FRBSF Economic Letter
2002-19; June 28, 2002
Towards a Sovereign Debt Restructuring Mechanism
Over the 1990s, public and private international borrowers shifted the
composition of their external financing—instead of relying primarily
on loans from a syndicate of a few banks, they turned to issuing bonds.
This has resulted in many more creditors of various kinds holding claims
on sovereign debt in the forms of different debt instruments with different
time horizons.
Under usual circumstances, this shift has some desirable consequences.
With a wider creditor base, the risk of lending to a country is spread
more widely, so the country can borrow at more favorable terms. Moreover,
reducing banks' exposure to borrowers' risk lessens the risk of financial
contagion when financial difficulties arise in any individual borrowing
country.
However, the experiences in recent financial crises suggest that when
a country does require a debt restructuring, the outcomes are likely to
be less orderly than those obtained in the days of bank financing. Under
bank financing, it was possible to assemble the major claimants of a problem
debtor and work out an acceptable rescheduling. In the case of bond finance,
in contrast, the set of claimants is much more numerous, widespread, and
heterogeneous. As a result, it can be very difficult to work out an agreement
because a small group of "holdout" creditors can veto any package
that they fail to find acceptable. This difficulty is commonly known as
a collective action problem. It is particularly severe for bonds written
in the United States, where changes to the original terms of a bond require
agreement by all bondholders. In response, there has been a call for reforming
the institutions governing sovereign debt restructuring.
In this Economic Letter, I examine two proposals that have been
put forth for reforming the debt restructuring process. One advocates
a decentralized approach, and it is currently associated with policymakers
in the U.S. Treasury. The other, sponsored by the International Monetary
Fund (IMF), proposes a formal workout mechanism. Despite their differences,
the proposals are not mutually exclusive, and at this point it appears
that a set of new policies on debt restructuring will include elements
of both proposals.
The decentralized approach to the collective
action problem
Many policymakers, most notably officials of the U.S. Treasury (see Taylor
2002), advocate addressing the collective action problem by including
three new types of clauses in sovereign bond contracts issued in the United
States. This is a decentralized approach in the sense that it does not
require a central authority to manage the process.
The first type of clause calls for a majority voting rule. This would
allow a "super-majority" of bondholders, say 75%, to agree on
the terms of a debt restructuring. Eichengreen and Mody (2000) studied
the impact of majority voting clauses on debt issued in the United Kingdom,
where such clauses are common, and found evidence suggesting that they
do not result in increased borrowing costs.
The second type of clause establishes rules governing the renegotiation
process. These clauses would specify the terms of creditor representation,
as well as the information that the debtor would be required to provide
in a renegotiation. The designated "creditor representative"
would have a formal role in these renegotiations, with the authority to
negotiate on behalf of the creditors and to initiate litigation against
the debtor nation, and it would act according to the dictates of a majority
of bondholders.
The third type of clause specifies the terms for launching restructurings.
In particular, the Treasury advocates a "cooling-off period"
between the date that the debtor announces its intention to restructure
and the date the creditor representative is chosen. The cooling-off period
is envisioned to last about 60 days (Taylor 2002).
Problems with a purely decentralized solution
While the IMF welcomes the inclusion of collective action clauses in
bond issues as a fundamental component of addressing problems in sovereign
borrowing (see, for example, Krueger 2002), it has argued that a policy
based solely on the inclusion of such clauses is not sufficient.
One concern is, what country would be willing to go first; that is, since
collective action clauses have not been a regular feature in bonds issued
in many countries, including the U.S., there is a perception that no individual
country would want to be the first to include such clauses in a major
issue. The problem is that, if investors saw that one country was leading
the way in including such clauses, they might think this country is abnormally
concerned with debt renegotiation procedures and assume that it perceives
a higher than average probability of finding itself in a renegotiation.
The investors would then punish that country with inferior credit terms.
Anecdotal experiences from sovereign issues in the U.S. bond market suggest
that sovereign borrowers have been discouraged by their underwriters from
including such clauses because of this concern.
A solution to this problem would be to alter the incentives faced by
sovereigns issuing bonds in the U.S. such that all issuers immediately
jumped to the inclusion of collective action clauses. For example, the
Treasury has discussed the possibility that the IMF could withhold assistance
from any country that failed to include such clauses. Alternatively, the
IMF could offer superior borrowing terms to issuers who include such clauses.
With a sufficient combination of sticks and carrots, all developing nations
would perceive it as in their interest to include collective action clauses
in their bond issues. Consequently, there would be no stigma against any
individual nation doing so.
Of course, the IMF may not wish to provide such a pledge. One could envision
a scenario where a government that failed to include such clauses could
find itself in economic difficulty after the fact. Under those circumstances,
it may be hard for the IMF to resist providing assistance to a country
that is taking positive steps to address its financial difficulties. The
IMF may then violate its pledge and damage its credibility.
Another limitation of collective action clauses as a coordination solution
is that while they may mitigate coordination problems among heterogeneous
bondholders, they would fail to address differences across different classes
of debt holders, such as claimants on syndicated bank loans. Treasury
proposes that decisions be made on an issue-by-issue basis through majority
voting, with inconsistencies across different types of debt claims to
be handled through an "arbitration process" (Taylor 2002). Even
so, there is a large stock of debt instruments currently outstanding that
do not contain such clauses. To deal with this difficulty, the IMF proposes
a "super collective clause" that would allow for restructuring
a given instrument after an affirmative vote by a super-majority of all
creditors, not just those of the instrument in question.
However, countries typically issue debt in a number of legal jurisdictions,
so there is no guarantee that such a clause would be interpreted the same
way across jurisdictions, even if it were worded identically. Consequently,
the IMF maintains that, for collective action clauses to work, they must
be accompanied by a formal workout mechanism. This mechanism could be
established through an amendment to the IMF Articles of Agreement.
Details of a formal workout mechanism
The mechanism proposed by the IMF would allow the debtor to request a
temporary standstill from the Fund. During this period, the debtor would
negotiate a rescheduling or a restructuring, with IMF approval, with its
creditors. Capital controls would be used to ensure that reserves did
not flee the nation during this negotiation period. Krueger (2002) has
noted that creating a formal workout mechanism need not significantly
expand the IMF's legal authority. Ultimate approval of the terms of the
restructuring could remain in the hands of a majority of a super-majority
of creditors, across a broad range of credit instruments, and the sovereign
debtor. If the standstill ended without an agreement, a super-majority
of creditors could extend it.
The IMF's proposed international workout mechanism has four main features.
First, there would be a stay on creditor enforcement during the negotiation
period. Second, debtor behavior would need to be constrained during the
negotiation period to ensure protection of creditor interests. In particular,
the debtor would be prohibited from allocating funds to non-priority creditors,
and the debtor government would be required to pursue policies consistent
with maintaining its capacity to service its debt obligations. It is envisioned
that the latter goal could be achieved under an IMF-supported adjustment
program. Third, private creditors would be encouraged to provide new financing,
perhaps through some kind of explicit seniority mechanism favoring new
money over old claims. This provision also could be mandated by a super-majority
of creditors.
Finally, creditors would be bound by the terms agreed upon by the super-majority
through collective action clauses. In this way, the IMF need not be making
decisions that undermine creditor rights. However, the IMF would assess
whether the terms of the agreement would adequately reduce the debt burden
to a sustainable level. If it felt that it did not, the IMF could withhold
further financing.
Remaining issues
There is some fear that a more orderly workout mechanism would have the
undesirable impact of easing the pain of debt restructuring and thereby
increase the probability of default. The IMF has two responses to this
fear. First, because restructurings currently are so costly, countries
wait as long as possible to ask for debt restructuring. This can delay
movement towards serious reform and it also can result in reduced creditor
payoffs. Second, even though the cost of requesting a restructuring will
be reduced by a workout mechanism, restructurings still will be sufficiently
disruptive and costly to ensure that debtors will not enter into them
if they can be feasibly avoided.
Another issue is the treatment of domestic creditors. It is clear that
the poorer is the treatment of domestic creditors, the greater will be
the amount of funds remaining for servicing foreign debt. This is, of
course, a highly controversial issue. The IMF has raised it without taking
any formal stance on this point, merely stating that judgments about sharing
the burden between domestic and foreign creditors would need to be made
on a case-by-case basis that incorporates the impact of such decisions
on the domestic financial market.
Finally, there is the issue of adjudicating disputes. Throughout most
of the issues raised above, there is a tension between the stance that
decisions are to be left in the hands of a super-majority of creditors
and the perceived need for a rapid and orderly workout that disrupts the
domestic economy as little as possible. For example, this tension arises
in determining the fairness of restructuring terms after approval by the
creditor super-majority, as well as in determining the appropriate burden-sharing
both among different classes of foreign creditors and between foreign
and domestic creditors. The IMF has acknowledged that it would be difficult
for its Executive Board to adjudicate disputes of this kind. Instead,
it envisions an independent panel of judges insulated from IMF management
to play that role.
Conclusion
While there has been a spirited discussion about the proper mechanisms
to deal with problems in the international debt markets, one should not
underestimate the degree to which a consensus is emerging. Officials at
the IMF have backed away from their initial calls for an IMF-run international
bankruptcy court in favor of an independent review process. The U.S. Treasury
continues to advocate a more decentralized approach, but also acknowledges
that at the end of the day some sort of arbitration procedure will be
necessary to reconcile claims across different classes of sovereign creditors;
it seems likely that this arbitration procedure will need to operate at
a multilateral level. As such, it appears that the emerging consensus
will be a set of policies designed to encourage collective action clauses,
as the U.S. Treasury is advocating, while ultimate arbitration across
different classes of claimants will fall to a multilateral entity, as
is being advocated by the IMF.
Mark M. Spiegel
Research Advisor
References
Eichengreen, Barry, and Ashoka Mody. 2000. "Would
Collective Action Clauses Raise Borrowing Costs?" NBER Working
Paper No. 7458.
Krueger, Anne O. 2002. "A
New Approach to Sovereign Debt Restructuring." Speech delivered
to the Indian Council for Research on International Economic Relations
in Delhi, India December 20, 2001. International Monetary Fund.
Taylor, John B. 2002. "Sovereign
Debt Restructuring: A U.S. Perspective." Conference on "Sovereign
Debt Workouts: Hopes and Hazards?" Institute for International Economics,
Washington, DC.
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