio will remain above 100% until at least 2026 under the IMF’s plan. The country owes China $7.4 billion (20% of its external debt), leading to concerns that its borrowing costs from the market will become even more burdensome. Some observers question whether the IMF’s analysis of a country’s debt sustainability is overly optimistic.

Others fear that restructuring efforts focused on extending repayment deadlines, which may persist until China changes its approach, will transform insolvent countries into permanently illiquid ones, trapped in a cycle of recurring short-term crises.

For President Hichilema, the next challenge lies in dealing with private-sector creditors as part of Zambia’s ongoing restructuring. He must decide whether to emphasize the favorable terms secured from official donors, which remain intact even if the economy struggles, or assure bondholders that he is actively working toward a future where the terms become stricter and the country’s prospects improve.