Sovereign Bonds: The Debt Sustainability Dilemma in the Light of the Covid-19 Pandemic

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This article by Simisola Eyisanmi paints a rather gloomy picture of Nigeria’s economic situation, compounded by our dwindling oil revenues and the fallout from the Covid-19 pandemic; predicting that it may result in a debt crisis, and Subnational and Sovereign Bond defaults in the very near future. Some suggestions as to the steps which may be taken in terms of solutions, are also proferred

Introduction

The Covid-19 spread was with alarming speed, infecting millions and bringing economic activity to a near standstill as countries imposed restrictions to halt the spread of the virus. For an emerging economy such as Nigeria that has barely recovered from the 2016 economic recession, the odds are not just higher, but the pandemic may just be the catalyst to propel it into another brutal and painful recession. Like most oil-dependent economies already saddled with dwindling oil revenues as a result of the slowdown in global economic activity, the economic fall out of Covid-19 will most likely aggravate Nigeria’s unhealthy debt service to revenue ratios. Urgent and aggressive policy action is therefore required, to be taken to avert the debt crisis that may arise as a consequence of the Covid-19 pandemic.

The Global Economic Impact

The tumultuous effect of the pandemic in Nigeria, is heightened by its over-dependence on oil for its export earnings. The drastic decline in global economic activities due to the pandemic, has, however, led to a steep drop in Nigeria’s crude oil revenues, which accounts for one-third of the public revenue in 2020. As of March 2020, the Senate put Nigeria’s total debt profile at N33 trillion. Given the decline in net private capital flows as a result of the pandemic, the International Monetary Fund (IMF) approved Nigeria’s request for emergency financial assistance in the sum of SDR 2,454.5 million (US$ 3.4 billion, 100 percent of quota) under the Rapid Financing Instrument (RFI), to meet Nigeria’s urgent balance of payment needs. An additional $3.5 billion is also expected from other multilateral lenders.

The Covid-19 pandemic has thus, led to a dire review of the country’s revenue expectations and a downward revision of the 2020 fiscal budget. Furthermore, the antecedent effect of the pandemic will include a deficit in fiscal funding, debt sustainability issues, capital flows, and revenue pressures.

Government and Corporate Bonds: Debt Sustainability

A Bond is a debt security in which the authorised issuer owes the holders a debt, and depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. Federal Government Bonds are currently the largest component of the Nigerian domestic bond market – representing about 87% of the market whilst Subnational and Corporate Bonds represent about 13% of the market, which incidentally accounts for the illiquid Subnational bonds market.

Sovereign and Subnational Bonds

Notwithstanding the assurances of the Federal Government, there is the looming apprehension that the economic fallout of the pandemic may very well trigger Subnational and Sovereign Bond defaults in the very near future.

In the case of States and Federal Government agencies, Section 256 of the Investment and Securities Act, 2007 provides that:

“Upon a default by a body to meet its obligations under a bond issuance, and after the expiration of six months therefrom, the trustees of the bond shall present the copy of the irrevocable letter of authority/guarantee for repayment issued by the Accountant General of the State/Federal Government to the Accountant General of the Federation to deduct at source from the statutory allocation due to the issuer, for the purpose of redeeming any outstanding obligations”.

Given the uncertainties around revenue generation, a pending fiscal deficit, and the country’s inability to fund its FAAC monthly allocations to State Governments, the likelihood of a default in State and Federal Government bonds, is imminent. The Irrevocable Standing Payment Order issued by the Accountant General of the State/the Federal Government is therefore, of no consequence where the revenue generation is insufficient to meet the debt obligations.

In the absence of a specific legal framework to address a sovereign’s debt default, commercial terms and arrangements are often undertaken with bondholders to restructure the debt obligations. The Covid-19 pandemic crisis makes a default on sovereign debt more likely than not, and it is on account of this prospect that Nigeria’s Finance Minister has opened talks with multilateral lenders to suspend debt repayments for 2020. Where agreement cannot be reached, and a default is declared by the bondholders, Nigeria may face the same debt crisis experienced by Greece in 2015, when it almost declared bankruptcy because it failed to pay the sum of €1.5bn to the International Monetary Fund when it was due. The debacle left Greece on the brink of collapse.

In the event of a default by the Federal Government on its Eurobonds, bondholders will either have to give up future profits or enter into decades-long litigation that is costly and undesirable. The key Bonds terms relating to enforcement and renegotiation matters that will have to be critically examined, to address the extent by which the Nigerian government can seek a suspension of interest payments and restructure the debt are:-

Enforcement

The Argentine debt crisis of 2011 and its aftermath, depicts the major shift in the legal framework of international sovereign debt markets. Prior to the Argentine crisis, defaulting governments were protected by the principle of sovereign immunity, and the absence of a supranational legal authority to enforce payment. However, following the default in Argentina, a suit was filed by dozens of hedge funds in New York against the Argentine government. 15 years later, these holdout creditors obtained a favourable court ruling, that compelled the government to pay over $10 billion as settlement. In other words, the veil of sovereign immunity has been pierced, and cannot be relied upon to prevent enforcement by the courts.

Furthermore, debtors frequently waive sovereign immunity in the commercial documents governing the bonds. Thus, creditors will be able to obtain foreign judgements against them. While this means that creditors can institute a lawsuit, it does not mean that creditors can collect on their debts.

Renegotiation Clauses

In the event of a default, the creditors can, as a group, increase their collective welfare by giving the sovereign a partial relief. The contract terms that facilitate the ability of creditors to grant sovereign partial relief in dire times, are referred to as Collective Action Clauses (CACs) and classified below. The CACs permit bondholders to modify the terms of the bond, through collective action:

i) Non-payment modification

This provision governs the modification of the non-payment term, that is, terms other than principal, interest, and time of payment. Typically, some fraction of bondholders between 50 and 75%, can vote to alter the terms and bind all of the bondholders to the revised terms.

ii) Payment modification

This clause governs the modification of payment terms, but it tends to vary based on whether the bonds are governed by New York or English law. Since the early 2000s, bonds issued under New York law allow that the payment terms can be modified by a vote of 75% of the bonds. In bonds under English law, there is frequently a requirement that there be a physical meeting of the holders. Typically, 50% is the quorum for the first meeting and 75% of those holders, have to vote for there to be a binding modification of the payment terms.

iii) Aggregation

The typical modification clause, operates within a single bond issue. Aggregation provisions operate across all of the sovereign’s bond issuances. The typical aggregation clause requires that a minimum percentage, typically 66.7% of the bonds of a particular issuance, agree to a proposed modification of payment terms. The aggregation clause also requires agreement among the bondholders aggregated across all of the issuances of the sovereign (typically, at the 85% level, in terms of the monetary value of all issuances). If both conditions are met, then the restructuring agreement becomes mandatory for all bondholders.

It is also important to note that, the concept of “force majeure”, “state of necessity” and “fundamental change of circumstances” is inscribed in the 1969 Vienna Convention on the Law of Treaties, as well as in several national legislation, mainly regarding contracts. These legal principles also form part of international common law and are therefore, applicable to all debtors and creditors without it being necessary to prove their consent to be bound by them or the illegality of the debt.

The United Nations International Law Commission defines force majeure as follows:

“The impossibility to act legally (…) is the situation that arises when unforeseen circumstances beyond the control of the person or persons concerned absolutely prevent them from respecting their international obligation, by virtue of the principle that one cannot do the impossible.”

The Preparatory Committee of the Conference for Codification (The Hague, 1930) accepts the applicability of the force majeure argument to the debt, because, according to the Committee, “the State is held responsible if, through a legislative provision […] it suspends or modifies total or partial service [of the debt], unless it is forced to do so by financial necessities”.

International jurisprudence explicitly recognises this argument, which legitimises a suspension of debt repayment to both private and public creditors such as States, the IMF, and the World Bank.

Subnational Default

About N109 billion of public domestic debt, is expected to mature by Q4 2020. Despite expecting marginal economic recovery from the last quarter of 2020, the expected impact of economic shocks is likely to send panic signals to bondholders who apprehend a credit default.

During the 2015 and 2016 economic recession, there was a similar situation of potential defaults on bank loans by State Governments, but the Federal Government launched a debt-restructuring programme for about 23 States through the issuance of N574.78 billion in bonds, aimed at reducing their debt service obligations. Also, States like Bauchi and Niger opted for the restructuring of their bonds, at that time.

Once investors begin to perceive uncertainty in the ability of the States to repay bondholders, there will be more investors scrambling to pull money from the subnational secondary market which is already considered relatively illiquid, and causing spreads to widen. This may further increase market yields, thereby making any delayed attempt at restructuring costlier for the States. Since debt markets are a source of financing projects, planned infrastructure projects in States may experience a slowdown.

Available Remedies

In Nigeria, the Issuance prospectus in defining default events, often stipulates the remedies and enforcement of remedies. Besides, the engagement of Trustees to the Issue, ensures the Attorney-General of the Federation deducts from the statutory allocation of the State, such amounts as are specified by the Trustees as required to be paid into the Sinking Fund to redeem any outstanding obligations. The Investment and Securities Act 2007, also permits suits, actions, or proceedings as may be expedient. The State Government will also have to file such default, with the Securities and Exchange Commission.

However, it should be noted that subnational bond defaults are rare. According to Moody’s in its 2019 report, in the past 48 years, there have been only 113 defaults in the total amount of a little over $72 billion across all sectors in the United States of America.

Conclusion

It is advisable that subnationals immediately commence plans to restructure existing loans, to create more fiscal space. Consideration should therefore be made, to negotiate debt service moratoriums for subnational issuers on foreign currency loans owed to bilateral and multilateral lenders, to ease debt service costs and fiscal burden on the States.

Simisola Eyisanmi, Legal Practitioner, Senior Associate and Head of the Financial Markets Group, Chris Ogunbanjo LP, Lagos