1 Fixing Sovereign Debt Restructuring 1 July, 2015 Martin Guzman 2 and Joseph E. Stiglitz 3 Abstract Recent controversies surrounding sovereign debt restructurings show the weaknesses of the current market‐based system in achieving efficient and fair solutions to sovereign debt crises. This article reviews the existing problems and proposes solutions. It argues that improvements in the language of contracts, although beneficial, cannot provide a comprehensive, efficient, and equitable solution to the problems faced in restructurings—but there are improvements within the contractual approach that should be implemented. Ultimately, the contractual approach must be complemented by a multinational legal framework that facilitates restructurings based on principles of efficiency and equity. Given the current geopolitical constraints, in the short‐run we advocate the implementation of a “soft law” approach, built on the recognition of the limitations of the private contractual approach and on a set of principles – most importantly, the restoration of sovereign immunity – over which there may be consensus. We suggest that in a context of political economy tensions it should be impossible for a government to sign away the sovereign immunity either for itself or successor governments. The framework could be implemented through the United Nations, or it could prompt the creation of a new institution. Keywords: Sovereign Debt Crises, Sovereign Debt Restructuring, International Lending JEL Codes: F34, G33, H63, K12, K33 1 We are indebted to Sebastian Ceria, Richard Conn, Matthias Goldman, Daniel Heymann, Brett House, Kunibert Raffer, Sebastian Soler, participants of the Conference on “Frameworks for Sovereign Debt Restructuring” at Columbia University, the ECON 2014 Forum at University of Buenos Aires, the RIDGE Forum on Financial Crises at Central Bank of Uruguay, the First Session of the Ad Hoc Committee of the United Nations General Assembly on a Multilateral Legal Framework for Sovereign Debt Restructuring, and seminar participants at Javeriana University (Bogota), the Central Bank of Argentina, the UNCTAD Conference on “Legal Framework for Debt Restructuring Processes: Options and Elements” at Columbia University, the INET Annual Conference at OECD, the Research Consortium for Systemic Risk Meeting at MIT, and the International Institute of Social Studies in The Hague for useful comments, discussions, and suggestions. We are grateful to the Ford and Macarthur Foundations for support to the Roosevelt‐ IPD Inequality Project, and the Institute for New Economic Thinking for financial support, and to Debarati Ghosh and Ines Lee for research assistance. 2 Columbia University GSB, Department of Economics and Finance. 3 Columbia University, University Professor.
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FixingSovereignDebtRestructuring1
July,2015
MartinGuzman2andJosephE.Stiglitz3
Abstract
Recent controversies surrounding sovereign debt restructurings show the
weaknesses of the current market‐based system in achieving efficient and fair
solutions to sovereign debt crises. This article reviews the existing problems and
beneficial, cannot provide a comprehensive, efficient, and equitable solution to theproblemsfacedinrestructurings—butthereareimprovementswithinthecontractualapproachthatshouldbe implemented.Ultimately, thecontractualapproachmustbecomplemented by a multinational legal framework that facilitates restructuringsbasedonprinciplesofefficiencyandequity.Giventhecurrentgeopoliticalconstraints,intheshort‐runweadvocatetheimplementationofa“softlaw”approach,builtontherecognition of the limitations of the private contractual approach and on a set ofprinciples –most importantly, the restoration of sovereign immunity – overwhichtheremaybeconsensus.Wesuggestthatinacontextofpoliticaleconomytensionsitshouldbeimpossibleforagovernmenttosignawaythesovereignimmunityeitherfor
itself or successor governments.The framework couldbe implemented through theUnitedNations,oritcouldpromptthecreationofanewinstitution.
Keywords: Sovereign Debt Crises, Sovereign Debt Restructuring, InternationalLending
JELCodes:F34,G33,H63,K12,K33
1WeareindebtedtoSebastianCeria,RichardConn,MatthiasGoldman,DanielHeymann,BrettHouse,Kunibert Raffer, Sebastian Soler, participants of the Conference on “Frameworks for SovereignDebtRestructuring”atColumbiaUniversity,theECON2014ForumatUniversityofBuenosAires,theRIDGEForumonFinancialCrisesatCentralBankofUruguay,theFirstSessionoftheAdHocCommitteeoftheUnitedNationsGeneralAssemblyonaMultilateralLegalFrameworkforSovereignDebtRestructuring,andseminarparticipantsatJaverianaUniversity(Bogota),theCentralBankofArgentina,theUNCTADConferenceon“LegalFrameworkforDebtRestructuringProcesses:OptionsandElements”atColumbiaUniversity,theINETAnnualConferenceatOECD,theResearchConsortiumforSystemicRiskMeetingatMIT, and the International Instituteof Social Studies inTheHague foruseful comments,discussions,andsuggestions.WearegratefultotheFordandMacarthurFoundationsforsupporttotheRoosevelt‐IPD Inequality Project, and the Institute for New Economic Thinking for financial support, and toDebaratiGhoshandInesLeeforresearchassistance.2ColumbiaUniversityGSB,DepartmentofEconomicsandFinance.3ColumbiaUniversity,UniversityProfessor.
4Itisnothighdebtpersethatisbadforeconomicgrowthorfullemployment,ascarelessstudiesthathadbeeninfluentialinthepolicydebatehavesuggested(ReinhartandRogoff,2010;see,inparticular,theimportantcritiqueofHerndon,Ash,andPollin,2014).Indeed,standardgeneralequilibriumtheoryargues that there is a full employment equilibrium regardless of the level of debt (Stiglitz, 2014).Instead, it is the difficulty of running expansionary macro policies when primary surpluses areallocatedtodebtpayments intimesofrecessions(whichare indeedoftenassociatedwithhighdebt)whatmakesdebtaconstraintforeconomicrecovery.Notetoothateventhen,itisnotonlytheeconomicconstraintswhichmatter,butthosearisingoutofpolitical economy—a political economy which itself is affected by the largely ideological researchreferred to in the previous paragraph. In particular, for countries like the United States which canborrowevennowatanegativereal interestrate—andborrowedatvery lowreal interestratesevenwhen its debt to GDP ratio was in excess of 130%—borrowing for public investments that yieldsignificantlyhigherreturnsthanthecostofcapitalcanimprovethenation’sbalancesheet.5The only situation inwhich the temporary assistance (“bail‐out”)mightmake sense is if there is aliquiditycrisis,e.g.marketsareirrationallypessimisticaboutthecountry’sprospects,withtheevidencethattheyarewrongexpectedtoberevealedinthenot‐too‐distantfuture.Butitisironicthatthoseinthe financialmarketwhichnormallyprofesssuchfaith inmarketssuddenlyabandonthat faithwhenmarketsturnskepticalonthem;andthatatthatpoint,theyseemwillingtorelyonthejudgmentofagovernment bureaucrat or an international civil servant over that of the market. There are otherirrationalitiesimplicitinthesearguments:itissometimessuggestedthatiftheinterventionstabilizes,say,theexchangerate,thatwillrestoreconfidenceandpreventcontagion. ButifitisknownthatthereasonthattheexchangeratehasbeenstabilizedisthattherehasbeenIMFintervention,whyshouldthestabilizationoftheexchangeratechangebeliefs,andespeciallysoiftheinterventionisannouncedto be short term? And if there are reasons to believe that the IMF would not intervene in othercountries(e.g.becausetheyare lesssystematically importantor lesspoliticallyconnected), thenwhyshould the intervention in one country change beliefs about the equilibrium exchange rate in theothers?Itisevenpossiblethatitcouldhaveadverseeffects(Stiglitz,1998).6Evenifthefundswereofferedwithoutsuchconditions,totheextentthatthefundsarenotusedforaddressingthefundamentalproblemsthatmakedebtsunsustainable,thecountrywouldbeworseoffoverthelongrununlesstherewascommitmenttoprovidethesefundsindefinitely—whichisineffectequivalenttoadebtwrite‐off.
3
Distresseddebtors need a fresh start, not just temporary assistances. This is in the
best interestofthedebtorandthemajorityof itscreditors:Precludingarapidfresh
start for the debtor leads to large negative sum games, where the debtor cannot
recoverandcreditorscannotbenefit fromthe largercapacityof repayment that the
recoverywouldimply.
Lackof clarity for resolving situations inwhicha firmor a country cannotmeet its
Within a country, bankruptcy laws are designed to prevent this chaos, ensuring anorderly restructuring and discharge of debts. They establish how restructuringwillproceed, who will get paid first, what plans the debtor will implement, who willcontrol the firm, etc.Bankruptcies are typically resolved throughbargaining amongtheclaimants,butwiththebackdropofa legal framework,andwitha judiciarythatwilldecidewhateachpartywillget,basedonwell‐definedprinciples.
Bankruptcy laws thus protect corporations and their creditors, facilitating theprocessesofdebtrestructuring.Amoreorderlyprocessnotonlylowerstransactions
Goodbankruptcy laws facilitate efficient and equitable outcomes in otherways; forinstance,inencouraginglenderstoundertakeadequateduediligencebeforemakingaloan.
Butthereisnocomprehensiveinternationalbankruptcyproceduretoensureproperresolution of sovereign debt crises. Instead, the current system for sovereign debt
SDR a major issue. Countries in desperate need of addressing profound debtsustainabilityissues,likeGreeceatthemoment,areconfrontingtherisksofachaoticrestructuringandthisdiscouragesthemfromundertakingtherestructuringsthatarenowrecognizedasdesirable,oreveninevitable.
Besides, thegaps in the legaland financial internationalarchitecture favorbehaviorthat severelydistorts theworkingsof sovereign lendingmarkets.Theemergenceofvulturefunds—investorsthatbuydefaulteddebtonthecheapandlitigateagainsttheissuer,demandingfullpaymentanddisruptingthewholerestructuringprocess—asrecentlyseeninthecaseofArgentinerestructuring,isasymptomofaflawedmarket‐
basedapproachfordebtcrises’resolution.
Recent decisions8have also highlighted the previously noted interplay amongmultiple jurisdictions, none of which seems willing to cede the right to adjudicaterestructuringtotheothers(GuzmanandStiglitz,2015b).
7Andwhen they do not take too long, theymay not achieve the objectives of restructuring thatwedefine in section 2. This is the case of the Greek debt restructuring in 2012. The dealwasmostly asocializationofbanks’debtsthatwasnotconducivetotherecoveryoftheeconomy.Threeyearslater,the country is still suffering an even worse depression: GDP has fallen by 25 percent since thebeginning of the recession, and the unemployment rate is above 25 percent in January 2015 (asreportedbyHellenicStatisticalAuthority‐LaborForceSurvey,2015).8Where anAmerican court seeminglyhas takenanaction affectingpaymentsonArgentineanbondsissued in other jurisdictions, such as the UK, and a British Court has ruled that they cannot do so(EnglandandWalesHighCourt(ChanceryDivision)Decisions,CaseNo:HC‐2014‐000704).
(by 124 votes to 11, with 41 abstentions).9The framework should complementcontracts, putting in placemechanisms that would establish how to solve disputesfairly.Building itonaconsensualbasiswillbeessential for its success.This in turnrequiresfulfillingasetofprinciplesoverwhichthedifferentparties involvedwouldagreeon,anissuethatweanalyzeinthisarticle.
While,aswehavenoted,theimportanceoftheabsenceofanadequatemechanismforsovereign debt restructuring has long been noted (see also Stiglitz, 2006), fivechangeshavehelpedtobringtheissuetotheforeandmotivatetheglobalmovementfor reformof existingarrangements: (a)Onceagain,manycountries seem likely to
faceaproblemofdebtburdensbeyondtheirabilitytopay;(b)courtrulingsintheUSand UK have highlighted the incoherence of the current system and made debtrestructurings,at least insome jurisdictions,moredifficult ifnot impossible; (c) themovementofdebtfrombankstocapitalmarketshasgreatlyincreasedthedifficultiesofdebtrenegotiations,withsomanycreditorswithoftenconflicting interestsat thetable;(d)thedevelopmentofcreditdefaultswops(CDSs)—financialinstrumentsfor
In absence of information asymmetries and contracting costs, risk‐sharing (equity)contracts would be optimal; there would be no bankruptcy. But under imperfectinformationandcostlystateverification,completerisksharingissuboptimal,andtheoptimalcontractisadebtcontract(Townsend,1979).11
Informationasymmetriesandcostlymonitoringcharacterize theworldof sovereignlending,which explains thewidespread utilization of sovereign debt contracts. Theoptimaldebtcontractmaybeassociatedwithpartialrisksharing,includingdefaultinbadstatesandacompensationfordefaultriskintheformofahigher(thantherisk‐free)interestrateingoodstates.
If default were never possible, the borrower would absorb all the risk. Under theassumptionsof risk‐neutral lenderswho candiversify theirportfolios in aperfectlycompetitiveenvironment,theexpectedutilityofeachlender(whoiscompensatedfortheopportunitycost)12wouldbethesame,buttheborrower’swouldbelowerthanitwouldbewithgoodrisksharingcontracts.Moreover,ifthepossibilityofdefaultwere
10Below,wewillexplainsomeofthereasonsforthegrowthofvulturefunds.11In private debtmarkets, other considerations relating to adverse selection andmoral hazard alsomilitate for at least some reliance on debt. See, e.g. Stiglitz (1985). The problems of costly stateenforcementforsovereigndebtmarketshave,wethink,beengreatlyexaggerated,andtherehavebeenseveralimportantproposalsforsuchbonds.(ArgentinaactuallyintroducedGDPlinkedbondsaspartofitsdebtrestructuring.)12Thiswouldbeeven true if lenderswere riskaverseandmarketshighly competitive. Under theseassumptions,eachlenderwouldreceivethecertaintyequivalentreturnfromeachoftheirinvestments.Thoughsuchanassumptiondominateswithinthefinanceliterature,therearereasonstobeskeptical.Still,theconclusionthatforcingtheborrowertoabsorballtheriskisnotefficientholds.
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The probability of entering into situations of debt distress depends on a variety of
economic conditions13but alsoon the actionsof thedebtor.14Andonce thedistress
that are conducive to efficiency ex‐ante (i.e. the “right” decisions at themoment of
lending) and ex‐post (i.e. at the moment of resolving a debt crisis). It should also
ensureafairtreatmentofallthepartiesinvolved.
2.1. Efficiencyissues
A system thatmakes restructurings too costly induces political leaders to postponethe reckoning.When there are nomechanisms in place that would ensure orderlyrestructurings,theperceivedcostsofdefaulttothepartyinpowerbecometoolarge.Therefore, “gambling for resurrection”, delaying the recognition of debtunsustainability,maybetheoptimalstrategyforthedebtor.
Delays are inefficient. Theymake recessionsmore persistent and decrease what isavailableforcreditorsifadefaultoccurs.16Inthepresenceofcross‐bordercontagion,
13Importantly, italsodependsonthediscrepancybetweentheexpectationsonthefuturecapacityofrepaymentandtherealizationsthatdeterminetheactualcapacityofrepayment.SeeGuzman(2014).14Thenatureofthedistressalsodependsonactionsofthecreditors,i.e.theirwillingnesstorollover.15Thereissomecontroversyoverwhetheraftertheresolutionofthedebtthereisastigmathatmakesitmoredifficult for theborrower toborrow. There is theory (and someevidence) thatmarketsareforwardlooking, inferthatthecostofbankruptcyissufficientlyhighthatfewifanycountriesgointodefault if theycanavoidit—andthatthereforethereisnoinferenceofaflawed“charactertrait”thatcan bemade from a default; as a result of the cleaning of balance sheets, at least following a deeprestructuring,therewillbemoreaccesstocreditmarkets. Russia’s1998defaultfallsintothismodel.SeeStiglitz(2010).16That is, there are both macro‐inefficiencies and micro‐inefficiencies. In the chaos surroundingdisorderly debt distress situations, assets typically do not get used in the most efficient way, andcomplementaryinvestmentstothoseassetsarenotundertaken.
and the combination of financial constraints and decreases in private and publicdemandbringonamajor recessionordepression. Theywrongly reason that if thecountryisspendinglessonitself,ithasmoretospendonothers—torepayitsdebts.But they forget the large multipliers that prevail at such times: the cutbacks inexpenditure decrease GDP and tax revenues. The underutilization of the country’sresourcesmakes it more difficult for it to fulfill its debt obligations—the austeritypoliciesarenormallycounterproductiveevenfromthecreditors’perspective.
Anothercriticalfeatureisex‐anteefficiency.Asystemthatdoesnotputanyburdenonthe lenders ex‐post does not provide the right incentives for due diligence ex‐ante.
Selection of “good” borrowers requires in general specific actions from the lenders,suchasscreening(beforelending)andmonitoring(afterlending).Theexistenceofamechanismforsovereigndebtrestructuringwouldactasasignalthatmoneywillbelostunlessduediligenceisapplied.
as now, large fractions of lending aremediated through capitalmarkets, not banks.
Arguably,thatwasoneoftheconsequencesofthepassageofthecreditor‐friendlyUSbankruptcy law reforms in 2005 (through the Bankruptcy Abuse Prevention and
17Itisimportanttorealizethatthenormalpresumptionthatmarketsontheirownareefficientfailsinthiscontextforalargenumberofreasons: thereareimperfectionsandasymmetriesandincompleteriskmarkets (and in such situations, there is a strong presumption that markets are not efficient).Moreover,thecontextinwhichwearemostconcerned—wherethereissignificantunderutilizationofresources—isoneagaininwhichthereisapresumptionofmarketinefficiency.Finally,thebargainingthat surrounds debt resolution is itself evidence of the absence of perfect competition, anotheressentialassumptionifmarketsaretobeefficient.See,e.g.GreenwaldandStiglitz(1986).
an equity issue, as the lack of proper mechanisms affect all countries but moreseverely those that are riskier). Of course, debtors that aremore likely to defaultshouldpayahigherinterestrate.Theproblemisthatiftherestructuringmechanismisinefficient—asthecurrentsystemis—itover‐penalizestheseborrowers,andtheexpost inefficiencyalsogetstranslatedintoanexante inefficiency,astheunnecessarilyhighpenaltydiscouragesparticipationinthecreditmarket.
A flawedsystem like thecurrentone that reliesmoreonmechanisms for “bailouts”(as the European Stability Mechanism) instead of providing mechanisms forrestructuringalsocreateslargeinter‐creditorinequities,asonlythecreditorsthatgetpaid with the resources of the “bailouts” benefit, while the expected value of the
claimsof theotherclaimants(suchas thecreditorswhosedebtsmature ina longerterm, or the workers and pensioners whose wages depend on the capacity ofproduction of the economy that decreases precisely as the consequence of theausterityoftenassociatedwiththoseplans)decreases.
Finally, there is a problem of equity between formaland informalcreditors—those
of the important ways in which sovereign debt is different from private debt.Typically, therearea largenumberofsuchclaimants—pensioners, thosedepending
bankruptcy code (pertaining to the bankruptcy of public bodies) recognizes theimportanceoftheseclaimants,intheabsenceofaninternationalruleoflawthatgives
Restructurings involve a public good problem: each claimant wants to enjoy thebenefitofthecountry’sincreasedabilitytorepayfromdebtreduction,buteachwantstoberepaidinfull.
Theexistingframeworksfailtosolvethepublicgoodproblem.Instead,theyprovidethe conditions for the emergence of vulture funds. The vulture funds are a class ofholdouts thatarenotreally in thebusinessofprovidingcredit tocountries. Instead,
theyareengagedin“legalarbitrage”.Theirbusinessconsistsinbuyingdebtindefault(orabouttobeindefault)insecondarymarketsatafractionoftheirfacevalue.Then,theylitigateincourts,demandingfullpaymentontheprincipalplusinterest(typicallyat an interest rate thatalready includes compensation fordefault risk).Avictory incourtsbringsexorbitantreturnsontheinitialinvestment.
Their modus operandi relies on a legal framework that has weakened sovereignimmunity, and on a flawed design of contracts. They resort to activities (many of
any holder of exchange bonds would be barred from receiving payments. Theinjunctionwasbasedonapeculiarinterpretationofparipassu,18acontractualclausethatissupposedtoensureequaltreatmentamongequallyrankedcreditors.19
Thedesignofcontractsalsofacilitatestheemergenceofvulturefunds.Manyexistingdebt contracts do not have collective action clauses (CACs)—clauses that allow amajorityofbondholderstoagreetochangesinbondterms(forexampletoreducethevalueoftheprincipal)thatarelegallybindingtoallthebondholders,includingthosewhovoteagainsttherestructuring.Somecontractsdoincludethembutthemajority
isdefinedatthelevelofeachindividualbond.20
Under a unanimity rule, vulture funds can emerge easily.With CACs at the level ofeachsecurity,vultures’behaviorismoreconstrainedbutitisstillpossible.Theycanstillbuytheminimumfractionthatwouldblocktherestructuringofauniqueseriesofbonds,andbydoingsotheywouldbeabletoblockthewholerestructuring.
A formula for aggregation of CACs (over different classes of bonds), as the one
18The judge's decision was peculiar in other ways: it forced the trust bank into which funds weredeposited to enforce his decision, i.e. the trustee was forbidden from distributing funds that it hadreceived on behalf of the restructured bonds. Thus, to enforce one contract, it had to break othercontractual arrangements. There seemed to be little rationale for the Courts decision about whichcontractstorespectandwhichtoabrogate.Thus,thedecisionwasnot(asithassometimesbeenput)aboutthesanctityofcontracts.19Theupshotisthatvulturefundsarepoisedtogetreturnsontheir“investments”morethanfivetimesgreaterthantheholdersoftheexchangebonds.20Inthe1990s,bondsissuedintheLondonmarketundertheEnglishlawcontainedCACs,whilebondsissuedintheNewYorkmarketunderthelawofthestateofNewYorkdidnot(EichengreenandMody,2003).Mexicowas the firstcountry toput theseclauses in itscontractsunder the jurisdictionof thestateofNewYorkin2003.
onmarkets tosolvebankruptcies. Every country has a bankruptcy law. Theory also
shows that under realistic conditions markets are not able to provide efficient
restructuringson their own, as they areunable to reach efficient solutionson theirowningeneral,exceptunderveryrestrictiveandunlikelyconditions(GreenwaldandStiglitz, 1986). 22 There are important market failures that are present inrestructurings–eitherforcorporationsorforsovereigns.
The evolution of the legal frameworks has been instrumental for the emergence ofvulturesand thedebilitationof sovereign immunity. Sovereign immunityhad firstlybeen challenged with the sanction of the Foreign Sovereign Immunity Act in 1976
(Schumacher,Trebesch,andEnderlein,2014),andmorerecentlybylitigationoverthechamperty defense – an English common‐law doctrine, later adopted by US statelegislatures,thatprohibitedthepurchaseofdebtwiththeintentofbringingalawsuitagainstthedebtor(BlackmanandMukhi,2010).
The case ElliottAssociates,LPv.Bancode laNaciónand theRepublicofPeru was agame changer for the interpretation of legal frameworks affecting sovereign
immunity. Elliott hadbought Peruviandebt in default and sued the country for full
payment in theNewYork courts. TheUSDistrict Court for the SouthernDistrict of
New York ruled that champerty applied, dismissing Elliott’s claims. But the Second
Circuit of Appeals reversed the decision, stating that the plaintiff’s intent inpurchasing the Peruvian debt in defaultwas to be paid in full or otherwise to sue.
Then, according to the Second Circuit, Elliot’s intent did not meet the champerty
requirementbecauselitigationwascontingent.Suchaninterpretationisabsurd,asit21In aworld of globalization, thedistinction between foreign anddomestic bondsmaynot be clear.Moreover,therulesofthegamewouldbeexpectedtochangethemix.22This is especially truewhen there are largemacro‐economic disturbances. SeeMiller and Stiglitz(1999,2010).
The problems are aggravated by the non‐transparent use of CDSs. A CDS separatesownershipfromeconomicconsequences:theseemingownerofabondcouldevenbebetteroffintheeventofadefault,asthepaymentsovertheCDSwouldbeactivatedinsuchevent.
The opacity of thismarketmakes unclear the real economic interests of thosewhohave a seat at the restructuring bargaining table. They provide another reason fordelayedrestructurings,withitsassociatedinequitiesandinefficiencies.
Theunbalancedbackgroundfornegotiations
ThelegalframeworksandthebailoutpoliciesoftheIMFdeterminethebackgroundofthe negotiations (cf. Brooks, Guzman, Lombardi, and Stiglitz, 2015). The currentarrangementsfavorshort‐termcreditorsagainstlong‐termcreditors,includinginthe
latter group the “informal creditors” (the citizens towardswhich the sovereign has
Every bad loan is equally the result of bad lending and bad borrowing: these arevoluntary agreements. But a system the puts the onus on the debtor (i.e.making itmore likely that more of the debt will be repaid) encourages bad lending—itencourages banks to encourage the government today to borrow too much,exacerbatingthealreadypresentdistortion.(Thereisafurtherargumentforputtingmoreoftheonusonthelenders:theyaresupposedtobetheexpertsinriskanalysis;
that is supposed to be their comparative advantage; government officials typicallyhave no expertise, and rely on the judgments of those in the financial marketconcerningreasonabledebtlevels.)
The International Capital Market Association (ICMA), with the support of the IMF,proposestoresolvethefailuresinsovereigndebtrestructuringbymodifyingthedebtcontracts’ language. The new terms include a formula for aggregation of collectiveactionclauses(CACs)andaclarificationoftheparipassuclause.
The formula for aggregation allows bondholders across different series of bonds tovote collectively in response to a restructuring proposal. The decisions of asupermajority (defined by acceptance of the aggregate principal amount25 ofoutstandingdebt securities of all of the affected series)would be binding to all thebondholdersacrossallseries.
Theclarificationofparipassuestablishesthat,unlikejudgeGriesa’sinterpretationinArgentina’s case, “the Issuer shall have no obligation to effect equal or rateablepayment(s)atanytime”withrespecttoanyotherExternalIndebtednessoftheissuer,andinparticulartheissuer“shallhavenoobligationtopayotherExternalIndebtedness
at the same time or as a condition of paying sums due on theNotes and vice versa”(ICMA,2014).Inotherwords,ICMAstatesthatparipassudoesnotmeanwhatjudge
Griesainterpretedittomean.23Evenwithmarkedtomarket, there isalwaysachancethat thecountrywill recoverandthebondswill pay off. If the write‐down is greater than the expected loss (recall, that if there is not arestructuring now, there is a chance, even a likelihood that matters will get even worse, and thenecessarywrite‐downwill be even greater) then thewrite‐downwill be associatedwith a decreasetodayinthevalueofthefirm.24Similarproblemsarise,ofcourse,withdomesticdebt,andplayedanimportantroleintheevolutionoftheU.S.financialcrisis.SeeStiglitz(2010b).25Thereisstillaproblemwhendebtisissuedindifferentcurrenciesandtherearemarkedchangesinexchange rates (as in the EastAsian crisis.) Depending on the rules, itmay be relatively easy for avulturefundtobuyenoughbondstoblockarestructuringortoobtainasettlementthatadvantagesitoverotherclaimants(theissueismoreextensivelyanalyzedinsection5).Similarproblemscanarisesimply when there are different maturities: long dated bonds might, for instance, sell at a markeddiscountrelativetoprincipalvalues.
those times, distributive conflicts getmagnified.26The private contractual approach
doesnotsolvetheseissuesaccordingtoefficiencyorequityconsiderations,butonthebasisofrelativebargainingstrength(related,forinstance,totheabilitytowithstandlarge litigationcostsanddelays).Outcomesaregenerally inefficientandinequitable.That is why no government relies on the private contractual approach within itsboundariesforprivatedebts.Theadvocatesoftheprivatecontractualapproachhaveneverexplainedwhy,ifitwereasgoodastheyclaim,ithasbeenuniversallyrejected.Andasthecomplexitiesofsovereigndebtrestructuringaregreater,theneedfortheruleoflawislarger.
Theproblemwithexistingcontracts
The IMFestimates that roughly30percentof the$900billion inoutstandingbondsissuedundertheoldtermswillmatureinmorethan10years.Approximately20%ofthosestocksdonot includeanykindofCACs,andvirtuallyallof the80%thatdoesinclude themhaveCACs thatoperateonly at the level of each security (IMF,2014).
What would prevent the current problems from arising if those debts had to be
Debt issuedunder theold terms could inprinciplebe exchanged for securities that
incorporate the new terms. But what would rule out holdout behavior if such aproposalwere carried out? The vultureswould have an incentive not to exchange
26That is, if thecountryhad issuedonlyonesetofbonds, therewouldbeaclearmeaningtoequity:repaymentsshouldbeproportionaltothefacevalueofthebonds.Thisisnotsoif,asitisthecaseinpractice,therearemanydifferentkindsofbonds.
ontheoutcomeofthebargainingprocess.Indeed,ifseniorcreditorsweresufficientlysmallrelativetothejuniorcreditors,thereisapresumptionthattheirsenioritywouldnot be fully taken into account, and under the proposed arrangements, there isnothingtheycoulddoaboutit.Seniorcreditorswouldanticipatethispossibility,andwould react by demanding different contract terms ex‐ante (for instance, an earlyseniorcreditmightlimittheamountofjuniorcreditorbondsthatcouldbeissuedsoasnot todilutevoting interests,but thatwouldhaveadeleteriouseffectongrowth;alternatively,hecoulddemandahigherinterestrate27).
Whencountriesissuedebtunderdifferentjurisdictions,establishingpriorityofclaimscould be a daunting task, with multiple contradictions. Contracts could become
inconsistent in crises times. For example, the terms of a bond issued under thejurisdictionA couldstatethat theholderof thatbondhaspriorityoverall theotherclaims.ButatthesametimeanotherbondissuedunderthejurisdictionBcouldstatethesame. If itwerenotpossible tosatisfybothclaimsat thesametime,howwouldprioritybedetermined?Whowouldultimatelyjudgeoverit?Itmightbeimpossibleto
to this problem within the contractual approach is not easy. Governments could
decide togive full creditor rights to social security claimants.But then, governmentagencieswouldbefiduciaryforthoseclaimants,whichmight“drownout”traditionalcreditors–anissuethatwouldbeanticipatedandthatwouldalsobereflectedintheinterestratesandthecontractterms.
Under a decentralized private contractual approach, anticipating all of thesepossibilitieswouldresultinhighlycomplexcontracts,andsolvingthedisputeswouldrequire intricate and lengthynegotiations,with complex legal questions, andwouldalmost surely cast apallofuncertaintyoverwhatmighthappen in theeventof theneedforarestructuring.
to signal they are unlikely to default—jurisdictions that will make an eventualrestructuringverydifficult.Otherdebtors,byactingdifferently,wouldsignalthatthey
frameworks for sovereign debt restructuring should recognize these perverse
incentives, and should consequently make it impossible to sign away sovereign
immunity.
On the creditors side, a decentralized negotiation would face the opposition ofinvestors that use sovereign bonds as collateral, and that in a world of less thanperfectcorporategovernancewillopposetoseethevalueofthebondswritten‐downintheshortterm,evenifnotwritingdebt‐off leadstomoresustainabilityproblems,andlargerhaircutsinalongerterm.
There are other modifications to the standard contract that could improve the
workingsofthemarket‐basedapproach.Theyentailregulationsoncontracts,changesin domestic legislation, and the inclusion of clauses that make debt paymentscontingentontheeconomicsituationofthedebtor.
30Arrow andDebreu have established that only if therewere a complete set of riskmarketswouldcompetitive markets be efficient. Some in the financial market thus argued that introducing newsecurities (such as CDSs) helps complete themarket, and thus improves societal welfare. But thatconclusionignoresthebasicinsightsofthetheoryofthesecondbest,whichdemonstratesthatinthepresence ofmultiplemarket failures, reducing the scope of one could actually (and under plausibleconditions, often would) lead to a decrease in societal welfare. Thus, Newbery and Stiglitz (1982)showedthateliminatingbarrierstotrade,inthepresenceofimperfectionsinriskmarkets,couldleadallindividualsinallcountriestobeworseoff.Inthiscontext,GuzmanandStiglitz(2014a,2015a,2015d)haveshownthat introducingthesenewinstrumentsforbettingmayactuallyincreaseeconomicvolatilityandloweroutputpermanently.
positions of parties involved in the restructuring negotiations should be fully
disclosed.32
Reinstatingvariantsofthechampertydefense
If investors that purchase debt in defaultwerewilling to settle under “reasonable”conditions, theywould just provide a liquidity service in themarkets for defaulteddebt,andcouldthuscontributetoavoidinganevenlargerdepressioninbondspricesinsuchcircumstances.But that isnotwhatvulture fundsdo.Reinstatingvariantsofthechampertydefensethatprohibitthepurchaseofdefaulteddebtwiththeintentoflitigating against the issuer, together with a clarification of the pari passu clause,would undermine the vultures’ business, correcting the numerous inefficienciesassociatedwiththeirbehaviorthatwehaveidentified.33
GDPindexedbonds
31TherecentcaseofArgentinedebtrestructuringillustrateshowperverseincentivescanturn.IntheaftermathofJudgeGriesa’sinjunctionthatblockedthepaymentsofthecountrytoitsbondholders,theInternationalSwapsandDerivativesAssociation(ISDA)classifiedthecrediteventasadefault.Interestingly,oneofthemembersofISDAcommitteewasElliotManagement,thesamevulturefundthatwaslitigatingagainstthecountry.(ThedebtcontractonlyspecifiedthatArgentinaturnovertherequisitefundstothe"agent"–whichArgentinadid.Argentinawasthusnotinbreachofthecontractswhichithadsignedintheprocessofrestructuring.Indeed,Argentinahadevenwarnedinvestorsinitscontractofthepossibilityofthesedifficulties.Thatiswhytheso‐calleddefaulthasbeenlabeledaGriesafault,todistinguishitfromanormaldefault,whereapartyactuallybreachesakeycontractprovision.SeeGuzmanandStiglitz(2014b)).32Some have suggested going further: banning the purchase of SCDSs by third parties (Brook,Lombardi,Guzman,andStiglitz,2015).33One could even imagine some variant of such a clause being inserted into the contract: that nosecondarypurchasersofthebondcouldmakeaclaimincourtforanamountgreaterthanthepriceatwhichhehadpurchasedthebond.Whilesuchaprovisionarguablymightlowerthepriceofthebondat issuance(requiring thesovereignborrower topayahigher interest rate), theeffect is likely tobeminimal:fewbuyabondontheexpectationthatitwillgointodefault.
the extreme events associated with crises, automatically convert to GDP‐linked
bonds.)
Thecapacityforcountercyclicalfiscalpolicieswouldalsoimprove.Thenumbersmaybe significant: Bank of England economists (Barr, Bush, and Pienkowski, 2014)estimatethatGDP‐linkedbondscanincreasefiscalspace,thatis,theycanincreasethelevel of what is called “sustainable debt.”34 (Itmust be noted, however, that “debtlimit” is a subjective concept whose quantification requires taking a stance on theexpectations about the government’s capacity for generating revenues—acomplicated issue over which it’s relatively easy to make wrong assumptions,especially in the most volatile economies, that are the ones more likely to need
restructurings. The IMF itself has been systematically overestimating the speed ofrecovery of economies in crises, as well as the multipliers in response to theconditionalitiesimposedonthe“bailed‐out”countries.SeeGuzman,2014).
howimproved,won’tsolvethebasicproblemofsovereigndebtrestructures. Thesecountries are advocating for institutionalizing amultinational statutory solution, as
reflected in the Resolution 68/304 passed by the General Assembly of the United
Deadlines. The sovereign should initiate the restructuring in a timely way. Theframework should provide the right incentives for avoiding delays in the initiationandinthefinalizationoftherestructuring.Therefore,itmustsetspecificdeadlinesforthe different stages of the process. This would make the whole process morepredictable.
Lending into arrears. The framework must recognize the macroeconomic
externalities associated with debt crises resolution. Thus, it should facilitatecountercyclicalmacroeconomicpolicies.Provisionsoflendingintoarrears,accordingtowhichcreditorswholendwhiletherestructuringprocessisbeingcarriedonwouldreceiveseniortreatment,shouldbecontemplated.
hazard problem, as it negatively affects creditors’ incentives to enter intorestructurings. Therefore, the framework should incorporate clauses of stays for
litigation, which would prohibit litigation in courts between the initiation and the
finalizationoftherestructuringprocess.
Litigations could still occur in jurisdictions that do not endorse the framework,
remaining a problem as a largeproportion of debtswill still be issuedunder those
35Raffer (1990, 2015) explains that the essential points of the special insolvency procedure formunicipalitiesintheUS(Chapter9,Title11,USC)canbeeasilyappliedtosovereigns.
23
jurisdictions. However, judges of non‐participating jurisdictions could consider the
giving up sovereign immunity. The benefitwould be amore orderly restructuring.
But countries would, at least initially, worry about the fairness of the tribunal.
Besides, geopolitical problems would be intense: How would the members of theinternational court be appointed?What interestswould they represent? Indeed, itmight even be difficult, at least initially, to define the principles that should guiderestructuring. The intense debateswithin countries over the design of bankruptcylawshouldmakeitclearthatresolvingtheseissuesinternationallymightbedifficult.Thecreditorcountrieswouldpushforcreditor‐friendlyprinciples,andconverselyforthedebtorcountries.
There is a single principle which countries could agree to which would restore asemblanceofordertotheglobalsovereigndebtmarket:therestorationofsovereign
immunity. Moreprecisely: thereisaconsensusthatthereshouldberestrictionsonwhatcountsasacceptablecontracts.Individualscannotsellthemselvesintoslavery.Manycountriesdonotallowcertainkindsofperpetuities. Thereshouldbeaglobalagreementthatnocountrycansurrender itssovereignimmunity(evenvoluntarily).Such a restriction is particularly important given the political economy problems
discussedearlier. It is tooeasy for a government today to surrender the sovereignimmunityofsomegovernmentinthefuture,inreturnformoneythatwouldenhance
itspopularityandthewealthofitssupporters.
Tothisshouldbeaddedaframeworkthatwouldfacilitaterestructuring.Thiswouldoccur throughwhat might be called a “soft law” approach, with the creation of an
Theworld of debt restructuring needs tomove to a different equilibrium. There isconsensus on the necessity of this, but there are different views on how to moveforward.Ontheonehand,thebusinesscommunityandtheIMFadvocatefortweakingthe termsofcontracts.Although thesuggestednewterms(aggregationofCACsandclarificationoftheparipassuclause)areimprovementsovertheoldterms(termsthatclearly did notwork), they still leave a legacy of problems unaddressed. There arefurtherimprovementsthatcanbeimplemented,aswediscussedinsection6.
But with incomplete contracts, even with all those improvements, a variety of
problemswill remain. In times of default, debt contractswill need to be rewritten.Under a market‐based approach for restructurings, outcomes will be moredetermined by bargaining power than by considerations of efficiency and equity.Particularly disturbing is the fact that most countries that are entering debtrestructuringsareinaparticularlyweakposition,andthusparticularlyvulnerableto
pressure from creditors to agree to terms that are adverse to their long termsinterests. Andtheknowledgethatthisissogivesriseitselftobadlendingpractices,
especially in the context of the political economy problems we discussed earlier:
While this approach is not a panacea, we believe it represents a substantial stepforward—andasubstantialstepbeyondtheprivatecontractualapproach.
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