CIGI and the Financing for Development Office, Department of Economic and Social Affairs, United Nations (FfDO) invite media attending the IMF and World Bank Group annual meetings in Tokyo to attend their joint panel, titled Facilitating International Adjustment through Timely Debt Resolution.
This panel of policy makers, private sector representatives and academics will focus on the need to ensure timely, effective international adjustment in a manner consistent with sustained global growth and continued adherence to the system of open, dynamic international trade and payments constructed over the past 65 years. The panel will explore the calculus of economic and political factors influencing debt default decisions to assess the extent to which voluntary or statutory rules-based approaches can contribute to an orderly, timely framework for the restructuring of claims that reduces costs to debtors and private creditors alike. Key questions are whether steps can be taken to improve upon the prevailing ad hoc, voluntary approach that has dominated the restructuring of sovereign debt over the past decade, or whether a more formal system for dealing with situations of fundamentally unsustainable debts is needed.
International Adjustment and Sovereign Debt Restructuring
In a narrow sense, the objective of the Tokyo panel is to assess the extent to which a consensus exists on how best to promote the restructuring of sovereign debt. However, in a world marked by large imbalances, enormous fiscal challenges and unemployment that remains too high in a number of countries, a somewhat broader goal for the panel is to highlight the need to facilitate timely external adjustment, consistent with the return to full employment and the maintenance of the system of open international trade and payments that has been constructed over the past 65 years or more.
International Adjustment in Historical Perspective
The mechanics of the international adjustment process have evolved over time.
Under the Bretton Woods system, adjustment was facilitated through the compression of domestic “absorption” — private consumption, investment and government expenditures. The adjustment process was supported by short-term balance of payments support from the IMF, which spread the adjustment burden out over time, thereby encouraging member countries to eschew beggar-thy-neighbour policies “destructive of national and international prosperity.” At the same time, the size of adjustment problems in the Bretton Woods era was largely constrained by the widespread adoption of capital controls among most member countries that limited imbalances to differences in national savings and investment rates — typically a few percentage points of GDP.
The collapse of the Bretton Woods system led to a system of flexible exchange rates where international adjustment was facilitated by nominal exchange rate adjustments, which, in theory at least, would be driven by current account imbalances with exchange rates adjusting smoothly over time to close trade imbalances. In practice, however, the flexible exchange rate era coincided with the development of large, deep and dynamic international capital markets. Increased capital flows rendered capital controls more porous and led to very large changes in nominal exchange rates, translating into correspondingly large real exchange rate movements given short-term price stickiness.
The increased size of imbalances financed by private capital flows, meanwhile, led to bigger adjustment challenges. Moreover, with the widespread adoption of capital account liberalization by the early 1990s, the nature of international financial crises changed. Rather than problems of current account adjustment unwinding over several quarters, the capital account crises that now arise can be triggered by a shift of confidence, leading to sudden stops and reversals of capital flows. The result is crises that more closely resemble bank runs than Bretton Woods era balance of payments problems and the compression of a much larger adjustment burden into a much shorter period of time — weeks instead of quarters.
In this environment, putting the full burden of adjustment on the Bretton Woods mechanism of reducing domestic absorption, as is the case today in several euro zone countries, requires draconian cuts to private consumption, investment or government expenditures. Such measures can undermine broad public support for sound policy frameworks and increase the attractiveness of policy options that, while intended to insulate the country from external shocks, in effect constitute policies to shift the burden of adjustment to other countries. Because its resources are dwarfed by potential outflows of private capital, meanwhile, the IMF is less able to assist its members to strike a judicious balance between financing and adjustment as it had in the Bretton Woods era of limited private capital flows.
Similarly, relying on exchange rate adjustment alone can also be problematic. Very large exchange rate movements generate correspondingly large asset valuation effects; for debt issued in a foreign currency, the resulting mismatch can quickly make the debt burden unsustainable. Moreover, “fire sale” prices of domestic assets in terms of foreign currency can resuscitate capital inflows, but carry with them the risk of eroding support for open international trade and payments.
Sovereign Debt Restructuring
A decade ago, in the wake of a series of devastating crises beginning in Mexico in 1994 and culminating with Argentina’s default, the international community explored a range of possible options to facilitate timely, orderly restructuring of sovereign debt. In a sense, the objective was to augment the international adjustment “toolkit” in cases where debt burdens had become so high that they were widely viewed as unsustainable and possibly posed a risk distorting the incentives to pursue sound macroeconomic policies.
These efforts to develop a better framework for the timely, orderly restructuring of sovereign debt were marked by cleavages between those prepared to support so-called “voluntary” approaches, in which bondholders would accept contractual modifications that facilitated restructuring, and those who supported a more formal, statutory approach — the Sovereign Debt Restructuring Mechanism (SDRM) — as developed by the IMF under then First Deputy Managing Director, Anne Krueger. In the event, the decision was taken to abandon statutory approaches and concerted efforts were made to include collective action clauses (CACs) in new bond issues of key emerging market economies.
The issue of sovereign debt restructuring fell off the international policy agenda as a result of the ample global liquidity and the benign global environment that preceded the global financial crisis, which may have lulled policy makers and private investors into a false sense of complacency regarding the risks associated with sovereign lending. After a hiatus of several years, however, the protracted debt problems of some euro zone members have reanimated the debate on sovereign debt restructuring. Underlying earlier discussions was a perception that the status quo increased costs on all parties:
- creditors are harmed by protracting negotiations, as asset values are dissipated by continuing uncertainty and possibly bad policies;
- the debtor is adversely affected, as growth falls, unemployment rises and support for sensible, sound economic policies erodes; and
- the IMF’s credibility and effectiveness in assisting its members strike a judicious balance between financing and adjustment are impaired.
A better framework for restructuring that reduces the protracted nature of the renegotiation process, returns the country to a sustainable growth path sooner and preserves the bonding role of debt could reduce these deadweight losses.
At the same time, a key factor behind efforts to develop a better framework for the timely, orderly restructuring of sovereign debt was the recognition that how restructurings are managed ex post will affect creditor and debtor behavior ex ante. In this respect, such a framework would help finesse the dynamic inconsistency problem confronting the Fund once it is realized that a member has slipped from sustainability to un-sustainability. Absent some framework that contains the cost of saying “no” to more financing, efforts to avoid countries “gambling for redemption” on IMF resources will not be credible; if these efforts are not credible, they will not affect behaviour.
Then, as now, opinion is divided on the question of voluntary versus statutory. To some extent, this may be a false dichotomy — the fundamental objective is to reduce deadweight losses while preserving the bonding role of debt, not how it is secured. In this respect, the key objective of a well-designed domestic bankruptcy regime is to assuage coordination problems and promote wealth maximization by:
- debt discharge to avoid the perverse incentives created by a debt overhang;
- limiting asset seizures and creditor runs in the restructuring process and preserving asset values; and
- reducing the scope for rogue creditors, or less pejoratively, “opportunistic behaviour,” to disrupt restructurings broadly acceptable to the (super) majority of creditors.
At the domestic level, the first of these is determined by a disinterested judge that balances the interests of all stakeholders as well as the public interest, writ large. At the sovereign level, absent some formal international bankruptcy court, the equivalent of debt discharge is determined by bargaining between the creditors and the debtor over the size of prospective "haircuts" or reductions in net present value of the debt. The key issues here are debt sustainability assessments and the degree of fiscal adjustment that can be sustained over time. Of course, views on these issues differ between creditors and the debtor creating the potential for protracted disputes that can delay needed reforms and dissipate asset values. In theory, the IMF can play the role of disinterested third party providing advice on these matters. Yet, as the size of crises has increased and scope of IMF programs have grown, concerns have emerged that it can no longer provide unbiased estimates of the feasible adjustment effort that heavily indebted borrowers can sustain. The potential for the IMF’s preferred creditor status to result in a subordination of private claims heightens these concerns.
Under most domestic bankruptcy regimes, the second objective is enforced through a court-sanctioned stay on proceedings and debtor-in-possession (DIP) financing which accords priority to new lending to a firm undergoing a court-supervised restructuring. In a sense, for the creditor, the quid pro quo to the creditor is the breathing space provided to the debtor to reorganize and propose an orderly restructuring; similarly, while new lending under DIP financing enjoys priority, it helps preserve the asset values of all creditors by, for example, keeping the firm in operation. At the international level, a sovereign can invoke force majeure to impose a standstill through a suspension of payments. The issue is whether there are efficiency gains from either embedding standstills in debt contracts (a “voluntary” approach) or, alternatively, creating a framework for the international endorsement of standstill to signal when a country is seeking a breathing space to identify and implement policy reforms that “grow the pie” to the benefit of all. Meanwhile, the IMF can be thought of as the analog of DIP financing for sovereigns, notwithstanding the concerns raised by private creditors, as the IMF extends support only if the member is already confronting severe financial difficulties; its support is intended to stabilize the situation to the benefit of all creditors.
The third key objective of sound bankruptcy frameworks is achieved through court-administered cram down provisions that prevent a small minority of creditors from blocking a restructuring plan that is supported by most creditors. A decade ago, the prevailing view was that coordination problems with respect to bonded debt held by a large, heterogeneous bondholder community would pose an impassible obstacle to timely, orderly restructuring. The SDRM therefore sought to replicate key features of domestic practice. The decision to defer further work on the SDRM shifted efforts to promote timely, orderly restructurings focused on the adoption of collective action clauses and voluntary codes of behaviour governing the restructuring process. And while CACs have now largely become “boiler plate” in most bond issues, they are subject to a number of limitations, notwithstanding the innovative approaches developed by legal practitioners. Most important of these obstacles is the problem of aggregation in which coordination problems across individual bond issues, all of which have CACs and the requisite super-majorities, can block a restructuring plan across the universe of outstanding claims: even if you are prepared to accept a write down on your bond, you are loath to do so if individuals holding other bonds refuse to do likewise.
More generally, it is probable that, to get timely, orderly voluntary restructurings, there has to be a credible threat of involuntary solutions — either by force majeure by sovereign borrowers or through some framework of rules. The domestic analog 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, 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 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 asset values are dissipated in staking out 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.
Objectives for the Panel
Viewed through this lens, the issue can be framed in terms of how best to replicate the outcome of well-functioning domestic bankruptcy regimes that balance the need to secure timely, orderly restructuring of sovereign debt and the importance of preserving the bonding role of debt. Ideally, the panel discussion will identify specific, concrete measures to advance that goal. Doing so would help promote the international adjustment process and sustain the broad consensus in favour of the open, dynamic international trade and payments system that has been the wellspring of development for millions around the globe and the source of hope for millions more.
For a complete list of CIGI's work on sovereign debt restructuring, please visit:
Declan Kelly, Communications Specialist, CIGI
Tel: 519.885.2444, ext. 7356, Email: [email protected]