Blog
New Sovereign Debt Restructuring Mechanisms

by Ylmaz Akyüz

In this article I will discuss the potential of the Sovereign Debt Restructuring Mechanisms (SDRM), bearing in mind that we are dealing with an evolving phenomenon. The proposal made a year ago was quite different from what we have before us today, and there may be further changes before anything is finally agreed.

UNCTAD was the first international organization calling for orderly workout procedures for developing countries’ debt, drawing on certain principles of national bankruptcy laws, notably chapters 9 and 11 of the United States Law. It raised the matter during the debt crisis in the 1980s, noting in its 1986 Trade and Development Report that the absence of a clear and impartial framework for these problems trapped many developing countries in situations where they suffered the stigma of being judged de facto bankrupt without the protection and relief which come from de jure insolvency. After the East Asian crisis UNCTAD returned to this issue in TDR 1998, making specific proposals, and then developing them further in TDR 2001.

In referring to bankruptcy principles in crisis management and resolution, UNCTAD pursues two interrelated objectives. On the one hand, it recognizes the need to prevent financial meltdowns and deep economic crises in developing countries facing difficulties in servicing their external obligations. Such crises often result in a loss of confidence in markets, collapse of currencies and hikes in interest rates, inflicting serious damages on both public and private balance sheets and leading to large losses in output and employment and sharp increases in poverty. All of these occurred in East Asia, Latin America and elsewhere during the past 10 years. On the other hand, UNCTAD is aware that mechanisms are needed for an equitable restructuring of debt which can no longer be serviced according to the original provisions of contracts. Attaining these two objectives does not require full-fledged international bankruptcy procedures but only the application of a few key principles, which are as follows.

(A) A debt standstill, irrespective of whether debt is owed by the public or private sector, and whether debt servicing difficulties are due to solvency or liquidity problems (a distinction which is not always clear-cut). The decision for a standstill should be taken unilaterally by the debtor country and be sanctioned by an independent panel rather than by the IMF because the countries affected are among the shareholders of the Fund which itself is also a creditor. This provision would automatically imply a stay on litigation. Such a procedure would be similar to the WTO safeguard provisions, allowing countries to take emergency actions when faced with balance-of-payments difficulties. Standstills may need to be accompanied by capital controls in order to stop speculative attacks on currencies and to gain greater autonomy in monetary policy.

(B) Provision of debtor-inpossession financing, automatically granting seniority status to debt contracted after the imposition of the standstill. The IMF should lend into arrears for financing imports and other vital current account transactions rather than for meeting the claims of creditors and maintaining convertibility. There should be strict limits to IMF crisis lending since otherwise it would be difficult to ensure private sector involvement.

(C) Debt restructuring including rollover, write-off, etc., based on negotiations between the debtor and creditors, and facilitated by the introduction of automatic rollover clauses and the Collective Action Clauses (CACs) in debt contracts.

These principles still leave open several issues of detail, but they nonetheless could serve as the basis for a coherent and comprehensive approach to crisis intervention and resolution. How does the SDRM relate to such a framework and how effective would it be in responding to and resolving financial and debt crises in developing countries?

The SDRM is effectively a mechanism designed to facilitate sovereign bond restructuring for countries whose debt is deemed unsustainable. It concerns a handful of emerging markets, primarily in Latin America, and it has little interest for other developing countries which do not or cannot issue international bonds, as is generally the case in East Asia and sub-Saharan Africa respectively. The proposed mechanism is quite innovative in bringing debtors and bondholders together whether or not bond contracts contain CACs, in securing greater transparency, and in providing a mechanism for dispute resolution. Thus, it is a step forward in sovereign debt restructuring.

However, there is considerable room for improvement in its design even without extending its scope and objectives. First, compared to national bankruptcy principles, creditors are granted considerable leverage: there would be no generalized stay on the enforcement angle_FKP.p65 6 6/19/03, 10:57 AM7 of creditor rights and hence no statutory protection for debtors against litigation; and creditor permission would be required in granting seniority to new debt needed to prevent disruptions to economic activity.

Second, the proposal could result in a significant increase in the role and power of the IMF even though this is, supposedly, not the intention. A role for the Fund appears to be envisaged in decisions on debt sustainability. The Sovereign Debt Dispute Resolution Forum (SDDRF) would have no authority to challenge decisions of the IMF Board or determine on issues relating to debt sustainability. But the past record of the Fund in assessing sustainability (in Russia, Argentina and HIPC) is not very encouraging, suggesting that it may be facing political, not just technical, difficulties in making sound judgment on debt sustainability.

More fundamentally, the SDRM is designed to collect the debris rather than to put out the fire. Clearly it would not help countries facing liquidity shortages in servicing their public or private debt and runs on their currencies such as those witnessed in East Asia or more recently in Brazil and Turkey where current IMF programmes are based on the assumption that debt is sustainable under feasible policies. But even for countries with clearly unsustainable sovereign debt, the SDRM provides no new mechanism to stem attacks on their currencies and prevent financial turmoil. It includes a provision to discourage litigation by sovereign bondholders through the so-called ‘hotchpotch’ rule. Such a rule may not be very effective against litigious investors (the so-called ‘vultures’). More importantly, it does not address the problem of how to stop financial meltdown, since in a country whose debt is judged to be unsustainable, currency runs would take place whether or not bondholders opt for litigation.

Finally, the current proposal does not fundamentally address the problems associated with IMF bailouts. It can reasonably be expected that countries would generally be unwilling to declare themselves as insolvent and to activate the SDRM. Instead, they would be inclined to ask the Fund to provide financing in order to address their liquidity problems. In most cases it might be difficult for the Fund to decline such requests on grounds that the country is facing a solvency problem. Indeed, as part of its promotion of the SDRM, the IMF has suggested that unsustainable debt situations are rare. Here lies the rationale for limits on IMF crisis lending whether the problem is one of liquidity or insolvency: with strict access limits creditors cannot count on an IMF bailout, and debtors will be less averse to activating the SDRM and standstills when faced with serious difficulties in meeting their external obligations and maintaining convertibility. This means that to encourage countries to move quickly to debt restructuring the SDRM should be combined with limits on crisis lending. But this could create problems unless private sector involvement is secured through a statutory standstill and stay on litigation.

The SDRM proposal has not elicited strong support from developing countries for several reasons. Many countries fear that the introduction of statutory and even contractual mechanisms for debt restructuring would impair their access to international capital markets and discourage capital inflows. This is often the reaction of countries which have become heavily dependent on capital inflows. There is some ambivalence in the IMF response to such concerns. On the one hand the Fund recognizes that the SDRM may prevent over-lending and over-borrowing but on the other they refer to some empirical studies to argue that CACs and spreads are not correlated. In reality, the introduction of statutory standstills and restructuring mechanisms could indeed deter certain types of capital inflows but this may not necessarily be undesirable. Another source of concern is that the proposed mechanism may give too much power to the IMF where participation of developing countries in decision making is highly restricted. This concern is expressed mostly by countries which do not depend on foreign capital to supplement domestic savings, but have nevertheless experienced boom-bust cycles in capital flows and speculative attacks on their currencies. Independent assessment of debt sustainability and expansion of powers of the SDDRF, as well as a fundamental revision of voting rights and procedures in the Fund could help meet their concerns.

In conclusion, despite the shortcomings in its design and objectives, the SDRM could potentially be fine-tuned to bring some improvements in sovereign bond restructuring. As it stands, it does not constitute a coherent and comprehensive framework for crisis intervention and resolution. Not only would it not solve everything, a point conceded by its architects, but it would also not address the most important problems connected with financial and currency crises. Much of this work still remains to be done.

Ylmaz Akyüz is Director of the Division on Globalization and Development Strategies at UNCTAD and contributed to the WIDER study on Governing Globalization: Issues and Institutions (Oxford University Press, 2002). This article is based on Remarks made at the International Policy Dialogue: New Sovereign Debt Restructuring Mechanisms—Challenges and Opportunities, Berlin, 21 February 2003.