The Covid-19 pandemic has caused many solvency and liquidity problems for economies across the world.
The dual challenges of increased spending necessary to mitigate the health effects of the crisis, and revenues falling due to falling growth and trade, has raised debt burdens for vulnerable countries. Higher financing costs or limited access to external financing only exacerbate this issue for developing economies.
What is the G20 Common Framework plan?
The G20 had already established the Debt Service Suspension Initiative (DSSI) in May 2020, rendering 73 countries eligible for a temporary suspension of debt-service payments owed to their official bilateral creditors.
Of these, 46 countries have deferred $5.7 billion in 2020 debt service payments, freeing up funds for countries to fight the pandemic and shore up their economies.
In recognition that Covid-19 could require further treatment on a case-by-case basis, November 2020 saw the G20 launch a common framework designed to help countries defer or negotiate down their debt as part of a wider relief programme.
The framework requires that participating debtor countries seek treatment on comparable or better terms from other creditors, including the private sector.
Importantly, the new framework brought in official creditors that were previously not part of the established Paris Club process, facilitating coordination for debt treatments tailored to debtor countries’ specific situations.
This was the first time that the G20 countries had agreed upon a common framework for restructuring government debt, signaling the strong international desire to help the world’s poorest countries tackle their growing debt problems.
However, there has also been hesitation to join the scheme, even from countries both eligible and in financial quandaries. This is due to concerns that accepting debt suspension might affect their credit ratings, despite S&P Global stating that it will undertake a case-by-case assessment of countries seeking debt relief.
Fundamentally, the scheme encourages governments to defer or negotiate down their debt to private creditors as part of a broader relief campaign. Interruptions to private creditor payments can trigger widespread financial market and legal problems and are typically regarded as defaults by credit ratings firms.
For example, the credit ratings agencies S&P and Fitch both slashed Ethiopia’s sovereign credit rating after its government indicated that it would join the G20 common framework plan. Ethiopia was the first country with an international government bond and not already in default to join the initiative.
Why do sovereign credit ratings matter?
A sovereign credit rating is an independent assessment of a country’s creditworthiness, representing the likelihood that a government might be unable to meet its debt obligations in the future.
Such debt obligations refer to those governments that undertake commercial creditors alone. They do not reflect their ability and willingness to service other types of obligations, such as debt owed to other governments or the IMF.
These ratings give investors insights into the level of risk associated with investing in a particular country’s debt, which is why a country needs to obtain one to issue bonds in external debt markets.
The lower a government’s credit rating, the more concerned lenders will be that loans will not be repaid in the future. Therefore, higher interest rates will be placed on amounts to be loaned.
In addition, a good sovereign credit rating does not solely increase a government’s access to liquidity, but can also signify a healthy economic environment, in turn drawing in foreign direct investment.
When ratings agencies cut a country’s rating, this prompts a sell-off in their sovereign bonds and drives up borrowing costs for the government. There is also the untold opportunity cost of all the investment that would have been enjoyed had foreign investors not been frightened away by economic uncertainty.
Are these ratings still important today?
The main functions and consequences of sovereign credit ratings reside in how other parties respond to them. If lenders and investors place less value on credit ratings, a downgrade will not be disastrous.
For example, in October 2020, ratings agency Moody’s lowered the United Kingdom’s sovereign debt rating to “Aa3” from “Aa2”, citing weakening economic and fiscal strength. Despite this ominous warning, it seemed to be business as usual in the markets, with the pound even rising on the Monday after the announcement.
A major aspect of this response was that investors were simply unconvinced by Moody’s assessment. In a broader context, the UK’s debt to GDP ratio is well below historical peaks. The UK has not defaulted on its bonds since the time of Charles II.
It has a strong legal system for investors seeking legal recourse if a default occurs. If a country has strong fundamentals, ratings based on current economic outlooks may not be weighed as heavily by investors.
Unfortunately, the countries eligible for the G20’s DSSI and Common Framework plan do not have this luxury, as weak fundamentals are a significant part of why a country would consider joining such initiatives in the first place. Thus, credit ratings remain important to developing economies, many of which are loath to give up access to the capital markets.
As the Covid-19 pandemic rages on, it seems that countries holding out might have a tough choice to make. While postponing debt payments may be an adequate stopgap measure, tackling debt sustainability in the form of debt cancellation may have to be the next step.
On the one-year anniversary of the pandemic’s start, one can only hope that our economic recovery will be as swift as the downturn was unexpected.