China and the COVID-19 Debt Crunch

“It’s like they grab you by the neck and pin your back to the wall,” the ambassador said. 

We were having a fairly candid discussion about negotiations with a lender over his country’s debt levels, a country that had, by then, raised debt from all over the world – the private sector through Eurobonds, multilateral lenders, as well as bilateral lenders and China, too. And I understood. That fear of being helpless, unable to move, is what a number of politicians, government representatives, and diplomats around the world are concerned about right now, as the COVID-19 pandemic spreads.

Opinion shapers, experts, and journalists are using phrases such as debt crisis, debt diplomacy, debt relief, debt forgiveness, and debt moratoriums. Countries with alleged “debt problems” are being downgraded by ratings agencies. In February 2020, even before revising global growth forecasts due to COVID-19, the International Monetary Fund (IMF) classified half of low-income countries (LICs) around the world as already “debt distressed” or at high risk of becoming so. There have been specific calls for China, as a lender reported to play a huge role in many countries’ debt positions, to cancel or at least suspend requests for debt payments.

Are these concerns backed up by facts? And what is the solution for Asian, African, and other developing countries – including those part of China’s Belt and Road Initiative (BRI)?

Of all the solutions being discussed so far, including those seen as fairly radical, none address the fundamental problem of helplessness the ambassador shared in our candid conversation years ago.

The right solution is a re-imagining of the debt system to have borrowers “club together.”

Most Poor Countries Are in Debt to Others – And Need to Be

I am loath to use the analogy of the individual in debt to extrapolate to a country level, but in order to explain the complexities being generated by the COVID-19 crisis for countries in debt, I think it might just be helpful.

The majority of individuals across the world have debt, from microloans to mortgages. So do the majority of governments. Both rich and poor governments, on behalf of their citizens, have debt. For most rich country governments, their debt is often lent from within their own countries – their own central banks, or their own private banks. But for most poor country governments, the debt has been lent to them from external sources – by other governments and multilateral organizations, as well as private lenders.

Why do they need debt? Just like individuals often can’t manage to pay for university (student loans), a new business, or even a new home (mortgage) upfront, governments often need debt to pay for roads, trains, new housing projects, or to invest in the quality of their education or health systems. The African Development Bank has estimated that African countries cannot raise taxes or other funds domestically for basic infrastructure needs valued at over $68 billion per year, let alone all the other key requirements of their citizens. Asia is better placed, but still has major financing gaps, estimated at $141 billion per year.

China is already filling some of this gap.

China Has Been a Very Useful Lender for Many Poor Countries

In the recent past, China has been accused of “debt diplomacy” – effectively luring in African and Asian governments to take certain foreign policy positions on the promise of extra loans. The assumption behind this narrative is a lack of agency and accountability on the part of the governments that borrow from China. However, there are logical, rational reasons for Asian, African, and other developing country governments to seek loans from Chinese banks in addition to other private banks, other governments, or the multilateral banks.

First, as already mentioned, these governments need to look externally. They can’t get the necessary financing from their own economies, nor build infrastructure or invest in other ways to grow without loans. In particular, the point at which countries “graduate” from being low income and move to being lower-middle income is precipitous. A 2017 study by Galiani, Knack, Xu, and Zou found that when countries graduate over this threshold, aid falls by 59 percent (as a share of GNI). However, access to new loans – even from China – is not always easy. A recent study by Morris, Parks, and Gardner at the Center for Global Development analyzed a dataset of 157 countries, and compared World Bank to Chinese lending terms (grace periods, interest rates, and maturities) for projects over the 2000-2014 period. They found that while Chinese lending terms appear to be more challenging (less concessional) than those for World Bank projects, they also found that loans provided by Chinese institutions tended to be larger than those provided by the World Bank (the average size of loans was $307 million and $148 million, respectively), potentially indicating that Chinese banks lend for types of projects that the World Bank and other multilateral institutions do not. The authors also found that China provided loans to 30 countries that the World Bank didn’t, and that Chinese loan terms were comparatively easier (more concessional) than private sector terms.

Second, Chinese banks tend to employ a different methodology to assess loans compared to multilateral development banks, which means Chinese actors are able to offer loans in certain sectors – such as infrastructure – more easily and speedily. A 2018 study by the Infrastructure Consortium for Africa suggested that for some categories of infrastructure projects, countries have had to wait over nine years for project approval from multilateral banks. Part of the challenge is risk assessment. The fact is, China lends differently. Loan eligibility is typically conducted on the basis of projected returns from a specific project. The aspect of which country the project would be in, or “political risk” as it is sometimes termed, is a minimal consideration. In other words, Chinese lenders look at loans as business propositions, and worry less about individual credit history than other bilateral or multilateral lenders might. In addition, loans can be offered to fund projects that have been won by a Chinese company through a public tender process, which also speeds processes up.

Third, China has been open to debt cancellation and restructuring in the past. The official Chinese government position is that China will always respond and support countries that ask for assistance with loan management. A study conducted by my firm – Development Reimagined – in partnership with the Oxford China Africa consultancy in 2019 found that overall China had written off a total of $3.8 billion worldwide between 2000-2018, of which $1.7 billion was to Highly Indebted Poor Countries (HIPCs). Over the same time period, the United Kingdom and the United States provided $800 million and $2.3 billion, respectively, of debt relief to HIPCs across the world. Separately, a study by Rhodium Group found Chinese lenders have restructured or refinanced over 24 individual loans across the world over the past decade.

As a result of these rational factors – factors determined not just by China but also by how others in the lending system work – China has become a relatively more attractive lender to developing countries.

Estimates for the proportion of loans provided by China to developing countries vary widely, but, for instance, a study of 48 African countries by the Jubilee Debt campaign suggested that 20 percent of their debt was owed to China, versus 35 percent to multilateral institutions, 32 percent to private creditors, and the remaining 13 percent to the “Paris Club” – bilateral lenders such as the U.S., U.K., and France. A recent IMF paper suggested that since 2010, private sector bonds have been the fastest growing source of finance for several low-income countries. On the other hand, in a June 2019 working paper for the Kiel Institute for the World Economy, Horn et al claimed that for low-income countries between 2010 and 2015, total lending from China exceeded lending from the multilaterals and private sources.

But why does any of this matter in the context of COVID-19?

COVID-19 Is Creating New Costs and Making Debt Difficult to Repay

The COVID-19 crisis is not just a health crisis – it is a global economic crisis. At the individual level, as people around the world get laid off, furloughed, or can’t go to informal markets to trade, they are asking their lenders to give them grace periods or “mortgage holidays.”

At the country level, economies are suffering, especially those that are dependent on other countries for their income. The reduction in economic activity in the largest economies – initially in China and then Europe and the United States, in particular – has meant that poorer countries dependent on flows to and from these economies, including for tourism or sales of raw commodities such as oil, or consumer goods such as clothing or flowers, have faced difficulties. Their governments are collecting less taxes and jobs are under threat.

And then there has been the “lockdown” effect. For countries that have taken stringent action to curb the crisis – a category that includes African, Asian, and other developing countries – governments are having to spend a great deal of extra money. They have had to buy medical equipment and build new hospitals or quarantine centers that they did not foresee, while introducing new “pro-poor polices” like paying for free water and electricity to keep people at home, or giving out large cash transfers to vulnerable populations and laid-off formal and informal workers. Construction projects that were being financed by loans are also being delayed, as workers cannot go to them safely, which adds to costs.

With dramatically reduced financial inflows and mounting internal costs, then, COVID-19 is making it very difficult for governments to repay loans. 

My firm has estimated that so far African governments have budgeted over $44 billion to address COVID-19 – an average of 1 percent of their GDP – and have, on average, introduced at least three different types of policies to support the poorest people in their countries. Introducing these new policies so quickly is both complex and challenging to oversee and enforce. At the same time in comparison to richer economies, the spending is small, even in relative terms. The Center for Strategic International Studies (CSIS) has estimated that as of April 29, G-20 countries will spend approximately 9.3 percent of their GDP on domestic fiscal stimulus measures. What the poor countries have budgeted is not enough.

Thus, just as individuals are speaking to their lenders or mortgage providers as they face COVID-19 problems, governments are now speaking to their financiers because of the pandemic. The difference, however, is that rich countries can generate most of these extra funds from banks or lenders within their own economies, but poor countries – including those in Asia and Africa – must reach out to international lenders, including China, to help.

International Lenders, Including China, Are Responding

On March 25, two weeks after the WHO had declared COVID-19 a pandemic, and as Ethiopia itself detected a 12th case of the new coronavirus – after having closed schools and banned public gatherings nine days earlier – Prime Minister of Ethiopia Abiy Ahmed wrote an open letter calling for extended financial support to help African countries deal with the pandemic. A month later, on April 30, he wrote another open letter asking for debt cancellation for African countries. Based on the latest World Bank figures, in 2018, African countries owed around $494 billion to external lenders. Abiy’s request was the equivalent of an individual asking for a mortgage to be completely or at least partially written off.

By Abiy’s second letter, two groups of actors had responded to his initial request.

First, the member states of the IMF and World Bank – whose voting shares are dominated by the wealthiest countries in the world – agreed to help. Twenty-five countries, 19 of them in Africa, were given an average of $20 million in aid (as grants) to help fund their debt repayments. That’s similar to giving benefits or cash transfers to individuals to help pay their monthly loan installments. It acted as a “payment holiday” for the countries.

Then, one by one, member states of the IMF and World Bank agreed that if poorer countries met a range of criteria, they could get new “emergency” loans that would need to be repaid after three to five years. These loans would give the poor countries extra temporary spending power. So far, these types of loans have been made to 30 African and four Asian and Pacific economies, totaling over $15 billon. And it is likely that more will be made in the coming months. In total, 120 countries across the world have approached the IMF for support. 

Calculated using IMF shareholdings (quotas), that means the United States has effectively lent out an extra $2.6 billion (17.5 percent of the total) to low-income countries, Japan $1 billion, China $1 billion, and the U.K. $600 million.

Second, the G-20 – the group of the 20 wealthiest countries in the world, including China – agreed to a “debt service payments standstill,” which is, using the individual analogy, similar to a mortgage holiday. This meant that the 77 countries covered – of which 40 are in Africa – would not need to make any interest payments or other principal payments due to these 20 wealthy countries individually until at least the end of 2020, at which point they will resume (or be postponed again). On average, this should free up at least $159 million per country for urgent COVID-19 spending.

In addition, more recently, some private banks – which typically issue and manage debt with instruments known as “bonds” – have indicated a willingness to help, coordinated by the Institute of International Finance (IIF). However, based on past experience, this negotiation is likely to be the most protracted. Back in the late 1990s and early 2000s, when debt relief under what became called the Highly Indebted Poor Countries (HIPC) initiative was being discussed, the multilateral banks and governments cancelled debts around a year before private sector banks did. In addition, some practices by private banks went in the opposite direction. So-called “vulture funds” began to buy the debt of countries that had defaulted, and then sue the defaulting countries years later to get the funds back at much higher values. They effectively acted as “bailiffs” or “third party debt collection agencies” at the international level. This practice was eventually outlawed by several countries, such as the U.K., but there is a risk that it might resume.

Are these responses enough to help developing countries manage the economic damages of COVID-19? Could China do more and cancel debt unilaterally, and thereby encourage others to do so as well?

China Could Do More, But There Are Risks in Going Alone 

Being a relatively large lender does not confer a responsibility on China to be the first mover in being generous to debtors. However, it is possible in theory that being generous first could have positive impacts on how other lenders see the remaining debt and therefore help them to be more generous to their debtors, too.

Indeed, the international community has expressed so much concern about loans from China that any signal that China will somehow slash or defer debt first could be viewed positively. It could help developing countries argue that they have enough fiscal space to manage COVID-19 challenges and that any possible downgrades from ratings agencies are unwarranted. It could also help developing countries to avoid “default,” the equivalent of declaring bankruptcy, and thereby help protect them against being blacklisted from new loans for legitimate future needs.

For instance, China could restructure loans, and even set out openly the “principles” it will use so that countries can come forward with specific calculable proposals. For example, Chinese banks could say they will reduce interest rates for the lowest-income countries by, for instance, 2 percent, and for middle-income countries by 1 percent. Or Chinese banks could declare that loan repayment periods will be extended by five or 10 years. These could provide helpful “comprehensive” buffers for borrowers, not “one-size-fit-all” because they will adjust depending on the countries’ actual loan balance. Indeed, all lenders could use similar principles.

But action by China could equally be interpreted negatively by other lenders. For so many countries, Chinese lending is still seen as fairly opaque and therefore it is hard to fully understand the magnitude. Any declaration of how much debt is being cancelled or deferred by China could be seen as too much or too little. That could lead ratings agencies and private sector lenders to overreact and trigger a spiral: Defaults in all sorts of countries and multiple opportunities for dreaded “vulture funds” to sweep in where they can.

This is why coordination with other lenders – whether the G-20, or via the IMF and World Bank – is not just useful for China but also for developing countries – especially those that have not yet fully assessed or declared loans from China (or others).

What exactly should poorer countries be trying to get from China, and possibly others, as far as their loans are concerned? Are calls for full debt cancellation justified? 

Full Debt Cancellation Is Not Necessarily in Recipient Countries’ Interests 

Going back to the analogy of an individual, there are very few people right now who are asking for their mortgages to be written off as a result of the economic difficulties that COVID-19 is presenting. Anyone doing so would need to be ready to never get a loan again over their lifetime, appearing in all sorts of blacklists. Businesses similarly approach declaring bankruptcy with trepidation – and will usually do all they can to restructure their business, defer loans, write off loans (partially), get new investors, or offer new sources of collateral first before doing so. The consequences for credit worthiness in the future are harsh. Banks don’t appreciate write-offs or bankruptcy either – these sorts of defaults, especially if widespread, make their own portfolios look poor. We need to just look at the 2008 financial crisis to see this.

And this defines what developing counties don’t need. They don’t need more expensive loans (which will just make the problem worse), nor just the equivalent of short “mortgage holidays,” but they also don’t need a total “write-off” of existing loans.

So what is the solution? The solution is a significant, transparent, and coordinated restructuring of the system for debt to developing countries. What’s needed is a borrower’s club.

COVID-19 Makes a Re-Imagining of the Debt System Urgent 

COVID-19 is not just a huge shock, it is also exposing vulnerabilities in the world system and in ourselves that in the past we were able to work around or hide. How countries issue, use, and manage debt globally is one of those vulnerabilities. The global debt system is opaque and problematic on so many levels. Some countries hide their loans; some hide their debts. Some countries are assessed as having debt problems while others with the same relative levels of debt are not. For instance, take Mauritius, which, according to World Bank figures has the seventh worst debt-to-GDP ratio in Africa; while Kenya’s ratio is far smaller, it has recently been downgraded by ratings agencies.

It is also incredibly challenging to compare and contrast the international marketplace for loans. It is difficult to obtain information on the interest rates, grace periods, or repayment periods for the loans from many lenders (including China), and in reality, these figures are often negotiable.  In addition, some lenders coordinate through mechanisms such as “the Paris Club” as well as by injecting money into multilateral banks to pool their loans. New lender coordinating mechanisms are being created – for example an “Africa Private Creditor Working Group” (AfricaPCWG). But there are no such coordinating mechanisms for borrowers. The system is incredibly skewed toward meeting the immediate needs of creditors. 

If a long-lasting solution to COVID-19 debt problems is to be sought, the multilateral debt system itself needs to be re-thought and re-imagined.

Just under two years ago, my firm organized a retreat for African ambassadors based in China, with special guests including the astute former finance minister of Guinea, Malado Kaba. One of the suggestions that came out of the discussion was a regular meeting of African finance ministers to discuss and exchange the experiences of their loans with China. Over the past few weeks, under the leadership of another incisive woman, Executive Secretary of the UN Economic Commission for Africa Vera Songwe, we have seen African finance ministers convene to discuss their debt situations, come up with solutions, and also initiate discussions with certain lenders and groups, for example the IIF and AfricaPCWG. This extra coordination is warranted at this time, but could become unwieldy or unfocused. However, it could have a real effect if it could actually lower the risk profile for African and other borrowers. How?

Let’s go back to the individual analogy. The world is now familiar with microloans. Back in 1976, when the Grameen Microfinance Bank was first created in Bangladesh, they were revolutionary. Previously, people had only been able to take out loans from banks as individuals, which left many out of the system, especially the rural poor, who had no regular predictable income or collateral to guarantee repayments with. Grameen’s microloans enabled people to club together to take loans, as well as make slower and smaller affordable repayments together. The system, though it had faults, has been replicated globally and allowed hundreds if not millions of people to get access to finance to durably lift themselves, their families, and their friends out of poverty.

This kind of revolution is necessary in the international financial system. Current international loan markets, as they are shaped, exclude and penalize the poorest countries in the world – the very countries that need loans most. The means by which Chinese banks assess projects as if they are “business propositions” is the closest the world currently gets to a less exclusive system, but it is still not enough. Previous requirements for debt relief and restructurings, and now COVID-19, prove that the Chinese loan model is also vulnerable to external shocks.

A borrower’s club – replicating the groups of poor people that first came together to get loans from the Grameen microfinance bank – could provide a long-term solution. The countries would together apply for finance, agree to projects in each country, be accountable to each other for small regular repayments, and agree upon their own relevant thresholds or criteria for internal defaults (e.g. oil price falls). The club would collate and issue repayments as one to different lenders on different schedules – while also keeping aside a certain amount as a cushion.

The huge benefit to lenders of such a club would be similar to the benefit microfinance provided for banks. The borrower’s club would remove the individual “country-based” and “political” risks that underlie so many restraints of the current debt system. Lenders would be able to look at new loans as real growth or business propositions, and use the club’s accountability mechanisms plus reserve cushions as collateral. The borrowers would essentially take on and manage more risk, yet get more debt in order to grow.

Reinjecting Equity and Boosting Transparency

This borrowers club can also be combined with other suggestions that have been made for solving the COVID-19 debt challenge.

For instance, Gallagher, Ocampo, and Volz have proposed that IMF member states – as they did after the financial crisis in 2008-2009 – issue or reallocate special drawing rights (SDRs) held by the IMF for countries to deal with COVID-19. Historically, SDRs have been issued in proportion to member states’ quotas – meaning the largest countries, which already have their own domestic debt management systems, get the most SDRs – but it is not impossible for the member states to agree to allocate them to middle- and low-income countries only, or everyone but the G-20, for example.

More or reallocated SDRs would allow countries in debt to exchange those SDRs for finance to put toward existing debts or pay for new expenditures, similar to drawing down from a “trust fund” they until now didn’t have access to, or a business generating “equity” from new collateral. Those countries that don’t need to draw down would not have to, but could save the SDRs for another “rainy day.”

Indeed, a borrower’s club could be initially focused around managing the new or reallocated SDRs.

Alongside this, and to deal with the long-term vulnerabilities that COVID-19 is exposing, calls have been made for lenders, including China, to encourage borrowers to manage their debts better. For instance, debtor countries should develop systems to classify loans and grants, work out their debt profiles, as well as publish figures consistently and annually. Back in 2013, Harvard economist Sendhil Mullainathan and Princeton psychologist Eldar Shafir explained in the book Scarcity how individuals who are most in debt often have the worst capacity to manage it. It is why in the U.K., for example, nongovernmental organizations, such as the Citizens Advice Bureau, exist. While the IMF and World Bank often offer to help with debt transparency, it might be preferable for an arms-length body – potentially funded by but not answerable to any lenders – to help. There are systems to build on – for example, aid management systems and the Global Partnership for Effective Development Cooperation – and again, a borrower’s club could create or propose a relevant “monitoring” institution.

The Bottom Line: Debt From China Is Only One Challenge 

The COVID-19 crisis is forcing a reassessment of how we live and function, both at the individual level and at the international level. China has been lending more and more to poorer countries, and in many cases is a key port-of-call for those countries in seeking more debt and support to grow as well as to survive COVID-19. But it is a fact that countries are turning to China because the international system for loans is broken. Too many countries still “find their backs against the wall” as that one ambassador put it to me, many years ago. Not enough finance is accessible to poor countries to deal with COVID-19, let alone meet the Sustainable Development Goals by 2030, yet the same countries are also accused of having too much debt. 

Complete debt cancellation – rather than alleviating pressure – could actually send countries into a beyond dire situation, harming their economies and shutting off avenues for large poor populations to escape poverty for decades. COVID-19 is truly exposing the world’s debt conundrum. The time is now for all lenders and borrowers to use creative thinking to construct long-term solutions. 

If not now, when?