[stop-imf] IMF's Krueger on Sovereign Debt Restructuring

[Robert Weissman]

http://www.imf.org/external/np/speeches/2003/010403.htm

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
encoursge 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.



*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.



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