By Mohamed Z M Aazim, Vikas Panday and Difie Boakye-Mensah, Debt Management Unit (DMU), Commonwealth Secretariat
In a recent policy paper by the Commonwealth Secretariat, it is argued that the increase in debt service payments linked to variable interest rate borrowing is primarily due to the continuing global rise in interest rates, rather the transition from the London Interbank Offered Rate (LIBOR) to other reference benchmarks. LIBOR provided loan issuers with a benchmark for setting interest rates on financial market borrowing, among other types of debt.
In this blog, we will unpack this issue and explore several policy options that could help Commonwealth countries, especially low- and middle-income economies, tackle the debt management challenges arising from variable interest rate borrowings. Read the paper here.
Interest Rate Trends
Interest rates are rising around the world. For instance, the U.S. policy interest rates have risen from 0.25 per cent to 0.50 per cent in March 2022 to a target range of 5.00 per cent to 5.25 per cent by May 2023.
This upward trend in interest rates is observed in most advanced and developing economies. It is expected that these high interest rates will persist for some time to effectively reduce inflation.
LIBOR Transition
LIBOR, a widely used variable reference rate, is being phased out by 30 June 2023. It will be replaced by the Secured Overnight Financing Rate (SOFR) as the underlying base rate for most international variable interest debt instruments.
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Impact on Debt Service Payments
There is a strong correlation between U.S. policy interest rates and variable interest rate benchmarks, affecting the debt service obligations of low and upper-middle-income countries.
Over the past 15 months, debt service obligations have multiplied when tied to variable interest rate benchmarks. While the LIBOR rates remain higher than the SOFR rates (neutral of spread adjustment), both have seen an increase of approximately 400 basis points during this period.
Analysis of Interest Rate Scenarios
To understand the impact of rising interest rates, our policy paper compared effective variable interest rates and interest costs for a portfolio with a notional stock of USD 1 billion linked to LIBOR or SOFR during 2022 and 2023. The analysis also considered a further increase of 25 basis points in interest rates in the second half of 2023.
The results revealed an increase of 300 to 565 basis points in effective interest rates across different variable interest rate scenarios over the same period.
Applying the increase in effective interest rates, debt service costs on the variable rate debt would have risen between 319 per cent and 1,671 per cent over two years from January 2022.
To put this into perspective, for a six-month servicing cycle of a USD 1 billion portfolio, payments would have increased from USD 1.70 million to USD 30.16 million in the case of LIBOR, and from USD 2.01 million payments to USD 29.70 million payments in the case of SOFR during the same period.
Unpacking the Causes
The findings suggest that the surge in debt service payments is primarily driven by the increase in policy interest rates during the reference period, rather than solely on account of the transition from LIBOR to SOFR.
Factors, such as global efforts to tame inflation through interest rate hikes and risk aversion by financial intermediaries, have complicated the application of reference rates for variable financing and servicing of existing variable rate debt. Additionally, governments face elevated financial vulnerabilities, with many carrying significant debt burdens.
Policy Options
To reduce exposure to variable reference rates linked to debt contracts, Commonwealth countries have the opportunity to negotiate the re-fixing of reference rates at favourable levels. This approach can benefit both the borrower and the lender.
For new financing contracts, considering a wide array of policy options is crucial. These options can include:
- introducing caps and floors;
- using a weighted scheme of reference rates;
- employing credit-enhancement-based financing; and
- incorporating clauses linked to economic cycles.
It is essential to proactively monitor existing debt vulnerabilities, especially those incurred during challenging times, such as the COVID-19 pandemic, energy price shocks and climate disasters. Governments should assess the risks associated with their debt portfolios and take appropriate measures to address any potential issues.
Furthermore, renewed joint efforts to drive policy discussions on reforming the Global Financial Architecture are essential to ensure prudent public debt management.
By implementing these measures, we can effectively handle the challenges that arise from variable interest rate borrowing, while ensuring that sufficient funds are relieved to finance Sustainable Development Goals.
Media contact
- Snober Abbasi Senior Communications Officer, Communications Division, Commonwealth Secretariat
- T: +442077476168 | E-mail
