Sovereign debt crises often persist because there is no clear, universally accepted framework to determine the order in which creditors are repaid when a country defaults. Unlike domestic insolvency systems such as the U.S. Chapter 11 bankruptcy code, which outline specific rules for ranking creditors, sovereign debt restructuring relies on informal conventions and evolving practices. This ambiguity complicates negotiations, often prolonging debt relief efforts for indebted nations.

Reza Baqir, global head of sovereign advisory services at Alvarez & Marsal and former governor of the State Bank of Pakistan, highlights the need for a more structured approach. He points out that multilateral institutions like the International Monetary Fund (IMF) traditionally enjoy “preferred creditor” status, meaning they are typically paid in full and excluded from restructuring talks. On the other end of the spectrum, bondholders—who accept higher risks in exchange for elevated returns—are usually ranked lowest and expected to accept significant reductions or "haircuts" during restructurings.

However, Baqir emphasizes that many countries' largest creditors are not solely the IMF or bondholders but include multilateral development banks and official bilateral lenders. These creditors fall into an ambiguous gray area regarding their place in the creditor hierarchy, with no formal guidelines in contracts or treaties to clarify whether they should be treated as preferred or commercial creditors. The preferences assigned to these entities currently depend on case-by-case negotiation and informal practice, leading to prolonged disputes.

The case of Zambia illustrates the challenges associated with this lack of clarity. Even five years after its 2020 default, Zambia’s debt restructuring remains unresolved, partly due to disagreements over the status of Afreximbank, a regional development bank, and whether it should be given preferred creditor treatment. Similar complications are anticipated in Venezuela’s ongoing debt negotiations.

Baqir argues that the current system is unsustainable and calls for reform. He proposes that preferential treatment in restructuring should be based not on the identity of the lender but on the concessional nature of the loan terms provided to the debtor country. Under this approach, creditors offering lower interest rates or more generous financing conditions would face smaller haircuts in restructuring processes, regardless of whether they are official or commercial entities.

This principle, Baqir notes, could be implemented transparently by using existing concessionality calculators maintained by institutions like the IMF and World Bank. Moreover, such a system would incentivize official lenders to provide more favorable financing terms, benefiting debtor countries and potentially reducing the overall cost of sovereign borrowing.

While major multilateral development banks and certain creditors currently benefiting from preferred creditor status may resist changes due to concerns over increased funding costs, Baqir stresses that the status quo’s opacity and uncertainty impose significant costs. Disputes over creditor ranking slow down restructuring, invite litigation, and complicate negotiations—all of which worsen outcomes for both borrowers and lenders.

As sovereign debt challenges continue globally, Baqir concludes that the international financial community needs a modern, robust framework with clearly defined rules to govern sovereign debt workouts, replacing informal conventions with a consistent and transparent hierarchy based on loan terms rather than lender identity.