Sovereign debt restructurings have increased meaningfully in the past few years, with Argentina, Sri Lanka, Ghana, and Zambia all undertaking them. In addition, the number of countries that the International Monetary Fund (IMF) classifies as being in debt distress, or at high risk of debt distress, has more than doubled from 2015.

As a response, global institutions such as the Paris Club of bilateral creditors, the IMF, and the World Bank have designed frameworks to make the restructuring process easier and quicker for distressed sovereigns. To that end, they launched the bilateral Debt Service Suspension Initiative (DSSI) in 2020. This led to the suspension of $12.9 billion in debt service payments for the 48 countries who signed up. The Common Framework has now succeeded the DSSI, and, in addition to debt suspensions, also facilitates limited write-downs. However, so far, the take-up has been limited to four countries, Chad, Ethiopia, and Zambia in 2021 and Ghana in 2022.

While bilateral creditors pushed both initiatives, they asked the private sector to take part on comparable terms. The DSSI also asked multilateral lending institutions (MLIs) to explore options for suspending debt service payments over a certain period. In the end, this didn't happen, and when the Common Framework was launched, it appealed to MLIs to "develop options for how best to help meet the longer-term financing needs of developing countries, including by drawing on past experiences to deal with debt vulnerabilities such as domestic adjustment, net positive financial flows and debt relief". Nevertheless, to date, no MLI has participated in a debt restructuring due to its status as a preferred creditor.

The most recent initiative, established in February 2023, was the Global Sovereign Debt Roundtable, which focuses on harmonizing processes and standards for sovereign debt restructuring across all types of creditors. In both of the meetings held during the year, it agreed that MLIs should participate in restructurings by providing net positive flows of concessional finance and grants. However, some countries, primarily China, have expressed strong views that MLIs should be part of sovereign debt restructurings to share the burden equally.

Calls to temporarily relieve countries of their debt burdens have also resulted in climate resilience debt clauses (CRDCs). These allow small low-income island states and other low-income countries vulnerable to the effects of climate change to suspend debt repayments for up to two years if a pre-agreed natural disaster or other weather-related disaster occurs. Inter-American Development Bank (IADB) has already developed a loan that includes these clauses for any sovereign requesting them.

In this Credit FAQ, S&P Global Ratings examines how MLIs' involvement in sovereign debt restructurings and loan extensions could affect the preferred creditor treatment (PCT) assessments that inform our ratings on the MLIs. We also outline our views on CRDCs and whether we consider them to be arrears events.

Frequently Asked Questions

How does S&P Global Ratings factor PCT into its ratings on MLIs, and how does it define arrears?

We include PCT in our criteria as an important tool for assessing policy importance, that is, the relevance we think an MLI has for its shareholders. We also use it when determining the loss-given defaults that we apply in our capital model. When we revised our MLI criteria in 2018, PCT was one of the main components to which we gave a more significant weighting (see "What Our New Criteria Has Meant For Multilateral Lending Institutions," published on April 12, 2019). This improved both the issuer credit ratings and stand-alone credit profiles on MLIs, mainly because lower sovereign risk weights to reflect MLIs' strong decade-long repayment track records generally strengthened their capital ratios.

PCT has long been an established and fundamental principle that has allowed MLIs to price their loans to sovereign borrowers with low creditworthiness at rates that disregard much or all of the credit risk. This is because MLIs count on always coming ahead of other creditors and not being involved in restructurings. This assumption has proved sound over the decades, and arrears owing to MLIs have been a fraction of those owing to the bilateral and commercial creditors.

Instead of participating in restructurings, MLIs generally ensure that sovereigns benefit from grants or a higher amount of additional loans compared to the amount that matures every year. This creates a positive net flow of loans with below-market interest rates that incentivizes sovereigns to remain current with their payments. In the case of a protracted arrears situation, the MLI discontinues all disbursements until the sovereign resumes its payments.

We base our view of PCT on an arrears ratio, specifically, the sovereign loans of the country in arrears as a proportion of the entire sovereign loan book. We consider a sovereign to be in arrears when any of its loan repayments to the MLI are 180 days overdue. We apply a cross-default consideration and consider all loans to that sovereign as being in arrears. The size of the sovereign exposure in arrears versus the total loan book size is important, so we distinguish between small and large arrears. The assessment ranges from very strong (below 0.5%), all the way up to weak (above 15%).

For any given sovereign, our arrears ratio includes 100% of the MLIs' loans to that sovereign if it is in arrears currently, or 25% of the loans if the sovereign had been in arrears within the past 10 years but is now up to date with its payments.

The arrears are low for the major MLIs lending to sovereigns globally (see table 1). In addition, MLIs have a policy to never write off a loan, so a country can be in arrears for decades (Zimbabwe, for example). MLIs' provisions for loans in arrears are therefore small and typically cover the foregone compound interest.

Table 1

Does S&P Global Ratings' criteria differentiate between debt forgiveness and debt extension, and how do these events affect PCT?

We have always seen debt forgiveness as a clear-cut arrears event unless the MLI is otherwise compensated for most of its losses. We also see government-led debt-relief programs as being tantamount to arrears events, and therefore the sovereigns that benefit from them as being in arrears, unless the MLI is otherwise compensated for most of its losses (see paragraph 32 of our criteria for rating MLIs). We would consider any write-downs that go beyond this definition as arrears events, and they would affect our PCT ratio.

Examples of debt-forgiveness programs that we do not consider arrears in our MLI criteria are those for Heavily Indebted Poor Countries and the Multilateral Debt Relief Initiative. This is because sovereign shareholders providing additional capital resources fully compensate the MLIs for the debt write-downs they provide to borrowers. Similarly, a very small loss for an MLI involved in a larger overall restructuring would generally not constitute an arrears event, and therefore we would not account for it in our PCT ratio.

Contrary to debt forgiveness, debt extensions have the potential to be reimbursed. However, we view debt extensions in a similar way to debt forgiveness under our criteria because they can have a significant economic impact on the MLIs' financial metrics. This is similar to our view of traditional sovereign arrears that affect MLIs' balance sheets, although MLIs could recover these at a later stage. Consequently, shorter-term debt extensions where the MLI is mostly compensated for the net present value of a loan would not constitute an arrears event, and therefore we would not account for it in our PCT ratio.

Conversely, the uncompensated relief that some of the sovereigns in debt distress require to reach a sustainable debt-repayment trajectory is often a significant multiple of the magnitude we would consider eligible for exclusion from the arrears definitions in our criteria. For example, in the recent case of Zambia, we understand that the proposal for its bilateral debt extension reduced the net present value of the debt by some 40%. This would have been an arrears and PCT event for us should an MLI have participated in the extension.

What effect would increasing arrears have on MLIs and PCT, and is there any room for such arrears without affecting the ratings?

We tested a hypothetical scenario whereby MLIs exposed to sovereigns with recent cases of debt restructuring would have to restructure the debt without proper compensation. This allowed us to gauge the potential impact on their PCT assessment (see table 2).

Table 2

In all cases except Argentina, for IADB, the sovereigns' debt restructurings by themselves would most likely not prompt any rating changes, all things being equal. In those cases, the PCT ratio wouldn't move significantly, and any downward shift in the capital ratio would not automatically lead to a change in either our PCT assessment (for African Development Bank Group and the International Bank for Reconstruction and Development), or the overall rating (for the International Development Association and Asian Development Bank).

Conversely, Argentina is one of IADB's major exposures, and its uncompensated debt restructuring could materially affect the PCT assessment, and hence would likely trigger a downgrade. Having said that, pressure could also arise from deteriorating funding conditions should arrears increase as significantly as in the scenario in table 2. This, in turn, could put pressure on ratings if it meaningfully impairs the MLI in carrying out its mandate.

We also assessed how much additional arrears the MLIs could accumulate before rating changes would be almost certain. All the entities in the sample could accumulate significant additional arrears before we would likely consider a rating change deriving from our PCT assessment on its own (see table 3). However, we believe that all these entities have very strong policy importance thanks to their broad mandate, long track record, and significant shareholder support, excluding our view on PCT.

Table 3

We believe that such MLIs are better placed to withstand a deterioration of their PCT assessment due to a handful of smaller countries, than other MLIs that rely more heavily on preferential treatment as their mandate may be more niche and other forms of shareholder support may not be as strong.

In all cases, we stressed the arrears ratio by up to 15%. Above that threshold, our view of PCT would likely shift from moderate to weak. An assessment of weak PCT would likely trigger downgrades for all entities. Arrears could hypothetically increase between eight and 44 times before we would reach such a threshold.

Both hypothetical scenarios only focus on our PCT assessment. They demonstrate that MLIs have some headroom to participate in debt restructurings and extensions falling within the scope of our arrears definitions. However, this would impair the arrears ratio and trigger a multi-notch shift in our PCT assessment.

In addition, such high levels of arrears would likely pressurize other rating factors, such as the liquidity and funding assessment, shareholder support, governance and management, or the assessment of an institution's risk management. Furthermore, for entities that provide countercyclical financing in periods of stress, such high arrears would not tally well with the need to maintain prudent risk and capital management, as well as substantial headroom over the PCT thresholds in case of adverse scenarios and rapid credit growth.

In addition, such high arrears would lead to meaningful drops of between 400 and almost 1,000 basis points in all the MLIs' capital ratios, reflecting the higher risk they bear on their balance sheets. This would severely curtail ongoing and future lending activity and available lending headroom, something that would contradict the ongoing initiatives to enable MLIs to provide more resources.

Would S&P Global Ratings expect MLIs' business model to change if they started participating in sovereign debt restructurings or extensions?

Since their inception, MLIs' role has been to channel low-cost funding from the capital markets to low-income sovereigns and the private sector, the latter on more commercial terms. MLIs price loans and make risk decisions based on the PCT principle being respected and the fact that they are exempt from participating in sovereign debt restructurings. As such, they never write a loan off and count on a long enough time horizon to recover the loan in full. We believe that the MLI sector has built its business model for sovereign lending around PCT.

If MLIs were asked to participate in uncompensated sovereign restructurings on an equal footing with commercial and bilateral creditors, it is highly likely that their pricing would have to dramatically change, or shareholders would have to be willing to move toward an International Development Association model, where capital increases happen every three years to account for the risk of being loss-making. Both options seem difficult given the borrowers' fiscal constraints, but also nonborrowers' reluctance to provide additional resources of the magnitude needed.

Does S&P Global Ratings consider the use of CRDCs to be an arrears event under its methodology?

We understand that CRDCs allow a sovereign taking a loan from an MLI to delay principal and/or interest payments for up to two years should a pre-defined climate event occur. Typically, these events would involve a competent third party declaring a natural disaster, or be based on observable metrics on rainfall, wind speeds, droughts, or earthquakes, for example.

So far, the conditions of these loans are adjusted so that interest payments increase after the standstill period to preserve the loan's original weighted average life or net present value, resulting in a limited impact on the MLI. We expect the loans to be targeted at low-income sovereigns and small islands nations that are particularly exposed to extreme environmental shocks.

Generally, we do not consider these events part of our arrears definitions if they meet the following two conditions:

• They are part of the loan contract at signing and have defined the conditions of any climate-related event before such an event occurs; and
• In line with paragraph 32 of our MLI criteria, they are mostly compensated for, in other words, they are almost neutral to the net present value.

Excluding CRDCs from our arrears metrics would likely be neutral to our view of PCT in the enterprise risk profile and initial capital adequacy assessments. However, we would take further qualitative considerations into account as part of our management and risk position assessments. For instance, we would expect that the CRDCs do not constitute a significant part of the portfolio. Consequently, their activation would not meaningfully affect an MLI's balance sheet.

By contrast, if these programs became a large component of the MLIs' balance sheet it could have a significant impact on financial metrics if many were triggered at the same time. In addition, if they ended up releasing cash flows to repay commercial debt such that private creditors were better off than the MLIs, this would, in our view, challenge the sector-wide principle of PCT. If the effect was material, it could eventually bring the MLIs' role and business model into question.

In that respect, we do not view CRDCs as similar to other types of large-scale government-led compensated debt-relief programs that are exempt from our arrears calculations as per paragraph 32 of our MLI criteria. In the past, these programs removed risky exposures from the MLIs' balance sheets and the size of the program did not affect our assessments as the nonborrowing shareholders fully compensated the MLIs.

Related Criteria

• Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology, Jan. 31, 2022

Related Research

• What Our New Criteria Has Meant For Multilateral Lending Institutions, April 12, 2019