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The Shanghai Model: A Potential Solution for Debt Distressed Countries?

By Ying Qian

At this year’s first G20 Finance Ministers and Central Bank Governors Meeting in Jakarta, Indonesia, members issued a communiqué highlighting the unevenness of the global economic recovery from the COVID-19 pandemic. Among many factors, debt distress and increased commodity prices pose potential risks to many developing countries. The G20 finance ministers and central bank governors called for advancing the Common Framework for Debt Treatment beyond the Debt Service Suspension Initiative (DSSI) and to ensure fair burden-sharing in line with the comparability of treatment principle among private creditors and other official bilateral creditors.
Despite the many challenges of the ongoing COVID-19 pandemic, win-win scenarios on debt are still within reach. In particular, the successes of Brady bond transactions from the 1980s and 1990s offer a potential model for distressed debt restructuring in the pandemic era. Although the initial scheme involved dollar-denominated bonds and included most private creditors as participants, the model can be expanded to incorporate creditors and currencies from other countries that could deliver impactful results.
One such proposal is the “Shanghai Model”, recently suggested by researchers from the People’s Bank of China, wherein Brady-like bonds, denominated in Chinese renminbi (RMB), could potentially be used to restructure distressed debts owed to Chinese financial institutions by heavily-indebted countries. In addition to debt sustainability assessments and necessary policy reforms to help debtor countries regain economic stability and growth, the new Brady-like RMB bonds could help promote the development of global RMB bond markets.
From a debt sustainability perspective, many debtor countries have experienced boom-and-bust economic cycles and debt crises, given their economic structures and debt mismatches in currencies, maturities, interest rates, and cash flows. RMB-denominated Brady-like bonds would provide debtor countries with a more diversified basket of currencies in their liabilities, as well as longer-term debt options. State-contingent debt instruments, such as commodity-price-linked bonds (CLB) could also be part of the mix, as their repayment terms depend on the price of a debtor country’s export commodities, providing a natural hedge for primary commodity-producing countries to counter negative impacts of boom-and-bust cycles.
For example, coffee, cocoa, bananas, and other commodities dominate many African countries’ key export lists. In Zambia, copper accounts for more than 70% of its exports. During commodity price booms, producing countries receive greater hard currency flows and can repay existing debts more easily, while the opposite is true during commodity price slumps. Thanks to this natural hedge, CLBs can be used as a countercyclical debt instrument for these countries, as debt service payments rise during booms and ease during slumps.
As discussed in a recent Boston University Global Development Policy Center working paper, the optimal debt portfolio with different debt instruments denominated in various currencies and with contingent repayment profiles can reduce the impact of exchange rates, commodity price, and economic cycle fluctuations on debt sustainability, as well as improve debtor countries’ credit ratings and reduce financing costs. In fact, World Bank research calculates that in a risk-minimizing debt portfolio for Sub-Saharan Africa (SSA), general dollar-denominated debt should only account for about 30 percent of its debt and should be linked to the price of SSA’s most important commodity exports, including cocoa, coffee, cotton, copper, and oil.
Creditor countries may also enjoy a natural hedge if the price of the concerned primary commodity is a major cost factor for their production. Rising commodity prices will lower revenue for producers in the creditor country, but this can be partly or wholly compensated by higher interest income from CLBs invested in by producers. CLBs can also be attractive alternatives for many types of investors to alter the portfolio mix, given the varied repayment profiles and acceptable credit ratings.
CLBs have not been widely used in the market partly due to the seemingly zero-sum game nature of issuers and investors failing to see the benefits of natural hedges. However, the market is in a rare situation where both groups are properly incentivized, as debtors need to restructure to avoid defaults with the help of haircuts and credit enhancements, and creditors are looking for better hedges and returns as primary commodity prices are rising fast.
Another win-win scenario is to bring green and climate change financing into the overall distressed debt restructuring packages. This can be done through different angles, either the debt to green finance swap, or to use sovereign green bonds as collaterals for Brady-type bonds. For better mainstreaming green finance in debtor countries, more technical assistance will be needed to develop strong capacities and build prudent market infrastructure of green finance.
In all, whether through the Shanghai Model or other approaches, creditors, particularly Chinese creditors, should collaborate with partners to engage and work with debtor countries on broader policy and institutional development issues. Doing so will help debtor countries regain stable economic growth and become contributing factors in the global drive for sustainable growth.
Ying Qian is a Non-Resident Senior Fellow with the Global China Initiative at the Boston University Global Development Policy Center and a freelance consultant and researcher.

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