THE COMING SOVEREIGN DEBT DISASTER

This article was first published on July 1, 2020, by The American Interest.

This Time It’s Really Different

FRANK VOGL

The COVID crisis has injected a legitimate humanitarian imperative into bailing countries out of a sovereign debt crisis of historic proportions. The hastiness of the bailouts, however, is setting up all sorts of dire unintended consequences.

There has never been an international sovereign debt crisis on the scale of what is now unfolding. The International Monetary Fund (IMF)—the lender of last resort to governments—reports that more than 100 countries have requested emergency loans.

Normally, the IMF looks solely at the levels of economic distress in determining whether to grant loans. This time, humanitarian concerns are running right through what is rapidly evolving into an unprecedented disruption of global sovereign bond markets. The COVID-19 pandemic is producing severe balance-of-payments strains for many economies. Many debt-laden nations are in urgent need of food, medical and other essential imports, and require emergency loans and debt relief.

For years, governments across the world have raised vast sums through international bond issues—World Bank data shows that excluding China, the total stock of long-term international debt held by middle- and low-income level countries amount to approximately $4.8 trillion.

The bankers who manage these issues, and the investors who purchase them, have had a single-minded focus on securing a high rate of return on their cash. They have frequently ignored the fact that many bond issues have been on behalf of kleptocratic regimes—indeed, the international bond financing system has enabled international grand corruption.

COVID IMPACT

No matter. Now there is a COVID-19 induced global economic crisis and the sovereign debtors need more cash. All of the debtor nations are finding paths to fresh cash or to official moratoriums on debt repayments, irrespective of the corruption that pervades a considerable number of these borrowers.

Some 3,000 IMF officials are processing the loan applications from their homes as the pandemic lockdown continues, and the IMF’s Executive Board of Directors is approving the deals as rapidly as it can. The IMF bailouts are coming fast and furious, supported by multi-billion dollar aid packages from the World Bank, and debt moratoriums have been offered to approximately 70 of the world’s poorest nations by the United States and other leading Western governments.

This whole rescue edifice is ultimately financed to a most considerable degree by Western taxpayers. If the emergency loans are not repaid, and the poorest countries cannot service their debts once the moratorium periods end, then we will be paying the bills.

And, indeed there are real risks to these bailouts. Many of the debtor countries have kleptocratic regimes that have got into their debt difficulties in large part because of the theft of vital national currency reserves by public officials. There is absolutely no guarantee that portions of the emergency cash now flowing into the central banks of dozens of countries will not be stolen.

Time and again when nations get into sovereign debt difficulties, the IMF mounts its white horse and charges to the rescue as the global lender of last resort. Sovereign debtors count on the Fund, as do the international capital markets. With this latest crisis, the IMF has had to assemble a giant cavalry to charge forth on a rescue mission without precedent.

COMPOUNDING PROBLEMS

According to IMF staff economists, as of the end of May, “emerging markets saw capital outflows of over $100 billion, nearly twice as big (relative to GDP) as those experienced during the Global Financial Crisis.” And when the U.S. Federal Reserve started its vast program in late March to provide cash to the financial markets, governments in emerging markets and developing countries rushed to raise new cash through bond issues, amounting to more than $70 billion, according to IMF Managing Director Kristalina Georgieva.

Compounding problems for many oil-exporting countries has been the acute volatility in global oil prices. Many of these oil-exporters, from Russia to Nigeria and Angola, have well-entrenched corrupt regimes. So, too, do many other countries with long records of accessing the international bond markets, whether Belarus or Egypt or Turkey. Citizens of these and many more countries who have foreign currency in their safes and under their mattresses have been urgently striving to move their loot to safer havens, and the capital flight is mounting.

The IMF is providing funds through its “Rapid Financing Instrument,” a facility that enables countries to get cash very quickly without any of the traditional IMF conditions. The funds are designed to guard against balance-of-payments emergencies and ensure that the borrowing countries can pay for essential imports. The IMF has no tools in place to monitor how the borrowing governments use the cash that it is now lending under its emergency programs. Eventually, the IMF will do audits, but this will be long after the cash has been disbursed.

Given the profiles of many of the elites in charge of these needy countries, much of the money may find its way into secretive holding companies registered in offshore tax havens, or into numbered accounts in Swiss banks. And as a result, many countries will be back to the IMF in due course for more traditional loans of a longer-term nature. Fund officials have told me that some of these future negotiations will be tense if the borrowing governments cannot account fully for how they used their emergency loans.

Many of the poorest countries have successfully campaigned for a total official foreign debt moratorium. Western creditors have complied and are likely to extend the current moratorium beyond the end of this year, quite possibly forgiving much of the debt in due course. Quite a number of these countries also need emergency cash and the IMF is opening its “Rapid Credit Facility” for them that provides concessional loans with no conditions attached. Adding debt upon debt is the World Bank, as well as the other multilateral development banks, who are now processing billions of dollars of emergency loans to add to the economic relief demands and support efforts to deal with the healthcare crisis caused by COVID-19.

RESTRUCTURING and DEFAULT

As an example, take Argentina, which has defaulted on its sovereign international debts nine times through the decades. It has failed in recent weeks to reach a debt restructuring agreement with its private creditors who hold $65 billion of its bonds. The country has a long history of governmental grand corruption and current Vice President, and former President, Kristina Kirchner, has only escaped a trial on corruption charges because she holds an official political office. Nevertheless, the IMF is quietly pressing creditors behind-the-scenes to be generous with Argentina in the current negotiations, arguing that the COVID-19 crisis demands a resolution of this bond debacle.

Overcoming the debt difficulties that are building for dozens of middle-income and developing countries in order to sustain an eventual economic recovery, “may be the most severe financial problem we face in the post-COVID world,” according to former U.S. Treasury Secretary Larry Summers. Summers notes that in past crises almost all the international debt of these countries was on behalf of governments with sovereign guarantees. Now, he points out, in addition to the official sovereign debts, which Western governments and multilateral institutions like the IMF may have to deal with (often by injecting fresh cash, or writing off debts for the very poorest countries), there is a formidable amount of debt owed by governments to private international investors, debts created by corporations in developing countries that were able to raise cash through bond issues, as well as very large debts owed by many nations to Chinese government institutions.

At least part of the blame for this sorry state of affairs lies with the Western financial sector. Investment banks, for example, make hefty commissions from managing sovereign bond issues on behalf of governments with shady records and questionable creditworthiness without any measurable reputational risk accruing to them. Investors themselves—the hedge funds, the wealth management groups at major banks, the pension funds, and others—happily line up too, seeking yield on sovereign debt from emerging market countries at a time when U.S. Treasury bonds are paying almost nothing.

BOND MARKET BRIBES

But scratch a bit below the surface of the deplorable state of “business as usual” and you will see a more deeply troubling picture. Goldman Sachs, for example, has yet to resolve its legal entanglements with both the U.S. Department of Justice and the Malaysian justice authorities that relate to sovereign debt. Two senior executives of the bank not only allegedly bribed Malaysian officials to win the contract to raise around $6 billion in international bonds for the government’s economic development fund (known as 1MDB), but those same executives allegedly helped then-Malaysian Prime Minister Najib Razak and his cronies to steal approximately $4.5 billion of the proceeds.

Similarly, a group of bankers, including a trio of senior executives at Credit Suisse in New York, arranged bonds issues for over $2 billion guaranteed by the government of Mozambique for use in infrastructure projects between 2013 and 2016. According to an unsealed indictment from March 2019, the bankers, investment managers, and Mozambican government officials allegedly organized “a brazen international criminal scheme.” This involved the theft of around $200 million. The state-owned companies in whose name the bonds were issued defaulted on around $700 million as the bonds came due. The bankers pleaded guilty to assorted charges, including money laundering.

There are of course many other ways in which banks go about seeking to obtain lucrative contracts to manage sovereign bond issues. For example, banks frequently provide substantial gifts to senior Chinese government officials and hire the relatives of powerful officials connected to state-owned companies that subsequently provide business to the bank. In 2019, a Securities and Exchange Commission investigation found, for example, that Deutsche Bank hired the daughter of the chairman of a Chinese state-owned enterprise, just before entering into business with the Chinese company. (Deutsche Bank settled the case, along with similar allegations about hiring the relatives of Russian officials, for $16 million without admitting or denying wrongdoing.)

China benefits in other, more subtle ways. The United States, Japan, and the West European countries strongly support the debt moratoriums, the emergency no-questions-asked loans, and the country bail-outs. After all, the entire global financial system relies on these instruments as a backstop for its casino antics. Beijing, for its part, is the largest creditor to a large number of countries in sub-Saharan Africa, Central and Western Asia, and in other regions as well. Combined, some 50 developing and middle-income countries owe China more than $380 billion.

For the most part, the terms and conditions of these loans are not publicly disclosed by either the Chinese or the borrowing governments. Many of the loans have supported infrastructure development, including China’s “Belt and Road” program. In some cases, the Chinese may be forced to restructure their loans. But as they do, they will be sure to extract further concessions that enhance their political influence in the borrowing countries. In other cases, the borrowers will have to use the IMF and other similar cash sources to finance their debts to the Chinese.

SYSTEMIC CHALLENGE

The mounting sovereign debt crisis raises fundamental issues about the whole system of international government bond issues—a system where each key component cries out for reform.

The ease with which even highly corrupt governments can raise vast sums of cash routinely in the global markets highlights the failure by investors—mostly institutional investors—to do meaningful due diligence. All they seem to look at is yield—they can earn 0.4 percent on Amazon bonds or more than ten times as much on 4.7 percent Credit Bank of Moscow bonds.

The investor mentality reflects a culture in finance that is driven solely by the desire to make large bonuses fast. The culture of short-term profit maximization is dominant. It was a major cause of the 2008 financial crisis and it profoundly influenced the irresponsible activities so evident in the sovereign debt arena now. Many changes are needed, starting with changing the incentives and compensation systems to focus on long-term goals and to penalize those whose short-sightedness ends in substantial investor losses.

Boards of directors at banks and investment firms need to be far more engaged in setting standards, and in treating CEOs harshly when employees engage in reckless activities to make quick profits. Boards, not regulators, are the only ones that can fundamentally change the culture in institutions. Leading central banks have engaged in promoting voluntary approaches by the private sector in recent years, stimulated in part by two important reports on the topic by the Group of 30, the association of former finance ministers and central bank governors and prominent elder statesmen of banking. So far, however, the reform progress has been slow.

There is scope for significant change at the lender of last resort: the IMF. The Fund and other official lenders need to do far more to monitor how their emergency loans are being used by borrowing governments and deploy safeguards to prevent theft of such funds. The Fund’s counterparts are finance ministries and central banks and, when it comes to the immediate emergency of COVID-19 related funding, it has not raised with borrowers the possibility of third-party monitoring. The Fund could consider, for example, hiring civil society organizations in many countries to perform this vital role, together with experienced journalists.

The IMF also needs to engage with the investment community. Its annual reviews of all national economies need to be sharper in terms of warning investors of the real risks that may exist in countries. These reports should also highlight the ways in which governments have used their borrowed funds, and should pay more attention to corruption matters. Ukraine, for example, received a $5 billion COVID-19-related IMF loan on May 21, 2020, after demonstrating that it is implementing significant anti-corruption measures. The IMF was tough on Ukraine, but so far this has been an exceptional case. It should instead serve as an important precedent. The broader message from the IMF to investors needs to be clear: “We will not bail out governments that default on their bonds if it is clear that proceeds from such bonds were stolen.” Threatening to revoke their backstop should put yield-hungry investors on notice.

LAUNDERED CASH

Finally, the unprecedented sovereign debt problems cannot be separated from issues related to curbing illicit international financial flows. The harder it becomes for kleptocrats to launder their cash into Western capital markets, the more there will be sensitivity in borrowers and investors alike that the integrity of all aspects of sovereign international borrowing is important.

Many initiatives are now gaining traction, such as strengthening anti-money laundering enforcement and ensuring transparency in the beneficial ownership of secretive holding companies, mostly registered in offshore tax havens. But there are no major international anti-corruption organizations that are focusing on the vast, albeit complex, world of sovereign debt. This needs to change—there is a great deal of work to be done and a lot of stolen loot to be accounted for.

The sovereign debtors are in deep trouble, but the rescue programs are deemed, at least for now, as absolutely essential by Western governments to secure the soundness and stability of the global financial system. No American government—be it led by Democrats or Republicans—will want to see the international sovereign debt debacles spill over onto Wall Street. A stiff price, in terms of unprecedented Western/IMF/World Bank aid and loans, is being paid to ensure this goal.

If we’re not careful, the near-term winners will be those kleptocratic regimes that are gaming the system. And longer-term, China, at least in terms of its geopolitical ambitions, may emerge as the biggest winner in this global debt debacle.