CIGI is co-hosting an Expert Group Meeting on sovereign debt restructuring at the United Nations tomorrow. The meeting will be held against a backdrop of intensifying concerns about the future of the single European currency and the potential disruption that could result from a Greek exit from the euro zone. In this regard, after a hiatus of several years the unfolding crisis in Greece reanimates the debate on sovereign debt restructuring that raged a decade or more ago.
At that time, there was a perception that the status quo approach to debt restructuring, which can result in long, drawn out negotiations, increases costs to all parties:
- private creditors are harmed, as asset values are dissipated by continuing uncertainty and possibly the adoption of bad policies by the debtor;
- sovereign debtors suffer, as growth falls, unemployment rises and support for sensible, sound economic policies erodes; and
- the IMF is adversely affected, as its credibility and effectiveness in assisting its members strike a judicious balance between financing and adjustment is impaired.
A key factor behind efforts to develop a better framework for the timely and orderly restructuring of sovereign debt was the recognition that how restructurings are managed ex-post will affect creditor and debtor behaviour ex-ante. As Paul O’Neil, the U.S. Treasury Secretary at the time, put it: “We need something between moral hazard and catastrophic collapse."
Think of efforts to provide that middle ground as a way of finessing the dynamic inconsistency problem confronting the IMF once it is realized that a member has slipped from sustainability to un-sustainability. Regardless of how intently the official sector wants to foster a restructuring of debt that includes a write down of private sector claims rather than provide additional official sector financing through the IMF and other official lenders, if the outcome is a disruptive and disorderly outcome with the costs above, the path of least resistance will be to take a chance, hope for improved economic conditions and provide additional financing. This gambling for redemption could pay off. More often it does not, amplifying the losses that are eventually realized. Absent some framework that contains the cost of saying “no” to more financing, access limits and constrained discretion can be strengthened, but they will be credible; and if they are not credible, they will not affect behaviour.
The simple fact is that, to get timely, orderly, voluntary restructurings, there has to be a credible threat of involuntary solutions. The domestic analogue is restructurings done in the “shadow of the courthouse.”
Debtors and creditors know that they can either come to voluntary solution or litigate. From a private perspective, however, the latter option entails deadweight losses in the form of legal fees — the more money that goes to pay their lawyers, the less money on the table to be divided between the creditors and the debtor.
The point here is that the threat of an involuntary solution “through the courthouse” creates the incentives to do a deal more quickly which preserves the size of the pie to be divided. Moreover, the rules provided by the bankruptcy regime help anchor expectations of the likely outcome of the “involuntary” (litigation) approach. As a result, time and resources aren't dissipated in meaningless posturing over positions that both sides know would not be supported by the disinterested bankruptcy judge.
Of course, the rules are not mechanical; uncertainty about the eventual restructuring remains. But the rules reduce confidence intervals around likely outcomes and this is what fosters timely voluntary restructurings. In this respect, the key objective of any sensible bankruptcy regime is to assuage coordination problems and promote wealth maximization by:
- providing for the discharge of excessive debt burdens to avoid the perverse incentives created by a debt overhang;
- limiting asset seizures and creditor runs in the restructuring process;
- preventing rogue creditors, or less pejoratively, “opportunistic behavior,” from disrupting restructurings broadly acceptable to the (super) majority of creditors.
At the domestic level, the first of these will be determined by a disinterested judge; at the international level, absent some formal international bankruptcy court, by bargaining between the creditors and the debtor over the size of prospective “haircuts.” The other objectives are promoted through automatic stays, debtor-in-possession financing, and cram down provisions — the “stay, DIP, bind” trinity. A decade ago, the IMF's work on the Sovereign Debt Restructuring Mechanism, together with the Fund’s Lending into Arrears Strategy, was intended to replicate them.
Of course, work on the SDRM was blocked and efforts to promote timely, orderly restructuring of sovereign debt focused on the adoption of collective action clauses, which have now become “boiler plate” and the voluntary codes of behavior championed by Jean-Claude Trichet. Notwithstanding their importance, I wonder if, over the past two years, Trichet regretted his decision to support voluntary codes and perhaps rued the absence of some formal, internationally-sanctioned framework for sovereign restructuring.
In any event, subsequent to the SDRM debate voluntary approaches evolved, as legal practitioners developed new approaches to voluntary restructurings. These approaches and their limitations are the subject of the second session of tomorrow's meeting.
On this score, it will be interesting to hear participants’ views on the extent to which successful voluntary resolutions can be attributed to cases in which the debtor’s position was deemed hopeless, or country conditions improved significantly (resulting in too “lite” a haircut), or there was a credible threat of involuntary means (Greece comes to mind).
In addition, it is important to consider the extent to which the success of voluntary approaches post-Argentina is independent of global macro-economic conditions. In a global economy awash in liquidity and money searching for yield, creditors may have been too forgiving (so that they could normalize payments and get that extra spread over Treasuries) and borrowers eager to get back in the borrowing game. Would we observe the same outcomes today, I wonder?
Five years after the onset of the global financial crisis, the global outlook is far different. In this respect, the crisis in Europe may hold the key to this important debate. With much of the Greek debt socialized in the hands of official sector creditors (ECB, EFSF and IMF) all of whom assert preferred creditor status, any further restructuring of Greek debt will result in punitive haircuts for remaining private investors. In this event, the lesson will be that the only rule is that there are no rules. That would lead to a cry of righteous indignation the likes of which hasn’t been heard in a very, very long time. At that point there may well be a constituency for “rules” that, yes, benefit the debtor, but also protect creditors.
Failure to make progress on such rules could have serious consequences. This is because bonding technology is determined endogenously. Consider, for example, the switch from bank debt in the 1980s to 1990s. What accounts for shift? The answer is that lending in the debt crisis of the 1980s was through the banks and subject to restructuring, while bonded debt was deemed de minimus and escaped unscathed. In this regard, if the remaining Greek bondholders do get wiped out, we could face the prospect of a marked decline in bonded debt to sovereigns; yet, with global banks in such terrible shape, we won’t have bank lending either.
Not a particularly encouraging prospect for a global economy that remains dangerously unbalanced.