Gaming out Sovereign Default When China Is a Major Creditor


Game theory is a useful framework for modeling aspects of sovereign debt recoveries, given that it models the interactions among debtors and creditors in the lending/borrowing “game.” While there is a long-established set of precedents for Paris Club (U.S. & European) and multilateral (IMF, etc) creditors’ actions, we still have little available information about how China will act in debt negotiations. The increasing presence of China as a single large bilateral creditor in our markets, therefore, is worth modeling to see what kind of postures they might take. As commercial lenders alongside sovereign and multi-lateral lenders, we and our investors have a stake in the possible answers provided.

Since the inception of GMO’s Emerging Country Debt strategies in 1994, there have been many big structural shifts in the marketplace. One is the very emergence of the bond market itself, to which GMO has borne witness all along the way. In 1994, bonds accounted for about 15% of the external debt of emerging countries. In 2017, this figure was 44%. Over the ensuing years, bonds have essentially replaced bilateral (countryto-country) loans, while loans from multilateral organizations (such as the World Bank, IMF, and others) have remained at 20-25% of the total. A second big structural shift is the emergence of China as a creditor to other emerging countries, a process that has accelerated in recent years as a result of the Belt and Road Initiative. Opacity in the data prevents a fully accurate accounting, but by some estimates China (via its state policy banks and other entities) accounts for about 30% of the public sector external debt of Sub-Saharan Africa, for example. This is corroborated by the line in Exhibit 1 showing that China has been the source of about 40% of disbursements of external debt to Africa in the past 10 years.1 This level of exposure means that China will be an important “player” in some future debt restructurings. In this piece, we employ simple techniques from game theory to model how China might change, for better or worse, recovery outcomes for bondholders.

Thankfully, sovereign debt is an asset class with a relatively low observed incidence of default.2 When defaults occur, recovery values are essentially a function of two things: 1) the sovereign’s ability to pay (as governed by the economic and public finance realities); and 2) the strategic interaction among the “players,” in this case sovereign debtors and their creditors, which takes into account relative attitudes toward debt relief, economic adjustment, and strategic goodwill. The primary determinant of recovery value is the former, but the latter can also influence the outcome, positively or negatively. Moreover, recovery values in sovereign restructurings show wide variation over historical periods, ranging from 30% of face value on the low end to 90% on the high end. We already have an in-house model for estimating recovery based on the economic fundamentals. By understanding the strategic interaction among players a little better, we might be able to narrow the range of uncertainty around these estimates.

The Set-up of the “Game”

So, how might we model this strategic interaction? This is where game theory techniques can be useful.3 Imagine a simple interaction between debtor and creditor in which the debtor can offer economic policy reforms (PR) that will benefit the creditor (because it reduces country risk over time), while the creditor can offer debt write-off (DW) that will benefit the debtor.