This factsheet is no longer being updated. The information it contains may, therefore, no longer be current.
A Factsheet - January 2003

Proposals for a Sovereign Debt Restructuring Mechanism (SDRM)

The IMF's crisis prevention efforts are aimed at reducing the number of financial crises over time, but it is unrealistic to expect that all member countries will be able to avoid all crises all of the time. In rare instances where countries amass unsustainable debt burdens, they must restructure their obligations. Currently, the international financial system lacks a strong legal framework for the predictable and orderly restructuring of sovereign debt, which drives the cost of default even higher. The IMF is trying to create a framework for an equitable debt restructuring that restores sustainability and growth, without including incentives that unintentionally increase the risk of default.

In September 2002, the International Monetary and Financial Committee (IMFC) endorsed the Fund's work and requested the IMF to develop a concrete SDRM proposal for consideration at the April 2003 Spring meetings.

What is the problem?

In recent years countries have turned increasingly from bank loans to bond issues to raise capital. As a result, the international capital markets are more diversified and function more efficiently. Specifically, there is a broader investor base available to provide financing for emerging market sovereigns, which has helped diversify risk. But there is a serious downside if a country faces unsustainable debt. Private creditors have become increasingly numerous, anonymous and difficult to coordinate. This problem is exacerbated by the variety of debt instruments involved and the range of legal jurisdictions in which debt is issued. When faced with a restructuring, individual creditors, unlike banks, have more incentives to hold out for the best possible terms, or to sue for better terms. Also, disagreement over the relative treatment of different types of creditors are more likely.

Countries facing severe liquidity problems go to extraordinary lengths to avoid restructuring their debts to foreign and domestic creditors because they know that even an orderly debt restructuring can damage their economy and banking system. Moreover, a disorderly restructuring can sever access to private capital for years, leading to crisis. As a result, countries with unsustainable problems wait too long before confronting them, which is harmful to the country, its citizens and the entire international community.

What is the solution?

Better incentives for debtors and creditors to agree on prompt, orderly and predictable restructuring of unsustainable debt are needed. Domestic bankruptcy law serves as a useful model in the insolvency context, but the applicability of the corporate model is limited by the unique characteristics of a sovereign state. Considerable work has been done to identify "best practices" in core areas. Properly adapted, many of the following key features could be incorporated into the design of a sovereign debt restructuring mechanism ("SDRM").

Majority restructuring—The mechanism would allow a sovereign and a qualified majority of creditors to reach an agreement that would then be made binding on all creditors that are subject to the restructuring.

Deter disruptive litigation—The mechanism would discourage creditors from seeking to enhance their position through litigation during the restructuring process. The current SDRM proposal does not include an automatic stay on the enforcement of creditor rights. Rather any amounts recovered by a creditor through litigation would be deducted from its residual claim under an approved restructuring agreement (through the application of the so-called "Hotchpot rule").

Protecting creditor interests—An SDRM would need to include safeguards that give creditors adequate assurances that their interests are being protected during the restructuring process.

Priority financing—As a means of inducing new financing, an SDRM could exclude a specified amount of new financing from the restructuring, if such exclusion were supported by a qualified majority of creditors.

Going forward

In April 2002 the IMFC endorsed the IMF's view of the problem and encouraged it to investigate a "twin-track" approach to solving it.1 The first, a statutory approach, would create a legal framework that would allow a qualified majority of a country's creditors to approve a restructuring agreement which would be binding on all. In order to make the agreement binding on all creditors, enactment of a universal statutory framework would be necessary. The second approach would incorporate comprehensive restructuring clauses, so-called "collective action clauses," in debt instruments. Collective action clauses, found in sovereign bond contracts, limit the ability of dissident creditors to block a widely-supported restructuring on an individual bond issue.

Both approaches have been subject to intense and constructive debate, within the Fund and in other fora, throughout 2002. The IMFC reviewed progress at its September 2002 meeting.

Conclusion

Reforming the sovereign debt restructuring framework is a formidable task that will take many years to develop and implement. These reforms are just one part of the IMF's larger effort to

improve crisis management, and are intended to complement crisis prevention and crisis management efforts undertaken in response to the market turmoil in the late 1990s. Those reforms include: revamping of existing lending tools; examining the analytical framework it uses to assess debt sustainability; and clarifying the Fund's policy on the access members have to IMF lending. The result will be better allocation of global capital and a stronger, more stable, and more efficient international financial system.

For more information on SDRM:

International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring
Address by Anne Krueger
First Deputy Managing Director, IMF
November 26, 2001

A New Approach to Sovereign Debt Restructuring
Address by Anne Krueger
First Deputy Managing Director, IMF
December 20, 2001

New Approaches to Sovereign Debt Restructuring: An Update on Our Thinking
Address by Anne Krueger
First Deputy Managing Director, IMF
April 1, 2002

IMF Board Holds Informal Seminar on Sovereign Debt Restructuring
Public Information Notice (PIN) No. 02/38
April 1, 2002

A New Approach to Sovereign Debt Restructuring
A Pamphlet by Anne O. Krueger
Published April 2002
International Monetary Fund

IMF Board Discusses Collective Action Clauses in Sovereign Bond Contracts
Public Information Notice (PIN) No. 02/77
July 26, 2002

Statement on Sovereign Debt Restructuring Mechanism—Further Considerations
Statement by Anne Krueger
First Deputy Managing Director, IMF
September 4, 2002

IMF Board Discusses Possible Features of a New Sovereign Debt Restructuring Mechanism
Public Information Notice (PIN) No. 02/106
September 24, 2002

Sovereign Debt Restructuring: Where Stands the Debate?
Speech by Jack Boorman,
Special Advisor to the Managing Director, IMF
October 17, 2002

Sovereign Debt Restructuring Mechanism—One Year Later
Address by Anne O. Krueger
First Deputy Managing Director, IMF
December 10, 2002

Sovereign Debt Restructuring; Messy or Messier?
Remarks by Anne O. Krueger
First Deputy Managing Director, IMF
January 4, 2003

IMF Board Discusses Possible Features of A Sovereign Debt Restructuring Mechanism
Public Information Notice (PIN) No. 03/06
,
January 7, 2003


1Communiqué of the International Monetary and Financial Committee of the Board of Governors of the International Monetary Fund, April 20, 2002.


Sovereign Debt Restructuring Mechanism (SDRM)
Questions and Answers

Last Updated: August 05, 2013

A. Nature of the Problem
A.1 What problems is the SDRM proposal trying to solve?
A.2 What are the objectives of the SDRM?
A.3 How would the SDRM contribute to crisis prevention and crisis resolution?
A.4 Is the SDRM a solution to the holdout problem (or the "rogue creditors" problem)? If so, how do you respond to the view that the holdout problem has not been a big hindrance in sovereign debt restructurings to date?
B. Features of the SDRM
B.1 What are the main features of the SDRM?
B.2 Will claims of the Paris Club (official bilateral creditors) be included under the SDRM?
B.3 Will sovereign domestic debt be covered by SDRM?
B.4 Why shouldn't the claims of the IMF be brought under SDRM? Why should the Fund have preferred creditor status?
B.5 What is the collective action clauses (CAC) approach? How does the SDRM approach differ from the CAC approach?
B.6 What are the parallels with domestic (national) bankruptcy laws?
C. The IMF's Role under SDRM
C.1

What would be the role of the IMF under the SDRM?

C.2 Would the institution of the SDRM lead to smaller or more selective financial support packages from the Fund?
D. Concerns and Criticisms
D.1 How do you respond to the argument that the SDRM would not have been of much help in the financial crises of the past decade?
D.2 Isn't SDRM trying to fix something that "ain't broke"? Russia, Ecuador, Pakistan, and Ukraine managed to restructure their debts. Doesn't this show that current processes are doing the job?
D.3 Wouldn't SDRM override creditors' legitimate rights to enforce claims?
D.4 Wouldn't debtor countries use the SDRM too often?
D.5 How do you respond to the concern that the SDRM will lower capital flows to emerging markets and raise borrowing costs?
D.6 What empirical evidence can we bring to bear on the likely impact of the SDRM on the flows of capital to emerging markets and on borrowing costs?
D.7 How have officials of emerging market countries reacted to the SDRM proposal?
D.8 How have creditor groups reacted to the SDRM proposal?
D.9 Is the SDRM targeted at the debt problems of low-income countries?
D.10 Why shouldn't countries be allowed to use the SDRM to disqualify odious debt (i.e., debt related to arms purchases, debt accumulated by previous non-democratic or corrupt regimes, etc.)?
D.11 Why reschedule at all? Why don't countries with unsustainable debt burdens just repudiate them, and use the savings to bolster spending on domestic health, education, and infrastructure?

A. Nature of the Problem

A.1 What problems is the SDRM proposal trying to solve?

  • A country (`sovereign") sometimes finds itself, through some combination of bad luck and bad policies, with an unsustainable debt burden. A sovereign debt is unsustainable when, under any realistic set of policies and circumstances that can be envisaged, the debt-to-GDP ratio (or debt-to-export ratio in some cases) will rise without limit. In such cases, one way or another, the country's debt have to be restructured—that is, the net present value of the debt will have to be reduced relative to its face value.

  • But the process of restructuring is costly and painful, and so a country's policymakers typically delay entering into a discussion with their creditors. Often, the debtor country resorts to last ditch policies that make the situation worse and the ultimate adjustment even more difficult. Ordinary people can end up paying a tremendous economic and social cost as a result. Creditors are also damaged by these delays, since the value of their claims would be better preserved if the economic dislocation in the debtor country were less severe.

  • In addition, uncertainty about how the situation in one country is going to resolve itself often spills over to the market valuation of debt and assets of other emerging markets and developing countries.

  • Such a situation can leave the IMF, and the international community more broadly, with two unpalatable options: either withhold official financial assistance and let the country sink further into a state of crisis, or try to assist it with an IMF-supported program—even though the odds of the program's success may have been greatly reduced by the delay in dealing with the debt problem.

  • Delays in carrying out restructurings in large part result from the growing complexity of international financial markets and the increasing diversity of creditors. Difficulties can arise in several areas, including:

    • Collective action: A restructuring solution that is acceptable to the majority of creditors can be vetoed by one or a few minority creditors who wish to "hold out" for more favorable terms for themselves.

    • Creditor coordination: Governments of emerging markets now issue debt to a diffuse group of creditors with diverse economic interests, in different legal jurisdictions, and using a variety of instruments. It is difficult to get all of the creditors into a room and hammer out a solution that is acceptable to all.

  • The SDRM proposal would fill a gap in the international financial system by providing a framework to help resolve such problems.

A.2 What are the objectives of the SDRM?

  • The central objective is to put countries and their creditors in a better position to restructure unsustainable sovereign debts in an orderly and timely manner. The SDRM would provide the legal basis for creditors, in particular, to do so.

  • A less disorderly and drawn out debt restructuring process would be to the benefit of all concerned. The citizens of the countries whose debts are being restructured would benefit as the period of economic dislocation is reduced. And creditors would gain since their asset values are preserved.

  • The SDRM would also increase the efficiency and stability of the global financial system. By creating a more predictable environment for workouts in cases of unsustainable debt burdens, the overall risk of lending to emerging market countries would be reduced. This should lower the costs of accessing markets for emerging market countries with strong policies. Moreover, a more predictable restructuring framework should also yield greater stability of capital flows, as uncertainty over the modalities of a debt workout are reduced.

A.3 How would SDRM contribute to crisis prevention and crisis resolution?

  • The SDRM would complement valuable reforms that have already been undertaken in response to the emerging market financial crises of the 1990s.

  • The SDRM would contribute to crisis prevention. By providing greater clarity concerning the circumstances under which debt would be restructured and the process that would be followed, private markets would reduce lending to countries with already high debt-to-GDP ratios. And by reinforcing the fact that the official sector is not waiting on the sidelines to bail out imprudent creditors, it should help prevent crises by discouraging over lending and over borrowing.

  • In addition, SDRM would make crisis resolution more orderly and less costly. First, it provides incentives for countries to face up to their problems promptly, before the point of default. An orderly and timely restructuring preserves considerable value for all stakeholders, in contrast to a disorderly default where the value of claims in the secondary market typically plummets. Second, in those cases where resolution is necessary, there would be less debt to deal with. However, it should be emphasized that the proposals would not make restructuring an easy option, as the economic dislocation implied by even an orderly workout could be considerable. Moreover, there is no intention to reduce the incentives to service debt when it's still feasible to do so.

A.4 Is the SDRM a solution to the holdout (or "rogue creditor") problem? If so, how do you respond to the view that the holdout problem has not been a big hindrance in sovereign debt restructurings to date?

  • One of the aims of the SDRM is to make it easier for a debtor that reaches agreement with a super-majority of creditors to avoid holdouts. But the SDRM is also intended to catalyze the creation of a restructuring process that will help to resolve a range of other problems.

  • The holdout problem is most acute prior to a default, when creditors may consider that they have a reasonable prospect of continuing to be paid in line with the original terms of their contracts. As a result of the rational behavior of individual creditors, it may be difficult to reach an agreement that would be in the interests of creditors as a group.

  • The holdout problem is probably less acute following a default, as the options facing creditors—particularly those with no appetite for litigation—have narrowed. It is worth noting, however, that there have been recent holdout problems in Peru, the Congo, and some creditors have started litigation against Argentina. More generally, it is true that cases to date are few and that holdouts have not managed to derail restructurings, although in some cases "buying out" holdouts has had a cost. But the delays in reaching agreement with creditors have imposed substantial economic costs on debtors and creditors alike.

  • The holdout problem may become more prevalent in future, as successful litigation by some creditors in one case may increase the incentives for others to try it. In addition, the possibility that holdout creditors can attach future payments on restructured debt and receive better treatment than cooperating creditors distorts incentives and can derail efforts for a cooperative restructuring. It is likely to be of particular importance in cases in which the creditors are being asked to accept substantial debt and debt service reduction.

  • Ideally, the SDRM would encourage a country with unsustainable debt and its creditors to restructure before it gets to the point where default is the only option.

B. Features of the SDRM

B.1 What are the main features of the SDRM?

  • A big enough majority (a supermajority) of creditors could vote to accept new terms under a restructuring agreement. Minority creditors would be prevented from blocking such agreements or enforcing the terms of the original debt contracts—that is, they would be bound by the decision of the supermajority.

  • The SDRM would include a mechanism that would deter disruptive litigation by creditors during the debt restructuring negotiations. But there would be no automatic stay on enforcement.

  • Creditors would have assurance that the debtor will negotiate in good faith and will pursue policies—most likely designed in conjunction with seeking financial support from the IMF—that help protect the value of creditor claims and help limit the dislocation in the economy.

  • The SDRM would establish transparency requirements that would, among other things, enable creditors to have information about how other creditors are being treated during the restructuring process.

  • Creditors could agree to give seniority and protection from restructuring to fresh private lending, in order to facilitate ongoing economic activity through the continued provision of trade and other types of credit.

  • A dispute resolution forum would be established to resolve disputes that may arise during the voting process or when claims are being verified.

B.2 Will claims of the Paris Club (official bilateral creditors) be included under the SDRM?

  • It is likely that, in cases where Paris Club creditors have significant claims, such debts would need to be covered in a comprehensive restructuring. The question is whether they should be covered under the SDRM or whether the restructuring should be done in parallel outside the framework, relying on the Paris Club's existing restructuring practices. There is some inclination to exclude Paris Club claims from the formal framework of the SDRM; but we will continue to discuss how to proceed here with the Paris Club and the private creditor community.

B.3 Will sovereign domestic debt (i.e., sovereign debt governed by domestic law and subject to the exclusive jurisdiction of the domestic courts) be covered by SDRM?

  • No, not by the SDRM. In some circumstances, it may be necessary to restructure sovereign domestic debt if the overall burden is to be reduced to a sustainable level. And nonresident investors may only be willing to provide substantial debt reduction if they know that domestic creditors are shouldering a fair share of the burden too. But decisions on the inclusion of domestic debt would have to be made on a case-by-case basis, taking careful account of the different nature of these claims, as well as the possible impacts on the value of the assets of the domestic banking system and on the domestic capital market. In any event, domestic debt would not be restructured under the SDRM, since governments typically have at their disposal tools for restructuring domestic debt that are not available in the case of external debt.

B.4 Why shouldn't the claims of the IMF be brought under SDRM? Why should the Fund have preferred creditor status?

  • The IMF is not a commercial organization seeking profitable lending opportunities. In fact, it often lends precisely at the point where other creditors are reluctant to do so, and at interest rates that are below those that would be charged at that juncture by the private sector. In so doing, the IMF helps countries to catalyze private financing and to avoid disorderly adjustment and policies that would harm themselves, private creditors, and other countries. Putting IMF claims together with commercial claims in a workout would fundamentally undermine the Fund's capacity to play that vital role in future.

B.5 What is the collective action clauses (CAC) approach? How does the SDRM approach differ from the CAC approach?

  • Collective action clauses apply to individual bond issues. They would permit a specified super-majority of holders of a particular bond issue to agree to a restructuring that would be binding on all holders of that issue. By preventing holdouts in individual bond issues, such clauses would thereby facilitate any needed restructuring. The use of CACs would be an improvement over the current system and the IMF is committed to promoting their use among its member countries. But currently, most bonds do not include these clauses.

  • In a general restructuring, the CAC approach would require separate decisions from holders of each individual bond issue. Creditors of issues not accepting a restructuring offer would have the right to pursue their interests in the courts in the country/state under whose laws the debt instruments were issued.

  • The SDRM proposal goes farther than CAC and could complement it nicely. The SDRM is a more comprehensive approach than CAC because:

    • The SDRM would deal with the whole existing stock of debt, including instruments that do not explicitly provide for collective action. Even if CACs became more widely used in new bond contracts, the CAC approach would still fail to cover existing instruments that lack such clauses.

    • The SDRM would allow a single vote to restructure multiple debt instruments by aggregating the votes of creditors holding participating debt instruments. In other words, the SDRM permits the debtor and its creditors to act as if all of this debt were governed by a single collective action clause.

    • The SDRM would provide for an impartial dispute resolution process to protect creditors against fraud. The difficulty in providing such protection in the context of CACs has been a major impediment to developing a contractual approach to aggregation.

    • The SDRM would allow a super majority of creditors to approve new money that could help limit the scope of economic dislocation during the restructuring process. CACs do not have this feature.

    • The SDRM would enter into force for all countries at the same time. In contrast, there could be a "first mover" problem associated with CACs—that is, emerging market economies might resist including CACs in their bond issues fearing that investors will interpret such inclusion as a signal that restructuring is more likely and will thus require a higher risk premium.

B.6 What are the parallels with domestic (national) bankruptcy laws?

  • The SDRM proposal has been inspired both by existing collective action clauses and by the principles of domestic bankruptcy. As a result, it has some similarities but also important differences with domestic bankruptcy regimes. Both bankruptcy and the SDRM are designed to help a debtor reorganize its finances and activities to restore debt payments by allowing creditors to decide collectively on a restructuring. But the SDRM is designed to leave crucial decisions to creditors and the debtor—and thus to avoid the need to create the equivalent of a bankruptcy judge that has the power to grant a debtor legal protection. In particular, the SDRM does not include an automatic stay on the enforcement of creditors' rights.

  • Of course, we must be cautious in drawing parallels between domestic bankruptcy regimes and the sovereign context. In the latter, there is no ultimate sanction of liquidation, policies are not supervised by a bankruptcy court, and creditors cannot insist on a change in management. We are not proposing a bankruptcy mechanism for countries, but simply a mechanism to facilitate debt workout negotiations between a debtor and its creditors.

  • Nevertheless, it is worth noting that Chapter 11 of the U.S. Bankruptcy Code, and the move in a number of European countries to adopt statutory rehabilitation frameworks, reflects a recognition of the potential benefits of moving rapidly to protect economic value and the interests of stakeholders—including shareholders, creditors, and the labor force in the nonsovereign context. The fact remains that both countries and their creditors would be well served by moving rapidly to put debt into a sustainable basis. Market failures that introduce unnecessary delays into this process lead to debtors and their creditors to bear costs that are unduly large.

C. Role of the IMF under the SDRM

C.1 What would be the role of the IMF under the SDRM?

  • The proposal does not envision new legal powers for the existing organs of the IMF. The decisions would be those of the debtor and a supermajority of creditors or of an independent dispute resolution forum. The IMF does not want to insert itself as judge or arbiter into the middle of a restructuring discussion between debtor and creditors.

  • At the same time, the IMF has a crucial role to play in enabling the international community to reach a judgment on the sustainability of a country's debt and the appropriateness of its economic policies. But the Fund plays this role right now, even in the absence of the SDRM. In cases where there is a Fund program, there has to be some degree of consistency between the Fund's judgments about a sustainable economic program and the feasible size of primary budget surpluses, on the one hand, and the extent of restructuring agreed to by the creditors and the debtors, on the other. At the end of the day, things have to add up such that the agreed restructuring, financial support from the IMF, financial support from other sources catalyzed by the IMF-supported program, and the country's own efforts at adjustment succeed in restoring the country to a sustainable situation.

  • In broad terms, the Fund's role will continue to be what it has been to date, namely that of signaling its willingness to support a country's economic policies and providing financial assistance to members implementing appropriate policies through an IMF-supported program.

C.2 Would the introduction of the SDRM lead to smaller or more selective financial support packages from the Fund?

  • The international community's backing for such an approach would reaffirm the principle that IMF financial support should be geared to countries with (temporary) liquidity problems and not to countries with unsustainable debts. So the proposal's effect should be to tilt Fund financial support toward cases that are worthy of support and where the Fund's resources can successfully address underlying problems.

D. Concerns and Criticisms

D.1 How do you respond to the argument that the SDRM would not have been of much help in the financial crises of the past decade?

  • There has been great diversity in the types of financial crises in the last decade, and no single instrument, the SDRM or any other, would have been able to tackle every one of them. This diversity is an argument for having more—not fewer—instruments in the tool-kit for crisis prevention and resolution. SDRM would have helped in crises where sovereign debt restructuring was a necessary part of the solution.

  • A question more relevant than how useful SDRM would have been in the past is how helpful is it going to be in future. As more countries gain access to private capital markets—which is an objective of the international community—a framework for the more orderly resolution of unsustainable debt situations (in those rare cases when they do arise) would be of help.

  • The SDRM is part of a package of reforms for crisis prevention and better crisis resolution and should not be viewed in isolation. Other elements of the package include improvements in assessments of debt sustainability; strengthening the capacity to resolve banking system difficulties; changes in IMF lending and access policies that will more clearly prescribe the scale of IMF financial support; and streamlined conditionality.

  • In short, we are not proposing the SDRM in isolation, we are not proposing it as a solution to all problems, and we are not pursuing it to the exclusion of other needed reforms.

D.2 Isn't the SDRM trying to fix something that "ain't broke"? Russia, Ecuador, Pakistan, and Ukraine managed to restructure their debts. Doesn't this show that current processes are doing the job?

  • This is essentially an argument that we should continue to muddle through sovereign debt crises. Debtor countries and their creditors have paid large costs in recent cases of sovereign default. Some may argue that bankruptcy should be messy—that the costs are necessary to discipline debtors to avoid default. Our view is that the costs at present are too high and too disruptive to the international community as a whole (see A.1). Doing nothing is therefore not an option.

  • Moreover, there were some special features in the cases mentioned that would not be present in general. For instance, Ecuador made aggressive use of exit consents and it is not clear that this strategy can be used in the future—particularly if creditors change bond contracts to make use of exit consents more difficult. In Pakistan's case, most of the instruments were held by major Middle East institutions, reducing the diversity of the creditor base. Most of Ukraine's bonds had collective action clauses. And all three of these countries (Ecuador, Pakistan, Ukraine) had only a handful of bonds.

D.3 Wouldn't the SDRM override creditors' legitimate rights to enforce claims?

  • The latest SDRM proposal does not include provisions for the imposition of an automatic stay on the enforcement of creditors' rights.

  • What the SDRM would do is to redistribute powers from individual creditors to a super-majority of creditors (which, it should be noted, is what CACs would do as well).

  • The SDRM proposal contains many safeguards, including to prevent abuse, provide for adequate transparency in the voting process, and protect the seniority of credit.

  • Problems of coordination and collective action across a diverse group of creditors are market failures that lead to major losses; correcting them will in fact improve the value of creditors' claims.

D.4 Wouldn't debtor countries use the SDRM too often?

  • Even with the SDRM, debt restructuring would be a costly option. The prospect of economic dislocation, political upheaval, and damage to the country's reputation in international capital markets would still make countries loath to approach their creditors for a restructuring—let alone default—on their debt service obligations in all but the most extreme circumstances. Debt restructuring would remain an economically painful process—and one that debtors would rightly remain reluctant to enter into.

  • In any case, the SDRM would be available only to countries whose debts are unsustainable, and where debt restructuring is thus inevitable. It is hard to argue that facilitating orderly debt workouts in such cases would weaken the credit culture or create moral hazard.

D.5 How do you respond to the concern that the SDRM will lower capital flows to emerging markets and raise borrowing costs?

  • No, quite the opposite. In the domestic context, the existence of a bankruptcy law makes debt markets more efficient. In the United States and in many other countries, corporate debt has long been subject to bankruptcy proceedings, and yet corporate bond markets have thrived. The same principle should hold for international capital markets. If the SDRM is successful in reducing uncertainty surrounding the process of restructuring, and provides effective incentives for debtors to approach their creditors while there is money on the table and before full-blown crises take hold—then recovery values on restructured debt should increase, and the cost of capital should decline. It should also increase the attractiveness of the asset class as a whole.

D.6 What empirical evidence can we bring to bear on the likely impact of the SDRM on the flows of capital to emerging markets and on borrowing costs?

  • Anecdotal as well as more systematic empirical evidence on the impact of collective action clauses on borrowing costs may be relevant to assessing what would happen under the SDRM. When the G-10 report in 1996 first advocated the use of collective action clauses, there was strong opposition on the grounds that they would lead to higher borrowing costs. This argument became much less persuasive when it was pointed out that these clauses already existed in British trust-deed bonds. Likewise, several data and news services that report in detail on each new bond issue never explain the pricing of a bond in terms of the presence or absence of collective action clauses. More systematic econometric investigations, including a study presented at the IMF's annual research conference in November 2002, have also failed to uncover any systematic impact of collective action clauses on borrowing costs for the asset class as a whole.

D.7 How have officials of emerging market countries reacted to the SDRM proposal?

  • The IMFC, the governing body of the IMF which includes representatives of both emerging markets and industrialized countries, expressed support for the approach and asked for a full proposal for consideration at their Spring 2003 meeting.

D.8 How have creditor groups reacted to the SDRM proposal?

  • Some have expressed concerns that debtor countries would use the SDRM "too often." But ultimately, a debtor cannot use the SDRM without the consent of a supermajority of its creditors (see D.4 above).

  • There have also been questions about how the role of the IMF would change once SDRM is in place, and questions on numerous technical and legal questions about the specific design of the SDRM. These issues are being further discussed with creditors, both from the financial and legal community.

  • Other creditors recognize the potential gains to them from the SDRM approach, and recognize that it would provide incentives for a more structured and organized negotiation process with debtors.

D.9 Is the SDRM targeted at the debt problems of low-income countries?

  • No, the debt problems of low-income countries are being dealt with under the Highly Indebted Poor Country (HIPC) initiative. The SDRM addresses issues concerning sovereign debt to private sector creditors, and is thus more relevant to emerging market countries that have borrowed on international capital markets. That said, there are a small number of countries eligible for assistance under the HIPC initiative that also have large debt outstanding to private creditors; the SDRM could be relevant to their situation as well.

D.10 Why shouldn't countries be allowed to use the SDRM to disqualify "odious" debt (i.e., debt related to arms purchases, debt accumulated by previous non-democratic or corrupt regimes, etc.)?

  • One of the key principles underlying the SDRM is that any interference with contractual relations should be limited to those measures that are necessary to resolve the most important collective action problems. But disqualifying "odious" debt would involve a radical change in the validity of creditor claims and the sanctity of contracts, which would have adverse implications for the operation of capital markets. It would introduce a new risk factor over and beyond the nature of credit and the repayment terms. It would undermine the efficient operation of secondary markets, and have an adverse effect on emerging market borrowers to make issues in primary markets.
D.11 Why should a country with an unsustainable debt burden try so hard to avoid default? Why not just repudiate the debt, and use the savings to bolster spending on domestic health, education, and infrastructure?
  • The costs of the economic turmoil that typically follow a default are enormous. And many of these costs are likely to be even larger if the debt is repudiated—that is, if no effort is made to restructure its repayment. Such costs would far outweigh the short-term gains.

  • The balance of payments crisis that results from a default is invariably more severe than otherwise. A default—and particularly a repudiation—undermines confidence that the government will respect property rights. Will domestic bank assets be confiscated? Will the rights of investors holding equity or owning businesses be curtailed? The consequence is capital flight and a large reversal of inflows.

    Argentina 2002 vs. Brazil 1999 is an excellent example of how much higher the costs can be under default than under a "mere" currency crisis by itself.

    • Brazil suffered a currency crisis in 1999. Debt flows collapsed, but were offset by a boom in FDI owing to the bargain-basement prices that were available after the devaluation.

    • Argentina suffered a currency crisis and then defaulted in 2002. Both debt and FDI flows collapsed, and the net capital outflows were much higher than in the case of Brazil. In spite of the devaluation and bargain-basement prices, investors feared that they might not be able to repatriate profits or that they would be subject to confiscatory measures, or worse.

  • The domestic financial system is usually devastated by a default, since banks typically hold large amounts of government debt. Credit, and even intermediation, are severely impacted, and output collapses. Even if the government manages to selectively default on external credits only, the reversal of capital flows that follows from the default will put a severe strain on the financial system.

  • International trade often declines following a sovereign default. This can result as trade credit dries up, and also because creditors may wish to punish the defaulter or dissuade the country from defaulting again in future. The latter effect should be especially important in the case of debt repudiation. Andrew Rose (University of California-Berkeley) has found that the decline in bilateral trade suffered by sovereign defaulters adds up to about a year's worth of trade spread out over 15 years.

  • Future access to capital markets can be impeded and borrowing costs are likely to remain high for a long time. Historically, countries that defaulted on their external debts lost access to international capital markets until they reached an acceptable settlement with their creditors. But even after settlement, interest rates on new borrowing tended to remain high, at least until a good track record was (re-) established. Empirical studies have shown that countries that wrote down their debts in the late 1980s under the Brady plan still face higher borrowing costs today as a consequence.

  • Expenditures on health, education, and infrastructure are extremely important. In the long run, countries that maintain investor confidence and good access to international credit markets are able to finance much more generous social and infrastructure expenditures than countries that are isolated from the global financial community.

IMF EXTERNAL RELATIONS DEPARTMENT

Public Affairs    Media Relations
E-mail: publicaffairs@imf.org E-mail: media@imf.org
Fax: 202-623-6220 Phone: 202-623-7100