Sovereign Debt Restructuring: A US Perspective
Speech at the conference "Sovereign Debt Workouts: Hopes and Hazards"
Institute for International Economics
Thank you for giving me the opportunity to speak here today. I would like to use the opportunity to discuss US policy regarding the process of sovereign debt restructuring in emerging markets.
It is clear that reform of this process is long overdue. There has been much useful study and discussion since the mid-1990s when problems with the process became apparent, including the 1996 Rey Report of the G-10, numerous G-7 statements since then, and most recently the stimulating discussion of several reform options by the International Monetary Fund. But the time for study and discussion of options should be ending. The time for action is here.
The truth is that many emerging markets have not performed well in recent years. Investment flows going through these markets have declined sharply; net private capital flows dropped from an average of $154 billion per year from 1992 through 1997 to $50 billion per year from 1998 through 2000. Even if you ignore the high years of 1995 and 1996, there has been a sharp reduction. There have been too many crises, which have discouraged capital flows and damaged the affected economies. Clearly we would like to see fewer crises. We would like to see a sustained recovery of investment in the emerging markets along with lower interest rates. Ultimately we would like to see the poor developing economies become truly emerging market economies.
Currently there is a great deal of uncertainty surrounding the sovereign debt restructuring process. When it becomes apparent that a country's sovereign debt situation is unsustainable and a restructuring is in order, many difficult questions arise about what will happen next. What will the debtor government do and when? How will the discussion with the creditors be structured? How will the private sector respond? Will holdout creditors upset the whole process? If a restructuring is chosen, how long will it take? Will the restructuring lead to a sustainable situation? Will creditors be treated equitably and fairly? This uncertainty complicates decision-making for everyone—the private sector, the official sector, and the sovereign government itself.
A more predictable sovereign debt restructuring process for countries that reach unsustainable debt positions would help reduce this uncertainty. It would thereby lead to better, more timely decisions, reducing the likelihood of crises occurring and mitigating crises that do occur. Ideally sovereign debt restructurings would never have to take place, because ideally countries would never get into unsustainable debt situations. But we have a long way to go before we get to that ideal. The aim of reforming the sovereign debt restructuring process is not to reduce the incentives that sovereign governments have to pay their debts in full and on time. Those incentives—primarily the benefit of continued access to capital at reasonable interest rates—will remain. Rather the aim is to reduce the uncertainty that now surrounds restructurings.
Actually implementing a reform of the debt restructuring process will require a great deal of financial diplomacy. There are many participants in emerging markets with many different economic and political interests and points of views. Practicality is essential. People have to understand clearly how the reformed process will work and why it will work better than the current process.
Guidelines for a Decentralized, Market-Oriented Approach
In our view, the most practical and broadly acceptable reform would be to have sovereign borrowers and their creditors put a package of new clauses into their debt contracts. The clauses would describe as precisely as possible what happens when a country decides it has to restructure its debt. In this way the contracts would create a more orderly and predictable workout process. Such clauses represent a decentralized, market-oriented approach to reform because both the contracts and the workout process described by the contracts are determined by the borrowers and lenders on their own terms.
What should these new clauses look like? In decentralized fashion, many of the details would be determined by the borrowers and lenders as new bonds are issued, but the legal templates should conform to several essential guidelines.
First, there should be a majority action clause. Currently, the clauses in many bonds require the consent of 100 percent of bondholders to change the financial terms. Thus, a small minority can prevent a restructuring that the majority of bondholders feel is in their best interests. In contrast, majority action clauses allow a super majority—bondholders holding, for example, 75 percent rather than 100 percent of the principal—to agree to a restructuring. The decision of this super majority is binding on the minority. Thus, a majority action clause would prevent a small minority from delaying or otherwise disrupting an agreement and would thereby add predictability to the restructuring process. Majority action clauses are now in sovereign bonds issued under UK law. However, sovereign bonds issued under New York law generally and by tradition have no such clauses. There is no legal reason why such clauses could not be included.
Second, there should be a clause describing the process through which debtors and creditors come together in the event of a restructuring. This clause would specify how the creditors would be represented and what data the debtor must provide to the creditors' representative and within what period of time. The representative would be able to negotiate with the debtor, and thus have more than simply administrative responsibilities such as accounting for and distributing payments. The representative, rather than individual bondholders, would have the power to initiate litigation, but would have to act with the instructions of a certain fraction of bondholders.
Third, there should be a clause describing how the sovereign would initiate the restructuring. It may take a period of time—perhaps several weeks—for creditors to come together to get the relevant information, choose a representative, and decide how to proceed with the debtor. Thus, there is a need for a "cooling off" period-between the date when the sovereign notifies its creditors that it wants to restructure and the date that the representative is chosen-setting a fixed limit of, say, 60 days. During this period a temporary suspension or deferral of payments might be necessary, and the possibility of such a suspension or deferral should be incorporated in the clause along with appropriate penalties. During this limited cooling off period, bondholders would be prevented from initiating litigation.
What is required to make this reform happen? First, we need to work together with emerging market countries, the official sector, and market participants to get agreement that this approach is the most practical way to proceed at the current time. I hope that we can move expeditiously towards such an agreement. Second, there may be a need to develop some incentives to encourage borrowers and lenders to incorporate such terms in their debt contracts.
Recent empirical work comparing bonds issued under New York, U.K., and other jurisdictions suggests that existing differences in clauses may have only a small impact on the attractiveness of such bonds to individual borrowers. Nevertheless, it may be necessary to overcome a perception on the part of borrowers that omitting such clauses would cut a few basis points from the interest rate on sovereign debt. There are two possibilities. First, the official sector could require that these clauses be used by any country that has, or is seeking, an IMF program. Second, the official sector could provide some financial enhancement, such as slightly lower charges on IMF borrowing for countries that include these clauses in their debt. Such an enhancement would be especially useful to encourage borrowers to swap existing debt for debt with the new clauses.
Of course, this decentralized contract-based approach is not the only option that has been proposed for reforming the sovereign debt restructuring process. Indeed, among the options recently presented by the IMF is a more centralized approach in which the IMF articles would be amended and the IMF or some newly created entity could step in and impose its decisions on the process. These alternative options call for a larger role for the IMF or the newly created agency than the more decentralized and market-oriented approach.
A number of questions can be raised about the decentralized approach, especially when considering alternatives. What is the scope of the debt treated by the new clauses? There is no reason to restrict the scope of such clauses to bonded debt. It would be appropriate, for example, to include such clauses in bank debt along with bonded debt; indeed such clauses are already incorporated in many syndicated bank loans. Another question concerns aggregation of all the different bond issues and the different types of debt. In our view, it is most practical to incorporate the majority action and other clauses into debt on an issue-by-issue or loan-by-loan basis, letting any inconsistencies caused by different types of issues or jurisdictions be handled in an arbitration process for which the contracts could provide.
Part Of An Overall Strategy
This proposal for reform of the sovereign debt restructuring process should viewed as an integral part of our broader strategy toward emerging markets.
That strategy starts with crisis prevention. Individual countries and the IMF must carefully monitor and transparently report on economic conditions; when economic trends appear unsustainable the tough decisions must be made before the crisis occurs. The reformed restructuring process should help policy makers make those tough decisions in a timely manner.
Limiting official sector support when countries reach unsustainable debt situations is also a key element of our emerging markets strategy. Large official sector support packages for countries with unsustainable debts effectively bail out private investors holding high-yield debt instruments. It is becoming clearer that official sector support in such cases is being limited to a significant degree. Some have argued that additional numerical access limits should be placed on individual countries, but the most effective and credible way to limit official sector support in such situations is to reduce the incentives to provide such support. In this respect, sovereign debt restructuring reform will go a long way to help limit official sector support in such cases. The uncertainty that currently exists leads to pressures for large support packages. Reducing this uncertainty will reduce such pressures.
Trying to keep contagion low and emphasizing that our decisions are not based on unfounded claims of contagion is another essential part of our strategy. Early last year, we examined the contagion issue carefully. We commented on the fact that market participants were paying more attention to economic fundamentals, differentiating between countries and events. We noted that these changes should reduce contagion, and, in fact, contagion has come down significantly during the past year even in the face of the terrible economic situation in Argentina. To the extent that the decentralized approach to sovereign debt reform enables market participants to more accurately predict official actions, it will focus even more attention on fundamentals. This too will help with the contagion problem.
I began this talk by stressing the need to move expeditiously to reform the process of sovereign debt restructuring in emerging markets. I have now outlined the key elements of a workable, decentralized, market-oriented approach to reform, which includes:
- A package of new collective action clauses.
- Guidelines for borrowers and lenders as they set the detailed terms of these clauses.
- Incentives-including financial incentives-to encourage countries to adopt such clauses.
I hope that we can now concentrate on the implementation of this kind of reform in the weeks and months ahead. I look forward to working with all of you on this important initiative.