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Global Finance--Operating in a Politicized World. New Rules, New Game? Speech by Jack Boorman, Special Advisor to the Managing Director, IMF
January 28, 2003
It's a pleasure for me to be here to address this group on the subject of sovereign debt restructuring. As bankers, you have a deep interest in the debate which is under way—and I understand that not all of you and your colleagues in the private capital markets are yet fully convinced of the wisdom of the IMF's proposals on this subject! I'm also happy to be part of a conference that involves Georgetown, as I have some connection to the University, and I am Jesuit educated through both high school and college.
Before I touch on the specific issue of sovereign debt restructuring, let me say just a few words about the activities of the IMF in a closely related area, that is, in efforts to prevent the kind of financial crises we have seen in too many countries over the last two decades. Even with the best possible mechanism for crisis resolution and sovereign debt restructuring, we will not be able to claim success unless we do better at reducing the number of crises and the need for such a mechanism.
I like to think of our efforts in this area under two headings: crisis prevention and crisis mitigation. Crisis prevention involves both managing economic policy and developing the institutional infrastructure of market economies to reduce vulnerabilities and increase the capacity of the system to withstand the inevitable shocks that occur, especially in countries that open their economies to global trade and global finance. Crisis mitigation involves mechanisms to limit the self-aggrevating forces that are often unleashed at the beginning of a crisis and that increase the depth and severity of the crisis.
Some of the elements of crisis prevention are pretty obvious:
There are other elements that could be added to the list, but I am sure you can fill them in yourselves. The Fund, along with other institutions, is working hard to improve country performance in many of these areas. One noteworthy venture is the joint program by the World Bank and the IMF to conduct intensive health check-ups of the financial sectors of member countries. Developed and developing countries alike are being urged to sign up for these Financial Sector Assessments or FSAPs. Canada was among the first to have an FSAP and Japan's FSAP is underway; Brazil and other emerging market economies have also subjected themselves to such assessments.
Another area of progress is the development of standards and codes. Reports on the observance of standards and codes, or ROSCs, are now available for many countries. They provide information on the extent to which countries are following best practices in prudential supervision and regulation, in the transparency of their monetary and fiscal policies, in the provision of data and other information, and in a number of other areas. The institutions can produce these reports and many of them are available on the Fund's website. They will have their intended impact, however, only if the private creditor community makes greater use of the information produced in these exercises when doing credit analyses and risk assessments of countries.
On crises mitigation, there need to be better mechanisms to keep things from unraveling when stress develops in the economy. We have seen too many crises in which moderate stress becomes a major collapse because of the self aggrevating dynamics that are set in motion. Indonesia in 1997 may be the best—or worst—example of this phenomenon. Among other things, the crisis was made much worse:
These are all areas in which work is underway, but much more effort—and some innovative ideas—are still needed. Progress in these areas will help make countries more resilient in the face of the inevitable tensions and fluctuations that occur in market economies.
Now let me get to the main topic. The SDRM—Sovereign Debt Restructuring Mechanism—is the proposal that has grabbed the most attention and invited the most controversy of all the recent initiatives of the IMF. The SDRM is both a crisis resolution and a crisis mitigation device. I believe it could help mitigate and limit sovereign debt crises if it were triggered sufficiently early in appropriate cases to help prevent the economic dislocation that often occurs when countries resist dealing with their debt problem, even as the debt becomes rather clearly unsustainable. All too often, countries continue to reach for less and less credible—and ultimately self defeating—policies, in the hope of finding redemption from their debt problem. The result is an unnecessary use and wasting of international reserves, which reduces policy options when the crisis is finally confronted; massive dislocation in the economy; and a loss of value to everyone involved, both creditors and the citizens of the country itself—and especially the poor—as the economy implodes. This also puts the official community, and the IMF, in particular, in a difficult position in deciding whether to support those often futile policy efforts. Argentina is a recent case in point.
Let me address the three issues regarding SDRM put into the agenda for this session:
First on the proposal itself. Let me stress that this is an evolutionary phenomenon. We have listened carefully to all who have reacted to the original proposal sketched out by Anne Krueger over a year ago. In particular, we have taken on board a number of the concerns raised by private market participants, by academics and NGOs, and by practitioners in bankruptcy proceedings.
In a word, the SDRM, through a universal treaty, would provide a legal framework that would make binding the decisions of a supermajority of creditors in agreeing with a sovereign debtor on a restructuring of its outstanding debt. Such agreement could either precede or follow an event of default, preferably the former as that could help minimize the economic disruption and the associated costs to the economy and loss of value to creditors that often follow default.
Under the SDRM, there would be five major features, somewhat analogous to the basic features of domestic bankruptcy:
1. the sovereign debtor would have legal protection, de facto or de jure if required, from disruptive legal action by creditors while negotiations were underway. An early version of the SDRM proposal would have given the Fund the power to endorse such a stay on litigation or make the stay automatic. In the revised proposal, responding, inter alia, to the views of market participants, private creditors would be given a role in these decisions. Why have we made this change? After extensive consultations, IMF staff is now of the view that while an automatic stay has its merits, it does not constitute a proportionate response given the magnitude of the risk of litigation. Moreover, it may not fit comfortably with other features of the mechanism. In the corporate context, an automatic stay is normally accompanied by a moratorium on payments to all creditors—this ensures fair treatment of all creditors; that is, it ensures intercreditor equity. In the sovereign context, however, it is unlikely that a sovereign will stop paying all creditors, in part because of the ramifications of a suspension of payments for the domestic financial system.
2. The creditors would have assurances that the debtor will negotiate in good faith and will pursue policies—most likely to be designed in conjunction with seeking financial support from the IMF—that help protect the value of creditor claims and help limit the dislocation in the economy. The Fund's recently revised policy on lending into arrears works strongly in this direction.
3. Creditors could agree to give seniority and protection from restructuring to fresh private lending to facilitate ongoing economic activity. Perhaps most importantly, this could involve the continued provision of trade credit and would be akin to debtor in possession financing. I have to note that this is proving difficult to formulate and raises important issues about the role of the Fund itself in providing such priority financing. We need to do more thinking and consult more broadly on this aspect of the mechanism.
4. A supermajority of creditors could vote to accept new terms under a restructuring agreement; minority creditors would be prevented from blocking such agreements or enforcing the terms of the original debt contracts, i.e., they would be bound by the decision of the majority. And,
5. a dispute resolution forum would be established to verify claims, to assure the integrity of the voting process, to adjudicate disputes that might arise, and, essentially, to guide the process when a country activated the SDRM.
Note that in all of this there are no new legal powers for the IMF. The decisions to be taken would be those of the debtor and a supermajority of creditors following negotiations between the debtor and its creditors. The Fund's role would continue to be essentially that of signaling its willingness to support and provide financial assistance for the government's adjustment program.
In my view, there are important advantages to the statutory approach proposed under the SDRM. These include: (1) the immediacy of its applicability to all sovereign debt upon the statue becoming effective—a big advantage compared to the contractual or collective action clause approach; (2) its uniform application across all debt and across all jurisdictions, i.e., aggregation across all debt instruments or all classes of instruments for voting purposes would be possible; again, this is something not likely to be feasible under a contractual approach; and (3) the creation of a single dispute resolution forum to assure integrity to the process and to avoid ambiguities of language or interpretation. The establishment of the SDRM under an international treaty, most appropriately through an amendment to the Fund's Articles of Agreement, would assure legal uniformity across all jurisdictions.
There are numerous specific issues raised by this proposal and nothing is as yet cast in stone, although significant progress is being made. For example, while it is the intent to be comprehensive in including claims against the sovereign under the umbrella of any restructuring agreement, it is recognized that it may be appropriate to define classes of creditors for voting purposes rather than to try to aggregate votes across all claims. At the same time, it is agreed that the number of such creditor classes should be kept small; that they should not be pre-specified in a treaty, but dealt with on a case by case basis; and that approval by each class should be required to complete the restructuring, i.e., each class should have a veto over the final, comprehensive agreement. This last point will require striking a delicate balance to ensure that the classification process itself does not create holdout problems.
There also seems to be agreement emerging that sovereign debts governed by domestic law and subject to the jurisdiction of domestic courts could be excluded from the SDRM. There is also some support for excluding official bilateral claims from the SDRM and dealing with them in the Paris Club format. This may require certain changes in the policies and practices of the Paris Club. In both cases, however, any action taken to restructure these kinds of debt would have to be in the context of close collaboration and coordination with the creditors restructuring under the SDRM. There is also broad agreement that the debt of the Fund itself and some other IFIs, as preferred creditors, would not be subject to restructuring under this mechanism.
Let me be clear on one point here. The issue regarding domestic debt or bilateral official claims is not whether the debts should be included in the restructuring; in some cases they certainly should be! The issue is, rather, whether they are dealt with specifically under the SDRM or, instead, under a coordinated process in which procedures specific to, and possibly more effective in, dealing with those claims are employed. The latter seems to be the more widely accepted approach, although this, like many other issues, requires further discussion.
The Sovereign Debt Dispute Resolution Forum, the SDDRF (with apologies for the unpronounceable acronyms!) is one of the most novel elements of this proposal. Specific modalities for the SDDRF, including procedures for selecting members to serve on the Forum, are proposed in the latest staff paper that has been circulated and posted on the Fund's website and are under active debate. As with some of the other elements of the SDRM, there are contentious issues here—especially regarding the means by which to assure independence to such a forum, including independence from the Fund. There are also issues regarding the degree of activism appropriate to such a forum—the more active it were to become, the more it may approach the role of a bankruptcy court, which is not the intention.
Let me say a few words about the alternative proposals to SDRM. These involve primarily suggestions to rely on a contractual approach by including collective action clauses (CACs) in bond contracts and to elaborate a voluntary code of good conduct for all parties involved in a sovereign debt restructuring. The IMF is fully engaged in the discussion of these proposals and regards them as complementary to the statutory approach taken in the SDRM proposal.
Collective action clauses apply to individual bond issues. They would permit a specified super-majority of holders of a particular bond issue to agree to a restructuring that would be binding on all holders of that issue. They could also include provisions similar to the sharing clauses in bank syndications, and representation clauses to help facilitate discussions between the debtor and its creditors. Some advocates of CACs also speak of the use of exit consents to encourage participation in restructurings, by making the original instruments less attractive to potential holdouts after the restructuring takes place.
My own view is that the SDRM is a more comprehensive and a more promising approach than CACs for a number of reasons. First, the SDRM would deal with the entire existing stock of debt, including instruments that do not explicitly provide for collective action. Even if CACs became more widely used in new bond contracts, the CAC approach would still fail to cover existing instruments that lack such clauses, including bank claims and other forms of debt.
Second, the SDRM would allow a single vote to restructure multiple debt instruments by aggregating the votes of creditors holding participating debt instruments. In other words, the SDRM permits the debtor and its creditors to act as if all of this debt were governed by common collective action clauses, under a single legal jurisdiction.
Third, the SDRM would provide for an impartial dispute resolution process, inter alia, to protect creditors against fraud. The difficulty in providing such protection in the context of CACs has been an impediment to developing a contractual approach.
Fourth, the SDRM, would allow a super majority of creditors to approve new money that could help limit the scope of economic dislocation during the restructuring process. The CACs suggested to date do not have this feature.
And fifth, the SDRM would enter into force for all countries at the same time. In contrast, there has been a "first mover" problem associated with CACs. No emerging market economy has wanted to be the first to introduce CACs in its bond issues for fear that investors will misinterpret this as a signal that restructuring is more likely and thus demand a higher risk premium.
Notwithstanding what I consider weaknesses in these proposals, the use of CACs would be an improvement over the current system and the IMF is committed to promoting their use among its member countries. Likewise, we support the initiative to develop a code of good conduct. Transparent guidelines or best practices can be useful in making markets work more effectively. Indeed, this is the philosophy that guides the work on standards and codes, which I described earlier in my remarks.
Now let me turn briefly to the other questions:
What has been the reaction of member governments? This is changing terrain, not least as the proposal itself undergoes modification in light of the reactions from governments, markets, academics, NGOs, bankruptcy practitioners and others. Elaboration of the proposal is supported by all members of the Fund, i.e., none have said "give it up!" In fact, the guiding body of the IMF, the IMFC, has asked that staff, management and the Executive Board continue to work on two tracks, pursuing proposals for both SDRM and for collective action clauses. It has further asked that a concrete proposal on SDRM be formulated and presented to the IMFC for consideration at its Spring Meetings in April. This is what we are doing, and a two day Workshop/Conference held at the Fund last week was one example of the outreach in which we're engaged to formulate in more concrete terms the various elements of the proposed mechanism.
But what is the strength of support among the membership? Most of the membership is supportive of the general outlines of the proposal, with some differences of view on a number of the specific elements. But these specific differences are not, I believe, of a nature that would lead to a withdrawal of support. The major skepticism registered is from the United States and some of the emerging market countries. And this is critical! An amendment to the Fund's Articles of Agreement would require approval by 85 percent of the membership (by voting power); thus, these constituencies in the membership would have to support it. Officials in the United States, as reflected in a speech last week by R. Glenn Hubbard, the Chairman of the Council of Economic Advisers, remain to be convinced that a statutory basis is needed to achieve the cooperation required from private creditors to make restructuring work. They appear to prefer a modification and strengthening of CACs and the creation of a voluntary creditor dispute resolution forum that could "...... operate akin to a domestic bankruptcy court in that a borrower could approach the Forum and request the initiation of proceedings for a restructuring", including "...... (verifying) creditor claims and monitor(ing) the voting process." They would want to give time to observe the effectiveness of the operation of such a forum. As Mr. Hubbard says: "If it (the voluntary forum) proves ineffective, then the case for statutory change is even stronger."
Among some of the emerging market country members, there is a sense that if the SDRM proposal is of concern to creditors—as it is—it should be of concern for the debtors, since there are no debtors without creditors, and debtors feel their access to international credit markets may be threatened. They are also hearing from the private markets that the existence of such a scheme would increase the spreads on such borrowing. A recent press release put out by the International Institute for Finance (IIF) and a number of market associations portrays the SDRM as "An Unnecessary and Counterproductive Mechanism" and asserts that "If implemented it would raise borrowing costs and further weaken flows." I must say on this latter point, however, that there is no credible evidence supporting that assertion. The challenge here, in particular, is to make the case better than we have that the SDRM holds the promise of making international capital markets work more efficiently, not less, and, therefore, could reduce the cost of borrowing and increase access for good credit risks. I'm not aware of any credible arguments that the existence of domestic bankruptcy for private corporations adversely affects the operation of domestic credit markets.
Finally, on the reaction in private markets. The document I just referred to from the IIF and others is the most visible indication of the objections raised to SDRM by some in the private sector. In many quarters, the reaction has been negative to the specific proposal, but more positive to the case that has been made that there is a problem, and that something new is needed to deal with sovereign debt crises. This, in itself, is a big change from the position evident over the past several years when even CACs were resisted and markets insisted they could successfully restructure if countries would only approach them for help. Various groups in the private sector are now actively working to develop model collective action clauses and are discussing a code of conduct to guide the actions of all parties in the context of a sovereign debt crises. I expect proposals in these areas to surface even in the course of the week.
Let me conclude by suggesting that, when assessing any of the proposals that have been made, they need to be subjected to a number of tests. Questions about the impact of the proposed system on the efficiency of markets and, therefore, on access to and spreads on international credit is critical. But so too are the questions regarding the capacity of any proposed system to produce reasonably orderly restructurings within a time frame that limits the dislocation and loss of value too often associated with these events. Everyone gains from that preservation of value and, here, the SDRM has the edge. It holds better promise, I believe, for creating the confidence needed for all parties to be willing to reach for its activation when a country's debt situation has become unsustainable.
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