EUROPEAN SHADOW FINANCIAL REGULATORY COMMITTEE
Joint Statement No. 4 of the European, Japanese, Latin American and the U.S. Shadow
Financial Regulatory Committees
October 7, 2002
Reforms in the
Process of Restructuring International Sovereign Debt
The recent annual meetings of
the IMF and World Bank highlighted two proposals to reform the process for restructuring international sovereign debt: collective
action clauses (CACs) and a Sovereign Debt Restructuring Mechanism (SDRM), the so-called statutory approach to reform.
Neither the IMF nor its critics believe that these measures would be sufficient to minimize the
likelihood of sovereign debt crises or to ensure that they are efficiently resolved. Nonetheless the proposals
have attracted widespread attention and deserve careful analysis. The Shadow Committees believe that the
IMF proposals go both too far and not far enough. They go too far with respect to the immediate reforms
suggested for the sovereign debt resolution process. We favor a more gradual approach that begins by strengthening
existing contractual means for resolving debt problems. They fail to go far enough with regard to reforming
the IMF’s policies that give rise to incentives to postpone the recognition and resolution of unsustainable debt.
A central objective of recent reform proposals is to alleviate conflicts among
creditors that often arise during the debt renegotiation process. In particular, holdouts by a minority of creditors can delay
debt resolution and prevent sovereign debtors from regaining access to international credit sources. The Shadow Committees
believe that this problem can be addressed by the general adoption of CACs, which would impose majority rule on bond creditors.
The Committees further believe that this goal can be achieved by voluntary actions on the part of creditors and debtors supplemented
by the use of incentives for creditors and debtors to adopt CACs. At this time, the Committees do not endorse the adoption
of the statutory approach to debt resolution. However, in the event that the use of CACs alone proves inadequate after a period
of trial, a statutory approach may have to be reconsidered.
The ideal debt restructuring reform would seek to achieve the following objectives:
- discourage countries from overborrowing
and creditors from overlending;
- reduce the
likelihood of sovereign debt crises by reducing moral hazard, inter alia by ensuring that creditors, who
were compensated ex ante to bear risk, share appropriately in the ex post losses;
- when debt burdens become unsustainable, reduce the recognition lag during which
economic conditions deteriorate to the disadvantage of the debtor country and creditors before the restructuring
process is begun;
- once the debt restructuring process
has begun, ensure a prompt resolution; and
a resolution that will enable the country to regain access to stable capital flows.
SDRM and innovations in CACs mainly address the fourth criterion,
but don’t adequately address the others. The likelihood of sovereign debt crises and delays in recognition
depend on several additional factors, including importantly, IMF lending that supports unsustainable policies.
Attention to improved debt restructuring mechanisms should not distract attention from the importance of reducing the
recognition lag and the role the IMF has played in unintentionally enabling undesirable delays in recognizing and dealing
with unsustainable debt.
Creditor Coordination Problems
One of the central objectives of the IMF proposals is to deal with collective action problems among creditors that
arise in the debt renegotiation process. This is often characterized as the holdout or rogue creditor problem,
in which a minority of creditors delay resolution until their demands are met, to the detriment of other creditors and the
debtor. The CACs proposal deals with this problem directly by binding all bondholders to the will of a
CACs would serve as an alternative to existing ex post mechanisms (e.g., exit consents, defined below) used
by sovereigns to encourage creditors to share in the outcome of the renegotiation process. One advantage
of CACs over existing mechanisms is a potentially beneficial impact on IMF lending; by making the renegotiation process more
predictable, CACs may also reduce pressure on the IMF to support unsustainable sovereign borrowers.
Another advantage of CACs is the elimination of potential legal
uncertainties and delays. Current legal uncertainties may limit the usefulness of exit consents. Exit consents
are contractual amendments to existing bond contracts accepted by a simple majority of bondholders who have agreed to exchange
those bonds for renegotiated debt. The attraction of holding out as a minority bondholder is reduced if
the old debt now contains undesirable contractual amendments. There is, however, some uncertainty about which amendments are
permissible. CACs would avoid those legal uncertainties.
The Shadow Committees believe that the impact on the cost of issuing debt from including
CACs in bonds is unlikely to be significant. Furthermore, the adoption of CACs would not foreclose other
useful innovations in private contracting that could facilitate debt resolution.
The Case for Encouraging CACs
CACs are not a new idea. In fact, they already
exist in international bonds issued in the United Kingdom, Luxembourg and Japan. If CACs are attractive,
why are they not generally adopted voluntarily? To the extent that the widespread use of CACs
would reduce the prospects for an IMF bailout (as we have argued they might), neither borrowers nor debtors may want to adopt
them. If bonds containing CACs are more costly to issue, an argument often made by sovereign debtors and
creditors, two other reasons may be relevant. First, the benefits of a more orderly renegotiation process
may extend beyond the issuing debtor and its creditors to include reduced cross-country contagion. Those
benefits cannot be captured by the issuing debtor or its creditors and therefore might not encourage a country to adopt beneficial
CACs. Second, national leaders facing short-term political pressures might be unwilling to trade-off slightly
higher current debt service costs for lower prospective renegotiation costs.
This suggests that there may be a benefit from official encouragement
of the adoption of CACs. Indeed, some have suggested that adoption be made mandatory. For
example, one mechanism could involve amendment to the Articles of Agreement of the IMF to require appropriate changes in the
law of each member nation (a more modest version of the IMF’s proposal to amend the Articles of Agreement to establish
an SDRM). A more moderate approach would be to require that countries that benefit from IMF support adopt
CACs, or to provide access to lower-rate multilateral financing for countries that adopt CACs voluntarily. It
would also be desirable to remove the existing customary impediments to CACs in the U.S. Contrary to popular
belief, CACs are permissible in sovereign debt contracts under the U.S. Trust Indenture Act of 1939. Official
encouragement of the adoption of CACs in sovereign debt contracts issued under U.S. law may be useful in overcoming customary
resistance to CACs.
Do We Need the Statutory Approach?
If CACs are adopted for all new issues of debt, there still remains a
serious problem regarding the outstanding stock of debt that does not contain CACs. Transitional issues, however, should not
derail desirable long-run reforms. One of the stated motivations for the IMF’s SDRM proposal is that
it would solve the transitional problem by encompassing new debts and preexisting debts within the same resolution mechanism.
But there are other approaches that would also accomplish that objective. For example, an alternative possibility
would be to swap non-CAC for CAC debt. Various possible G7 initiatives could encourage, or even subsidize, such swaps if the
transition problem were deemed sufficiently important.
Another rationale sometimes offered for SDRM is the need to insulate sovereigns
from adverse court judgments during the renegotiation process. This concern is overstated.
Recent episodes indicate that sovereigns are able to protect themselves from such judgments, with the possible exception
of transactions in the clearing and settlement process. But this problem could be remedied more directly
by legislation to protect sovereign debtors from attachment during the clearing and settlement process, comparable to the
protection of wire transfers found in the U.S. Uniform Commercial Code for firms in bankruptcy.
Advocates of the SDRM argue that a key advantage of the statutory
approach is the ability to coordinate the resolution of many different debts (bonds, bank loans, swaps, etc.) through statutory
rules that define the relative power of creditors (e.g., veto power of creditor classes over restructuring plans, as proposed
by the IMF). Advocates see this as a more orderly alternative to the raw bargaining that takes place among sovereigns and
creditors during a renegotiation.
is not clear whether the statutory approach would hasten the renegotiation process. For example, the vesting of veto power
over restructuring plans in different classes of debt holders could produce a slower process in comparison to the result produced
by a debt swap organized by the sovereign in which the relative positions of creditors are determined by the sovereign’s
judgment of what would work best. It is also far from clear where it would be best to vest the oversight
authority over the proposed statutory process.
Given those uncertainties, and given the limited experience with renegotiation of international
bonds over the past four years, it is too early to conclude that the statutory approach is warranted. Unlike efforts to increase
the use of CACs, there may be important irreversibilities in establishing the statutory approach, as doing so might foreclose
desirable alternatives from evolving within the contractual approach. On balance, we believe that it would
be best to leave the statutory approach on hold for the time being, preserving it as an option to consider if the strengthening
of the contractual approach proves inadequate.
Is more needed? We believe so, because we remain
skeptical that either our proposal for strengthening CACs or a statutory process would address the important problem of the
delayed recognition of unsustainability. That problem has more to do with incentives to delay on the part
of sovereigns (who have short-term political motives) and creditors (who see the option of receiving an IMF bailout as a basis
for resisting renegotiation). Thus, the G7 and the International Monetary and Financial Committee of the IMF should focus
more effort on establishing proper incentives within the IMF to ensure that IMF loans do not delay debt resolution.
Indeed, part of the
reason for uncertainty about the efficacy of the contractual approach today is that IMF actions in the past have made it very
hard to observe how creditors and sovereigns would behave in a world where they really were left alone to renegotiate.
A further advantage of IMF reform would be that it would help us determine whether a statutory approach was truly needed
Other reforms outside
the IMF may also be desirable for altering creditors’ incentives to act in ways that would reduce capital flow volatility
in emerging market countries. For example, a proposed reform to the Basel Accord would aggravate the existing
distortion in international capital regulation that encourages shorter maturity lending to emerging market economies, thus
exacerbating capital flow volatility. On the contrary, the Basel Accord should be modified to remove that
distortion. (See Latin American Shadow Financial Regulatory Committee Statement No. 2, April 2001).
Given the rapid pace of innovation in
which market participants are developing new approaches to dealing with the inefficiencies in the debt renegotiation process,
we believe that an incremental approach is best. Consequently, CACs should be adopted. But
premature adoption of the SDRM might be counterproductive or foreclose other beneficial adaptations.