Emerging Debt: Time to Restructure

by Richard Marney and Timothy Stubbs, September 27, 2021

In the 2008 Global Financial Crisis (GFC), the financial system was a fundamental driver of the markets collapse and the subsequent severe recession. By contrast, in 2020–21, the financial system contributed importantly to containing the financial and economic damage of the pandemic. Banks built a firewall against widespread default by undertaking measures that included debt service deferrals, emergency funding lines, and waivers of financial covenants. Along with supportive macro-prudential, fiscal and monetary policies, these measures limited the economic fall-out from the pandemic on businesses and households to a degree that has surprised many analysts. The global macroeconomy has rebounded strongly.

Still, many countries — and especially emerging market and developing economies (EMDE) — have struggled to return to pre-pandemic levels of national income. Non-performing loans spiked last year, but the expected wave of bankruptcies and liquidations failed to materialize. Subsequent waves of Covid-19 infections, fuelled by a spread of new variants, slowed but did not derail the global economic rebound.

The crisis may have been contained, but it is not over. Indeed, the hard part could well be just beginning.

Consider first the current health of EMDE countries. The global recovery is characterized by a marked divergence between advanced economies and the EMDE cohort (ex-China). Many countries remain near or below pre-pandemic levels of economic activity, with the present spectre of stagflation looming. Fiscal accounts show elevated deficits reflecting heightened public health and social relief outlays, as well as smaller tax revenues during the pandemic. Debt levels have spiked and overall debt sustainable metrics have deteriorated over the course of the last 18 months.

This development has been especially acute amongst corporate borrowers. Global non-financial corporate sector debt rose by 8% of GDP from the fourth quarter of 2019 to the fourth quarter of 2020. In the EMDE space, this increase was close to 10% of GDP. Emergency multilateral support has safeguarded sovereign liquidity, as have local credit market forbearance measures and accommodating financial market conditions for corporate borrowers for the moment.

Yet over the longer-term, daunting debt sustainability risks are present for many debtors. The necessary domestic, fiscal consolidation to address these risks will weigh on growth. Further, monetary policy normalization in the major economies and tightening of global market conditions could adversely affect the cost and availability of the capital required to maintain financial stability and sustain economic activity. Lastly, the COVID-19 vaccine deficit represents a dire threat to a sustained recovery.

Moreover, whilst the banking systems of many markets retain adequate capital buffers to absorb current projected non-performing loans (NPLs) and have solid funding and liquidity sources, questions about the future remain. When forbearance programs are lifted and debt service payments recommence on restructured loans, what will happen to asset quality? Should growth falter due to fiscal consolidation and more restrictive monetary conditions, what happens to the operating cash flows and debt service capacity of the non-financial corporate sector? Financial institutions that entered 2020 with smaller capital buffers could well be put under pressure by a material weakening in systemic asset quality at a time of constrained capacity on the part of the sovereign to provide recapitalization and other financial support.

Lastly, even for borrowers who did not benefit directly from forbearance measures, their capitalization and liquidity postures, and hence defences against debt distress may well have weakened over the course of the pandemic. Resilience to a tightened fiscal and/or monetary policies, changing consumer preferences, disrupted supply chains, and a general climate of heightened uncertainty could well push more enterprises into negotiations with creditors. Beyond the headlines of airlines seeking bankruptcy protection and the images of long stretches of beaches with shuttered resort hotels, are many companies whose financial fragility has increased.

All of this taken together raises the real possibility of an increased incidence of debt restructuring over the medium-term.

The practical challenge of debt restructuring is a drawn out and often painful process of restoring debtor viability in the long run. In the words of Ilir Fani, Director of Corporate Recovery at EBRD, “The issues at hand when restructuring over-indebted companies are highly complex, sometimes painful as parties seek to ascertain and apportion losses in most cases, humanly difficult as egos collide, legally complicated as the old balance sheet situation gives rise to a new challenge.”

Those challenges are even greater in the EMDE space. These countries’ insolvency laws, judicial systems, an often nascent rule of law, business culture and other factors create a premium on a consensual (i.e., contractual) approach to debt restructuring. Workout specialists who can combine the softer, people-management skill sets with the knowledge of EMDE realities are in short supply but will be in high demand.

Our own work offers to insights into what is required. The objective is to convey the actual practice and real world of multi-creditor consensual restructuring transactions of debt in the private sector in both financial institution and corporate borrowers in EMDEs. Our approach is premised on the value of “war stories” that convey insights into the sequential phases of a restructuring from the build-up through resolution. Debt restructuring is as much art as science, as much about emotional intelligence as financial acumen. That is also particularly true where bankruptcy law and other institutional guidelines are opaque or fluid, as is often the case in emerging and developing economies.

Debt restructuring is unavoidable and active discussion is now opportune. The global community is striving to win the race between vaccinations and new variants in the context of rising threats to market stability, ranging from the potential default of Evergrande in China to the looming failure of the U.S. Congress to raise the debt ceiling. Even if those challenges are met, fiscal and external imbalances exacerbated during the pandemic in many emerging and frontier markets will remain and weigh on growth and financial stability. In this context, the incidence of debt restructuring will be with us for a long time. Informed parties on both sides of the negotiating table will serve global markets and all stakeholders well.

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Jackson Hole Economics

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