Debt Debacle Diplomacy: India’s G20 Stance and Tackling Holdouts in Sri Lanka

[By Divya Upadhyay]

The author is a student of National University of Advanced Legal Studies, Kochi.

 

Introduction

In the wake of the upcoming 18th G20 Summit being hosted by India, debt relief is one of the most significant changes posed to be brought in through India’s presidency for the 2022 – 23 tenure. Prime Minister Narendra Modi has recently highlighted India’s commitment to address matters of sovereign debt restructuring while at the same time decrying the advantage of debt crisis taken by “certain forces” – implying Chinese involvement through its massive lending programme under the Belt and Road Initiative to developing and emerging economies. In the South Asian region, particularly hit has been the Sri Lankan Economy with its external debt posed to reach a record high of  58.5 billion USD in 2023.

There is substantial discourse surrounding China’s dual role as the single largest creditor to Sri Lanka and its non – involvement in the multilateral debt resolution process, which has led to a significant lack of transparency. However, there has been relatively little discussion about the ancillary consequences stemming from this situation. China’s avoidance to cut down on Sri Lanka’s debt through writing off, disrupts the larger multilateral process initiated by the International Monetary Fund and Paris Club – an informal group of official creditors, seeking to find sustainable solutions for the debtor nations. The Paris Club operates based on the principle of “comparability of treatment”. This means that a debtor country should not accept less favourable terms from non-Paris Club creditors, such as China, than those negotiated with the Paris Club. In essence, this principle aims to ensure that all creditors are treated equally and that no single creditor, like China in this case, receives preferential treatment.

However, China’s unwillingness to participate in debt relief efforts can create a situation where private sector creditors are encouraged to demand more favourable terms from debtor nations. When China does not write off or reduce the debt, it sets a precedent where other creditors, especially private sector ones, may hold out for better repayment terms, further complicating the debt resolution process. Holdout creditors often reject the haircuts (or discounts) taken up by other creditors and insist on the full repayment of their debt. This reduces the debt relief received by the indebted country as well as increases the costs through disruptive individual litigation.

Sri Lankan Single Series CAC Problem

Thus far, the main policy response to solve this type of creditor coordination problem has been the introduction of Collective Action Clauses (CACs) in sovereign bond contracts. CACs are majority restructuring clauses, that alleviate the creditor coordination challenge by specifying threshold requirements for creditor approval and establishing a voting mechanism, often requiring a majority or supermajority vote. Once the threshold is met, the restructuring plan becomes binding on all creditors, preventing holdouts from obstructing the process.

However, restructuring expert, Lee Buchheit has noted that a CAC on some of Sri Lanka’s older dollar bonds gives creditors a potential opening to hold the sovereign nation hostage and stall restructuring negotiations.

This is a “single series” CAC, which allows a minority of bondholders to veto or demand terms in the negotiations. Single series CACs typically require a 66 ⅔% or 75% majority in “each individual series” irrespective of the aggregate acceptance rate. In Greece in 2012, in particular, more than half of the foreign-law bonds that had this type of bond-by-bond clauses did not reach the necessary voting threshold, resulting in large-scale holdouts despite CACs.

As opposed to this, “enhanced” CACs in Argentina, Ecuador and Ukraine reduced the average duration of a sovereign debt restructuring from 3.5 years to 1.2 years. These enhanced CACs bind all creditors to any deal agreed to by a supermajority of creditors, making it easier to get to a deal, and removing the power of holdouts.

Indian Intervention to Avert Hold Out

The difficulty in Sri Lanka’s case is that while a majority of its private creditors hail from Western developed economies, the pivotal bilateral creditors originate from Asia. Middle-income countries such as China and India, alongside high-income Japan, wield notable significance. Effective collaboration between official creditors notably China and the Paris Club of Creditors, thus becomes paramount.

To avoid a repeat of earlier debt crises and “a lost decade”, restructuring efforts should prioritize write-downs rather than emphasizing maturity extensions and interest rate reductions. The IMF relies on the Debt Sustainability Assessment as its primary tool to evaluate debt sustainability risks. If this assessment indicates the necessity of write-downs to restore sustainability, they should take precedence over other measures like extending maturities and reducing interest rates, a practice observed in China. Past major debt crises in the 1980s and 1990s were only resolved when the focus finally shifted to debt relief through write-downs, first with the Brady Plan and later the Heavily Indebted Poor Country Initiative. However, both these measures primarily accommodated low-income countries.

While India through its G20 presidency has expanded the focus to even middle-income countries such as Sri Lanka, it can further establish a local South Asian threshold through its domestic framework. India could take from the three New York proposed legislations, which seek to address some of the challenges that sovereigns face when seeking to restructure their debt. This would address the efforts of some holdout creditors to frustrate or circumvent the consensual resolution of a sovereign debt crisis.

The proposed legislations would apply a CAC-style collective voting process to a wide range of New York law-governed debt claims. Assembly Bill A2102A will retrospectively change debt contracts by introducing the statutory collective voting mechanism under a new Article 7 to the New York State Banking Law. This would override any existing CACs to make the mechanism binding. A second bill, A2970 aims to extend “burden-sharing standards” to include private creditors. Under these standards, private creditors would be required to absorb the same level of losses or haircuts, as the U.S. government, acting as a sovereign creditor, when a financially distressed low-income country qualifies for debt relief.

Conclusion

Because of this, even if Sri Lanka has single-series CAC frameworks, India, which is the country’s third-largest creditor and the president of the Global Sovereign Debt Roundtable, can set an example by imposing a South Asian threshold and retroactively altering the bond contracts’ legal terms. Prior to restructuring their domestic debt, Greece in 2012 and Barbados in 2018 took advantage of this “local law advantage” and inserted CACs into domestic law contracts. The captive nature of the domestic investor base may give sovereign authorities leverage over domestic investors, though to varying degrees across nations, making the holdout problem less of a problem in some cases. Further, it may also help counter China’s case-by-case approach which allows Beijing to delay the negotiation process based on the strategic value of the indebted country.

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