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The international community is poised to embark on a new round of debt relief in response to the COVID-19 pandemic. Bilateral G20 creditors (Paris Club and non-Paris Club alike) announced this week a moratorium on debt payments for low-income countries (LIC) until the end of the year. And the International Monetary Fund Board just approved debt relief for 25 countries. These actions set in motion what will likely become a major international debt relief exercise. But what about commercial creditors, which account for almost 20 percent of low-income countries’ total debt stock? The G20 is calling on commercial creditors to follow their lead and extend a moratorium on their debt. But if past is precedent external commercial debt could be shaping up to be major fault line in the debt relief process moving forward.

A key challenge that the Highly Indebted Poor Countries (HIPC) Initiative—the landmark international debt relief initiative launched in 1996—faced was providing comparable treatment to all creditors and achieving full creditor participation in the initiative. For the architects of HIPC, including the major international financial institutions and the Paris Club creditors, the cancellation process was fairly straightforward. But for non-Paris Club and commercial creditors the path to comprehensive debt-relief tended to be more fraught. This was particularly true for commercial creditors, who only made up about 10 percent of HIPC’s external debt stock but whose participation was essential to the initiative’s success. If countries were compelled to use the fiscal space created by multilateral and bilateral debt relief to repay commercial creditors, the viability of the HIPC initiative would have been undermined.

To bring commercial creditors into the debt relief process the World Bank set up a commercial debt buyback scheme. In theory, the plan would extinguish a country’s external commercial debt by repurchasing the paper at a small fraction of its face value. This often turned out to be an interesting proposition for private commercial creditors that had written the loans off their books. It was less interesting for distressed debt investors who were intent on recovering a big chunk of the face value of the loan.

But how did it work in practice?

The commercial debt buyback process was financed through the World Bank’s Debt Reduction Facility (DRF). The DRF was set up in 1989 but became explicitly linked to the HIPC initiative in 2004 in an effort to increase private sector participation. The facility was administered by the World Bank’s International Development Association (IDA) and financed through a combination of International Bank for Reconstruction and Development net income, donor contributions, and beneficiary governments’ own resources.

The first step in the commercial debt resolution process was to locate the totality of the external commercial debt, identify who held the debt (since debt often changed hands in the secondary market) and lay out a strategy to resolve it. The next step was to determine the size of the discount that would be offered to the creditors. The discount – i.e. the amount that the country would pay to repurchase the debt—was determined based on the “comparability of treatment” principle that underpinned HIPC and required that the discount applied to commercial creditors be comparable to that offered by bilateral creditors. The average discount price was 8.3 cents on the dollar.

The key for a successful debt buyback was getting as many creditors as possible to participate in the deal. Since this was an entirely voluntary process, high levels of creditor participation could require extensive rounds of negotiations and outreach. Per DRF rules, 90 percent of eligible debt had to be tendered in each operation and buybacks often did not go forward if they did not have robust creditor participation; as a result, between 2005-2010 the buybacks that went forward had a 98 percent participation rate. But participation was never a given. Many commercial creditors instead chose to pursue full recovery through legal measures. For instance, distressed debt investors—otherwise known as vulture funds—often were able to obtain court rulings that gave them legal authority to seize a HIPC government’s overseas assets in a given jurisdiction. As a result, holdout creditors sometimes ended up getting better deals through court orders than the creditors that participated in the buyback operation. In some cases, frustrated holdout creditors came back to the negotiating table for a second debt buyback. (In Liberia’s case the totality of its commercial debt was extinguished over the course of two debt buybacks.) Overall, the DRF supported 25 operations retiring $13.8 billion in external commercial debt.

It’s likely that in the months ahead policymakers will need to revisit the DRF model, especially if broader debt relief is the next step in international community’s measures to combat the economic fallout from the coronavirus pandemic. This will also require donor willingness to recapitalize the facility which will no doubt be a heavy lift, especially at a time when there are many competing demands on foreign assistance. But commercial debt will be a salient feature of a LIC debt-workout process since it represents a sizeable portion of total IDA debt holdings (around $50 billion) compared to what it was during the HIPC process (an estimated $14 billion). Moreover, many LICs have now gone to bond markets—which was not the case for HIPC countries -- so they have a whole new class of creditors that they will need to contend with. At the same time, only about a dozen IDA countries have commercial debt service to private creditors with ratios that exceed 20 percent of total debt service, so any future debt buyback operation might only be limited to a select group of countries. But one thing is for certain: distressed debt investors will be back. And HIPC’s past could be prologue here as preparations are underway to lessen the severity of the pandemic in the world’s poorest countries.

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CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.

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