(AP Microstock)
(AP Microstock)

Like it or not, there is very little that creditors of sovereign borrowers can do in the event of default. There was a time, of course, when the suspension of payments would lead to extra-jurisdictional sanctions — the deployment of gunboats and the seizure of the customs house. Thankfully, such measures are no longer considered legitimate.

For the past century or so, creditors have had very little recourse in the event of a sovereign borrower default.

It is possible to get a court judgement, but that is not the issue. The problem is enforcement. And, to the dismay of many a creditor over the years, the assets of sovereign states are generally immune to seizure for the satisfaction of judgements. Indeed, the doctrine of sovereign imunity is well established in legislation as well as in practice.

As a result of all of this, sovereign lending can perhaps be thought of as self-enforcing contract. Sovereign borrowers voluntarily honour their debt in order to maintain long-term access to capital markets either to finance long-lived investment projects or to smooth consumption in the event of future income shocks. But history is replete with episodes in which sovereigns accumulate too much debt and, subsequently, are unable to service their debts either because of bad luck or bad policies. In these circumstances, private creditors will eventually, inevitably, agree to a restructuring of some kind.

To be sure, the process is not ideal. Protracted delays in restructuring can result in a sharp compression of demand that can fray the social fabric and lead to the adoption of unsound policies "injurious of national and international prosperity." Such outcomes are harmful to creditors as well as the indebted country. Because the re-negotiation process depends on a range of factors, including divergences in the rate of time preference between the sovereign and its creditors, scenarios of the expected growth of the economy with and without renewed access to capital markets, and the rate of interest, the bargaining "game" is fraught with uncertainties.

Nevertheless, the rules of the game are reasonably clear. Moreover, innovations, such as the adoption of collective action clauses which facilitate the restructuring of bond issues based on the consent of a supermajority of bondholders, can help facilitate timely restructurings. And, as the experience of the past decade suggests, these rules can result in restructurings that are relatively timely.

A ruling by the Second Circuit Court of New York in favour of "holdout" investors — bondholders who did not accept a restructuring of their claims on Argentina a decade ago — could change that. Not only did the Court rule that these investors are entitled to the acceleration of their claims plus interest, but that they could seek enforcement of that judgement by blocking payments to bondholders that did agree to a restructuring a decade ago. If upheld, the ruling could introduce a new source of uncertainty into the restructuring process.

Before the ruling, bondholders had reasonable assurance that the sovereign's threat that holdout investors who didn't participate in a resturcturing would not be paid was credible — that, if a supermajority of investors agreed to a haircut, holdouts would not be treated better. Failing that assurance, investors would be loath to agree to a restructuring. Afterall, why would an individual agree to a haircut if, by doing so, they increased the chances that holdout investors would earn a higher return. In short, without that assurance, the coordination problem that collective action clauses were designed to assuage would once again be a threat to the timely, orderly resolution of sovereign payment difficulties.

This possibility and the uncertainty it introduces have reanimated the debate over sovereign bankruptcy. A follow up post will review a recent contribution by a blue-ribbon panel of economists, legal scholars and policy experts.

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