A New Approach to Sovereign Debt Restructuring -- Address by Anne Krueger, First Deputy Managing Director, IMF
December 20, 2001Address by Anne Krueger
First Deputy Managing Director, International Monetary Fund
Given at the Indian Council for Research on International Economic Relations
December 20, 2001
One message that has been drummed home to all of us by the events of the past year is that many of the issues we face in the modern world - economic, political, social, or environmental - cannot be dealt with adequately by nations acting alone. In many of these domains, cooperative responses are essential to get tough problems solved.
The topic I would like to talk about today is a good example. The international community has done much to strengthen the global financial system following the emerging market crises that began in Mexico in 1995. But some important weaknesses remain. Specifically, we need to look at ways to help countries with unsustainable debts deal with them in a prompt and orderly fashion - and without forcing the international community to bail out private creditors in a way that encourages inappropriate lending or investing in the future.
Last month I outlined an approach being considered by the staff and management of the IMF that we believe could help address this problem. This is not a formal proposal of the Fund, as we have not yet had chance to discuss it fully with our members - we look forward to doing so in the New Year. But I believe that an approach along these lines could make a valuable contribution to the strength and stability of the international financial system.
What I would like to do today is to briefly outline this new approach and then address a few of the objections and misconceptions that have been raised so far. We are a very long way from having every "i" dotted and "t" crossed, so I would welcome your thoughts on how best we could make progress in this area.
II. The Problem
When countries find themselves facing a shortage of foreign currency to service debts or pay for imports, temporary financial assistance from the IMF and agreement on a convincing economic adjustment package is normally sufficient to rebuild confidence among investors and lenders - and restore a country's access to foreign private capital.
But what if a country finds itself in a position where this catalytic approach is likely to prove ineffective? One solution would be for the official sector to lend a country all the money it needed to meet its obligations. This is neither possible nor desirable, especially if the country's debt burden is clearly unsustainable looking forward.
Unlike a domestic lender of last resort, the Fund cannot simply crank up the printing press. Its resources are limited, concretely and also by the understandable reluctance of our members to bail out private creditors and imprudent borrowers. Their reluctance is justified. Private institutions and sovereign borrowers risk being encouraged into imprudent lending and investing if they believe that the Fund will provide the creditors with the money they need to repay the debtor if things go wrong. That makes the international financial system less stable and less efficient.
So given these limitations, what if a country does find itself confronting a truly unsustainable debt burden? One way or another, it will have to be restructured. And it is better for the debtor, most of its creditors, and for the international community, if this can be done in an orderly way. To that end, it may be necessary for the offical sector to encourage private creditors to roll over their existing commitments and to limit their demands for repayment.
There is an obvious analogy here with a domestic bankruptcy regime. But for a variety of practical and legal reasons, sovereign debt problems are more complicated to deal with than those of companies or banks in a domestic context. In the 1980s restructuring sovereign debt was a long drawn out - but nonetheless mostly orderly - process that involved getting maybe 15 commercial banks round a table. In the early 1980s banks held around 85 percent of outstanding emerging market sovereign debt. The banks had good reasons to cooperate: similar institutional interests; a desire to secure future business from the debtor; a reluctance to offend regulators; and a legal obligation to share any proceeds of litigation with their fellow creditors.
In recent years countries have increasingly turned to bond issues to raise capital. As a result, the international capital market is more diversified and generally functions more effectively. But there is a downside when countries find their debts becoming unsustainable. Private creditors have become increasingly numerous, anonymous and difficult to coordinate - a problem exacerbated by the sheer variety of debt instruments and derivatives involved. Individual bondholders have greater incentives to sue delinquent creditors than banks, and are less amenable to arm-twisting by regulators. In one recent case a holdout creditor in effect held a country to ransom, threatening to push it into default with other bondholders unless the holdout was repaid.
No wonder then that countries facing severe liquidity problems go to extraordinary lengths to avoid restructuring their debts to foreign and domestic creditors. Countries know that even an orderly debt restructuring can deal a heavy blow to their economy and banking system; a disorderly restructuring can sever access to private capital for years to come, transforming an unpleasant drama into an enduring crisis. As a result countries with unsustainable problems wait too long before confronting the inevitable: too long for their own good, and too long for the good of the international community.
III. A Possible Solution
To address this problem, Fund staff and management have been thinking about a formal mechanism that would allow a country to request a temporary standstill on its debts, during which time the country would negotiate a restructuring with its creditors. The Fund would only approve such a request if the debt were judged truly unsustainable, a judgment that is clearly not an easy one to make. During this limited period, the country would have to provide creditors with assurances that money would not be allowed to flee the country, and that policies were being put in place to ensure that the country could repay its debts in the future.
In all probability, such a mechanism would need to be activated only very rarely. After all, when domestic bankruptcy regimes are well-developed and predictable in their operation, most corporate restructuring takes place "in the shadow of the law" rather than in court. We believe that the same would be true of a sovereign workout mechanism.
The formal element of the workout mechanism would need four key features:
- First, it would need to prevent creditors from disrupting negotiations on a restructuring by demanding repayment through national courts.
- Second, it would have to ensure that the debtor behaved itself during the period of the stay, treating creditors properly and adopting appropriate policies.
- Third, private lenders would need to be encouraged to provide new money with some assurance that they would be repaid ahead of existing creditors.
- And fourth, the mechanism would have to bind minority creditors into accepting a restructuring once it was agreed to by a large enough majority.
If these principles were to be established and enforced, it is clear that they would need the force of law in any country where enforcement might be sought. In practice, this means that they must have the force of law universally. Otherwise creditors will shop around for jurisdictions in which they have the best chance of enforcing their claims.
Getting every country to amend its domestic bankruptcy law - let alone to enforce it in a uniform way - would be a heroic undertaking. An alternative route might be to establish a treaty obligation by amending the Fund's Articles of Agreement. This would require the support of three-fifths of our members, holding 85 percent of the Fund's total voting power. The majority decision would then be binding on all our members. In any event, were this route or another taken, any new approach would require very broad support from the international community.
Since I first spoke about this possible new approach in Washington last month, it has stimulated a number of interesting reactions and alternative proposals. We look forward to talking to our members and all interested parties about them in the coming months. But let me just pick up now on six points made so far:
- First, people have questioned whether it would be appropriate for the Fund to interfere in the relationship between debtor and creditors, and to impose the terms of a restructuring on them. The simple answer is that we would have no intention of doing so and could not do so. The Fund would be mandating the process within which a restructuring would be negotiated, but not the outcome. The restructuring terms would emerge from negotiations between the debtor and creditors. But once the necessary majority of creditors had agreed the terms, the mechanism would make it possible to bind in minority creditors, thereby resolving the collective action problem.
- Second, people have asked why the Fund should exclude its own claims from a restructuring under the proposed new mechanism. This is to misunderstand the Fund's role as a lender. We are not a commercial organization seeking profitable lending opportunities. We lend at precisely the point at which the private sector is reluctant to do so - and at rates well below those that would be charged by private creditors. In doing so, we help avoid disorderly adjustment and discourage countries from adopting policies that would do unnecessary harm to themselves, their private creditors, and other countries. This is a public good that benefits that private sector and it would not therefore be appropriate to lump outstanding loans to the Fund with commercial claims in a workout. This would limit our ability to play that vital role in future.
- Third, a related critique asks whether the Fund can realistically act as an honest broker in the workout process, given that it is a creditor and therefore faces a conflict of interest. The involvement of the Fund in such a mechanism comes to mind naturally, as we are the most effective channel through which the international community can reach a judgment on the sustainability of the country's debt and economic policies, and on whether it is taking the necessary steps to avoid similar problems recurring in the future. But there are functions to which the Fund's existing structure would be less well suited: arbitrating disputes among creditors, or between the creditors and the debtor; verifying creditor claims; and confirming the integrity of votes on a potential restructuring. We would need some way to ensure that these aspects of the workout were seen to be carried out in a fair and transparent way.
- Fourth, people ask: what is in it for creditors? Well, when a country gets into trouble the fear of a disorderly workout - disrupted by legal challenges - can push the value of its debt down more sharply on the secondary market than would be the case in a more orderly and predictable environment. For creditors that mark to market, this can impose punishing losses. To be sure, some creditors relish disorder as a way to purchase distressed debt more cheaply. But most should favor a mechanism that helps preserve the value of their claims.
- Fifth, won't the mechanism make it more expensive for emerging market countries to access foreign capital? I believe not. A more orderly and predictable framework would help lenders and investors discriminate between good and bad risks more effectively. This should make it easier and cheaper for emerging market countries with strong policies to access foreign capital. (That is good news for countries like India that have been sure to repay debts in the past.) Countries with weak policies may find it more difficult, but that is no bad thing if it thereby encourages the authorities to tackle these weaknesses.
- Sixth, some observers have simply argued that the approach I have put forward is politically infeasible. I certainly would not seek to downplay the obstacles involved in getting proposals of this sort through some national legislatures. But many national authorities have expressed support for moving broadly in this direction as an investment in a more orderly and efficient international financial system. Trends in emerging capital markets are likely to make reform more attractive in the future. I should note at this point that even if such an approach were to enjoy unanimous political support, it would take two or three years to put in place. So none of what I have to say today has implications for negotiations we have under way with some of our members in crisis now.
Let me conclude briefly by putting this idea in a broader context. The free flow of international capital has delivered real economic gains to borrowers and providers alike, but at the cost of more frequent and severe financial crises.
The international community has put in place a twin-track response: to strengthen crisis prevention and to improve crisis management. We are strengthening crisis prevention by stepping up scrutiny of national policies and international markets; by improving communication between the public and private sectors, and by offering guarantees of financial support to countries with demonstrably sound policies. We are improving crisis management: by revamping our lending tools; and improving our policy advice to countries in trouble.
Adopting an international workout mechanism for countries with truly unsustainable debt positions could contribute to both these goals. It would make crisis management more orderly and less costly, by forcing countries to face up to their problems promptly. It would not, however, make restructuring an easy option, as the economic dislocation implied by even an orderly workout is considerable. 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 limiting overlending and overborrowing when times are good.
For these reasons, I believe that an approach of this sort could make a valuable contribution to the health of the international financial system. There are many technical, legal and analytical challenges we have to confront. I look forward to discussing them fully with our members in the New Year - and to hearing your views.