Former central bank governor urges reform in debt restructuring

The former acting governor of the State Bank of Pakistan, Murtaza Syed, has issued a stark warning about the country’s debt crisis, calling for urgent reforms in the debt restructuring process.

In an article published in ‘The Economist’, Syed added that in a previous article for the media outlet published last years, he cautioned that Pakistan’s policymakers and the IMF were flirting with disaster by pretending that the country’s public debt was sustainable. It was among 70 countries facing debt distress.

A year on, only Ethiopia has defaulted and Sri Lanka is restructuring its debt, while Pakistan is on the cusp of a record 24th IMF programme. But this veneer of stability is no cause for celebration.

From Egypt to Angola, debt servicing is crowding out development spending that’s needed to improve lives and build climate resilience (in Pakistan, interest payments are almost three times as high as spending on investment and three and a half times spending on education). These countries are gambling for resurrection by increasing taxes and slashing spending while praying for a growth miracle.

However, this gamble is only increasing the chances of a disorderly default and an unravelling of their social fabric, as recently witnessed in Kenya.He added that rescuing these countries hinges on increasing fiscal space by restructuring their debt. For this to happen, a taboo must be broken and innovative thinking is needed on dealing with new creditors and how the IMF approaches debt in its country programmes.

The taboo concerns debtor governments’ fear of debt restructuring. It is driven by not wanting to be perceived as inept economic managers, possible legal action by creditors and the consequences for future external funding.

All these fears can be overcome. In many cases, perceptions of ineptitude can reasonably be countered by highlighting the role of external shocks -- such as the unexpected tightening of global financial conditions or Covid-19 -- or of predecessor governments, who have often taken on odious debt of no benefit to the population on secretive and corrupt terms. Cover from legal action in foreign courts can be provided by major official creditors, as was done for Iraq, or could be automatically triggered by an IMF assessment that debt is unsustainable.

As for the market penalty for restructuring, international evidence -- including from Ukraine in 2015 -- shows that it is much lower and more short-lived than commonly feared, especially if the restructuring improves the country’s growth prospects. Inthis context, governments must not be afraid of restructuring lower-seniority commercial debt, which costs much more precisely because of this credit risk. Where domestic debt needs to be restructured too, Cyprus, Jamaica and Seychelles show it can be achieved without triggering financial instability.

On the creditor side, fresh thinking is needed on how to accommodate the interests of new official creditors such as China and the Gulf states, and securing relief from multilateral development banks (MDBs). The participation of new official creditors in debt restructuring needs to be more strongly incentivised and the IMF should assist debtor countries in bringing them to the table.

One idea is to allow the majority official creditor that offers debt relief the right to force other creditors to agree to a similar dilution of their claims. The right to cram down on other creditors as part of debt restructuring already exists in the norms of the Paris Club of official creditors and the creditor committee under the Common Framework -- a multilateral debt-rescheduling mechanism -- as well as in negotiations with private creditors. It needs only to be extended to new official creditors.

Meanwhile, for countries that owe large amounts to MDBs, their preferred creditor status poses a constraint. However, MDBs can at least roll over debt servicing coming due. And, if their shareholders are willing, they can also provide direct debt relief, as was done under the HIPC and MDRI initiatives, possibly in return for climate action by debtor countries.

The other big change that’s required concerns the central role the IMF plays in determining whether a country’s debt is sustainable or not. The fund needs to be clearer in its pronouncements by leveraging its impressive debt-sustainability assessment (DSA) machinery and cross-country research. Currently, the IMF’s statements on debt are fuzzy and the mechanical signals from its DSAs prone to being overridden by judgment. This must be rectified.

In Pakistan’s case, the IMF bases its assessment of whether debt is sustainable on an unrealistic projection of a sharp decline in debt over the next five years, on the back of an assumed ramp-up in growth despite endless fiscal austerity and elevated interest rates. For this to materialise, a country with a tax take of just 10 per cent of GDP will need to double its growth rate and run primary surpluses -- a feat Pakistan has only ever achieved during the American-led ‘war on terror’, fuelled by foreign grants -- indefinitely.

The IMF’s DSA framework itself acknowledges that such an adjustment is a Hail Mary pass, with only a one-in-seven chance of success based on international experience, and that the fund’s record of forecasting Pakistan’s public debt is spectacularly poor. If only these red lights in its DSAs were taken more seriously in the IMF’s assessment of debt sustainability.