Speech

Sovereign Debt Restructuring:
Messy or Messier?
Anne Krueger*
Annual Meeting of the American Economic Association
January 4, 2003
Washington, D.C.

Ever since the Mexican, Asian and Russian crises of the mid-l990s, efforts have been underway to find means for more effective prevention and resolution of currency-financial crises. Much has been done with respect to crisis prevention: exchange rate flexibility is much greater than it was; there is increased transparency and improved oversight of the financial system; and greater attention is paid to unsustainable policy stances. Work continues to strengthen economies' immunity to crises.

But no matter how much is done, there will inevitably be a crisis or crises. Much has already been learned with respect to crisis resolution and the international financial community is better equipped to cope with crises than was the case earlier. But, as with prevention, more can be done.

One item on the agenda, which should contribute both to prevention and to resolution, is dealing with unsustainable debt burdens of sovereigns. Two of the hallmarks of most of the l990s crises were, first, the importance of private capital flows, and their reversals, in triggering the crises and in intensifying their severity; and second, the involvement of the financial systems in them.

The countries afflicted by these crises were ones that had succeeded in raising per capita incomes and rates of economic growth. That success hinged in significant part on their having put in place economic policies that are conducive to economic growth, including a predictable legal framework, respect for property rights, openness to the international economy, and much more.

The fact that the policy framework was generally appropriate implied, among other things, that there were relatively high real returns to investment in these economies. That is of course the main reason why private investors were interested in them. At the same time, capital inflows permitted more rapid development than would otherwise be possible.

These associations of high real returns, growth, and appropriate policy stances continue. For these reasons, there is typically a strong stake for emerging markets to maintain international creditworthiness and policy makers go to great lengths to maintain their international reputations and market standings. An efficient private international capital market benefits both developing countries able to invest more than domestic savings at high real rates of return and investors in high-income countries realizing higher real returns and greater portfolio diversification than they could achieve without these investment opportunities.

Because countries are sovereign, their high stakes in maintaining creditworthiness are crucial for attracting international capital flows. For foreign creditors do not have the rights they do in domestic courts and hence must have other protections against default on the part of borrowers. This is especially true for sovereign borrowers; international lenders to private entities in emerging markets normally have the same protection as is afforded to domestic lenders. For sovereign borrowing, however, the chief protection foreign creditors have is the losses that would accrue to the sovereign debtor (both directly, through the future reduction in access to international credit markets, and through the effects on private economic activity of a sovereign default) in the event of failure to fulfill obligations. And these losses are heavy.

Failure of a sovereign to carry out debt-servicing obligations in accordance with contracts is therefore a last resort in emerging markets. The explosive growth of private international capital flows to sovereigns is one piece of evidence that private creditors believe that sovereigns will in general exert every effort to service their debts. And this belief appears to be well-founded.

However, there arises the occasional instance in which servicing debt according to existing contracts is not possible and debt is unsustainable. This can happen because of changes in external circumstances (a sharp and unanticipated permanent drop in the price of a key export, for example) or for other reasons. Often, all that is required is a flow rescheduling of existing debts, maintaining net present value. But in some circumstances, a rescheduling that maintains net present value can leave a country with a debt overhang. Then, a reduction in debt and debt service, reducing the net present value of outstanding obligations is necessary. Henceforth, I refer to rescheduling as a circumstance in which net present value is maintained (and which can therefore generally be undertaken by the sovereign under existing international institutional arrangements) and a reduction in debt when net present value is reduced.

It is important to bear in mind the definition of unsustainability: it is a circumstance when, regardless of the sovereign's efforts, debt relative to GDP (and therefore debt servicing relative to GDP) will grow indefinitely. In those circumstances, the economic net present value of the sovereign's debt is less than the face value of the debt; moreover, it will likely continue to fall until a restructuring is undertaken and growth resumes.

In reality, of course, a judgment as to unsustainability must be made on a probabilistic basis: there is always a chance, however remote, that new natural resources will be discovered, that the terms of trade will shift in a country's favor by an exceptional amount, or that some other very low-probability event will change the outlook. However, as borrowing continues and debt servicing obligations as a percentage of GDP rise, the probability of the sovereign being able to honor the net present value of all existing contracts falls. As that happens, growth rates drop, real interest rates rise, and probabilities drop still further. The process can continue until the sovereign recognizes that further efforts to maintain debt service will not begin to address the problem.

Even when the authorities in an overly-indebted country begin to recognize their difficulties, there are disincentives for instigating the restructuring. There is always the hope that the highly improbable favorable shock will materialize. Meanwhile, the consequences of announcing an inability to continue voluntary debt servicing are immediate and negative. A turnaround in the economy will take place after restructuring only after some time. Given political time preferences, that may in itself induce the authorities to delay facing the inevitable. But, in addition, there are significant uncertainties as to how to proceed to deal with creditors.

This was always true, but the problem has intensified as private capital flows have increased relative to official flows. In the l980s debt crisis, private creditors held less than half of outstanding sovereign debt. In Latin America, for example, 66 per cent of debt was to official creditors in the l980-85 period. Many of the private creditors were banks, and usually fewer than 20 banks that represented a very high percentage of outstanding loans to sovereigns. Even then, it was not until the Brady plan in effect orchestrated a debt reduction, and economic policies had been altered, that growth resumed in many countries. By the late l990s, private creditors accounted for over two thirds of outstanding Latin American debt, with official debt only 28 percent. Moreover, the private creditor base was more diffuse, among both banks and bond holders.

While this has been helpful in terms of bringing additional sources of capital to the table and facilitating the diversification of risk, it has increased significantly the collective action problem.

Just as a bank run might be avoided if all depositors refrained from withdrawing, but occurs when each depositor has an incentive to be the first in line, so there is a danger that individual creditors will decline to participate in a voluntary restructuring in the hope of recovering payment on the original contractual terms, even though creditors - as a group - would be best served by agreeing to a restructuring.

The problem of collective action is most acute prior to a default, where creditors may have some reasonable hope of continuing to receive payments. A debtor that had reached agreement with the bulk of its creditors on a restructuring would doubtless hesitate to default on a small amount of the original debt to secure unanimity. Recognizing this, holdout creditors may seek full payment once agreement has been reached with most.

Following a default, the options facing creditors, particularly those without an interest in litigation, are more limited and the problems of collective action may be less acute. There is no doubt that agreement on a restructuring would eventually be reached following a default. But there is substantial merit in trying to secure agreement on restructuring prior to default. A default, and the associated uncertainties regarding creditor-debtor relations, tends to be associated with widespread economic dislocation. This amplifies the costs that must be borne by debtors and their creditors.

If ways could be found for maintaining creditor rights and simultaneously reducing the duration and severity of the economic downturn associated with delays in debt reduction once it is evident to all that it must occur, there are potential gains for both creditors and debtor, and hence for the international economy.

There are two groups of proposals currently under consideration.¹ The first calls for more widespread use of collective action clauses (CACs). A second calls for a statutory approach, providing a legal framework against or through which sovereign debt restructuring could take place. CACs would be placed in individual bond issues, and would bind all bond holders to accept debt reduction and restructurings where a specified super majority of holders consented to it. This already happens under English law, and recently the European Union has decided to call for CACs in contracts issued in member countries. The United States Treasury has also called for CACs in individual sovereign bond contracts.

The advantages of CACs include the ability to prevent holdout creditors of individual bond issues and the greater ease of solving the collective action problem (especially if a trustee structure is used) when any form of change in the terms, including rescheduling, may be necessary. Inclusion of clauses in all new contracts would not, however, address issues associated with the existing stock of bonds; the full force of CACs would therefore not be felt for some period into the future. Moreover, each bond issue would constitute a separate class and CACs would thus not solve intercreditor equity concerns and collective action problems across bond issues or between bonds and other creditors (most importantly banks).

The proposal put forth by the IMF calls for a Sovereign Debt Restructuring Mechanism (SDRM), which is a statutory approach. The design of the SDRM has been guided by a number of principles. First, the mechanism should only be used to restructure debt that is judged unsustainable. Second, it should neither increase the likelihood of restructuring nor encourage defaults. Third, any interference with contractual relations should be limited to measures needed to resolve the most important collective action problems.

The principal feature of the SDRM is that it would allow a sovereign and a qualified majority of creditors to reach an agreement that would then be binding on all creditors subject to the restructuring, paying due regard to seniority among claims and the diversity of creditor interests. Giving creditors the ability to make this decision does not shift the legal leverage from creditors to the debtor; rather it increases the leverage of creditors over potential holdouts and free riders, enabling an agreement to be secured more rapidly.

The proposal does not contemplate an automatic stay on creditor enforcement or a general suspension of contractual provisions. Thus, it would not provide a debtor in default with the same type of legal protection found in corporate insolvencies. In ideal circumstances, a sovereign with unsustainable debt would use the SDRM before default, which is when there is greatest amount of value to be preserved but where collective action problems are most acute.

The proposal envisages that sovereign debt governed by foreign law would be covered by the SDRM; sovereign debt subject to domestic law would not be included. However, since foreign creditors would be entitled to vote upon proposed debt reductions, they would clearly take into account issues of intercreditor equity between sovereign debt issued under domestic and foreign law.

The proposal is designed to promote greater transparency in the restructuring process. Under the SDRM, procedures would be established to enable creditors to have adequate access to information regarding the debtor's general situation, including its treatment of all creditors, including those not subject to the mechanism. The sovereign would provide the information at the time of activation of the mechanism.

Given the ability to invoke the SDRM on the part of the sovereign (or to convene creditors' groups "in the shadow of the SDRM"), there would be early and active participation of creditors during the restructuring process. The SDRM framework would enable creditors to play an active role at earlier stages than is now possible, including through the formation of creditors' committees. Creditors would have the right to declare that the debtors were not acting in good faith, which would terminate the SDRM. Once that happened, creditors' rights would be just the same as they are under existing practices.

In discussions of the SDRM proposal, some have argued that the existence of such a framework would alter, and presumably weaken, creditor rights. In fact, the design of the proposal has been structured in an effort to increase creditor value for reasons already discussed, by aggregating rights now held by individual creditors. This would, at least to some degree, address the collective action problem. In addition, the possibility, that incentives for delay when restructuring is inevitable would be reduced, should cut the losses that occur in the time prior to the sovereign's decision.

As currently discussed (and it is still a work in progress), creditors could, under the mechanism, declare the sovereign to be failing to negotiate in good faith, and could vote to disband the mechanism. In such an instance, creditors' rights would be just as they are under existing practices.

Creditors and the sovereign would negotiate once the SDRM was invoked and claims registered. When a supermajority reached agreement, it would be binding on all creditors. To be sure, creditors holding sovereign debt under foreign law would want to know the sovereign's treatment of domestic debt, but that would not be subject to the mechanism since it would be handled under domestic law. However, as already noted, to enable creditors to form a judgment as to intercreditor equity, the SDRM procedures would require sovereigns to disclose sufficient information about their outstanding debt, both foreign and domestic. Full disclosure could in itself constitute a significant improvement for creditors as they attempt to evaluate the needed degree of restructuring.

It should be evident that debt restructuring negotiations under the SDRM could begin more rapidly if there were CACs in individual bond contracts, as the problems of identifying creditors could be more rapidly resolved. Thus, proposals for CACs and SDRM are complementary, as is recognized by the international community.

The role of the International Monetary Fund (IMF) in the SDRM as currently proposed is minimal. Amending the Fund's Articles of Agreement appears to be a simple way of binding all IMF member countries to the SDRM framework, and thereby avoid the problems that could arise if the same structure were proposed under a new international treaty. This is because the failure of even a few countries to adopt the new treaty could enable creditors to issue debt outside the jurisdictions in which SDRM could be used, thus giving rise to circumvention. However, the proposed Sovereign Debt Dispute Resolution Forum (SDDRF-a legal body whose functions would be to register claims and resolve disputes) would be independent of the Fund and its Executive Board, in parallel with approaches used in other organizations.

One of the questions that has been raised with regard to the SDRM and CAC proposals is how they would affect the volume of private capital flows to sovereigns in emerging markets. There are two parts to the answer. First, provision of a more predictable framework should provide incentives for lenders to assess credit risks even more closely than is currently the case, thus increasing the spread differential between countries with differing soundness of economic policies and hence prospects. As such, countries confronting the lowest spreads might borrow somewhat more, but countries confronting high spreads would borrow less (and might even avoid debt unsustainability). However, insofar as the framework is more orderly and predictable, and the time period during which sovereigns are delaying the inevitable is reduced, creditors should expect on average to confront smaller losses in net present value than they can expect under current circumstances. To the degree that economic losses (in terms of foregone output in the period prior to the decision to restructure) are smaller, there are potentially higher returns, and total capital flows to emerging markets as a whole should increase. Given the infrequency of need for restructurings, however, it is not evident how quantitatively important this phenomenon would be.

To conclude, brief mention should be made of the current status of the CAC and SDRM proposals. The IMF is encouraging individual countries to put CAC clauses in their new bond issues, and, as already mentioned, in some countries they are now the established practice. For the SDRM, the International Monetary and Finance Committee has asked the IMF to bring a concrete proposal to its spring meetings.² At that time, the international community will decide on what steps forward should be taken.

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*International Monetary Fund and Stanford University.

1 There are also several efforts underway, including at the IMF, for a "Code of Good Conduct" for debtors and creditors when restructurings are necessary.

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2 IMF staff papers pertaining to the SDRM can be found on the IMF's webpages.