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  Reforms in the Process of Restructuring International
                        Sovereign Debt



                  Posted: Monday, October 7, 2002

                  PAPERS AND STUDIES
                  Joint Statement of the European, Japanese, Latin American, and
                  U.S. Shadow Financial Regulatory Committee   
                  Publication Date: October 7, 2002

                  Executive Summary
                  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.
                  Guiding Principles
                  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
                    reach 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 super-majority.
                  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.
                  It 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.
                  Additional Reforms
                  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 in future.
                  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).
                  Conclusion
                  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.