Issues In Sovereign Debt Restructuring

The latest crisis in Argentina has helped focus the attention of senior finance officials in creditor countries and at the international financial institutions on what the IMF’s First Deputy Managing Director Anne Krueger calls “the need for better incentives to ensure the orderly and timely restructuring of unsustainable sovereign debts.” [1] The thinking is that there has to be a better way of dealing with unsustainable debt burdens in countries such as Argentina than the present arrangements, involving a disorderly combination of last-minute bailouts, delayed policy responses on the part of the debtor, enormous uncertainty and all the economic, social and political dislocations associated with a sovereign debt default. In this article, we look at the arguments in favor of alternative approaches and the associated difficulties and tradeoffs.

The problem

The essence of the problem is that, whereas there are institutional mechanisms in place for the orderly rescheduling of public sector debt (Paris and London Clubs), there is no equivalent framework for debt instruments held by the private sector. The 1990s have witnessed a dramatic change in the structure of financing to emerging markets, with bonds and direct investment replacing syndicated bank lending and official flows. However, sovereign bond contracts are virtually impossible to restructure, typically requiring almost unanimous consent. Successful lawsuits can trigger cross-default on other securities and accelerated repayment clauses; indeed, there is a well-established cottage industry of “vulture” funds which position themselves to take advantage of these weaknesses. To make matters worse, ownership of bonds is very diffuse, in contrast with the situation prevailing during the 1980’s international debt crisis, when sovereign borrowers could usually negotiate restructuring deals with a limited number of private banks.

The latest thinking on how to improve the system of incentives now in place to make sovereign debt restructuring a more predictable and orderly process involves greater use of collective action clauses in bond contracts, buttressed by the introduction of legal provisions that would give some statutory underpinning and legitimacy to the new debt restructuring arrangements. In the early stages of this debate, many private creditors opposed the introduction of such clauses in bond contracts, arguing that they might make restructuring too easy. It was felt that, until the large creditor countries themselves did this on their own contracts, other countries were unlikely to follow suit. However, the debate has broadened considerably more recently, as creditors and debtors have come to realise that some changes to the existing arrangements are necessary, to prevent what Anne Krueger calls the “unpalatable choice between disruptive and potentially contagious unilateral default, or bailing out private creditors and thereby contributing to moral hazard.” The more closely integrated nature of financial markets (reflecting a combination of trade and financial linkages and, at times, herding behavior) and the much larger volume of cross-border financial flows, have highlighted the potentially destabilising effects of disorderly defaults, both for the defaulting country and, through contagion, for the international economy.

A very complex issue 

One line of argument put forward by opponents to the introduction of  collective action clauses in bond contracts is that it could lead to a shift in incentives for the debtor country, which would see “default” as an easy way out of the crisis. This would in turn lead to perceptions among creditors that lending to emerging markets had become riskier, precipitating a fall in the pool of resources made available to such countries, and/or a rise in the cost of lending. Since the new debt restructuring arrangements would bring with them changes to the underlying international legal framework (see below), governments might indeed be tempted to avail themselves of  internationally sanctioned debt standstills.

Obviously, much would depend on the nature of the mechanisms put in place. First, the issue of whether the debt burden was truly unsustainable, justifying recourse to the new mechanisms, would presumably not be a unilateral decision made by the debtor, but would involve an independent assessment by the Fund or some other multilateral entity with the requisite expertise and credibility. Putting aside the technical issue of what would be the key elements of such an assessment, creditors would need to be persuaded that the debtor had actually made good-faith efforts to forestall a default in the first instance. More importantly, the key argument against the “easy way out” line of thought is that countries would still bear the cost of loss of access to international capital markets, as well as the concomitant erosion of reputation associated with credit ratings’ downgrades and all the disruptions to economic activity linked to debt defaults. The new mechanisms for sovereign debt restructuring would not likely reduce the short-term pain associated with default; rather, their aim would be to put arrangements in place which reduced the span of time when debtors and creditors are forced to operate in an uncertain legal environment, making possible a quicker resumption of debt-servicing in a post-restructuring scenario.

The IMF at the centre

The Fund’s latest proposals seek to incorporate as a key element of future restructuring deals a mechanism enabling “a super-majority of creditors - across the broad range of credit instruments - to make the terms of a restructuring binding on the rest.” To provide the right sorts of incentives, debtors would not only be afforded legal protection while debt restructuring negotiations were under way, but creditors would likewise need to be reassured that, in the middle of financial chaos such as that seen in Argentina in recent months, resources would not be leaking away, which could undermine the country’s future capacity to service its debts. A perception would need to be created that creditors would be treated in an even-handed way and that, whatever the causes of the crisis, the authorities were making the necessary policy adjustments to ensure a return to the capital markets. The mechanism would be triggered at the request of the debtor. In the most favourable circumstances this would be done before the country had formally declared a default. Indeed, the mechanism might eventually play the role of a purely precautionary arrangement, signaling to debtors and creditors that, in the absence of a debt-restructuring agreement, a legal framework existed which could ensure an orderly process of negotiation.

One line of thought against the creation of new institutional mechanisms to deal with sovereign debt restructuring is that, with the possible exception of Argentina, most of the recent cases of serious debt-servicing difficulties in emerging markets have reflected more liquidity shortfalls than actual insolvency. These have been dealt with in a variety of ways, involving combinations of additional official finance (Korea, Thailand and Indonesia in 1997; Russia 1998, Brazil 1999, Turkey 2000/01, Argentina 2001); debt rollovers (Asia, Turkey); domestic debt default (Russia), in all cases against a background of major policy adjustments. So, the argument goes, rather than adopting new approaches to debt restructuring, the focus should be on market-based mechanisms supported by better policies, to prevent an Argentina-style meltdown. The proposals being put together by the Fund certainly do not negate the (somewhat obvious) fact that better policies might well protect a country against future crises. The point rather is that, when debts become unsustainable and a sovereign default all but inevitable, financial chaos seems to be the only option available in today’s international financial framework.

Credible objections?

A more credible criticism of the Fund’s proposals is that, while intellectually appealing, they may fall victim to operational complexities in practice. First, even if use were to be made of collective action clauses in the sense proposed by the IMF (super majorities binding on all creditors), this would still leave untouched the existing stock of bond holdings. Second, bonds are only a part of the total debt held by the sovereign, and “debt sustainability” is a concept that makes sense only when it applies to all forms of indebtedness, across many jurisdictions with different laws and maturities.

Third, as noted by the IMF, the lack of collective action clauses in many countries may itself reflect lawmakers’ desire to protect the rights of minority creditors, whereas the whole basis of the “new approach” to sovereign debt restructuring is that a super majority of creditors would impose its will on the minority. Fourth, the idea of the need to adopt collective action clauses has been around for several years; most large industrial countries (other than the UK and Canada) have shown little enthusiasm for it. There remains a large constituency in senior policymaking circles among the G7 that is likely to continue to argue that the “do virtually nothing” approach is the optimal strategy, with collective action clauses added to sovereign bond contracts on a voluntary basis.

Against the background of the above operational difficulties, it is not surprising that the Fund has come forward with a much more ambitious proposal, calling for the laying down of “a statutory basis through a universal treaty obligation”, as opposed to “piecemeal amendments to domestic legislation.” This approach would prevent creditors fr om searching for jurisdictions where legal claims could be enforced; it would allow uniformity of interpretation under a single authority; it would preempt the “free-rider” problem, whereby countries would wait until others had amended their respective legislations; finally, it would envisage the creation of a single judicial authority to “arbitrate disputes and oversee voting.” The Fund argues that this new legal framework could be achieved through amending the IMF’s Articles of Agreement, requiring acceptance by three-fifths of its members, accounting for 85% of the total voting power.

Other questions

This is roughly where the debate is at present. There are some unanswered questions. Would debts to the official sector be included in the restructuring process?  This is a particularly relevant for Turkey, whose very large IMF debt actually exceeds the stock of outstanding eurobonds. More generally, what would be the role played by the Fund in the restructuring process, given its own role as a creditor, as likely arbiter in deciding that the country had an “unsustainable debt burden,” and its additional role as policy advisor in the period leading to the debt default (eg, Argentina)? Not surprisingly, the IMF argues that its own debts should be exempted from any future restructuring process, but this raises questions of IMF accountability and evenhandedness of treatment across creditors. How would sovereign debt to domestic creditors be treated? What would be the role of exchange controls?

These issues will continue to be discussed in coming months, and they certainly deserve further scrutiny. We are sympathetic to the broad thrust of the Fund’s proposals, mainly because they aim to introduce a measure of predictability and legal order wh ere, at present, there is virtually none, other than haphazard “market-based” (ie, chaotic) exercises. But we fear that the project may founder under the weight of institutional inertia in senior policymaking circles and the burden of operational complexities on which consensus will be very difficult to establish. We will provide an update of the issues to our readers later in the year, as the debate evolves.

[1] See, for instance Anne. Krueger’s speech “New Approaches to Sovereign Debt Restructuring: An Update on Our Thinking”, delivered on 1 April 2002 at the IIE in Washington DC.