Alternative approaches to sovereign debt restructuring.

• Author: Boorman, Jack

Serious gaps exist in the means available to deal with sovereign debt crises. In recent cases of sovereign default, both the debtor country and its creditors have paid large costs, in terms of lost economic activity and income and lost value of claims. Some people see these costs as necessary to discipline debtors to avoid default. Bankruptcy should be messy, they say. In the view of many, however, the costs incurred under the current international financial architecture are unnecessarily large, to the detriment of both the debtor and its creditors. Some in the private sector also point to the fact that they have been able to conclude agreements with countries that have accumulated unsustainable debt and have defaulted. They point to Ecuador as completed, and express confidence that Argentina can be dealt with when the Argentine authorities finally approach them for serious negotiations. But this is not good enough. The losses to the Ecuadoran and Argentine economies from the processes available in those two cases have been huge and, arguably, unnecessary. Thus, doing nothing should not be considered an option.

What then are the relevant alternatives for dealing with sovereign debt crises? There are essentially three:

1. A statutory approach to establish a universal legal framework to facilitate negotiations and to empower a supermajority of creditors to approve a debt restructuring agreement with a debtor country that would bind in minority dissenting creditors. This is the sovereign debt restructuring mechanism (SDRM) proposal of Anne Krueger, the first deputy managing director of the IMF. Although based on statute, this approach relies on decisions by creditors and is, in that sense, a market-oriented approach.

2. A broadening of the kind of collective action clauses (CACs) that are already included in some (mostly British law) sovereign bond issues and their incorporation into a wider array of debt instruments, possibly to include bank loans. These new and innovative contingency clauses would, inter alia, describe as precisely as possible the procedures by which holders of a specific debt instrument would interact with the sovereign debtor and among themselves in the case of a request by the sovereign for a restructuring of those claims. These proposals were first made by John Taylor, under secretary for international affairs at the U.S. Treasury.

3. A two-step process proposed by Ed Bartholomew and Ernie Stern of J. P. Morgan. In step one, creditors would effectively exchange outstanding debt for claims that include collective action clauses, which could then be used, in step two, to facilitate a restructuring agreement between a sovereign debtor and those creditors.

   What is needed is a system that produces a promise of orderly resolution of unsustainable debt situations that can be activated in a timely manner and that can proceed with reasonable assurance of finding agreement without undue delay--that is, a process that has a reasonably predictable end game. Limiting the kind of disruption and dislocation to the economy that has been seen in too many recent cases can help preserve substantial value both for the creditors and for the country and its citizens, including the poor who often suffer the most as a result of the economic fallout from financial crises.

   There are major issues posed in the search for a workable system to produce this desired result. How does one know when a country's debt is unsustainable and warrants an appeal to a bankruptcy mechanism? How can the incumbent government, and the relevant ministers and officials, be persuaded to accept that reality and approach creditors for relief? Who gets to decide or to vote on a final agreement? How is such an agreement to be made binding on potential holdout creditors? Where should a mechanism for dispute resolution reside? What is the role for the official community, and the IMF in particular, in all of this? And, how can leaders in other countries that may be tempted to appeal for debt relief through such mechanisms when such relief is not warranted be prevented from abusing the system?

   The underlying question regarding judgments about the sustainability of a country's debt is, in the first instance, an analytic matter. But it is also a political issue, as the capacity to service debt by a sovereign is, in part, a matter of its willingness and ability to implement policies to generate the resources needed to service that debt. Debt can almost always be serviced in some abstract sense, through additional taxation and through the diversion of yet more domestic production to exports to generate the revenue and foreign exchange needed to service the debt. But there is a political and social, and perhaps moral, threshold beyond which policies to force these results become unacceptable. Where that threshold becomes binding in a particular country is, in the first instance, for the government to decide. But it is also a matter for judgment by the official international community, through the IMF, whether to accept where that line is drawn when its assistance is requested.

   In supporting an adjustment program prepared by a country, the Fund is accepting the budgetary and balance of payments framework underlying that program and the debt service capacity incorporated therein. The Fund can neither avoid judgments on the sufficiency of the tax system in the context of the country's existing situation, in the capacity to meet certain basic needs in the economy, nor in the pace of adjustment projected for the external sector.

   Thus, the issue of sustainability is not a matter solely of economic or financial analysis, though the best analytics available need to be brought to bear in such judgments. All of the proposals for sovereign debt restructuring rely on these broader judgments that must be made. Ultimately, it will be the willingness of the international community, through the Fund, to support a country in its adjustment efforts, both while it is negotiating with its creditors and after a deal is struck to provide relief, that will signal the acceptability of the government's decision about where to draw the line. It will be the Fund's willingness to commit resources to continue to assist the country in the context of its negotiated agreement with its creditors that will signal the acceptability of that agreement to the official community. This is consistent with the fundamental role of the Fund envisioned under all of the proposals.

   What then are the elements of the three basic alternatives?

   The Sovereign Debt Restructuring Mechanism

   The SDRM, through a universal treaty, would provide a legal framework that would make...