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Borrowing costs after debt relief

Valentin Lang, David Mihalyi, Andrea Presbitero 14 October 2020

To mitigate the effects of the Covid-19 crisis, the international community has endorsed a programme
suspending debt service payments for poor countries. This column shows that the programme has led to a
substantial decrease in sovereign borrowing costs by providing liquidity. Importantly, the results do not lend
support to the widespread concern that such debt relief could generate stigma and signal debt sustainability Valentin Lang
concerns.    Assistant Professor of
International Political Economy,
University of Mannheim
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Related
The Covid-19 pandemic is putting government
finances of many developing countries under severe Legal air cover
Patrick Bolton, Mitu Gulati, Ugo Panizza
strain (Djankov and Panizza 2020). In response, a
range of proposals and calls for action have been COVID-19 in developing economies: A new
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floated by experts and policy makers (Bolton et al.
Simeon Djankov, Ugo Panizza
2020a, 2020b, Bulow et al. 2020; Horn et al. 2020;
Debt restructuring in the time of COVID-19
Landers et al. 2020). In a short time, the international
Silvia Marchesi, Tania Masi
community – under the leadership of the G20 – David Mihalyi
agreed to help poor countries by offering a suspension A debt standstill for COVID-19 in low- and Senior Economic Analyst, Natural
middle-income countries Resource Governance Institute
of debt servicing due in the second half of 2020. Patrick Bolton, Lee Buchheit , Pierre-Olivier
Under the Debt Service Suspension Initiative (DSSI) Gourinchas, Mitu Gulati, Chang-Tai Hsieh, Ugo
participating countries can ask their bilateral lenders to Panizza, Beatrice Weder di Mauro
defer debt service repayments by three years without
affecting the net present value (NPV) of public debt. The size of the liquidity provision under the
DSSI is non-trivial. For all eligible countries it amounts to $10.2 billion and accounts for about one
fifth of the fiscal shortfall due to the Covid-19 shock. However, many eligible countries so far have
been reluctant or refused to participate in the DSSI. This may seem a puzzling response to what at
first sight is free money at time of great need. Yet, these countries fear that DSSI participation may
signal debt sustainability problems that could trigger a downgrades of sovereign ratings and Andrea Presbitero
increases in sovereign borrowing costs.1 Associate Professor of Economics,
Johns Hopkins University
In a recent paper (Lang et al. 2020), we provide a first assessment of the short-term impact of the
DSSI on sovereign bond spreads. In particular, we test whether the potential benefits from short- Don't Miss
term liquidity provision outweigh any stigma effects that may be associated with participation in the Fostering FinTech for
debt relief initiative. Estimating the effect of debt relief on sovereign bond spreads is usually financial transformation
challenging, as debt relief initiatives are typically not randomly allocated. Comparing beneficiaries of Beck, Park

debt relief to other countries is thus not informative. The case of the DSSI, however, allows us to Fintech and digital
construct plausible counterfactuals. In contrast to most debt restructurings, the DSSI was currencies RPN. The soul of
the financial system
announced simultaneously for all 73 eligible countries and, thus, was not tailored to the needs of
Niepelt
individual countries. Also, the eligibility criteria were based on preexisting income thresholds rather
than on financing needs or on the severity of the shock, which crucially influence borrowing costs. The ECB strategy: The 2021
review and its future
Reichlin, Adam, McKibbin,
Sovereign borrowing costs declined by about 300 basis points
McMahon, Reis, Ricco, Weder
We exploit this event to analyse its impact on sovereign bond spreads of the 16 DSSI-eligible di Mauro
countries with international market access and available daily data. We used the synthetic control
method (SCM) developed by Abadie and Gardeazabal (2003) and now increasingly used in similar Events
contexts (see Marchesi and Masi 2020). For each DSSI-eligible country we construct a synthetic
VfS-Annual Conference 2021
control (or “doppelganger”) combining countries from a pool of middle-income non DSSI-eligible - Call for Papers
countries.2  26 - 29 September 2021 /
Regensburg University / Verein
für Socialpolitik
Figure 1 shows our main result. Comparing sovereign bond spreads of DSSI-eligible countries with
their synthetic controls shows that sovereign spreads significantly declined after debt relief. Several 7th Annual Monetary and
Financial Policy Conference
days after the DSSI was announced, the spreads of eligible countries were down by about 300 28 September - 8 October 2021
basis points (bps) more than in comparable, non-treated doppelganger countries. This average / Online / Money Macro And

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24/9/21 0:40 Borrowing costs after debt relief | VOX, CEPR Policy Portal
effect differs across countries, but it is negative for all borrowers that can benefit from the debt relief. Finance Society
This result is robust to different model specifications, including the generalized synthetic control Joint Workshop on
method (Xu 2017). Moreover, a set of placebo tests in space and time show that the effect on Incentives, Management and
Organization (IMO) &
spreads is due to the DSSI and cannot be explained by the (contemporaneous) request of an IMF Entrepreneurship Economics
programme. (ENT)
7 - 9 October 2021 /
Copenhagen, Denmark/ Online
Figure 1 Sovereign bond spreads in DSSI-eligible countries versus their synthetic controls /
CopenhagenMacro Days
Conference
7 - 8 October 2021 / Hybrid
online/in-person, Copenhagen /
Joint CEPR and Seventh
Banco de España Economic
History Seminar
8 - 8 October 2021 / Online /

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Notes: The figure plots the difference between the actual sovereign bond spreads and those of the synthetic control
QE and the Bank Lending
(spread gap) for the DSSI-eligible countries. The red solid line is the average of the country-specific spread gaps. The
Channel in the United
grey solid lines refer to countries which have joined the DSSI as of September 17, 2020, while the grey dashed lines Kingdom
Butt, Churm, McMahon,
refer to countries which have not formally requested to join the initiative (Ghana, Honduras, Kenya, Mongolia, Nigeria,
Morotz, Schanz
and Uzbekistan). The vertical lines indicate the announcement of the DSSI on April 15, 2020 (solid line) and the first
participation in the DSSI on May 1, 2020 (dashed line). The dots signal the country-specific participation in the DSSI.
Subscribe
See description in the main text. Source: Bloomberg, Our World in Data, and IMF World Economic Outlook.
@VoxEU
The drop in spreads seems to be due to liquidity provision
RSS Feeds
To discriminate between two mechanisms that could drive the results, we test for heterogeneous
effects of debt relief. We focus on two sources of heterogeneity—the size of the DSSI relief and the Weekly Digest
share of private creditors in debt service—and estimate their effects in a difference-in-difference
setting using the local projection method. This analysis shows that the decline in bond spreads for
DSSI-eligible countries is larger for countries that happen to have a larger share of debt service due
in the eligibility period (between May and December 2020, Figure 2, Panel A). By contrast, the
decline in spreads does not depend on the importance of private creditors (Figure 2, Panel B). As
there is no increase in spreads—not even for countries owing a large share of repayments to private
creditors—these results do not support the presence of a stigma effect. Instead, the results are
consistent with a positive liquidity effect due to the postponement of the debt service due in 2020. 

Figure 2 Liquidity provision versus stigma

A) Size of the DSSI relief

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B) Share of private creditors

Notes: The figures plot the impulse response functions of the differential effect of the DSSI announcement (t = 0)
between eligible and ineligible countries on sovereign bond spreads. Panels A and B split the sample between eligible
countries which received a DSSI relief above or below 0.5 percent of GDP and those with debt service due to private
creditors above or below 60 percent of total debt service due under the DSSI (both thresholds are median values). See
description in the main text. Data source: Bloomberg and IMF World Economic Outlook.

Discussion
The international community is currently discussing the possibility to extend the current initiative to
suspend debt service in developing countries to 2021. Our results suggest that this simple NPV-
neutral debt moratorium—involving no haircut for creditors—can indeed help countries weather the
crisis. 

Our findings also add to the broader literature on debt restructuring. They show that rapid and
unconditional provision of debt rescheduling to countries that face short-term liquidity shocks may
provide an effective instrument of financial support that can help avoid hard defaults (Trebesch and
Zabel 2017). In addition, our results support the design and adoption of simple state-contingent debt
instruments with floating grace periods to help poor countries mitigate their exposure to adverse
shocks (Cohen et al. 2008).

Two final qualifications are important. First, our results could be generalised to other situations in
which countries face a short-term crisis. In the presence of severe negative shocks, only postponing
debt service could contribute to a reduction in borrowing costs. However, this does not imply that
the suspension of debt service will be the optimal response to the Covid-19 crisis in the months to
come. If the shock persists, the liquidity crisis could evolve into a solvency crisis, as a change in the
long-term growth rate of the economy would affect debt sustainability. In such a scenario, a debt

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stock reduction could be required to reduce debt overhang and restore debt sustainability. Second,
our analysis looks at NPV-neutral debt relief provided by the official sector. How markets would
react if private creditors also joined the initiative (as asked by the G20 and the main international
financial institutions) remains an open question.

References
Abadie A and J Gardeazabal (2003), “The Economic Costs of Conflict: A Case Study of the Basque
Country”, American Economic Review 93 (1): 113-132. 

Bolton P, L Buchheit, P-O Gourinchas, M Gulati, C-T Hsieh, U Panizza and B Weder di Mauro
(2020a), “Born Out of Necessity: A Debt Standstill for COVID-19”, CEPR Policy Insight no 103.

Bolton P, M Gulati and U Panizza (2020b), “Legal air cover”, VoxEU.org, 13 October.

Bulow J, C Reinhart, K Rogoff and C Trebesch (2020), “The Debt Pandemic”, IMF Finance &
Development, Fall.

Cohen, D, H Djoufelkit-Cottenet, P Jacquet and C Valadier (2008), “Lending to the Poorest

Countries: A New Counter-Cyclical Debt Instrument”, Working Paper 269, OECD Development
Centre. 

Djankov S and U Panizza (2020), “COVID-19 in developing economies: A new eBook”, VoxEU.org,
22 June.

Horn S, C Reinhart and C Trebesch (2020), “China’s overseas lending and the looming developing
country debt crisis”, VoxEU.org, 4 May.

Landers C, N Lee and S Morris (2020), “More Than $1 Trillion in MDB Firepower Exists as We
Approach a COVID-19 “Break the Glass" Moment”, Center for Global Development.

Lang V, D Mihalyi and AF Presbitero (2020), “Debt Relief, Liquidity Provision, and Sovereign Bond
Spreads”.

Marchesi S and T Masi (2020), “Debt restructuring in the time of COVID-19: Private and official
agreements”, VoxEU.org, 4 May.

Trebesch C and M Zabel (2017), “The output costs of hard and soft sovereign default”, European
Economic Review 92: 416-432.

Xu Y (2017), “Generalized Synthetic Control Method for Causal Inference with Time-Series Cross-
Sectional Data”, Political Analysis 25: 57–76.

Endnotes
1 See reports by international institutions (IMF 2020, World Bank 2020), Think Tanks (ODI 2020)
and press coverage in The Economist and Reuters, among others. More details on the DSSI can be
found here and on the World Bank website.

2 Given that the dynamics of sovereign spreads depend on fiscal and economic performance, we
take real GDP growth, the current account, the fiscal balance, and public debt (all as shares of
GDP) as macroeconomic variables to construct the synthetic control. Also, to compare countries
with similar bond spreads dynamics before the DSSI, we match on spread levels at specific dates.
Finally, to take into account differences in the intensity of the Covid-19 crisis, we use the number of
cases per capita. See Lang et al. (2020) for details.

35 A A
Topics: 
Covid-19 Development International finance

Tags: 
Debt service, poor countries, COVID-19, borrowing costs

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