Special Event of the Second Committee on Sovereign Debt Restructurings: Lessons Learnt and Proposals for Debt Resolution Mechanisms ECOSOC 25 October 2012
1. In the past, sovereign debt issues were a confined problem, to the extent it was direct borrowing of the “sovereigns”, stemming from fiscal recklessness, abundant credit and macroeconomic vulnerabilities, as evident from the case of sovereign debt crisis of 1980s and HIPC phenomenon. Recent rounds of sovereign crises have resulted from a lethal combination of private capital flows and credit booms, financial engineering and excesses of corporate and sovereigns. So addressing sovereign debt crisis calls for larger public policy debates requiring us to fix the root cause of problems, which stems from a combination of:
- Lack of proper predictability of economic models, as they misguided policy makers; the models did not factor in market imperfections, information asymmetry, complexities of behavioural economics and the financial industry and as such their predictability results have come into question.
- Weak governance of economic policy design and implementation; even though globalization has fast integrated the world, the laws, policies and institutional mechanisms remain fragmented and do not induce confidence.
2. The reality is that sovereign credit crises reflect the symptoms of the problem but are not its root cause; as such this will remain a recurring problem. In this context, it is important to find solutions to fix the root cause of problem, while finding out effective resolution mechanisms to deal with the symptoms. It is important to deal with the symptoms so that its damages remain contained and resolution helps kick start economic recovery.
3. Debates on enhancing the procedures for sovereign debt restructuring have existed for a long time and had several reincarnations. From each of the major episodes of sovereign debt crisis we have learned important lessons. Yet, the international financial architecture remains static and we have failed to reach a consensus on how to change it. The political economy forces don’t allow sound practices to be enforced. It seems that as soon as the heat of the crisis cools down, the political will gets diluted. The world lacks a standing approach and body that can preserve the institutional memory of these episodes. The experience gained and the insights provided by a range of sovereign debt restructuring cases, do offer lessons which, if carefully applied, could facilitate smoother treatments of sovereign debt in the future, by providing a venue for information discovery and negotiation.
4. In offering my reflections on the topic, I propose to touch upon the changing characteristics of sovereign debt crises, as this round is different from experiences of the past debt crises. In addition, I would like to focus on the complexity of the problems, issues and constraints experienced in sovereign debt crises. Lastly I would share the perspectives of the panels UN DESA has organized in recent years, to consult experts in order to develop thinking on sovereign debt resolution frameworks – the good news is that we hear interesting perspectives, but there is no consensus on the way forward.
Distinct characteristics of the present round of discussions on sovereign debt restructuring
5. The current incarnation of the sovereign debt restructuring debate has several characteristics that make it stand apart:
- (i) For the first time in many years it concerns sovereigns in developed countries.
- (ii) The rules of the monetary union have made it difficult for countries to deal with sovereign debts, despite the fact that most of them were issued under local laws. In effect, the majority of EU countries issued more than 80 per cent of their public bonds under their own laws between 2003 and 2010
- . In addition, adjustment tools are more limited, as the exchange rate is not available as a policy instrument in a single currency union regime.
- (iii) Debt crises this time around involve substantial cross-border banking operations. The extent of shared risks have resulted in deeply intertwined banking and sovereign debt problems. Bank recapitalizations are necessary, yet sovereigns that often rescued banks in the past cannot lend a helping hand this time. In past crises, bad assets were with the private sector, while now bad assets are with the sovereigns.
- (iv) The resources required to rescue the banking system and help achieve sovereign debt sustainability are unprecedented in scale. Given the limitations of fiscal austerity and the absence of adequate institutional arrangements to provide liquidity of that magnitude, alternate resolution mechanisms are critical.
- (v) Market innovations, such as Credit Default Swaps (CDS), are now of common usage. According to a recent IMF Survey
- on the subject, the volumes of CDS contracts outstanding have increased manifold in the last 5 years, and there is now a relatively liquid secondary market for sovereign CDS trading in Europe and the US.
- (vi) Creditors are dispersed internationally, are larger in number and include pension funds, hedge funds and insurance companies.
Complexities, constraints and issues in the long-standing sovereign debt restructuring debate
7. The 2012 United Nations Report of the Secretary General on External debt sustainability and development3 conveys five main messages on sovereign debt restructuring.
8. First, the absence of clear rules and an established sovereign debt restructuring framework often results in lengthy debt renegotiations after which debtor countries have not always succeed in bringing themselves to debt sustainability.
9. Second, generally geographically dispersed creditors and bondholders have incentives to holdout from debt restructuring deals. Interestingly, a recent IMF Survey on the subject shows that, with the exception of some cases (such as the Dominica and Argentina), holdouts and litigation have not been as pervasive as expected in recent sovereign debt restructurings4.
10. Third, access to private interim finance is constrained for countries undergoing a debt restructuring process, because such financing is not able to secure the required “seniority” with respect to existing claims. During crises, the IMF and other official lenders usually provide access to new loans which are in practice, though not legally, treated as senior with respect to private claims.
11. Fourth, the lack of an established seniority structure leads in many cases to debt dilution and additional indebtedness, both before and after declaring financial distress, besides increasing borrowing costs ex ante, as the country’s market access gets increasingly restricted to more risk prone lenders.
12. Fifth, contrary to previous preconceptions, it has been shown that countries often try to postpone the beginning of a difficult, yet unavoidable debt restructuring process. This leads to destruction of value because a prolonged pre-default crisis mode for sovereigns may reduce both their ability and willingness to pay, making both the creditors and the debtor worse off.
Proposals, perspectives and collective wisdom towards a sovereign debt resolution framework
13. Parallel to UNCTAD “Principles on Promoting Responsible Sovereign Lending and Borrowing”5 , several initiatives have emerged with regard to these issues. In the private sector for example, discussions are under way regarding amendments to the “Principles for Stable Capital Flows and Fair Debt Restructuring”6 . Their objective is to incorporate the new developments associated with debt restructuring. Meanwhile UNDESA has launched a range of multi-stakeholder consultations on Sovereign Debt Restructuring7 to solicit views of distinguished experts from academia, policy makers and private sector representatives. These multi-stakeholder consultations have proceeded without a pre-conceived notion of whether a debt resolution framework would take place under the voluntary “contractual” or “statutory” approach.
14. In the recent UNDESA Panel Discussion in Tokyo, at the margins of the IMF-WB Annual Meetings, experts did see virtue in a “statutory mechanism”, but did recognize the complexity of designing an acceptable and enforceable framework. The discussions around a Sovereign Debt Restructuring Mechanism rooted at the IMF in the 2000s alerted creditors to the vulnerability of their position. It made it clear that their way out was to rely on litigation. This fostered innovations in contractual clauses, such as Collective Action Clauses to solve coordination problems. It also strengthened the development of principles and codes of conduct for sovereign debt like the ones mentioned before. Even though warranted, misgivings do exist despite the “codes of conduct” because of a general lack of enforceability.
15. The magnitude of the recent crisis might explain a perceived general willingness, including among private sector representatives in our consultations, to entertain a more rules-based approach. Such an approach, while constraining private creditors, would also protect them from arbitrary actions by sovereigns.
16. A balance between contractual and statutory instruments might result from this round of debates. The fate of previous attempts does not absolve us from seeking the creation of a system that actually addresses the issues that have been outlined.
17. An important and cross-cutting issue is that of transparency and availability of data. Parallel to private sector efforts to address this issue, the creation of an international registry of debt, reported by creditors and reconciled with debtors, has been proposed.
18. Another, perhaps more ambitious option, would be the creation of a neutral Sovereign Debt Forum, which would help assuage the information and analytical issues associated with the question of debt sustainability, as well as provide a permanent space for negotiations and consultations.
19. In situations of debt distress borrowers would benefit from some “breathing space”, not available in the current framework, to identify and implement a sound policy framework to promote sustainable adjustment, preserve asset values and support growth, to the mutual benefit of debtors and creditors. In practice, sovereigns can impose de facto standstills through the exercise of force majeure, given the absence of credible means to enforce judgments under sovereign immunity.
20. A fundamental issue is whether a more formal process for the declaration of a standstill, in conjunction with lending into arrears by the IMF, would enhance the debt resolution framework. Such a process would provide a stay on all litigation by individual creditors, preventing a panicked rush to the exits that usually triggers a rollover crisis and a race to the courthouse. Two proposals have been discussed in this regard. First, the inclusion of terms for standstills in bond and loan contracts, under the voluntary approach and second, the amendment of article VIII 2b of the IMF Articles of Agreement to include capital account transfers under the statutory approach.
21. It is quite evident that resolution of large magnitudes of distressed sovereign debt requires an established procedure and a clear set of rules. The cumbersome negotiations that culminated with the Greek voluntary debt restructuring in April 2012, are a distinct example. Although the debt exchange finally reached high private sector participation, amounting to 83.5 per cent and to 97 per cent with the activation of Collective Action Clauses8, the economic and social costs, as well as the underlying and persistent risks to global financial stability are too high to ignore.
22. Yet, no contractual clause or improvement, be it a collective action clause by itself or combined with aggregation clauses, or an exit consent clause, or any other clause can be expected to do the task of an orderly restructuring framework like the one we are discussing today. No contractual clause can ensure a fair and timely resolution of debt crises. Externalities, broader societal goals and distributional problems cannot be dealt with through by contracts. Contractual clauses cannot fulfill the goals of public policy.
23. The issue of seniority is fundamental for an enhanced sovereign debt restructuring framework. In most cases the official sector offers interim finance. However, the official sector may not have enough funds and its stand-alone intervention may generate moral hazard problems. Moreover, private sector creditors participating in the Greek exchange have been particularly concerned about equal treatment of creditors and subordination of private debt because of interim public sector finance.
24. A debt resolution mechanism capable of enforcing seniority would have its advantages: one would be allowing for interim financing (through debtor-in-possession provisions); a second one would be to prevent debt dilution and thus reduce borrowing costs and the risk of over-borrowing.
25. To solve the issue of availability of funds there is a proposal to combine, and thus leverage, IMF resources with private sector financing. In this case, the IMF could act as a coordinator, not principal lender, thereby reducing potential moral hazard and also conflicts of interest.
26. This statement aims at bringing out the changing game and dynamics of sovereign debt restructuring. It is clear that its origins go beyond direct sovereign borrowings. It results from the complications created by financial system excesses and private capital flows across borders. It also results from the increasing market recourse to more complex instruments of borrowing, where the risks go beyond institutions to individual bond holders.
27. In examining the issues and laying out ideas and proposals, the statement has deliberately eluded coming up with a prescriptive resolution. Instead, the strategy has been to share the perspectives coming from different debates on this issue. It is clear that sovereign debt restructurings will continue to take place in varied settings, and responses will be structured and shaped in line with the prevailing economic and political constraints.
28. These experiences continue to enrich us, by highlighting the many issues and constraints we face. As a result, considerable collective wisdom is being created. My hope, for this and future rounds of this debate on sovereign debt resolution, is that at some point there will be a proper system in place. That system should minimize the costs for all involved and ensure that responsible external debt plays a positive role in the global economy.
29. If Europeans cannot get an eventual framework for debt restructuring resolution, given the nature of the bloc and the attempts to nurture harmonization of European standards and legal frameworks to a certain extent, it might be difficult to perceive such a development elsewhere.
30. Yet, incremental steps towards an improved global framework are essential. The fate of previous attempts does not absolve us from seeking the creation of a system that actually addresses the issues that have been outlined, to the benefit of both creditors and debtors and, ultimately to the benefit of citizens and global financial stability.
1IMF (2012), IMF Working Paper, WP/12/203, “Sovereign Debt Restructurings 1950–2010: Concepts, Literature Survey, and Stylized Facts”, Monetary and Capital Markets Department. Available at: http://www.imf.org/external/pubs/ft/wp/2012/wp12203.pdf, page 42.
2IMF (2012), page 57.
3United Nations A/67/174, General Assembly Item 18 (c) of the provisional agenda*, Macroeconomic policy questions: External debt sustainability and development, Report of the Secretary-General.
4IMF (2012), Table 8, page 49.
5United Nations Conference on Trade and Development, Principles on Promoting Responsible Sovereign Lending and Borrowing, available at:http://unctadxiii.org/en/SessionDocument/gdsddf2012misc1_en.pdf
6Institute of International Finance, Principles for Stable Capital Flows and Fair Debt Restructuring. More information available at http://www.iif.com/emp/principles.
7Multi-stakeholder Consultations on Financing for Development Dialogues managed by FfDO on External debt of developing countries. More information available at:http://www.un.org/esa/ffd/msc/externaldebt/index.htm
8Institute of International Finance, Report of the Joint Committee on Strengthening the Framework for Sovereign Debt Crisis Prevention and Resolution, October 2012, available at http://www.iif.com/press/press+393.php, page 3.