The International Monetary Fund (IMF) is taking a new look at Sovereign Debt Restructuring. There are at least two major reasons for this: First, it is expected that official creditors play a unique role during sovereign debt crises, since lending of last resort becomes the only bridge over default and/or drastically forced adjustments when a country faces very restricted market access. Therefore it makes sense that a number of recent cases warrant an update on what has worked well or not. Second, particularly in light of the recent experiences of Argentina and Greece, the existing framework for sovereign debt restructurings has increasingly been seen as in need of fixing – perhaps even a revamping - if it is to facilitate more orderly processes and outcomes in the future.
An orderly sovereign debt restructuring would be one that places the debtor nation’s public debt on a sustainable trajectory, while minimizing procrastination and contagion. However, a review that Brian Pinto, Mona Prasad and I have done on the experience with the debt crisis of the 1980s, Russia 1998, Argentina 2001 and Greece 2010 led us to conclude that orderly debt restructurings may remain elusive, even with high-powered official intervention. We argued that, when solvency problems are intractable, a combination of an upfront haircut on private credits and official lending at the risk-free rate - reflecting its low risk - is the way to go.
Indeed, one of the two main findings of the IMF paper, according to Hugh Bredenkamp, Deputy Director of the IMF’s Policy, Strategy, and Review Department, is that “it appears that debt restructurings often come too late and are too limited to really restore debt sustainability. This can be very costly.”
It is not always simple to judge whether a stress situation is one that reflects insolvency (the present value of primary surpluses is less than the present value of outstanding debt obligations) or simply lack of liquidity (insufficient reserves to meet maturing debt obligations in the event that creditors do not roll these over). However, when a situation is clearly one of insolvency that cannot realistically be remedied by raising primary surpluses, procrastinating an adjustment of the present value of outstanding debt obligations is a lose-lose scenario: the debt overhang harms the country’s investments and growth, while recovery prospects for creditors as a whole worsen if debt remains rising because of high interest rates, not to mention contagion on other sovereigns may take place.
Official credit may not be helpful if it just postpones an inevitable debt restructuring, regardless of whether private creditors are bailed out. In the recent case of Greece, for instance, the IMF's ex-post evaluation of its 2010 Stand-By Agreement acknowledged that “an upfront debt restructuring would have been better for Greece although this was not acceptable to the euro partners. A delayed debt restructuring also provided a window for private creditors to reduce exposures and shift debt into official hands.” As I said here one year ago on the Greek sovereign debt restructuring:
“Had it come, say, one year ago, when Greece's insolvency was already beyond a doubt to everyone, chances are that the negative feedback loop between national banks and public debt in Portugal, Spain and Italy since then would have been less intense. Such a negative feedback loop would have at least not been aggravated by contagion from the lack of response to Greece's unsustainable path. Procrastination did not help avoid facing the eventual insolvency problem -- in the end, inaction made things worse, not better.”
To help ensure timely debt restructurings when they are deemed inevitable, the IMF paper suggests a discussion on a new multipronged approach. Besides increasing the rigor of debt sustainability and market assessments and tightening lending policy requirements, steps should be taken to avoid bailing out private investors with official resources. Furthermore, measures to mitigate the hurdles associated with restructurings should be promoted, whenever appropriate, as an incentive against procrastination of debt adjustment.
The second reason for welcoming an IMF revisit is well captured in the other main finding of the paper, as stated by Mr. Bredenkamp: “the current contractual, market-based approach to debt restructuring may be becoming less potent in overcoming collective action problems.”
There is indeed a potential “collective action problem” in every debt restructuring negotiation. Individual creditors are tempted to hold off against a haircut, with the hope of being paid in full if other creditors indulge. The introduction of collective action clauses (CACs) in debt contracts, purporting to make a debt restructuring legally binding on all holders of a bond whenever a pre-defined supermajority agrees to a proposal – including those who refuse it – has become the lynchpin of attempts to deal with that collective action problem.
Recent experiences in the cases of Greece and Argentina have undermined the confidence on relying on CACs as they now exist. CACs refer to individual bond classes and leave the collective action problem in their “aggregation” untouched. Both the Greek and Argentine processes of arriving at debt resolution outcomes have been hampered by the possibility of distinctive holdout strategies by different groups or classes of bondholders. As statutory approaches face strong resistance in the multilateral landscape, attention will most likely be focused on how to strengthen the existing contractual approach.
The bottom line? Sovereign debt insolvency happens! One must face it promptly, rather than sweeping it under the rug. It is therefore important to have appropriate mechanisms, rules and policies in place in order to deal with such a fact of financial life.
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