Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
May 7, 2007
A number of emerging market economies have experienced sovereign debt distress in recent years.
• The issue: What does cross-country experience tell us about the restoration of debt sustainability in sovereign restructuring cases?
• Findings: Overall, the experience is positive, but a few cases of preemptive restructuring were left with considerable vulnerabilities.
• The debate: Given the limited number of observations, there is no firm consensus on whether debtors' incentives in preemptive restructuring cases systematically influence the outcome.
Sovereign debt distress
The reasons were manifold and complex and often included overborrowing, prolonged recessions, banking or political crises, and exchange rate misalignments. As a result, the countries needed to restructure their sovereign debt obligations to restore sustainability. A recent IMF Occasional Paper reviews the experiences of eight countries that restructured their debt to private creditors between 1998 and 2005: Argentina, the Dominican Republic, Ecuador, Moldova, Pakistan, Russia, Ukraine, and Uruguay. It examines the initial conditions that gave rise to the debt operations, discusses the results of the restructurings, and asks whether sustainability was actually restored.
Paths into crisis
Although countries had quite different public debt-to-GDP ratios before the crises, these ratios tended to increase rapidly as economic and financial conditions worsened. The deterioration was largely because of the effects of rapid currency depreciation on foreign currency-denominated debt, declining economic activity, increasing interest obligations, and the fiscal cost of supporting a distressed financial sector (see chart). Higher debt paired with reduced market access typically generated debt servicing difficulties, ultimately culminating in either default or the urgent need for a preemptive restructuring to avoid a default.
How much debt relief?
Ultimately, all eight countries reached agreement on debt restructuring terms that were acceptable to creditors (though, among the cases considered, significant holdouts remain in Argentina). The scope of debt restructuring generally depended on the share of debt owed to private creditors, and the degree of debt relief varied widely across countries (see table). The amount of debt relief should, in principle, be tailored to ensure a return to debt sustainability. Because economic and financial conditions varied so much from country to country, it is not surprising that debt relief was quite varied. A key question is, however, whether the relief helped restore sustainability in the various cases. This is a difficult question to answer, because debt operations, in practice, took place in the context of contemporaneous changes in the economic environment and in domestic policies. However, it is possible to examine whether the debt operations, combined with supporting economic policies, contributed to a return to sustainability.
Criteria to assess sustainability
The Occasional Paper applies a number of economic criteria to assess the restoration of sustainability, taking into consideration both the solvency and liquidity aspects that the concept of sustainability encompasses (without, however, attempting an evaluation of other factors, such as political risks, that may also affect crisis probabilities). Given that these concepts are inherently forward looking, any assessment is necessarily subject to judgments, including on the probability of future debt distress.
• Developments in public debt levels and early warning systems. Debt crises have occurred at a very large range of debt ratios, and there are no obvious cutoff points for the debt ratio that would allow a clear distinction between sustainable and unsustainable debt levels. However, over the past 30 years, 60 percent of sovereign debt crises occurred when debt levels in the year preceding the crisis had been higher than 39 percent of GDP. Moreover, a 50 percent probability of being in a debt crisis is associated with a debt-to-GDP ratio of 80 percent. In addition, with the help of an early warning system model, the paper gauges debt-related vulnerabilities based on the historical experience of a large sample of countries.
• Liquidity indicators. A sovereign faced with large financing needs and/or a small pool of available resources stands an increased risk of incurring debt servicing problems. The study focuses on the ratio of reserves to short-term debt and the overall fiscal financing need in percent of GDP.
• Medium-term debt dynamics. IMF staff's medium-term debt projections and sensitivity analyses to a variety of shocks are used to gauge the likelihood that the debt-to-GDP ratio would stay on a stable or declining path over the medium term.
|
Post-default restructurings have received more debt relief than the preemptive restructurings. | |||||
| Debt Affected1 |
Debt Reduction2 |
Debt Affected1 |
Debt reduction2 | ||
Preemptive |
Post-default |
||||
|
Argentina, 2001 |
48 | 10 |
Argentina, 2005 |
53 | 75 |
|
Dominican Republic, 2005 |
14 | 1 |
Ecuador, 2000 |
45 | 25 |
|
Moldova, 2002 |
3 | 6 |
Moldova, 2004 |
9 | 58 |
|
Pakistan, 1999 |
1 | 8 |
Russia, 2000 |
39 | 44 |
|
Ukraine, 2000 |
21 | 5 | |||
|
Uruguay, 2003 |
49 | 8 | |||
|
Data: IMF; authors' calculations. 1Percent of public debt. 2Net present value reduction (in percent) at a common discount rate of 10 percent. | |||||
Key findings
Based on the battery of criteria and indicators considered, as of late 2005, relatively low debt vulnerabilities were found in Pakistan, Russia, and Ukraine; medium-range debt vulnerabilities in Argentina, the Dominican Republic, Ecuador, and Moldova; and somewhat higher, though declining, vulnerabilities in Uruguay.
All countries that restructured after defaulting exhibited clear symptoms of solvency problems and received substantial debt relief. The indicators presented in the paper no longer point to high debt-related vulnerabilities. Ecuador, Russia, and Argentina after its 2005 restructuring were all found to have low- or medium-range debt-related vulnerabilities. In Argentina's case, resolving arrears with creditors not participating in the debt exchange remains key to ensuring sustained access to international capital markets.
Solvency problems
Countries that restructured preemptively had quite diverse experiences. In Moldova and Pakistan, the scope of restructuring of private sector held claims was too limited to have a significant impact on sustainability. In Ukraine and the Dominican Republic, liquidity more than solvency was the issue, and the focus consequently was on debt service relief rather than debt reduction. A few other countries, however, where evidence pointed to solvency problems, could not secure sufficient debt relief. This was the case in Argentina's 2001 pre-default restructurings (the 2001 mega swap and subsequent Phase I restructuring) and in Uruguay.
Argentina defaulted shortly after the Phase I restructuring, while in Uruguay considerable debt-related vulnerabilities remained after the crisis, although they have recently declined significantly, also reflecting, in part, favorable global liquidity conditions.
Although the limited sample of restructuring cases implies that broad conclusions are highly tentative, the difference between the preemptive and post-default cases is rather striking. The preemptive group achieved considerably smaller debt reductions and, in cases that pointed to solvency problems, did not fare well in reducing debt vulnerabilities.
Role of incentives
The causes of this observation are not fully explained, but incentives may have played a role. In a preemptive restructuring, with mounting pressures on resources available to service debt obligations, a failure to reach agreement could subject the debtor to significant reputational, political, and economic costs because the country could be pushed into default.
Debtors may therefore be under pressure to acquiesce to debt restructuring terms that may not be sufficient to restore debt sustainability. The factors that affect creditors' and debtors' negotiation strategies are, however, complex and difficult to ascertain. Moreover, although countries that restructured their debt after defaulting have tended to receive greater debt reduction than those that restructured preemptively, they have also experienced, on average, more severe recessions.
