Sovereign Debt Restructuring Mechanism: One Year Later, Speech by Anne O. Krueger, First Deputy Managing Director, IMF
November 12, 2002
Ladies and Gentlemen: I welcome this opportunity to further the discussion on the IMF's proposal for a sovereign debt restructuring mechanism (SDRM). The proposal, initially presented a year ago, has stimulated a number of interesting reactions. I was pleased to find evidence of support for a statutory approach—which the SDRM is—from an association representing foreign bondholders. Their statement said:
"During the autumn of last year, a conference of jurists and public men of various countries ... [discussed] ... the possibility of international agreements upon the principles of law which should determine the liability of sovereign states and foreign subjects in their relations to one another. ... There can be no question as to the advantage that would result from such an agreement."
That quote is from the annual report of the Corporation of Foreign Bondholders. I only wish the report was dated 2002 and not 1874. It goes to show that the debate over how best to carry out sovereign debt restructurings has been with us for a very long time.
The question of how to handle situations of unsustainable sovereign debt acquired increased urgency in the 1980s, when private capital flows—mostly lending from private banks to sovereigns—had grown enormously relative to official flows. Then, in the 1990s, private flows—bonds as well as bank lending—exploded. As I will describe later, this diversity in debt instruments has added to the challenge of how to tackle situations where sovereign debt has become unsustainable.
Today, I want to focus on three interrelated issues. The first is the implications—for the debtor and the creditors—of unsustainable sovereign debts. The second is a brief reminder of where the proposals for sovereign debt restructuring stand. And the third is how the implementation of these proposals would affect the volume and terms of capital flows and functioning of international capital markets.
II. Unsustainable Debt Burdens
Let me turn first to unsustainable debt burdens.
Private capital flows greatly benefit source and destination countries. Lenders receive higher returns and can diversify their portfolios. Borrowers are enabled to invest more than domestic savings alone will allow. (There are, of course, major benefits in technology transfer, learning, and other areas of development as well, particularly from foreign direct investment, but these are not central to my concerns today).
Capital flows to sovereigns are a significant part of these flows and can finance necessary infrastructure and other public sector investments. When returns on these investments are high, economic growth accelerates, and debt-servicing is readily financed.
For most countries, most of the time, that is the end of the story. Occasionally, however, sovereign debt becomes unsustainable. And I want to focus for a moment on what that means, because that's the key to the SDRM proposal.
A sovereign debt is sustainable when the sovereign can, with reasonable policies, service the debt to an extent that the future debt-to-GNP ratio will ultimately stabilize or fall. It 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 the latter circumstance, debt will ultimately have to be restructured with a reduced net present value (NPV) relative to its face value. There are very important points to be made about these circumstances when they do arise:
- First, once debt is unsustainable, the true NPV of the stock of debt is below its face value as creditors cannot be repaid in full. Further borrowing by the sovereign dilutes the value of claims of existing creditors.
- Second, as debt-to-GDP mounts, real interest rates in the debtor country will rise. The sovereign may try to increase taxes or take other measures to service debt; but all of these measures are growth-reducing. Growth falters, and at some point real GDP itself can start falling, thereby increasing the debt-to-GDP ratio still further. A rising real interest rate at the same time increases interest costs of the debt.
- Third, in circumstances where the real rate of growth of the economy plus the primary surplus as a percent of GDP is less than the interest payments as a percent of GDP, the debt-to-GDP ratio will grow indefinitely.
- Fourth, as debt service rises, lenders see that debt sustainability is increasingly improbable, and at some point the supply of funds dries up, perhaps abruptly.
- Fifth, and importantly, when debt is clearly unsustainable, there comes a point at which the true NPV of the debtor's primary surplus can be larger if debt is restructured because the economy's growth prospects can increase and real interest rates can fall. This is the so-called debt overhang and it is in these circumstances that an orderly and prompt restructuring can create value for both creditors and debtor.
This last point is crucial—restructuring can increase returns to all parties in cases where debt is unsustainable. But the circumstances in which this is the case are highly limited. Nothing being proposed is designed to lead to restructuring when debt is sustainable—the process is far too costly and painful. Indeed, it is so painful that sovereigns typically put off the day of reckoning beyond the point when there are any reasonable prospects of the situation correcting itself.
It is for these extreme circumstances that there are proposals on the table to allow a more orderly resolution of crisis arising from, or accompanied by, an unsustainable debt burden. The proposals would contribute to both crisis prevention and crisis resolution.
They would contribute to crisis prevention because private markets would lend less to countries with already high debt-to-GDP ratios. The proposals will also reinforce the fact that the official sector is not waiting on the sidelines to bail out imprudent creditors; this should help prevent crises by discouraging overlending and overborrowing.
In addition, the proposals would make crisis resolution more orderly and less costly, by providing incentives for countries to face up to their problems promptly, and in those cases where resolution is necessary there would be less debt to deal with.
The proposals would not, however, make restructuring an easy option, as the economic dislocation implied by even an orderly workout could be considerable (and there is no intention to reduce the incentives to service debt when it's a feasible proposition).
Let me now briefly review where the discussion and proposals stand.
III. Where We Stand
As you know, there are two broad classes of proposals on the table. One is to introduce collective action clauses (CACs), which are already accepted practice in some markets, more universally in sovereign debt contracts. The other is for a statutory framework—the SDRM—under which broader debt restructuring might occur.
The proposals are intended to ameliorate delays in restructuring unsustainable debt by addressing problems that currently arise in those circumstances. Currently, a creditor who holds out can scuttle an agreement acceptable to the majority and quite possibly obtain better terms for himself. That also serves as a disincentive for other creditors to organize. In short, there is a lack of incentives to resolve the collective action problem.
Developments in capital markets have amplified these difficulties. Debt restructuring was difficult enough in the 1980s, when you could bring together the holders of the majority of a country's debt by getting representatives of 15 to 20 banks around a table. Even so, restructuring took a long time, and growth did not resume for many highly-indebted countries until after the inauguration in the late 1980s of the Brady Plan, which could be described as an informal kind of debt restructuring mechanism.
As already mentioned, things are even more complicated now. Over the 1990s, countries have increasingly borrowed by issuing bonds. As a result, the share of bonds in outstanding public external debt owed to private creditors has nearly quadrupled to about 60 percent in 2000. Diversification in the sources of finance is a healthy development, but it can become a hindrance when negotiating a restructuring.
This is because bondholders can be even more difficult to coordinate than bank creditors. Unlike bankers, bondholders often do not have long-term relationships with the debtor. Bondholders also have greater incentives to sue delinquent creditors, because unlike banks they do not have to share the proceeds of litigation. The situation is further complicated by the growing variety of debt instruments and derivatives in play. Because of all these factors, it is difficult to get everybody in the same room and hammer out an agreement that everyone accepts as a fair solution.
The two proposals—CACs and SDRM—would help bring about faster and more orderly restructuring. Let me try and describe briefly how each would work.
CACs apply to individual bond issues. They would permit a specified super-majority of holders of the bond issue to agree to a restructuring that would be binding on all holders of that issue—that's what the clause does. That would then prevent hold-outs in individual bond issues, thereby facilitating any needed restructuring. A registry of holders, or trustee arrangements, could accelerate the process. The use of such CACs would be an improvement over the current system and the IMF is committed to promoting their use among its member countries.
The SDRM proposal goes further than CACs and could complement it nicely. It provides a mechanism which, when activated, would enable creditors and debtors to negotiate a restructuring, aggregating across instruments, and ratifying an agreement binding on all by a specified super-majority. As with a domestic insolvency law, it would aggregate claims for voting purposes and could apply to all existing claims. An independent and centralized dispute resolution forum would be established to verify claims, insure the integrity of the voting process, and adjudicate disputes that might arise. By providing the locus and secretariat for these activities, this forum would enable a smoother and quicker negotiation than now seems feasible.
Activation of the SDRM—and the accompanying standstill—would take place only at the request of the sovereign and after a preliminary judgment of probable cause for unsustainability was made. In other words, there's a "double trigger"—the debtor has to ask for it but then it also has to be validated. Creditors would be empowered to declare that the sovereign was not bargaining in good faith at any time—and if they declared so, the standstill would be lifted and the situation would return to what it was before the mechanism was activated.
What formal role would the IMF have under the SDRM proposal? The short answer is: None. No new legal powers are envisioned for the Fund. The debtor country and its creditors would be the ones at the negotiating table. Using an amendment to the IMF's Articles of Agreement, which puts a legal framework on all our member countries, is a device to achieve supermajority restructuring with aggregation. In principle, a multilateral treaty could achieve the same purpose, but even one or two non-signers would impair the value of its existence substantially. Our aim is to make the process of reaching agreement on a necessary restructuring smoother, certainly not to dictate the terms.
At the same time, the IMF has a crucial role to play now, and in the future, 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. This is because there has to be some degree of consistency between the Fund's judgments about the sustainable economic program and the feasible size of primary surpluses, on the one hand, and the extent of restructuring agreed to by the creditors and the debtors, on the other.
So, 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 through an IMF-supported program (when the country's situation looks sustainable going forward).
Those in a nutshell are the main features of CACs and SDRM. Both were endorsed at the Annual Meetings of the World Bank and the IMF by the International Monetary and Financial Committee, the IMFC. The IMFC noted that CACs and SDRM are complementary proposals and asked for further progress on both. At the Fund, we are supporting both approaches and have been instructed to develop a concrete proposal on SDRM for consideration at the Spring Meeting of the IMFC.
IV. Imagining a World with SDRM
Let me now turn and ask what difference these proposals make to international capital markets.
What would the world look like once we were further along with both proposals, once an SDRM was in place and there was greater use of collective action clauses in debt contracts? What would happen to the flows of capital to emerging markets? How would the terms on which emerging markets can access foreign capital change?
Let's begin with the impact on capital flows. A more orderly framework for debt restructuring will provide investors greater incentives to differentiate between risks, thereby making it easier for countries with sound economic policies to attract capital. (Clearly, SDRM is not an issue for countries with an investment-grade rating.) Countries with weaker policies may initially find it more difficult, but they will quickly realize that better policies are needed to attract capital. So what would happen over time is that the incentives for countries to follow sound policies will increase. And this, in turn, should increase the attractiveness of emerging markets as an asset class and therefore the flows of capital to them.
Next, what about the impact of SDRM on the cost of borrowing for emerging markets? Pursuing the line of argument just made, the borrowing costs for countries with sound economic policies should fall as it would pay investors to be more active than in the past in differentiating among countries. So countries with sound policies would have a larger pool of foreign capital to draw on and better terms on which to borrow. Moreover, for a number of reasons, there should be over time a reduction in the borrowing costs for the asset class as a whole.
First, if more countries start to follow sound policies—because, as discussed, there would be increased incentives to do so to have access to foreign capital markets—the increased supply of capital to emerging markets as a whole would lower borrowing costs. Second, SDRM should increase investor recovery rates by shortening the negotiation process and putting in place an efficient workout procedure in which a lot of power is given to the creditors collectively; this in turn would lead to a reduction in borrowing costs. Finally, with the SDRM in effect, the expected size of the restructuring—the haircut, if you will—should also be smaller; that too should increase recovery rates and lower borrowing costs.
What I've said so far is theory. What empirical evidence can we bring to bear on the impact on the volume and terms of capital flows? One obvious source of evidence is the rich history of national bankruptcy laws from which the SDRM proposal drew some of its inspiration.
U.S. bankruptcy procedures, for instance, were an outgrowth of attempts to deal with numerous railroad failures in the 1850s at a time when there were no formal bankruptcy institutions. It was obvious that liquidating the railroad, and giving each creditor a piece of the track, was not a solution that would get anyone anywhere.
So procedures evolved that tried to maintain railroad's going-concern value. This required, among other things, new funds to keep the railroads running and pay suppliers; and this has since become known as debtor-in-possession financing.
Today, under U.S. bankruptcy law, when a private firm gets in financial trouble, it can "file under Chapter 11". This allows the ailing firm to suspend payments to all creditors and gives it breathing space to do one or more of several things: reorganize its finances and activities to restore debt payments; negotiate with existing creditors to restructure the debt; and try to attract new money with repayment preference given to these new creditors. These activities are carried out under the protection and guidance of a court of law. National bankruptcy law is designed to preserve the going-concern value of the firm (of course, in cases where the going-concern value exceeds the sale value of the assets when broken up).
No similar set of procedures exist for situations when sovereign borrowers have unsustainable debts. Of course, by definition, sovereigns are different from corporations and one should not expect that every aspect of the working of domestic bankruptcy laws would carry over to the sovereign case. Nevertheless, there are enough parallels that the SDRM proposal can be viewed, broadly speaking, as providing a counterpart to national bankruptcy proceedings.
In the national context, the existence of a bankruptcy law makes debt markets more efficient. In many countries, corporate debt has long been subject to bankruptcy proceedings, and yet corporate bond markets have thrived—in the United States, for instance, corporate bond markets expanded after the introduction of the 1978 bankruptcy act, the last major change in the country's bankruptcy laws. Almost everyone recognizes that bankruptcy law is an essential—if not vital—element for a well-functioning domestic economy. It is market-friendly.
Surely similar reasoning, allowing for the fact that it is sovereign debt, holds in the international arena as well. The predictability provided by SDRM—about the process to be followed in those rare cases when restructuring of sovereign debt is required—should increase the attractiveness of the asset class. Domestic bankruptcy laws are part of the rules of the game that help guide capital flows within a country toward well-managed firms and provide incentives for others to do better. Similar considerations should apply to flows across national boundaries.
Now, what about empirical evidence on the impact on borrowing costs? Of course, we haven't had an SDRM in place and so we don't have direct empirical evidence. But the anecdotal and more systematic empirical evidence on the impact of collective action clauses on borrowing costs may be relevant. When the G-10 report in 1996 first advocated the use of collective action clauses, there was strong opposition to it on the grounds that it 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 last week, have also failed to uncover any systematic impact of collective action clauses on borrowing costs for the asset class as a whole.
Let me now conclude. Unsustainable debts have to be restructured, one way or the other. The only question is at what cost. Adam Smith wrote that "when it becomes necessary for a state to declare itself bankrupt ... a fair, open and avowed bankruptcy is always the measure which is both least dishonorable to the debtor, and least hurtful to the creditor."
A more orderly process will be to almost everyone's benefit. The fact is that both the debtor country and its creditors stand to gain from a restructuring of unsustainable debts before the country has exhausted its reserves and condemned itself to a deeper economic downturn than necessary. At present, the threat of a disorderly workout means that the value of creditor claims falls more sharply on the secondary market when a country gets into trouble than it would likely do in a more predictable environment. A framework that allows creditors to preserve better the value of their claims and debtors to minimize output losses during the restructuring period helps both creditors and debtors. I have no doubt that they will increasingly come around to that view.
As I noted earlier, SDRM is part of the effort for better crisis prevention and resolution. No single instrument, SDRM or any other, is suitable for all crises. The SDRM is one of a set of instruments and policies that, taken collectively, will enable the IMF better serve all our member countries. So in addition to the work on SDRM, we will continue our work in these other areas as well, including finding ways to reward member countries that are pursuing sound economic policies.
Thank you very much.