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

IMF News, November 26, 2001

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• Published: November 26, 2001

I. Introduction

• Occasion: Given at the National Economists' Club Annual Members' Dinner, American Enterprise Institute, Washington DC.
• Date: November 26, 2001.
• Central problem identified:
  • There is a "gaping hole": no mechanism to give incentives for prompt, orderly restructuring of unsustainable sovereign debts.
  • The only available mechanism currently effectively requires the international community to bail out private creditors.
• Proposal purpose:
  • Create a catalyst — a framework offering a debtor legal protection from obstructive creditors in exchange for obligations to negotiate in good faith and implement preventive policies.
  • Model analogy: domestic bankruptcy court; better thought of as an international workout mechanism.
• Timing:
  • Management and staff of the IMF are discussing the approach and plan to discuss with the Fund's Executive Board next month.
  • Even with unanimous political support, implementation would take "at least two or three years."
• No immediate implications for current negotiations (examples cited: Argentina and Turkey).

II. Reforming the Architecture

• Context:
  • Growth of private international capital flows has benefits but increased frequency and severity of crises.
  • Affected countries have generally not retreated from global capital markets; instead they used corrective policies: "fiscal adjustment, financial sector strengthening, and more flexible exchange rate regimes."
• Crisis-prevention advances (three main elements):
  • Strengthened IMF surveillance of national economic policies and international markets.
  • Encouraged better communication between IMF, members, and private investors and lenders.
  • Created the Contingent Credit Line facility (public "seal of approval" to bolster reserves at very low cost).
• Crisis-management advances:
  • Adjustment programs now stress resolving balance-sheet problems in financial and corporate sectors as central.
  • Creation of the Supplemental Reserve Facility in 1997: advances large amounts for relatively short periods at penalty interest rates; lending requires agreement on economic policy measures.
• Constraints and moral hazard:
  • The Fund cannot print money; resources limited to quotas and borrowing agreements.
  • Reluctance of members to see resources used to bail out private creditors creates moral hazard concerns.

III. Involving the Private Sector in Crisis Resolution

• Definition and necessity:
  • Concerted involvement: encourage private creditors to roll over commitments and limit demands for repayment during crises when private capital is unavailable.
  • When a country has a large debt, stock (not just flows) matters; refusal to roll over stock creates persistent problems.
• Differences from 1980s restructuring:
  • 1980s: commercial banks dominated, steer committees worked (approximate example: "steering committee of maybe 15 people holding perhaps 85 percent of the debt"), incentives to cooperate existed.
  • Today: bond issues have grown faster than syndicated bank loans; creditors are more numerous, anonymous, harder to coordinate; debt instruments and derivatives add complexity.
• Creditor heterogeneity and holdout problem:
  • Bondholders include opportunistic secondary-market purchasers who may seek litigation rather than cooperation.
  • Individual bondholders have greater legal leverage than banks and are less vulnerable to regulatory pressure.
• Case examples and implications:
  • Pakistan, Ukraine, Ecuador: litigation fears turned out to be unduly pessimistic.
  • Peru case: Elliott Associates bought $20m of commercial loans guaranteed by Peru in 1997; demanded full repayment instead of Brady bonds; in June 2000 obtained a judgment for $56m and an attachment order against Peruvian assets used for commercial activity in the US; Peru settled rather than be pushed into default on its Brady bonds.
  • The Peru episode highlights the power of holdout creditors and a missing element in current approaches.
• Current IMF-endorsed approach:
  • Favors voluntary, market-oriented solutions; official financing limited; encourage voluntary creditor agreements where possible.
  • Fund should be prepared to give "implicit support to a temporary standstill" (lend to a country even though it is in arrears to private creditors) if the country implements a sensible adjustment package and negotiates in good faith.
  • Implicit support does not prevent holdouts from disrupting restructuring; thus inadequate as sole incentive.
• Need for a new, formal mechanism to address holdouts and coordination failures.

IV. A New Approach to Sovereign Debt Restructuring — Outline

• Core design concept:
  • A country could request a temporary standstill from the Fund during which it negotiates rescheduling/restructuring with creditors, with the Fund's consent.
  • Standstill likely to be "some months in duration"; debtor would have to provide assurances (e.g., temporary exchange controls) to prevent capital flight.
  • Primary objective: create incentives so indebted countries and creditors reach voluntary agreements "in the shadow of the law."
• Benefits:
  • Reduces secondary-market price drops by resolving collective action problems.
  • Outcome remains determined by debtor and creditors; holdouts restrained but final terms are negotiated by the majority of creditors.
  • Could contribute to a more stable international financial system and lead to more prudent assessment of risk by lenders and borrowers.
• Four key features the mechanism must be built on:
  • First: Prevent creditors from disrupting negotiations by seeking repayment through national courts (avoid "grab race").
  • Second: Provide creditors guarantees that the debtor will act responsibly (appropriate policies, good-faith negotiations, nonpreferential treatment).
  • Third: Encourage private lenders to provide fresh money, possibly by granting providers of new money some guarantee of repayment ahead of existing private creditors (a form of preferred creditor status).
  • Fourth: Bind minority creditors to a restructuring agreement once agreed by a large enough majority, preventing rogue creditors from leveraging attachments on assets.

V. Practical Questions Raised (six discussed)

• First — Legal basis:
  • To restrict creditors' enforcement in national courts the mechanism must have force of law universally; laws in a few leading countries would be inadequate because creditors would use favorable jurisdictions.
• Second — Who should operate it:
  • The Fund's involvement is essential: it can judge debt sustainability, economic policies, and balance-of-payments prospects.
  • Some functions (adjudicating disputes among creditors, verifying claims, confirming voting integrity) are not well suited to the Fund's existing institutional structure.
• Third — Activation criteria:
  • Standstill activated if a debtor's request is endorsed by the Fund.
  • Fund would agree if, given limitations on official finance, the member's debt profile was unsustainable and it had little prospect of accessing private capital in the foreseeable future.
  • Formal activation may be necessary even when there is broad agreement, to bind potential holdouts.
• Fourth — Ensuring debtor discipline during protection:
  • Analogous to IMF conditionality: standstill could be endorsed for limited periods and renewed following reviews of policies and creditor relations.
  • A maximum period for the stay beyond which continued protection would require approval of a required majority of creditors would encourage good-faith negotiation.
• Fifth — Scope of Fund financing:
  • After restructuring, Fund financing should be limited to amounts necessary to rebuild reserves and pay for essential services and imports.
  • "There should be no extra support to help finance payments to creditors on the restructured debt."
• Sixth — Types of debt covered:
  • Complex issues include sovereign debt owed to domestic residents and foreign debts owed by domestic residents other than the sovereign.
  • Reasons to include sovereign domestic debt:
  • Balance-of-payments problems can arise from flight of domestic investors in absence of capital controls.
  • Domestic debt may impose an unsustainable fiscal burden as crises depress activity.
  • External creditors less likely to accept reductions if domestic investors are repaid in full.
  • Treatment of foreign debts owed by nonsovereign residents:
  • Exchange controls can prevent companies from paying overseas creditors, exposing them to litigation.
  • Alternative: extend legal protection to these enterprises if they place payments they would have made into escrow accounts to be paid once exchange controls are lifted and the stay is terminated.

VI. Conclusion — Incentives and Political Dimension

• Incentives for debtor countries:
  • The approach would reduce restructuring costs and encourage earlier restructuring when debts are unsustainable.
  • It would not make restructuring an "easy option"; severe economic costs and risks to the banking system remain.
• Incentives for creditors:
  • May appear unattractive if they prefer bailouts, but official financing is limited.
  • The real choice is between orderly restructuring and disorderly restructuring; most creditors prefer the certainty of orderly processes.
  • Secondary-market values of claims are likely to be better preserved under an orderly framework.
• Overall promise:
  • The proposed approach offers a "fairer and more efficient process" that encourages prompt, orderly resolution of unsustainable debts, improving both crisis prevention and crisis management.
• Political imponderable:
  • Whether members are prepared to constrain their citizens' ability to pursue foreign governments through national courts in exchange for a more stable international economy is ultimately a political decision for member countries.

Address by Anne Krueger, First Deputy Managing Director, International Monetary Fund, Given at the National Economists' Club Annual Members' Dinner, American Enterprise Institute, Washington DC. November 26, 2001.

References

• Peru and the IMF
• Speeches
• PRESS CENTER
• https://www.imf.org/en/home