## 1. INTRODUCTION ## Source details **Canonical URL:** [1. INTRODUCTION](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2002/_pdp04.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2002/_pdp04.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2002/_pdp04.pdf.json) --- ### A. The Original SDRM Framework - New approach: Sovereign Debt Restructuring Mechanism (SDRM) presented by the First Deputy Managing Director (Box 1) described as a welcome initiative. - Motivation: - Recent experience shows the incentive structure for creditors and sovereign borrowers is inadequate to encourage voluntary, cooperative resolutions of crises (voluntary PSI). - Voluntary PSI contrasts with the priority assigned to PSI by the official sector as an instrument to achieve a better sharing of related financial costs and to reduce creditor moral hazard. - Uncertainty on crisis resolution methods and anticipation of high litigation costs have made voluntary PSI unattractive and involuntary PSI virtually impracticable. - IMF pressure and the gray area: - IMF faces severe and conflicting pressures: - Pushed by the private sector and, often, by the sovereign debtor, to extend exceptional financing far beyond traditional access limits to defuse default risk. - Pressed by main shareholders to increase PSI by making it a condition for exceptional financing. - A properly designed SDRM can: - provide a framework to enhance the possibility of voluntary PSI and offer an appropriate setup to make involuntary solutions possible when cooperative attempts fail; - allow for a more orderly debt restructuring, if needed, and limit some economic and social disruptions suffered by the sovereign debtor. - Changed creditor-debtor relationship: - If creditors are few, similar, and well organized and capital markets relatively closed, negotiated solutions without standstill are often feasible. - If creditors are many, sparse, and diverse and debt contracts lack collective action clauses, cooperative solutions are much more difficult; in this context, a standstill arbitrated by the IMF (as proposed under the SDRM) would freeze the game, give time to implement an adjustment program with IMF financing, and allow players to work on debt restructuring. ### Incentive-based perspective and objectives - The paper addresses key incentive-related issues of the SDRM framework. - An incentive-based perspective is essential to ensure consistency of the SDRM with the principle that crisis prevention and resolution should rely, as much as possible, on market-oriented solutions and voluntary approaches. - The SDRM should be an integral part of the overall PSI strategy, with incentives designed accordingly. - The economics of the SDRM must be set right to avoid wrong incentives that lead to overuse, misuse, or ineffectiveness of the instrument. ### Box 1. A NEW APPROACH TO SOVEREIGN DEBT RESTRUCTURING ### Summary of the proposed new approach - Proposal outlined in a speech delivered last November 26,2001, by IMF First Deputy Managing Director Anne Krueger. - Core idea: model sovereign-debt restructuring on corporate bankruptcy law by allowing sovereign debtors to seek legal protection (a time-bound standstill) while renegotiating with creditors. - Features of the standstill: - Temporary duration: lasting a few months; extensions would require IMF approval. - Possible imposition of temporary exchange controls to stop capital flight. - Primary objective: create a formal mechanism that gives debtors and creditors incentives to reach agreement voluntarily so the mechanism is rarely used. ### Four principles for a formal sovereign-debt restructuring mechanism - i) Creditors should not be allowed to disrupt negotiations by seeking resources in their own national courts. - ii) Debtor countries would need to provide assurances that they were negotiating in good faith and treating all creditors equally. - iii) Private creditors would be encouraged to lend new money by receiving some guarantee that they would be repaid ahead of existing private creditors. - iv) Once agreement on a restructuring had been reached by a large enough majority of creditors, the rest would be bound to accept the terms. ### Limited role for the IMF (analysis and rationale) - Debt sustainability analysis is inherently unreliable as the key instrument to decide on SDRM activation because it relies on macroeconomic projections and assumptions on policy behavior and political developments. - Information asymmetries among IMF staff, authorities, and markets increase the risk of errors. - Resources available to repay creditors are endogenous to crisis resolution (official financing, haircuts, fiscal adjustment are jointly determined), blurring liquidity vs solvency distinctions. - Implication: IMF should have a relatively limited role both in deciding when/why the mechanism could be activated and in actually activating it. ### Nature of the SDRM: “Improved default” and relation to involuntary PSI - SDRM involves an element of partial default by bringing about a standstill on payments, reducing the net present value of creditor claims even if terms remain unchanged after the standstill. - Functions: - Provides space for last-ditch voluntary PSI or orderly debt restructuring. - Saves sovereigns the high economic and social costs of all-out default and reduces transaction/uncertainty costs associated with disorderly default. - Sovereigns lack a liquidation value; creditors’ recovery value is endogenous to crisis resolution (reserves, adjustment, official financing, creditor willingness). - SDRM must leave the possibility of all-out default open and should not be a bailout of private creditors by the official sector. ### Critical trade-off and the need for an increasing cost structure (core analysis) - Risk: a credible SDRM may prompt investor pullout if creditors expect to lose from forced restructuring; the more credible/involuntary the SDRM, the earlier the pullout. - Trade-off: - SDRM payoff to creditors must be low enough to encourage voluntary PSI and limit moral hazard. - If payoff is too low, short-term oriented creditors may flee, precipitating crisis. - Design requirement: an institutional structure that yields strictly increasing costs for both debtor and creditors across the sequence: - Normal market conditions → voluntary PSI → intermediate PSI → SDRM standstill → all-out default. - Objective prioritization: main objective is to induce cooperative PSI; limiting default costs is a constraint. ### Costs for sovereign debtor and creditors - Sovereign debtor: - Costs assumed strictly increasing across steps: stronger IMF conditionality under SDRM; diminished market access; all-out default carries even higher political, economic, social costs. - Risk of debtor moral hazard if debtor rejects rollover expecting better terms under SDRM; can be mitigated by ensuring costs of SDRM exceed potential gains. - Creditors: - Majority likely to expect losses from all-out default; must expect to lose from SDRM relative to pre-SDRM offers but not as much as from all-out default. - Payoff constraint: renegotiated SDRM terms should fall between creditors’ demands and sovereign’s pre-SDRM offers. ### Enforcing the payoff constraint: three options discussed - First option: - Bind total official financing (including IMF) during the SDRM to a limit not larger than under pre-SDRM phase to cap official transfers to private sector. - Issues: determination of credit limits, credibility of compliance, potential to deprive international community of optimal exceptional financing, and does not fully prevent debtor using official financing/adjustment to repay creditors at better terms. - Second option (Anne Krueger’s element): - Limit official financing after restructuring to amounts necessary to rebuild reserves and pay essential services/imports; not used to finance payments to creditors on restructured debt. - Issues: requires joint determination of official financing, haircuts, new money, and fiscal adjustment; risks weakening credibility of access limits and inducing pressure for larger IMF involvement. - Third option: - Introduce a legal constraint preventing creditors from recovering more than their last offer in the pre-SDRM phase; last terms asked/offered would serve as benchmarks for SDRM negotiations. - Issues: feasibility, implementation, enforceability need careful exploration. ### Two-sided moral hazard and information problems - Under uncertainty and asymmetric information, both creditors and debtor might believe they gain from SDRM (two-sided moral hazard). - Ex ante exclusion of two-sided moral hazard requires credible, strictly increasing cost structure across the sequence so neither party has incentive to skip steps. ### Operational sequence for the SDRM (stylized) - Initial dialogue when sovereign faces critical payment difficulties; re-profiling possible for temporary liquidity problems. - If serious, voluntary PSI negotiations initiated; no exceptional official financing during pre-SDRM phase. - If PSI fails, sovereign may invoke SDRM and obtain time-bound standstill sanctioned by IMF or a third party if conditions justify: - a. Country and IMF negotiate a new program with strong conditionality or strengthen ongoing program. - b. IMF evaluates need for extra financing via thorough debt sustainability analysis; exceptional financing should not enable debtor to repay creditors at better terms than pre-SDRM; IMF must ensure debtor does not obtain renegotiation terms superior to pre-SDRM offers. - c. Creditors called to agree on new debt terms offering lower recovery ratios than those requested by creditors during failed pre-SDRM negotiations. - d. Creditors reconsider continuation of financial support; new money would carry seniority, could be subject to program outcomes, and would be more expensive than under successful PSI. - If SDRM fails, all-out default is next; no guarantee of SDRM success and no bailout from official sector if SDRM fails. ### Credibility, activation, and practical issues - Credibility of IMF access limits is essential; if official sector credibly limits financing pre-SDRM, it reduces gaming and preserves incentive to voluntary PSI. - Activation: - Letting IMF decide on sanctioning standstill raises signaling problems and risks making denial disruptive and counterproductive. - Alternative: let sovereign decide when to activate standstill and have IMF (or third party) sanction standstill automatically on sovereign request; markets would value the option ex ante, and a rational debtor would activate only when benefits exceed costs. - Other instruments to facilitate voluntary PSI: - Collective action clauses, exit consents, credit enhancements, universal rollover options, rules for sharing proceeds, and standing committees for sovereign non-bank debts (analogous to Paris/London Clubs) to reduce coalition and free-rider problems. - Implications for investment in emerging markets: - SDRM could decrease ex ante probability of all-out default and attract long-term investors while deterring short-term cross-over investors. - Expected differentiated financing costs: patient money might become cheaper; short-term funds may become more expensive. ### Conclusion (key takeaways) - Core incentive structure needed for SDRM success identified; paper argues for a limited IMF role because debt sustainability analysis is unreliable as a basis for activation decisions. - Central recommendation: enforce an increasing shape of costs to creditors and sovereign as they move across the sequence from normal conditions to voluntary PSI, to intermediate PSI, to SDRM, and finally to all-out default. - Important unresolved feasibility issues: - Political and legal difficulties from supranational nature of the instrument. - Time consistency and full credibility of IMF access limits—shareholders may not respect limits they set. - Difficulty of constraining creditors’ SDRM-phase payoffs relative to pre-SDRM offers; three options discussed but none are foolproof. - Need for credible expectation of a costly all-out default if SDRM fails to preserve incentive compatibility. *Source: _pdp04* ### 1. INTRODUCTION ### 1. INTRODUCTION ### A. The Original SDRM Framework - The new approach to sovereign debt restructuring (heretofore referred to as the Sovereign Debt Restructuring Mechanism - SDRM), presented by the First Deputy Managing Director (Box l), is described as a welcome initiative. - Recent experience with sovereign debt crisis management in emerging market countries shows that the incentive structure under which creditors and sovereign borrowers currently operate is inadequate to encourage voluntary, cooperative resolutions of crises (voluntary PSI). - Voluntary PSI contrasts with the priority assigned to PSI by the official sector as an instrument to achieve a better sharing of the related financial costs and to reduce creditor moral hazard. - Uncertainty on crisis resolution methods and the anticipation of high litigation costs have made voluntary PSI unattractive and involuntary PSI virtually impracticable. - A wide gray area has emerged between a purely catalytic approach by the IMF and sovereign default, placing the IMF under severe and conflicting pressures: - On one hand, the IMF has been pushed by the private sector and, often, by the sovereign debtor, to defuse the risk of default by extending exceptional financing far beyond traditional access limits. - On the other hand, the IMF has been pressed by its main shareholders to increase PSI by making it, at the very least, a condition for exceptional financing. - A properly designed SDRM can fill the gray area in two major ways: - provide a framework to enhance the possibility of voluntary PSI, and offer an appropriate setup to make involuntary solutions possible when cooperative attempts fail; - allow for a more orderly debt restructuring, if needed, and limit some of the economic and social disruptions suffered by the sovereign debtor. - The idea of the SDRM reflects the changed nature of the creditor-debtor relationship in recent years: - If creditors are few, similar in type, and well organized (as in the Latin American debt crisis of the 1980s or in Korea in 1997 and Brazil in 1998) and capital markets are relatively closed, a negotiated solution without standstill is often feasible. - If creditors are many, sparse, and diverse and the debt contracts do not carry collective action clauses, a cooperative solution to a debt crisis is much more difficult to reach; in this context, a standstill arbitrated by the IMF (as proposed under the SDRM) would freeze the game, give time to implement an adjustment program with IMF financing, and allow the players to work on debt restructuring. ### Incentive-based perspective and objectives - The paper takes on a number of key incentive-related issues of the SDRM framework. - An incentive-based perspective is deemed essential to ensure consistency of the SDRM framework with the recognized principle that crisis prevention and resolution should rely, as much as possible, on market-oriented solutions and on voluntary approaches.4 - The SDRM should be intended as an integral part of the overall PSI strategy, and its incentives should be designed accordingly. - The economics of the SDRM must be set right to avoid that wrong incentives lead to overuse or misuse of the instrument, or even make the instrument useless. *Source: _pdp04 - 1. INTRODUCTION* ### Box 1. A ### Box 1. A NEW APPROACH TO SOVEREIGN DEBT RESTRUCTURING ### Summary of the proposed new approach - Proposal outlined in a speech delivered last November 26,2001, by IMF First Deputy Managing Director Anne Krueger. - Core idea: model sovereign-debt restructuring on corporate bankruptcy law by allowing sovereign debtors to seek legal protection (a time-bound standstill) while renegotiating with creditors. - Features of the standstill: - Temporary duration: lasting a few months; extensions would require IMF approval. - Possible imposition of temporary exchange controls to stop capital flight. - Primary objective: create a formal mechanism that gives debtors and creditors incentives to reach agreement voluntarily so the mechanism is rarely used. ### Four principles for a formal sovereign-debt restructuring mechanism - i) Creditors should not be allowed to disrupt negotiations by seeking resources in their own national courts. - ii) Debtor countries would need to provide assurances that they were negotiating in good faith and treating all creditors equally. - iii) Private creditors would be encouraged to lend new money by receiving some guarantee that they would be repaid ahead of existing private creditors. - iv) Once agreement on a restructuring had been reached by a large enough majority of creditors, the rest would be bound to accept the terms. ### Limited role for the IMF (analysis and rationale) - Paper argues for a conception of a limited role for the IMF in the SDRM: - Debt sustainability analysis is inherently unreliable as the key instrument to decide on SDRM activation because it relies on macroeconomic projections and assumptions on policy behavior and political developments. - Information asymmetries among IMF staff, authorities, and markets increase the risk of errors. - Resources available to repay creditors are endogenous to crisis resolution (official financing, haircuts, fiscal adjustment are jointly determined), blurring liquidity vs solvency distinctions. - Implication: the IMF should have a relatively limited role both in deciding when/why the mechanism could be activated and in actually activating it. ### Nature of the SDRM: “Improved default” and relation to involuntary PSI - SDRM involves an element of partial default by bringing about a standstill on payments, reducing the net present value of creditor claims even if terms remain unchanged after the standstill. - Functions: - Provides space for last-ditch voluntary PSI or orderly debt restructuring. - Saves sovereigns the high economic and social costs of all-out default and reduces transaction/uncertainty costs associated with disorderly default. - Key contrast with corporate bankruptcy: sovereigns lack a liquidation value; creditors’ recovery value is endogenous to crisis resolution (reserves, adjustment, official financing, creditor willingness). - SDRM must leave the possibility of all-out default open and should not be a bailout of private creditors by the official sector. ### Critical trade-off and the need for an increasing cost structure (core analysis) - Risk: a credible SDRM may prompt investor pullout (run for the exit) if creditors expect to lose from forced restructuring; the more credible/involuntary the SDRM, the earlier the pullout. - Trade-off: - SDRM payoff to creditors must be low enough to encourage voluntary PSI and limit moral hazard. - If payoff is too low, short-term oriented creditors may flee, precipitating crisis. - Design requirement: an institutional structure that yields strictly increasing costs for both debtor and creditors across the sequence: - Normal market conditions → voluntary PSI → intermediate PSI → SDRM standstill → all-out default. - Objective prioritization: main objective is to induce cooperative PSI; limiting default costs is a constraint. ### Costs for sovereign debtor and creditors - Sovereign debtor: - Costs assumed strictly increasing across steps: stronger IMF conditionality under SDRM; diminished market access; all-out default carries even higher political, economic, social costs. - Risk of debtor moral hazard if debtor rejects rollover expecting better terms under SDRM; can be mitigated by ensuring costs of SDRM exceed potential gains. - Creditors: - Majority likely to expect losses from all-out default; must expect to lose from SDRM relative to pre-SDRM offers but not as much as from all-out default. - Payoff constraint: renegotiated SDRM terms should fall between creditors’ demands and sovereign’s pre-SDRM offers. ### Enforcing the payoff constraint: three options discussed - First option: - Bind total official financing (including IMF) during the SDRM to a limit not larger than under pre-SDRM phase to cap official transfers to private sector. - Issues: determination of credit limits, credibility of compliance, potential to deprive international community of optimal exceptional financing, and does not fully prevent debtor using official financing/adjustment to repay creditors at better terms. - Second option (Anne Krueger’s element): - Limit official financing after restructuring to amounts necessary to rebuild reserves and pay essential services/imports; not used to finance payments to creditors on restructured debt. - Issues: requires joint determination of official financing, haircuts, new money, and fiscal adjustment; risks weakening credibility of access limits and inducing pressure for larger IMF involvement. - Third option: - Introduce a legal constraint preventing creditors from recovering more than their last offer in the pre-SDRM phase; last terms asked/offered would serve as benchmarks for SDRM negotiations. - Issues: feasibility, implementation, enforceability need careful exploration. ### Two-sided moral hazard and information problems - Under uncertainty and asymmetric information, both creditors and debtor might believe they gain from SDRM (two-sided moral hazard). - Ex ante exclusion of two-sided moral hazard requires credible, strictly increasing cost structure across the sequence so neither party has incentive to skip steps. ### Operational sequence for the SDRM (stylized) - Initial dialogue when sovereign faces critical payment difficulties; re-profiling possible for temporary liquidity problems. - If serious, voluntary PSI negotiations initiated; no exceptional official financing during pre-SDRM phase. - If PSI fails, sovereign may invoke SDRM and obtain time-bound standstill sanctioned by IMF or a third party if conditions justify: - a. Country and IMF negotiate a new program with strong conditionality or strengthen ongoing program. - b. IMF evaluates need for extra financing via thorough debt sustainability analysis; exceptional financing should not enable debtor to repay creditors at better terms than pre-SDRM; IMF must ensure debtor does not obtain renegotiation terms superior to pre-SDRM offers. - c. Creditors called to agree on new debt terms offering lower recovery ratios than those requested by creditors during failed pre-SDRM negotiations. - d. Creditors reconsider continuation of financial support; new money would carry seniority, could be subject to program outcomes, and would be more expensive than under successful PSI. - If SDRM fails, all-out default is next; no guarantee of SDRM success and no bailout from official sector if SDRM fails. ### Credibility, activation, and practical issues - Credibility of IMF access limits is essential; if official sector credibly limits financing pre-SDRM, it reduces gaming and preserves incentive to voluntary PSI. - Activation: - Allowing IMF to decide on sanctioning standstill raises signaling problems and risks making denial disruptive and counterproductive. - Alternative: let sovereign decide when to activate standstill and have IMF (or third party) sanction standstill automatically on sovereign request; markets would value the option ex ante, and a rational debtor would activate only when benefits exceed costs. - Other instruments to facilitate voluntary PSI: - Collective action clauses, exit consents, credit enhancements, universal rollover options, rules for sharing proceeds, and standing committees for sovereign non-bank debts (analogous to Paris/London Clubs) to reduce coalition and free-rider problems. - Implications for investment in emerging markets: - SDRM could decrease ex ante probability of all-out default and attract long-term investors while deterring short-term cross-over investors. - Expected differentiated financing costs: patient money might become cheaper; short-term funds may become more expensive. ### Conclusion (key takeaways) - Paper identifies core incentive structure needed for SDRM success and argues for a limited IMF role because debt sustainability analysis is unreliable as a basis for activation decisions. - Central recommendation: enforce an increasing shape of costs to creditors and sovereign as they move across the sequence from normal conditions to voluntary PSI, to intermediate PSI, to SDRM, and finally to all-out default. - Important unresolved feasibility issues: - Political and legal difficulties from supranational nature of the instrument. - Time consistency and full credibility of IMF access limits—shareholders may not respect limits they set. - Difficulty of constraining creditors’ SDRM-phase payoffs relative to pre-SDRM offers; three options discussed but none are foolproof. - Need for credible expectation of a costly all-out default if SDRM fails to preserve incentive compatibility. *Source: Box 1. A, _pdp04 - Box 1. A* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2002/_pdp04.pdf_