FRBSF Economic Letter
2004-06; February 20, 2004
Resolving Sovereign Debt Crises with Collective Action Clauses
Ever since Mexico's "Tequila crisis" in
1994-1995, policymakers have debated how best to reduce the cost
of protracted sovereign
debt restructuring when emerging markets are in financial crisis.
Two dominant approaches have emerged. One promotes changes in the
bond contracts international lenders offer; in particular, it encourages
the use of collective action clauses (CACs) rather than unanimous
action clauses (UACs). The other approach proposes creating statutory
procedures for restructuring unsustainable debt.
At their spring 2003 meetings, the International Monetary Fund
and the World Bank decided to move forward with the contractual
approach while continuing to study the IMF's proposed Sovereign
Debt Restructuring Mechanism. This decision was shaped by Mexico's
successful launch in March 2003 of a $1 billion global bond in
New York that included CACs; subsequently, Mexico, Korea, South
Africa, and Brazil issued bonds with similar provisions.
CACs allow
a qualified majority of the holders of a bond issue (typically
representing 75% of the debt for sovereign debt) to
vote to bind all bondholders to a change in the terms of the bond
contract; UACs, in contrast, require that all holders vote on a
change in the terms of the contract. With UACs, individual bondholders
can take advantage of the situation and veto restructurings while
they hold out for preferential treatment; CACs effectively thwart
this behavior.
CACs are routinely included in bonds issued in the
United Kingdom and Luxembourg. For sovereign bonds issued in the
United States
(typically, under New York law), majority action clauses are rarely
applied to the terms of repayment, either the amounts or timing
of repayments. Under the Trust Indenture Act of 1939, publicly
issued corporate bonds must require the consent of all bondholders
to revise the terms of repayment. This act does not apply to sovereign
debt issued in the United States, but bonds issued in New York
overwhelmingly follow this convention. The same applies to sovereign
bonds issued in Germany, while Japanese law appears to require
the application of unanimous consent to international bond issues.
The
promotion of CACs raises at least three concerns. One is whether
the clauses actually do reduce the cost of protracted debt restructurings;
furthermore, if they do, then a negative consequence is that they
can induce "moral hazard"—that is, if the governments
of emerging market economies find it easier to handle debt crises,
they may not work so hard to avoid them, so debt crises might happen
more readily. Another concern is whether it will be very difficult
for countries whose existing bond issues feature UACs to make the
transition to CACs. A third concern is that CACs apply to individual
bond issues separately, so that CACs may not help when many bond
issues need to be restructured simultaneously in a coordinated
way. In this Economic Letter, I summarize the empirical
evidence on how interest rate premiums—that is, the spread between
a measure
of the interest rate on a relatively risk-free bond and the interest
rate on sovereign bonds—vary with the inclusion of CACs; I also
discuss how the differences in these premiums shed light on the
debate over the potential benefits of CACs for investment-grade
and speculative-grade countries.
Measuring the effects of CACs
Quantitative studies of the effects
of CACs generally compare the interest rate premiums between
bonds issued with and without
CACs, focusing on bonds issued in the U.K. with those issued
in the U.S. A higher premium suggests higher risk, which
implies that creditors expect the moral hazard problem to dominate
the
benefits of easing restructuring under stress. A higher premium
also should be associated with lower capital inflows to borrowers
and, perhaps, to resistance to the wider adoption of CACs.
A lower premium suggests that the encouragement of collective
action
provisions is beneficial. Studies by Eichengreen and Mody
(2000a,
b) and by Becker, Richards, and Thaicharoen (2000) concentrate
on premiums for the launches of primary issues, while Gugiatti
and Richards (2003) and Eichengreen, Kletzer, and Mody (2003)
expand the data to consider both primary and secondary market
premiums for a very inclusive set of bond issues. The data
sets and methods of analysis vary, but the last, and latest,
of these
papers analyzes data that include the universe of bond issues
studied by the others.
A major finding of Eichengreen and
Mody (2000a, b) and of Eichengreen, Kletzer and Mody (2003) is
that the credit rating
of the issuer
matters. The inclusion of CACs lowers interest rate premiums
on bonds issued by countries with investment-grade ratings
and raises
them for bonds issued by debtors with sub-investment-grade
ratings. General sentiment in the market for emerging market
bonds also
matters. Interest rate premiums on bonds issued with CACs
rise relative to premiums for bonds issued with UACs when the premium
for the Emerging Market Bond Index (EMBI) is higher, that
is,
when bonds issued from emerging markets generally are viewed
as riskier.
CACs lower borrowing costs, as evidenced by both launch and
secondary market interest rate premiums, for more countries
and by larger
amounts for investment-grade countries when the EMBI is lower,
that is, when the emerging bond market is strong. An interpretation
of this result is that investors fear that when the EMBI
is higher, individual debtor countries may use the general uncertainty
as
cover for taking greater risks which may lead to default.
Overall,
the empirical evidence to date supports the conclusion that
the use of CACs will modestly reduce funding costs for
investment-grade emerging market borrowers and raise them for lower-rated
countries.
The issues by Mexico and Brazil in late spring of this
year, issued under New York law with CACs, reflect the results
of these estimations.
Mexico's first issue featuring CACs, with a maturation
date in 2015, was priced to yield a spread of 313 basis points
over 10-year
U.S. treasuries at the time of issue. Exact comparison
bonds do not exist, but market analysis suggests that this bond
was priced
at a premium of about 8 to 10 basis points over otherwise
comparable bonds issued by Mexico with UACs. A similar
bond
issued in
April 2003, was thought to be issued at a small discount.
The empirical
analysis implies that a country that has just reached investment-grade
status (Mexico had bond ratings of BBB-/Baa2 from Standard
and Poor's and from Moody's, respectively) should realize
a discount
of about 25 basis points for such bonds relative to the
yield curve.
Brazil's $1 billion issue in late April was the first
speculative-grade bond issued under the initiative (Brazil's
ratings were
B2 and B+, respectively). This bond was not comparable
in that
it requires
approval of 85% of bondholders for repayment restructuring
while the other bonds issued require 75% majorities.
Some market observers
judged Brazil to be paying a penalty of 10 to 15 basis
points for the CACs, consistent with the empirical results
of Eichengreen,
et al., while others detected no premium or discount,
consistent with the notion that the penalty should fall as the
qualified
majority
requirement tightens.
The transition problem
More than two-thirds of current outstanding
emerging market debt carries UACs, and many of these bonds will
not mature
for several
years. Therefore, the transition to widespread use
of CACs might take some time. One question, addressed by
Eichengreen,
et al.,
is whether countries with predominantly UAC debt
will want to issue new bonds with CACs. Another is whether
markets
eventually will
revert to bonds issued with UACs. To investigate
these transition issues, they estimate how the share of outstanding
debt issued
in bonds with CACs affects the interest costs for
the
borrower. Consistent with the view that restructurings
are more likely
for low-rated debtors, they find that the interest
rate premium is
higher for bonds issued with CACs when the overwhelming
majority of outstanding debt carries UACs for low-rated
countries,
but not for higher-rated speculative-grade and investment-grade
borrowers.
They also find that when the majority of existing
debt is issued
with CACs, a new issue with UACs pays a premium for
low-rated issuers.
It may be that the holders of bonds with UACs fear
that they can be left hanging when the government restructures
the
majority of
its debt using CACs.
The coordination problem with
multiple bond issues
CACs are structured to help
coordinate the actions of holders of a specific bond issue. But
countries
may have
multiple
bond issues—for
example, Argentina currently has about 80 outstanding
bond issues—and that can raise another coordination
problem.
In particular, the
qualified majority of a single bond issue can
act as holdouts in the renegotiation of a country's
debt. Bankruptcy proceedings
address
this problem for corporations or individuals,
and it
is an important motivation for the IMF's proposals
to establish
international debt restructuring procedures.
Empirically, its importance
can
be considered
by estimating the effect of the number of bond
issues outstanding on the interest premium demanded
by investors
for bonds
issued
with CACs. Eichengreen, et al. (2003) do find
a small multiplicity premium for all issues, but
it is not
affected by whether
the outstanding bonds are issued with CACs.
Although
CACs do not exacerbate the coordination problem with multiple
bond issues, they might
be used to reduce
it for countries
that
are more likely to restructure through the
adoption of super-CACs during times of distress. For example,
Uruguay
undertook
an innovative bond exchange in April and May
of 2003. The new
bonds include
super-CACs that allow revisions of financial
terms if 75% of the holders of
an issue agree or if 85% of the holders of
all bond issues and 66.66% of the holders of each
affected issue agree.
The exchange
was successful, but the terms encouraged exit
consents, which deface old bonds, and the government
warned
that default
might be the
only alternative.
Are CACs a small step in the
right direction?
By pricing moral hazard in sovereign debt markets,
CACs could encourage market discipline.
By facilitating creditor
coordination,
CACs
also should reduce the costs in terms of
a nation's output that are due to protracted
debt restructurings.
Any substantial
benefits
of promoting CACs in sovereign bonds might
require further innovations to the international
financial
architecture.
For example, by
reducing the costs of debt restructuring,
CACs might relax the pressure
on the IMF to extend financial assistance
to countries whose debts may not be sustainable.
If both creditors
and debtors
perceive a lower probability of IMF intervention,
then greater market
discipline
might follow.
Kenneth Kletzer
Professor of Economics, UC Santa Cruz, and Visiting Scholar, FRBSF
References
Becker, Torbjorn, Anthony Richards, and Yungong Thaicharoen. 2000. "Bond
Restructuring and Moral Hazard: Are Collective Action Clauses Costly?" IMF
Working Paper.
Eichengreen, Barry, and Ashoka Mody. 2000a. "Would
Collective Action Clauses Raise Borrowing Costs?" NBER Working
Paper 7458 (January).
Eichengreen, Barry, and Ashoka Mody. 2000b. "Would
Collective Action Clauses Raise Borrowing Costs? An Update and
Extension." World
Bank Research Paper 2363 (June).
Eichengreen, Barry, Kenneth Kletzer,
and Ashoka Mody. 2003. "Crisis
Resolution: Next Steps." Brookings Trade Forum. Washington,
D.C.: Brookings Institution, forthcoming.
Gugiatti, Mark, and Anthony
Richards. 2003. "Do Collective
Action Clauses Influence Bond Yields? New Evidence from Emerging
Markets." Reserve Bank of Australia, Research Discussion Paper
2003-02 (March).
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