Sovereign Debt Restructuring Mechanism -- One Year Later, Address by Anne O. Krueger, First Deputy Managing Director, IMF

IMF News, December 10, 2002

Source details

Canonical URL: Sovereign Debt Restructuring Mechanism -- One Year Later, Address by Anne O. Krueger, First Deputy Managing Director, IMF

Other formats

Bibliographic details

Authors: Anne O. Krueger First Deputy Managing Director International Monetary Fund Presented
Published: December 10, 2002

I. Introduction

Presentation: European Commission, Brussels, Belgium.
Date: December 10, 2002.
Purpose: Review implications of unsustainable sovereign debts, status of proposals for sovereign debt restructuring (CACs and SDRM), and likely effects on capital flows and international capital markets.
Key framing: SDRM presented as a "work in progress" shaped by consultations; aim is to facilitate orderly restructuring only in cases of unsustainable debt.

II. Unsustainable Debt Burdens — findings and mechanics

Definition of sustainability:
- Sustainable: sovereign can, with reasonable policies, service debt so future debt-to-GNP ratio will ultimately stabilize or fall.
- Unsustainable: under any realistic policies and circumstances, the debt-to-GDP ratio (or debt-to-export ratio in some cases) will rise without limit.
Consequences and dynamics when debt is unsustainable:
- True NPV of stock of debt is below face value because creditors cannot be repaid in full.
- Further borrowing dilutes value of existing creditors' claims.
- As debt-to-GDP mounts, real interest rates in the debtor country will rise; growth-reducing measures to service debt can further impair growth.
- If (real growth rate of the economy + primary surplus as percent of GDP) < (interest payments as percent of GDP), debt-to-GDP ratio will grow indefinitely.
- Rising debt service can abruptly dry up supply of funds.
- Debt overhang: restructuring can increase the true NPV of the debtor's primary surplus by improving growth prospects and reducing real interest rates.
Policy implication:
- Restructuring can increase returns to all parties only in restricted circumstances when debt is clearly unsustainable; restructuring is costly and should not be used when debt is sustainable.
Prevention and resolution roles of proposals:
- Proposals would discourage overlending/overborrowing and make resolution more orderly, prompt, and less costly.
- They would not make restructuring an easy option nor reduce incentives to service feasible debt.

III. Where We Stand — proposals, concerns, and design principles

Two broad approaches:
- Collective Action Clauses (CACs): apply to individual bond issues; permit a specified super-majority of holders of that bond issue to agree to a restructuring binding on all holders of that issue.
- Sovereign Debt Restructuring Mechanism (SDRM): statutory framework to aggregate across instruments, enable negotiation and ratification by a specified super-majority, with an independent centralized dispute resolution forum.
Market context and rationale:
- Over the 1990s, share of bonds in outstanding public external debt owed to private creditors nearly quadrupled to about 60 percent in 2000.
- Bondholder fragmentation and diversity of instruments complicate coordination and increase incentives for litigation and holdouts.
Four creditor concerns raised and addressed:

1. Moral hazard: will reducing restructuring costs increase frequency of restructurings? 2. Creditor rights: will SDRM enhance debtor legal leverage vis-à-vis creditors? 3. Role of the Fund: will SDRM give Fund legal powers favoring its creditor interests? 4. Impact on bondholders: will SDRM reduce recovery values and subordinate international bondholders relative to domestic and Paris Club creditors?

Design principles emphasized:
- Use only for debt judged unsustainable.
- Limit interference with contractual relations to measures needed to resolve key collective action problems.
- Prefer pre-packaged activation: ideal activation after debtor negotiates with a qualified majority (example given: say 75 percent) of creditors, then make the agreement binding on the rest.
- No automatic stay on creditor enforcement or general suspension of contractual provisions during activation-to-agreement period.
- Promote greater transparency: sovereign must provide relevant information when mechanism is activated and when an agreement is proposed.
- Encourage early and active creditor participation, including creditors' committees.
- Safeguard integrity through an efficient and impartial dispute resolution process to verify claims and adjudicate disputes.
- Limit formal role of the Fund: SDRM would be established through an amendment of the Fund's Articles of Agreement but not give existing organs new legal powers; Sovereign Debt Dispute Resolution Forum intended to be independent and perceived as independent from the Fund's Executive Board.
- Fund will use existing financial powers (e.g., revised lending into arrears policy) to create incentives for appropriate use and collaborative dialogue with creditors.
Intercreditor coordination and Paris Club:
- Exclusion of Paris Club and domestic claims from SDRM does not mean they would avoid restructuring; coordination across creditor groups is envisaged.
- No final decision had been made to exclude Paris Club claims; officials were exploring whether inclusion (perhaps as a separate class) would be feasible.

IV. Imagining a World with SDRM — effects on capital flows and borrowing costs

Expected impacts on capital flows and investor behavior:
- More orderly framework should provide investors greater incentives to differentiate between country risks, benefiting countries with sound policies.
- Countries with weaker policies may initially face more difficulty attracting capital, creating stronger incentives to adopt sound policies.
- Over time, increased attractiveness of emerging markets as an asset class and greater flows to those with sound policies are expected.
Expected impacts on borrowing costs:
- Borrowing costs for countries with sound economic policies should fall as investors differentiate more actively.
- Reasons for a reduction in borrowing costs for the asset class as a whole:

1. More countries following sound policies increases supply of capital to emerging markets and lowers borrowing costs. 2. SDRM should increase investor recovery rates by shortening negotiation process and providing an efficient workout with collective creditor power. 3. Expected size of restructurings (haircuts) should be smaller with SDRM, increasing recovery rates and lowering borrowing costs.

Empirical and historical evidence cited:
- National bankruptcy laws (U.S. bankruptcy procedures evolved to preserve going-concern value during railroad failures in the 1850s).
- CACs: historical use in British trust-deed bonds shows no evidence of raising borrowing costs; several data and news services do not attribute bond pricing to presence/absence of CACs.
- Systematic econometric investigations, including a study presented at the IMF's annual research conference, failed to uncover a systematic impact of CACs on borrowing costs for the asset class as a whole.

V. Conclusion — summary findings and policy stance

Unsustainable debts must be restructured; timing and method determine extent of cost.
A more orderly process benefits both debtor and creditors by preserving claim value and minimizing output losses during restructuring.
SDRM is one instrument among many for crisis prevention and resolution; no single instrument suits all crises.
IMF will continue complementary work, including rewarding member countries pursuing sound economic policies.

Source: Sovereign Debt Restructuring Mechanism—One Year Later, Address by Anne O. Krueger, First Deputy Managing Director, International Monetary Fund; Presented at the European Commission, Brussels; December 10, 2002.