The previous post, here, highlights the uncertainty induced by ongoing litigation over the restructuring of Argentine debt that occurred a decade ago. A ruling by the Second Circuit Court of New York could, in effect, recast the rules of the game by which successful sovereign debt restructurings have been conducted since the Argentine default. By ruling that holdout creditors have a right to accelerated payments plus interest AND, of more significance, the provision to enforce that ruling, the Court has potentially changed the game.
An undesirable side effect of the ruling could be a return to the particularly messy debt restructurings of the 1980s, which led to protracted periods of lost output and impaired asset values that adversely affected borrowers and creditors alike. (That being said, the Court has tried to ring-fence the applicability of the ruling; it has conveyed the sense that the extraordinary injunctions it has sanctioned reflect the difficulties — frustration, perhaps — of dealing with a particularly recalcitrant borrower.)
A new report, "Revisiting Sovereign Bankruptcy," prepared by the Committee on International Economic Policy and Reform underscores the challenges and uncertainties of sovereign bankruptcy highlighted by the Second Circuit Court ruling and proposes options for making the process better. The report, which is available here, was discussed at a Chatham House rule discussion at the Brookings Institution in early October. The discussion revealed the extent to which the debate on sovereign debt restructuring has returned full circle to where it was roughly a decade ago. At that time, the question was whether to pursue sovereign debt restructurings through a "statutory" approach, such as the IMF's proposed Sovereign Debt Restructuring Mechanism (SDRM), or through "voluntary" inclusion of collective action clauses (CACs) that assuage the creditor coordination problems that can impede timely restructurings. Opinion was divided; in the end, lacking sufficient political support, the SDRM was put on the "back burner" and attention focused on the adoption of CACs.
Recent developments underscore the simple, fundamental observation that, while contracts are flexible, in the sense of being able to respond to the idiosyncratic needs of the contracting parties, they can also be "fragile." This fragility stems from the fact that, when a dispute arises over the contract, it will be subject to judicial interpretation. And, as the Second Circuit Court ruling illustrates, contractual terms are also subject to the vagaries of legal drafting. Over time, as the case law evolves, the interpretation of the clause will iterate on an "equilibrium" definition. But, in the meantime, there will be additional uncertainty as to meaning. In this regard, as one participant at the Brookings seminar noted, a "surgical statutory response" that provides greater clarity on the rules of the game would address uncertainties.
At the same time, the report aims to address two additional challenges that were prominent in the debate on a framework for sovereign bankruptcy that raged a decade ago. The first is getting the right incentives to assuage ex ante and ex post problems. Ex ante, there is a need to avoid the accumulation of excessive debt.
One approach advanced by the working group report is to establish an ex ante threshold on debt accumulation. Below the threshold (for example, the 60 per cent of GDP level set by the Maastricht agreement) the country would be eligible for emergency liquidity assistance from, say, the IMF or the European Stability Mechanism. Above that level, creditors could not count on a bailout in the event that the sovereign borrower experiences debt-servicing difficulties.
The threshold provides an automatic "brake" on debt accumulation, since the closer a country gets to the threshold, the more private creditors will start to factor in the costs of a possible disruption to debt servicing and the potential "haircut" from a restructuring. Costs to the borrower would rise, and this would reduce the demand for borrowing.
In these circumstances, the restructuring process would be characterized by bargaing between the sovereign borrower and its private creditors, without the added complication of efforts to "game" the official sector into providing support. In this respect, a credible, binding ex ante constraint aligns incentives and accelerates the restructuring process.
The operative word here is credible. A decade ago, considerable attention was paid to establishing credible, binding access limits on IMF financing, as had been the case for the Bretton Woods period. The idea was simple: if IMF resources are limited, the risk of gambling for redemption (delaying necessary reforms and adjustments) will be contained. The result of those efforts was a new framework for exceptional access, which in theory would limit cases of exceptional access by establishing a very high bar in terms of debt sustainability. And, yet, when the new framework was tested (in the case of Greece) it was, in effect, ignored.
This Greek episode illustrates the dynamic inconsistency problem that is at the core of the official sector's dilemma in dealing with sovereign bankruptcy. In brief, dynamic inconsistency is the potential for actions that may optimal ex ante to be sub-optimal if some condition is not satisfied. In the case of sovereign bankruptcy, the commitment not to provide IMF (or other official sector) resources is entirely sensible in that it creates incentives for sovereign borrowers and their private creditors to come to a timely restructuring. But if such a restructuring is not forthcoming, and the result is a financial crisis that has external effects on global markets, the commitment not to provide financing may look decidedly sub-optimal, particularly for an institution whose mandate is global financial stability.
All of this takes to the second key element in the debate over sovereign bankruptcy: the issue of rules versus discretion. As noted above, fixed, credible rules create incentive mechanisms, such as avoiding threshold effects in which risk premia adjust. In this respect, rules are designed to assuage the dynamic inconsistency problem by taking decision-making out of the equation.
Yet, such rules are unlikely to be globally optimal, however. Consider the case of thresholds on debt accumulation. Optimal thresholds can both change over time, as economies develop, and will likely differ across countries depending on legal and political systems. As a result, there will be an argument for discretion, so that the rule can be adjusted to the idiosyncratic charateristics of individual countries. This may result in rules that are better tailored to a specific country, but "discretion" invites charges of preferential treatment.
In a world in which countries are identical, this is unlikely to be a problem. A fixed rule that applies to one applies equally to others. But that is not the world we have. As a result, the decision to implement the fixed rule will be based on a tradeoff between the inefficiency of sup-optimal rules for individual countries versus the efficiency gains from better aligning incentive structures in the debt restructuring game.
A subsequent post will look more closely at other recommendations in the working group report.