A previous post, here, discussed a new report on sovereign bankruptcy — prepared by the Committee on International Policy and Reform and published by Brookings — that discusses the potential role of debt thresholds, working in concert with the IMF at the global level or the European Stability Mechanism at the European level, in creating incentives to limit the accumulation of debt, ex ante, and in facilitating timely, orderly restructuring, ex post. Debt accumulation beyond the threshold would make the sovereign borrower ineligible for emergency liquidity support and this would, the report contends, lead to higher risk premia as the debt level approaches the threshold. At the same time, the fact that a country with debt above the threshold would be ineligible for liquidity support in the event of a crisis would avoid gaming of the official sector and force creditors and the sovereign borrower to strike a deal.
As the earlier post notes, however, credibility is the key to effectiveness. If a threshold is not viewed as credible it will not be effective in conditioning expectations and changing behaviour.
The report identifies a number of additional changes that could advance the goal of timely, orderly restructurings, including strengthened contractual terms, immunization of assets and a new sovereign debt adjustment facility at the IMF. Building on the successful introduction of collective action clauses (CACs) a decade ago, the report highlights the potential use of an aggregation clause to address a key problem not resolved by CACs.
The purpose of CACs is to overcome the creditor coordination problem inherent in bond issues requiring unanimous consent to modify payment terms by allowing for modification by the super-majority (say, two-thirds of bondholders). This is, of course, an important advance. Yet, bondholders of one bond issue will be loath to accept a reduction in their claims if other creditors are not likewise forced to accept a reduction in their claims.
The intent of aggregation clauses is to subject the totality of borrower's debts to restructuring should a super-majority of the individual creditor classes agree. In effect, they would neutralize the capability of a few investors to impede a restructuring that is acceptable to a broad majority of creditors.
Immunization of a sovereign borrower's assets, meanwhile, would not protect the sovereign from the kind of litigation that has introduced uncertainty into the restructuring process. Holdout creditors could still get a judgement against a sovereign. But, by protecting assets and cash flows from attachment, it could re-balance the incentives to undertake such litigation in the first place. The effectiveness of this approach depends critically on the willingness of governments to legislate domestically and respect immunization provisions in other jurisdictions. Like the debate on the IMF's Sovereign Debt Restructuring Mechanism a decade ago, it is unclear if there is sufficient political will to pursue this approach.
Similarly, support for a new IMF debt adjustment facility may also be lacking. The intuition behind this idea is straightforward: recognize that the IMF will be called on to support sovereigns in severe financial distress with liquidity assistance, but condition that assistance on explicit debt sustainability criteria and debt restructuring. Such a mechanism would have incentive effects similar to the threshold proposed by the Committee. Yet, in some respects it would likely prove more controversial: the IMF would, presumably, be tasked with determining whether and how much of a haircut is required to restore sustainability. Private sector players are likely to view these assessments as biased, particularly as the IMF enjoys a de facto preferred creditor status.
So, where do all of these interesting and potentially useful ideas leave the sovereign debt debate?
Frankly, I am uncertain. Each of the suggestions, if implemented, could represent an incremental improvement in the process. But, I suspect that there will still be room for improvement and some would still look longingly at formal frameworks and conclude that they are still missing after all these years.