Liquidity support
For outright liquidity provision, large SDR allocations could be considered. This tool was used very successfully in the wake of the 2008 global financial crisis without any significant adverse side effects. While there wasn’t enough support from the IMF membership for such a move when it was first discussed in the spring of 2020, two factors could change the calculus: the absence of the hoped-for ‘V-shaped’ return to pre-pandemic normality in the real economy; and the change of political leadership in the US, which has veto power over decisions on SDR allocation. This means that as much as SDR 1 trillion ($1.4 trillion) could be allocated over the course of the next 14 months. Half of this amount could potentially be available any time before the end of 2021, with a further SDR 500 billion available from the start of 2022 (the ceilings, and their phasing, are based on thresholds imposed by US legislation, below which SDR allocations do not require congressional approval).
Each SDR 500 billion allocation would provide $21 billion of relief to DSSI-eligible countries without requiring costly or lengthy formalities, as well as over $150 billion to emerging markets and developing countries overall. Most countries in these groups are potentially vulnerable to sudden future liquidity droughts that would challenge their ability to finance themselves.
The impact of these SDR allocations could be further increased by setting up a trust or facility to ‘recycle’ SDRs from countries with no need for them – notably, countries such as G7 members that are issuers of reserve currencies. Such a trust would need to be managed by a multilateral institution. Depending on the preferences of participating countries, the trust could either just on-lend the SDRs it receives to countries in need of liquidity, or use them as equity to back up market-based borrowing, thereby leveraging the original SDR allocation and amplifying its impact.
Each SDR 500 billion allocation would provide $21 billion of relief to DSSI-eligible countries without requiring costly or lengthy formalities, as well as over $150 billion to emerging markets and developing countries overall.
Any decision on implementation of an SDR allocation would rest squarely with the IMF and its Board of Governors. Unified impetus from the G7 should be sufficient to make at least the first proposed allocation happen. In 2009, it took less than five months from endorsement of the idea at the UK-hosted G20 summit in early April of that year for the allocation to take effect in late August.
Setting up a trust would arguably be more of a greenfield effort, though a template for such a mechanism exists. Moreover, unlike with SDR allocation, it would not depend on the support of a specific percentage of the IMF membership. Rather, it could proceed on the basis of a coalition of the willing among SDR recipient countries that do not intend to use their allocations. The World Bank or regional multilateral development banks (MDBs) would need to agree to manage the trust, but they could be expected to do so if a majority of their shareholders requested it.
Debt restructuring
At their November 2020 summit, G20 leaders endorsed a common framework for sovereign debt restructuring. The new framework commits all official creditors – including China, the largest non-Paris Club creditor – to taking part in debt restructurings requested by DSSI-eligible countries in the future. This constitutes a significant step forward. However, it will also be important to learn from past mistakes, drawing lessons from previous debt crises and their aftermath. The key requirements are likely to include:
- Early and constructive engagement with creditors (with a view to avoiding default).
- Credible, independent debt sustainability analysis.
- A robust policy framework extending many years into the future.
- A vision of how to meet sensible financing needs over the medium and long term. For the poorest countries, this will probably require greater recourse to grants or highly concessional loans – which donor countries and MDBs can offer cheaply given the global low interest rate environment. SDR allocations can help here too. For market-access countries, issuing sustainable bonds – possibly including a built-in adjustment mechanism such as GDP-linked payments – should be part of the solution.
- Stronger alert mechanisms to course-correct when countries appear to be back on a path towards debt distress.
- Investment in the creation of a comprehensive public repository of sovereign and publicly guaranteed debt, possibly tied to strong expectations in the new common framework that any debt not disclosed in the repository would be treated as a first-loss absorber. The repository could rely on a combination of standard reporting tools, following the template for data on reserves developed by the IMF after the 1997–98 Asian financial crisis, and strong incentives, such as mandatory use of the template for any country applying for debt relief via the DSSI or for concessional lending from international financial institutions (IFIs). Over time, one would expect that markets, too, would reward countries willing to report their public debt transparently within the strictures of an agreed global standard. Compliance with such a standard could be audited on a periodic basis by the IFIs, with their conclusions made public.
The G7 and G20 could commission the IMF and World Bank to analyse the past 20 years of debt restructuring, going beyond mere assessments of process efficiency (as in the recently published review) and focusing instead on understanding what is needed to make the return to solvency long-lasting. The G7 and G20 could then consider jointly committing to the recommendations emerging from this exercise. This should be done ahead of the upcoming IMF review, due in 2021, of its ‘lending into arrears’ policy, which is where a lot of the recommendations would need to be reflected.
Frameworks for policy normalization
The IMF could usefully develop best practices or guidelines to help emerging-market central banks and fiscal authorities normalize policy smoothly once the brunt of the COVID-19 economic shock has passed, and before market pressure forces them to act. A Flexible Credit Line (FCL) – a facility that offers countries with very strong fundamentals de facto unlimited access to IMF resources on a precautionary basis – could be offered to countries willing to commit to these guidelines. This would provide the authorities in participating countries both with an incentive to pursue sound policies and with the credibility to reassure markets that they will do so, thereby making it far less likely that the FCL would need to be drawn on. As is the case now, the IMF would have the option of declining to renew FCL access, when reviewed every six months, if the member country did not adhere to the guidelines.
Of course, in some countries the fundamentals may have deteriorated too much to permit FCL qualification. In these instances, conditionality-based IMF-supported programmes may prove necessary. Even then, committing large amounts on a precautionary basis may be a good way to smooth the transition from exceptional macroeconomic policies without creating unacceptable political stigma.
The IMF has ample lending capacity, having used up only about $150 billion of available funds of roughly $1 trillion; indeed, it has committed only $40 billion since the start of 2020. However, it would be advisable for IMF member countries to review the adequacy of IMF resources on a more forward-looking basis should the aforementioned change in FCL use be approved. Member countries could also conceivably put in place new contingent resources, which could include the following: an increase in the New Arrangements to Borrow (NAB), which are standing collective borrowing agreements; or a new set of bilateral lending agreements that would be available as a back-up on an as-needed basis.
In the past, efforts to develop new IMF precautionary facilities giving countries access to large resources relative to their IMF quotas have been hampered by fundamental differences between, on the one hand, the views of potential borrowers as to which features make such facilities appealing and, on the other, the concerns of a subset of creditor countries anxious to avoid moral hazard and open-ended commitments. The creation in April 2020 of the ill-fated Short-term Liquidity Line is the latest illustration of these difficulties. It might therefore be advisable for the G7 to convene a working group with officials from large emerging markets to explore whether common ground can be found on a blueprint for enhanced precautionary facilities, the details of which the IMF could then elaborate.
Emerging-market capital market development
There is growing investor appetite globally for impact investing, which emphasizes the environmental and social benefits of investments as well as their financial returns. Where macroeconomic fundamentals are healthy, there is likely to be substantial demand for green and social bonds issued by emerging markets and developing countries, both in hard and local currencies.
However, the market for impact investing is still nascent. Liquidity is limited. This alone is a significant deterrent for many investors, who would otherwise welcome both the higher yields offered by emerging-market debt and the potentially positive contribution of impact investment to meeting the UN’s Sustainable Development Goals. In addition, perceived and historical risks remain too large for many investors to stomach. Conversely, many potential issuers fear having to pay a liquidity premium for issuing sustainable bonds; as a result, only a few have done so to date in emerging markets despite the abundance of projects that would qualify for this type of financing, particularly in a post-COVID-19 era in which the ‘build back better’ mantra will come to the fore. Collective action can help on several fronts:
1. Jumpstarting emerging-market sustainable bond issuance
- A simultaneous commitment by G20 members to finance a significant part of their funding needs in coming years through sustainable bonds would help to jumpstart the market, and would remove stigma about the returns associated with such instruments.
- In turn, the existence of a widely diversified market would increase the appeal of this nascent asset class to global investors.
- A broadly accepted framework already exists for defining a sustainable bond, which typically consists of a green bond, a social bond or a combination of both. The framework was developed by the International Capital Market Association (ICMA), and was used recently by Mexico for a very successful issuance. G7 and G20 members could usefully endorse this framework and commit to abide by it in their own issuance of sustainable bonds. This would considerably reduce the risk of ‘green-washing’, and limit the idiosyncratic due diligence requirements for each new issuance that currently hold back a number of potential investors.
Once issuance starts occurring at scale, liquidity concerns should diminish and demand for sustainable bonds should become entrenched, possibly even exceeding supply – as is now often the case for green bonds in developed markets, where a ‘greenium’ thus applies. Investor appetite will be also helped by increasing recognition that exposure to sustainable assets can make portfolios more resilient. Moreover, research suggests that climate change may over time make traditional forms of emerging-market debt less attractive for global investors because of its greater exposure to adverse impacts. Emerging-market sovereigns may see in the issuance of sustainable bonds a way to counter this development.
2. Exploring new ways to deploy official development assistance (ODA) and leverage MDB balance sheets
MDBs could be tasked by their shareholders to develop a menu of options, consistent with their respective mandates and institutional constraints, to use their balance sheets in a way that directly supports capital market development in emerging markets and developing countries, but with an emphasis on local-currency markets rather than on primarily lending directly to sovereigns and corporates. For example, the following approaches could be considered:
- De-risking of bonds and loans issued by sovereigns or corporates in emerging markets and developing countries. Securitization of loans would allow risk diversification. And bonds could be de-risked if tranching was implemented, with MDBs or bilateral lenders taking on the first-loss tranche.
- Credit enhancements in the form of guarantees if contingency features in bond contracts are activated. Although debt service relief linked to GDP shocks, commodity price shocks or natural disasters is theoretically attractive, in practice such provisions are seldom used because investors have a hard time pricing them. Moreover, by erring on the side of caution, investors tend to make the pricing of bonds including such provisions unattractive for issuers. However, this problem would be ameliorated if losses were taken at least in part by MDBs rather than entirely by bondholders when the trigger event arises. Having an independent official authority verify the circumstances of the trigger event would be useful in this respect. Guarantees could also help governments and their creditors reach common ground in some restructuring cases.
The climate finance track of discussions around COP26, scheduled for November 2021, should offer an opportunity to generate momentum for scaled-up allocations of ODA by the G7 and others. Deploying some of these funds in a way that encourages and supports access to private finance, along the lines discussed above, would maximize their impact.
