Sovereign Debt Restructuring Mechanisms
The Economist misses my ex-roommate Andrei Shleifer's point about the need for caution in constructing a "Sovereign Debt Restructuring Mechanism" [SDRM]. The Economist writes:
As things stand, creditors are clearly poorly protected. Emerging-economy bond markets have been characterised by high interest rates, overborrowing and frequent, painful defaults. But would the IMF's [SDRM] proposals improve the situation? In a new paper*, Andrei Shleifer, an economist at Harvard University, argues that they would not. He says that the SDRM selectively apes those aspects of American bankruptcy law that are kind to debtors, although domestic bond restructurings are legally required to be done "in the best interest of the creditors". For instance, a procedure that allowed a defaulting sovereign debtor to issue new bonds would, Mr Shleifer argues, remove the most powerful deterrent to default, lack of access to foreign capital.
The IMF replies that its proposal--at least in the latest of its several incarnations--does not weaken creditors' rights. It merely provides a legal framework within which a majority of creditors can restructure a country's debt. This strengthens the rights of the majority of bondholders at the expense of individual dissenters, but it does not reduce the rights of creditors overall. Indeed, says the IMF, bondholders should benefit from making defaults less costly to work out, because the value of bonds would fall by less when defaults happen. Unlike a domestic bankruptcy court, all big decisions under the SDRM would be made by creditors, not by a bankruptcy judge. A defaulting country would need the agreement of creditors to gain access to new private finance. The IMF itself would play virtually no part.
Taking today's plan at face value, it is hard to see what all the fuss is about. Yes, it would allow a majority of creditors to coerce a minority, but overall control of the procedure remains with the creditors; and, by speeding up default work-outs, it might help dud bonds to keep more of their value. The process of dealing with debtors in default would not change radically.
Andrei's point is that debt markets--at least debt markets in which borrowers are sophisticated and well-informed--have historically worked best where default has been rare and has involved the lowest possible loss for the creditors. Markets in which creditors sleep easily are those in which interest rates are lowest and the volume of borrowing highest:
...the stronger are creditor rights in the event of a default, the better developed are the debt markets. In the case of personal bankruptcy, creditor rights differ across the U.S. states. Some states have a much larger personal exemption--the assets beyond the reach of creditors in the event of personal bankruptcy--than do others. The available evidence shows that, looking across states, higher exemptions reduce the amount of credit available to low asset households (Gropp, Scholtz and White 1997), raise the costs and reduce the availability of mortgages (Lin and White 2001), and reduce small firms’ access to credit (Berkowitz and White 2002). La Porta et al. (1997, 1998) examine the relationship between creditor rights and the size of debt markets in 49 countries.... [C]ountries with stronger creditor rights have larger debt markets (see also Stulz and Williamson 2002). The evidence also shows that greater legal shareholder rights are associated with broader and more valuable equity markets. The few existing municipal bankruptcies illustrate a similar pattern. Courts expect creditors to be repaid, and generally speaking, they are repaid in full or nearly in full, and with only a short delay. This is done through municipal tax increases, expenditure cuts, as well as assistance from state governments in the form of cash or guarantees of long term bonds. Because they know they have to repay, municipalities borrow moderately, and lenders provide funds at low rates. There is even insurance against municipal default, pointing to the insignificance of moral hazard problems. In light of the evidence, the answer to Summers’s question is straightforward: the municipal bond market in the U.S. functions so well, with low spreads and few defaults, because creditors’ rights are sufficient to get paid in full after a default.
If one starts out from this perspective, SDRM proposals must successfully answer "yes" to two questions:
- Does it lead to a better resolution in cases where there is reason to think that debtors were poorly-informed, or that those who did the borrowing should not have had the authority to bind the nation, or that payback would place an extraordinarily undue and unfair burden on the borrowing country?
- Does it lead creditors to sleep more easily?
As Shleifer puts it:
In making reform proposals, the IMF has two admirable objectives. The first is for sovereign states to be able to borrow at low rates in private international markets to finance their development. The second is for sovereign states not to pay their creditors back... during... economic distress. The tension between these objectives explains the challenges of reform.
The IMF argues that its SDRM proposals would help creditors to sleep more easily by assuring them that one single truculent bond-holder can no longer block a restructuring that is approved by a majority of creditors. Shleifer worries that:
...the crucial--and most neglected--feature of the IMF proposal is a radical increase of lending into arrears. The development objective here is clear and laudable: such borrowing can finance exports and deficit spending and thereby relieve economic hardship. But... this reform... eliminat[es] the crucial carrot that allows recovery by creditors. If the country can borrow fresh funds without repaying old debt, it has no incentive to pay creditors anything, and in fact has every reason to remain in "sovereign bankruptcy" forever. The crucial features of U.S. Chapter 11 which counterbalance borrowing in arrears--the threats of liquidation or of acceptance of the creditors’ reorganization plan by the judge--do not exist for sovereign debt.... [W]ith the possibility of continued borrowing senior to the old loans, there is no reason to repay. And with no reason to repay, there is no sovereign debt market in the long run. In summary, all the proposals by the IMF share a common element: they reduce creditor rights... [and so] serve the admirable goal of reducing the burden of default.... Yet by cherry-picking the features of Chapter 11 most favorable to creditors, these proposals ignore the delicate balance between debtor protections and creditor rights that exists in both Chapter 11 and Chapter 9...
Instead, Andrei wants to see:
- "[C]ollateralized lending... expanded even in emerging markets. Countries can pledge their natural resource export revenues.... Mexico successfully pledged a portion of its oil revenues to the United States during the 1995 rescue,
and there is no reason why this experience could not become more common." - "[S]ecurities whose returns are linked to commodity prices or economic performance. Such equity-like securities would require lower payment during economic hardship, and higher payments in times of prosperity. They would avoid
many of the problems of self-fulfilling crises that the IMF is concerned with." - "[B]bankruptcy procedures [genuinely] similar to Chapter 9 or 11... includ[ing] collective action clauses and lending into arrears... [but] counterbalanced by... the presence of a court with power to enforce its decisions and a duty to find solutions that best serve the interests of creditors."
Economics focus
A better way to go bust
From The Economist print edition
Would new rules for sovereign defaults help the emerging-economy bond market?
THE market for emerging-economy government bonds is a shadow of its former self, and likely to remain so. In 1990, such governments raised a net $23 billion of private capital from issues of medium- and long-term bonds. In 1997, at the peak of the emerging-market boom, $88 billion flowed in. But last year, says the Institute of International Finance, a bankers' group in Washington, DC, the flow had slowed to $12 billion. The IIF does not expect 2003 to be much different.
Uncertainty about the world economy obviously plays a leading part in any explanation of why inflows have shrunk so much. In addition, investors are less starry-eyed than they were a few years ago, having suffered big losses in successive financial crises, from East Asia to Russia to Argentina. However, many bankers say a third problem is making matters worse: the International Monetary Fund's attempt to create new rules for dealing with countries that cannot pay their debts.
Just over a year ago, Anne Krueger, number two at the IMF, proposed amending the organisation's rules to create an orderly procedure for restructuring a bankrupt country's debts. Inspired by Argentina's spectacular collapse, Ms Krueger suggested creating a "sovereign debt restructuring mechanism" (SDRM), in order to make defaults less painful and messy.
The basic idea sounds sensible enough: to mimic some features of domestic corporate-bankruptcy rules. Just as American bankruptcy law has a "cram-down" provision that forces the terms of a restructuring on all creditors, so the SDRM would allow a majority of creditors to force a minority to accept a plan. At present, the restructuring of most sovereign bonds requires unanimity among bondholders. Conceivably, the SDRM could sanction a standstill on debt payments, as domestic bankruptcy law does, and allow countries that have defaulted to issue new senior debt, as firms in Chapter 11 can. Intrigued by the idea, if not convinced, the rich-country governments that control the IMF have asked for a detailed proposal by April.
However most financiers, whether bankers or bondholders, loathe the SDRM. Their main concern is that it would erode their rights as creditors, make defaults easier and more frequent, and as a result dry up the market for emerging-market bonds. Fearing higher interest rates and scarcer access to capital, many emerging-market governments have also criticised the plan. Partly as a result of this outcry from financiers and borrowers, America's government, whose support will be essential if the IMF is to change its rules, has grown more sceptical in recent months.
The concern over creditor rights is not irrational. Compared with creditors in most other markets, holders of sovereign bonds already have weak rights. It is hard, if not impossible, to grab assets when a sovereign borrower defaults. There is no international legal framework that can force a change of management (ie, throw out the government) when a badly run country goes bust. Instead, creditors rely on two levers. First, they can hassle a defaulting government by taking it to (a foreign) court. Second, a defaulting government will find it hard to regain access to international capital markets. Rather than gain a bad reputation, borrowers try hard to avoid going bust.
As things stand, creditors are clearly poorly protected. Emerging-economy bond markets have been characterised by high interest rates, overborrowing and frequent, painful defaults. But would the IMF's proposals improve the situation? In a new paper*, Andrei Shleifer, an economist at Harvard University, argues that they would not. He says that the SDRM selectively apes those aspects of American bankruptcy law that are kind to debtors, although domestic bond restructurings are legally required to be done "in the best interest of the creditors". For instance, a procedure that allowed a defaulting sovereign debtor to issue new bonds would, Mr Shleifer argues, remove the most powerful deterrent to default, lack of access to foreign capital.
The IMF replies that its proposal--at least in the latest of its several incarnations--does not weaken creditors' rights. It merely provides a legal framework within which a majority of creditors can restructure a country's debt. This strengthens the rights of the majority of bondholders at the expense of individual dissenters, but it does not reduce the rights of creditors overall. Indeed, says the IMF, bondholders should benefit from making defaults less costly to work out, because the value of bonds would fall by less when defaults happen. Unlike a domestic bankruptcy court, all big decisions under the SDRM would be made by creditors, not by a bankruptcy judge. A defaulting country would need the agreement of creditors to gain access to new private finance. The IMF itself would play virtually no part.
Taking today's plan at face value, it is hard to see what all the fuss is about. Yes, it would allow a majority of creditors to coerce a minority, but overall control of the procedure remains with the creditors; and, by speeding up default work-outs, it might help dud bonds to keep more of their value. The process of dealing with debtors in default would not change radically.
The underlying problem is suspicion: bankers, bondholders and many emerging-market borrowers worry that the IMF has a hidden agenda. The IMF could use the SDRM, once it is in place, as an excuse to trim official bail-outs, by demanding that private creditors take more of the strain when governments run into trouble. Another fear is that, whatever the rules of the SDRM are on paper, in reality politics will still trample on creditors' rights. That, argue the financiers, would be so disastrous that the mere threat of it is dampening sovereign-debt markets today.
* "Will the Sovereign Debt Market Survive?" Available on the internet at http://post.economics.harvard.edu/faculty/shleifer/papers/debt_NBER.pdf.
Posted by DeLong at February 06, 2003 04:54 PM | Trackback