By Brendan Ma (BCom (Finance) / LLB (Hons) V)
From Argentina to Zambia, states are struggling to overcome the economic impacts induced by COVID-19.
Plummeting export demand and commodity prices are driving sub-Saharan Africa towards a projected GDP growth rate of -1.6%, the worst on record. Meanwhile, for the tourism-dependent haven of the Maldives, the evaporation of international travel is expected to halve the government’s total tax revenue this year. Compared to the start of 2020, when the IMF projected positive per capita income growth in 160 countries, the IMF is now warning that 170 countries could experience negative growth.
Source: IMF
These impacts could be disastrous if they set off a global sovereign debt crisis. Prior to the pandemic, a massive debt wave had been building up across the world. The total debt (public, private, domestic and external) owed by developing nations accumulated to the highest figure in history (nearly 2x their combined GDP). Many economists would argue that the accumulation of sovereign debt is not a significant problem insofar as governments maintain the taxing authority and long-run productive capacity to pay what is owed when they fall due. In 2020, payments amounting to 3.9 trillion USD worth of payments are due from developing nations. Yet, with GDP, tax receipts and export revenues tumbling, many of these governments are facing the real prospect of defaulting on their debt.
Last month, Argentina defaulted on interest worth around 500 million USD. This was the ninth time Argentina defaulted. Sovereign debt lawyers and analysts are drawing comparisons to Mexico’s default in 1982. Back then, banks and investors in international credit markets halted or significantly reduced new lending to other indebted nations across Latin America. This triggered a long debt crisis amongst 27 emerging nations (including Argentina’s 5th default) and precipitated the ‘Lost Decade’ for the continent.
The question today is whether the international financial system has the legal protections necessary to avoid another ‘Lost Decade’.
The uniqueness of sovereign debt
At its core, sovereign debt is a contract between a government borrower and its creditor. This is often issued through government bonds and bills, although a significant proportion of bilateral debt owed to creditors, like China, is through loans.
However, sovereign debt is unique compared to a conventional debt contract. If a commercial debtor defaults, domestic bankruptcy laws will provide temporary protections to prevent creditors from litigating or seizing assets in a frenzied fashion. For example, in the US there are automatic stays which take effect immediately upon the filing of bankruptcy. In Australia, voluntary administration under the Corporations Act 2001 (Cth) triggers automatic stays to prevent the commencement or continuation of enforcement proceedings and prevents secured creditors from enforcing security interests (except for those with security over the whole or substantial part of the whole of the debtor’s assets).
There is no equivalent international bankruptcy system for sovereign debtors. Defaulting nations would instead be vulnerable to lawsuits or enforcement actions in a desperate attempt to protect creditor interests. During a financial crisis and health pandemic, this could be at the expense of preserving debtor government resources that are necessary to support domestic spending priorities such as funding a public health system.
On the other hand, sovereigns have traditionally enjoyed absolute immunity from being non-consensually sued in the courts of another country. Yet, since the mid-20th century, most countries have instead recognised a restrictive theory of sovereign immunity, particularly for commercial endeavours. Nations that enter the international marketplace as a borrower will be subject to overseas judicial proceedings as if they were a commercial party.
However, even if a creditor obtains a favourable judgment, courts will often avoid executing against the overseas property of the debtor state unless the property is used exclusively for commercial purposes. Since most overseas property of sovereigns relates to embassies, military installations and, in the case of Firebird Global Master Fund II Ltd v Republic of Nauru [2015] HCA 43, bank accounts used for inter alia holding term deposits on behalf of the government and running a national airline, legal proceedings are not necessarily an attractive option for creditors when a sovereign defaults.
Therefore most sovereign defaults are resolved through out-of-court negotiations to restructure the terms of the debt. However, that does not stop some opportunistic creditors from acting separately to collective negotiations and holding out for a better deal, or litigating. In the past ‘holdout creditors’ have included private vulture funds that buy distressed sovereign bonds with the aim of litigating or bilateral creditors who choose not to adhere to the collective outcomes of official negotiation forums, like the Paris Club.
The risk of fragmented creditor approaches poses major problems in a sovereign debt crisis. It delays the resolution of the crisis and prevents a vulnerable sovereign debtor from quickly regaining access to capital markets. Importantly, it also hinders collective approaches to difficult, yet necessary, debt relief proposals. If holdout creditors exist, then the other creditors at the negotiating table are discouraged from offering discounts or deferments on debt repayments because this relief would effectively be redirected towards paying the claims of the holdout creditors.
The international financial architecture has sidestepped these risks for a while. Whilst ad hoc sovereign defaults can be managed relatively urgently, COVID-19 is creating the possibility of a wave of sovereign defaults at once. Corralling all these disparate government and creditor interests with further defaults around the corner could be catastrophic and, according to the New York Times, ‘unlike anything we have seen’.
Relief has not gone far enough
Attempting to avoid this wave of near-term defaults, the world’s largest 20 economies agreed via the G20 in April to suspend all 2020 debt payments for the lowest-income countries. This frees up US$20 billion for developing nations to use on vital health and economic policies in domestic COVID-19 responses.
Whilst this is a step in the right direction, the relief only applies to debt owed to G20 nations. Private creditors are not yet obliged to follow suit. If they do not step up, then the debt relief provided by the G20 risks being directly used to repay private investors. For example, investors buying Zambian bonds at 38 cents on the dollar could generate significant profits if bondholders are repaid in full now that G20 debts are not payable in 2020.
Developing nations are arguably better off avoiding defaults and utilising their resources for pandemic recovery, than diverting it towards immediate creditor payments. Rather than relying on all creditors volunteering to provide relief, the extraordinary impacts of COVID-19 call for much more collective global solutions.
A role for the Security Council?
Avoiding a global debt crisis might require immediate protection for many developing countries against enforcement attempts by various creditors across the world. The UN Security Council has authority under Chapter VII of the UN Charter to impose legal immunities over state assets. This could prevent foreign enforcement by any creditor and provide the financial headroom for developing nations that the G20 intended to achieve.
This authority has been invoked previously to shield Iraq in the immediate post-Saddam era. UN Security Council Resolution 1483 immunised all Iraqi oil sales and cash proceeds from ‘any form of attachment, garnishment, or execution’. This encouraged collective restructuring of Iraq’s debts and led to debt relief of 80% in net present value terms.
United Nations Security Council
In order to act under Chapter VII, the UN Security Council must agree that the situation facing developing nations constitutes a threat to international peace and security. There can be no doubt that a sovereign default will accentuate the humanitarian crisis facing developing nations that are struggling to finance effective responses to the pandemic. A deepened economic and humanitarian crisis can further undermine the tenuous fabrics of political stability and peace in vulnerable nations.
According to the Max Planck Research Institute, there is a correlation between sovereign debt and the risk of armed conflict and civil war. The risk of default undermines a state’s ability to provide basic services for its own population; it can entrench poverty and the regression of socio-economic rights in defaulting states. In these environments, threats to peace can manifest through prolonged civil unrest and violent riots, a scenario familiar to Argentina and Greece at the apex of their most recent debt crises.
A sovereign debt crisis that engulfs many fragile developing nations simultaneously could be much worse. COVID-19 has exposed the cracks in the international financial architecture at a time when the most vulnerable states need its protection most. Avoiding another ‘Lost Decade’ will require action that is immediate, protective and – most of all – truly collective.