1
FixingSovereignDebtRestructuring1
July,2015
MartinGuzman2andJosephE.Stiglitz3
Abstract
Recent controversies surrounding sovereign debt restructurings show the
weaknesses of the current market‐based system in achieving efficient and fair
solutions to sovereign debt crises. This article reviews the existing problems and
proposessolutions.Itarguesthatimprovementsinthelanguageofcontracts,although
beneficial, cannot provide a comprehensive, efficient, and equitable solution to theproblemsfacedinrestructurings—butthereareimprovementswithinthecontractualapproachthatshouldbe implemented.Ultimately, thecontractualapproachmustbecomplemented by a multinational legal framework that facilitates restructuringsbasedonprinciplesofefficiencyandequity.Giventhecurrentgeopoliticalconstraints,intheshort‐runweadvocatetheimplementationofa“softlaw”approach,builtontherecognition of the limitations of the private contractual approach and on a set ofprinciples –most importantly, the restoration of sovereign immunity – overwhichtheremaybeconsensus.Wesuggestthatinacontextofpoliticaleconomytensionsitshouldbeimpossibleforagovernmenttosignawaythesovereignimmunityeitherfor
itself or successor governments.The framework couldbe implemented through theUnitedNations,oritcouldpromptthecreationofanewinstitution.
Keywords: Sovereign Debt Crises, Sovereign Debt Restructuring, InternationalLending
JELCodes:F34,G33,H63,K12,K33
1WeareindebtedtoSebastianCeria,RichardConn,MatthiasGoldman,DanielHeymann,BrettHouse,Kunibert Raffer, Sebastian Soler, participants of the Conference on “Frameworks for SovereignDebtRestructuring”atColumbiaUniversity,theECON2014ForumatUniversityofBuenosAires,theRIDGEForumonFinancialCrisesatCentralBankofUruguay,theFirstSessionoftheAdHocCommitteeoftheUnitedNationsGeneralAssemblyonaMultilateralLegalFrameworkforSovereignDebtRestructuring,andseminarparticipantsatJaverianaUniversity(Bogota),theCentralBankofArgentina,theUNCTADConferenceon“LegalFrameworkforDebtRestructuringProcesses:OptionsandElements”atColumbiaUniversity,theINETAnnualConferenceatOECD,theResearchConsortiumforSystemicRiskMeetingatMIT, and the International Instituteof Social Studies inTheHague foruseful comments,discussions,andsuggestions.WearegratefultotheFordandMacarthurFoundationsforsupporttotheRoosevelt‐IPD Inequality Project, and the Institute for New Economic Thinking for financial support, and toDebaratiGhoshandInesLeeforresearchassistance.2ColumbiaUniversityGSB,DepartmentofEconomicsandFinance.3ColumbiaUniversity,UniversityProfessor.
2
Keywords:DebtCrises,SovereignDebtRestructuring,DebtContracts,Bankruptcy
1. Introduction
Debt matters. In recessions, high uncertainty discourages private spending,
weakening demand. Resolving the problem of insufficient demand requires
expansionarymacroeconomicpolicies.But“excessive”publicdebtmayconstrainthe
capacityforrunningexpansionarypolicies.4Evidenceshowsthathighpublicdebtalso
exacerbates the effectsofprivate sectordeleveragingafter crises, leading todeeper
andmoreprolongedeconomicdepressions(Jorda,Schularick,andTaylor,2013).
Evenifprogramsoftemporaryassistance,e.g. fromtheIMF,makefullrepaymentofwhatisowedpossibleinthosesituations,doingsocouldonlymakemattersworse.Iftheassistanceisaccompaniedbyausteritymeasures,itwouldaggravatetheeconomicsituationofthedebtor.56
4Itisnothighdebtpersethatisbadforeconomicgrowthorfullemployment,ascarelessstudiesthathadbeeninfluentialinthepolicydebatehavesuggested(ReinhartandRogoff,2010;see,inparticular,theimportantcritiqueofHerndon,Ash,andPollin,2014).Indeed,standardgeneralequilibriumtheoryargues that there is a full employment equilibrium regardless of the level of debt (Stiglitz, 2014).Instead, it is the difficulty of running expansionary macro policies when primary surpluses areallocatedtodebtpayments intimesofrecessions(whichare indeedoftenassociatedwithhighdebt)whatmakesdebtaconstraintforeconomicrecovery.Notetoothateventhen,itisnotonlytheeconomicconstraintswhichmatter,butthosearisingoutofpolitical economy—a political economy which itself is affected by the largely ideological researchreferred to in the previous paragraph. In particular, for countries like the United States which canborrowevennowatanegativereal interestrate—andborrowedatvery lowreal interestratesevenwhen its debt to GDP ratio was in excess of 130%—borrowing for public investments that yieldsignificantlyhigherreturnsthanthecostofcapitalcanimprovethenation’sbalancesheet.5The only situation inwhich the temporary assistance (“bail‐out”)mightmake sense is if there is aliquiditycrisis,e.g.marketsareirrationallypessimisticaboutthecountry’sprospects,withtheevidencethattheyarewrongexpectedtoberevealedinthenot‐too‐distantfuture.Butitisironicthatthoseinthe financialmarketwhichnormallyprofesssuchfaith inmarketssuddenlyabandonthat faithwhenmarketsturnskepticalonthem;andthatatthatpoint,theyseemwillingtorelyonthejudgmentofagovernment bureaucrat or an international civil servant over that of the market. There are otherirrationalitiesimplicitinthesearguments:itissometimessuggestedthatiftheinterventionstabilizes,say,theexchangerate,thatwillrestoreconfidenceandpreventcontagion. ButifitisknownthatthereasonthattheexchangeratehasbeenstabilizedisthattherehasbeenIMFintervention,whyshouldthestabilizationoftheexchangeratechangebeliefs,andespeciallysoiftheinterventionisannouncedto be short term? And if there are reasons to believe that the IMF would not intervene in othercountries(e.g.becausetheyare lesssystematically importantor lesspoliticallyconnected), thenwhyshould the intervention in one country change beliefs about the equilibrium exchange rate in theothers?Itisevenpossiblethatitcouldhaveadverseeffects(Stiglitz,1998).6Evenifthefundswereofferedwithoutsuchconditions,totheextentthatthefundsarenotusedforaddressingthefundamentalproblemsthatmakedebtsunsustainable,thecountrywouldbeworseoffoverthelongrununlesstherewascommitmenttoprovidethesefundsindefinitely—whichisineffectequivalenttoadebtwrite‐off.
3
Distresseddebtors need a fresh start, not just temporary assistances. This is in the
best interestofthedebtorandthemajorityof itscreditors:Precludingarapidfresh
start for the debtor leads to large negative sum games, where the debtor cannot
recoverandcreditorscannotbenefit fromthe largercapacityof repayment that the
recoverywouldimply.
Lackof clarity for resolving situations inwhicha firmor a country cannotmeet its
obligationscanleadtochaos.Therecanbeextendedperiodsoftimeduringwhichthe
claimsarenotresolved,inwhichbusiness(eitherofthefirmorthecountry)cannot
proceed—oratleastproceedinthemostdesirableway.Inthemeantime,assetsmay
be tunneledoutof the firmor country, or at thevery least, productive investments
thatwouldenhancethevalueofthehumanandphysicalassetsarenotmade.
Within a country, bankruptcy laws are designed to prevent this chaos, ensuring anorderly restructuring and discharge of debts. They establish how restructuringwillproceed, who will get paid first, what plans the debtor will implement, who willcontrol the firm, etc.Bankruptcies are typically resolved throughbargaining amongtheclaimants,butwiththebackdropofa legal framework,andwitha judiciarythatwilldecidewhateachpartywillget,basedonwell‐definedprinciples.
Bankruptcy laws thus protect corporations and their creditors, facilitating theprocessesofdebtrestructuring.Amoreorderlyprocessnotonlylowerstransactions
costs,butavoidsthedeadweightlossesassociatedwithdisorderlyprocesses;indoingso,itmayevenlowerthecostofborrowing.
Goodbankruptcy laws facilitate efficient and equitable outcomes in otherways; forinstance,inencouraginglenderstoundertakeadequateduediligencebeforemakingaloan.
Thebenefitsofalegalframeworkprovidingfororderlydebtrestructuringhavealsobeenextendedtopublicbodies,forinstancethroughChapter9oftheU.S.bankruptcy
code.
Butthereisnocomprehensiveinternationalbankruptcyproceduretoensureproperresolution of sovereign debt crises. Instead, the current system for sovereign debt
restructuring(SDR)featuresadecentralizedmarket‐basedprocess,wherethedebtor
engagesinintricateandcomplicatednegotiationswithmanycreditors,withdifferent
interests,oftenunderthebackdropofconflictingnationallegalregimes.Outcomesareoftendeterminedonthebasisnotofprinciples,butofeconomicpower—oftenunder
the backdrop of political power. Restructurings come too little, too late. And when
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theycome,theymaytaketoolong.7Thelackofaruleoflawleadstoex‐anteandex‐
post inefficiencies,andinequitiesbothamongcreditorsandbetweenthedebtorand
itscreditors.
Furthermore,unlikedomesticbankruptcies, sovereignbankruptcynegotiations take
place inanambiguous legalcontext.Severaldifferent jurisdictions,allwithdifferent
perspectives, influence the process. Different legal orders often reach different
conclusionsforthesameproblem.Itmaynotbeclearwhichwillprevail(andpossibly
none of them would prevail), and how the implicit bargaining among different
countries’judiciarieswillberesolved.
Atthetimewewritethisarticle,eventsaremakingthereformoftheframeworksfor
SDR a major issue. Countries in desperate need of addressing profound debtsustainabilityissues,likeGreeceatthemoment,areconfrontingtherisksofachaoticrestructuringandthisdiscouragesthemfromundertakingtherestructuringsthatarenowrecognizedasdesirable,oreveninevitable.
Besides, thegaps in the legaland financial internationalarchitecture favorbehaviorthat severelydistorts theworkingsof sovereign lendingmarkets.Theemergenceofvulturefunds—investorsthatbuydefaulteddebtonthecheapandlitigateagainsttheissuer,demandingfullpaymentanddisruptingthewholerestructuringprocess—asrecentlyseeninthecaseofArgentinerestructuring,isasymptomofaflawedmarket‐
basedapproachfordebtcrises’resolution.
Recent decisions8have also highlighted the previously noted interplay amongmultiple jurisdictions, none of which seems willing to cede the right to adjudicaterestructuringtotheothers(GuzmanandStiglitz,2015b).
Thereisconsensusonthenecessityofmovingtoadifferentframework,buttherearedifferentviewsonthetableabouthowtomoveforward.
TheInternationalMonetaryFund(IMF)andthefinancialcommunityrepresentedby
theInternationalCapitalMarketAssociation(ICMA)recognizethatthecurrentsystem
7Andwhen they do not take too long, theymay not achieve the objectives of restructuring thatwedefine in section 2. This is the case of the Greek debt restructuring in 2012. The dealwasmostly asocializationofbanks’debtsthatwasnotconducivetotherecoveryoftheeconomy.Threeyearslater,the country is still suffering an even worse depression: GDP has fallen by 25 percent since thebeginning of the recession, and the unemployment rate is above 25 percent in January 2015 (asreportedbyHellenicStatisticalAuthority‐LaborForceSurvey,2015).8Where anAmerican court seeminglyhas takenanaction affectingpaymentsonArgentineanbondsissued in other jurisdictions, such as the UK, and a British Court has ruled that they cannot do so(EnglandandWalesHighCourt(ChanceryDivision)Decisions,CaseNo:HC‐2014‐000704).
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doesnotworkwell(ICMA,2014;IMF,2014).Theyareproposingmodificationsinthe
language of contracts, such as a better design of collective action clauses and
clarificationofparipassu—astandardcontractualclausethat issupposedtoensure
fairtreatmentofdifferentcreditors.Theseproposalsareimprovementsovertheold
terms, but they are still insufficient to solve the variety of problems faced in SDRs.
Anditisalmostsurelythecasethatnewproblemswillarise—someanticipated,some
not—withinthenewcontractualarrangements.
On the other hand, a large group of countries is supporting the creation of a
multinational legal framework, as reflected in Resolution 11,542 of the General
AssemblyoftheUnitedNationsofSeptember2014,thatwasoverwhelminglypassed
(by 124 votes to 11, with 41 abstentions).9The framework should complementcontracts, putting in placemechanisms that would establish how to solve disputesfairly.Building itonaconsensualbasiswillbeessential for its success.This in turnrequiresfulfillingasetofprinciplesoverwhichthedifferentparties involvedwouldagreeon,anissuethatweanalyzeinthisarticle.
While,aswehavenoted,theimportanceoftheabsenceofanadequatemechanismforsovereign debt restructuring has long been noted (see also Stiglitz, 2006), fivechangeshavehelpedtobringtheissuetotheforeandmotivatetheglobalmovementfor reformof existingarrangements: (a)Onceagain,manycountries seem likely to
faceaproblemofdebtburdensbeyondtheirabilitytopay;(b)courtrulingsintheUSand UK have highlighted the incoherence of the current system and made debtrestructurings,at least insome jurisdictions,moredifficult ifnot impossible; (c) themovementofdebtfrombankstocapitalmarketshasgreatlyincreasedthedifficultiesofdebtrenegotiations,withsomanycreditorswithoftenconflicting interestsat thetable;(d)thedevelopmentofcreditdefaultswops(CDSs)—financialinstrumentsfor
shiftingrisk—hasmeantthattheeconomicinterestsofthoseatthebargainingtable
mayactuallybeadvancedifthereisnoresolution;and(e)thegrowthofthevulturefunds,whosebusinessmodelentailsholdingoutonsettlementandusinglitigationto
getforthemselvespaymentsthataregreaterthantheoriginalpurchasepriceandof
thosethatwillbereceivedbythecreditorswhoagreedtodebtrestructuring,hasalso
9Thisisnotthefirstattempttoimplementaframeworkofthisnature.TheIMFhadcalledfortheimplementationofaSovereignDebtRestructuringMechanism(Krueger,2001;althoughtheIMFExecutiveBoardwouldhavedeterminedsustainabilityandjudgedontheadequacyofthedebtor’seconomicpolicies),andthereportoftheInternationalCommissionofExpertsoftheInternationalMonetaryandFinancialSystemappointedbythePresidentoftheGeneralAssemblyoftheUnitedNationshadpointedoutthenecessityofexploringenhancedapproachesfortherestructuringofsovereigndebt(Stiglitzetal.,2010).
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made debt restructurings, under existing institutional arrangements, much more
difficult.10
The restof thepaper is organizedas follows: Section2dealswith theobjectivesof
restructuring. Section 3 describes the current problems. Section 4 describes the
solution proposed by the ICMA and the IMF, and section 5 analyzes its limitations.
Section 6 discusses a set of further reforms that could be implemented within the
contractualapproach.Section7outlinestheprinciplesthatshouldguidethecreation
ofamultinationalformalframeworkforSDR.Section8concludes.
2. Theobjectivesofrestructuring
In absence of information asymmetries and contracting costs, risk‐sharing (equity)contracts would be optimal; there would be no bankruptcy. But under imperfectinformationandcostlystateverification,completerisksharingissuboptimal,andtheoptimalcontractisadebtcontract(Townsend,1979).11
Informationasymmetriesandcostlymonitoringcharacterize theworldof sovereignlending,which explains thewidespread utilization of sovereign debt contracts. Theoptimaldebtcontractmaybeassociatedwithpartialrisksharing,includingdefaultinbadstatesandacompensationfordefaultriskintheformofahigher(thantherisk‐free)interestrateingoodstates.
If default were never possible, the borrower would absorb all the risk. Under theassumptionsof risk‐neutral lenderswho candiversify theirportfolios in aperfectlycompetitiveenvironment,theexpectedutilityofeachlender(whoiscompensatedfortheopportunitycost)12wouldbethesame,buttheborrower’swouldbelowerthanitwouldbewithgoodrisksharingcontracts.Moreover,ifthepossibilityofdefaultwere
ruledoutineverystateofnature(forinstancethroughsufficientlyhighpenalizationof
default),theamountoflendingwouldbeseverelylimited.
10Below,wewillexplainsomeofthereasonsforthegrowthofvulturefunds.11In private debtmarkets, other considerations relating to adverse selection andmoral hazard alsomilitate for at least some reliance on debt. See, e.g. Stiglitz (1985). The problems of costly stateenforcementforsovereigndebtmarketshave,wethink,beengreatlyexaggerated,andtherehavebeenseveralimportantproposalsforsuchbonds.(ArgentinaactuallyintroducedGDPlinkedbondsaspartofitsdebtrestructuring.)12Thiswouldbeeven true if lenderswere riskaverseandmarketshighly competitive. Under theseassumptions,eachlenderwouldreceivethecertaintyequivalentreturnfromeachoftheirinvestments.Thoughsuchanassumptiondominateswithinthefinanceliterature,therearereasonstobeskeptical.Still,theconclusionthatforcingtheborrowertoabsorballtheriskisnotefficientholds.
7
The probability of entering into situations of debt distress depends on a variety of
economic conditions13but alsoon the actionsof thedebtor.14Andonce thedistress
arises,thedebtor’scapacityofproductionandrepaymentgoingforwardwilldepend
onhowthedebtsituationisresolved.Ifthedebtordefaults,shenormallylosesaccess
tocreditmarketsuntilarestructuringagreementisreached.15
Themechanismsinplacefordebtrestructuringdeterminehowallthesetensionsare
resolved.Agoodsystemshould incentivize lendersanddebtorstobehaveinaways
that are conducive to efficiency ex‐ante (i.e. the “right” decisions at themoment of
lending) and ex‐post (i.e. at the moment of resolving a debt crisis). It should also
ensureafairtreatmentofallthepartiesinvolved.
2.1. Efficiencyissues
A system thatmakes restructurings too costly induces political leaders to postponethe reckoning.When there are nomechanisms in place that would ensure orderlyrestructurings,theperceivedcostsofdefaulttothepartyinpowerbecometoolarge.Therefore, “gambling for resurrection”, delaying the recognition of debtunsustainability,maybetheoptimalstrategyforthedebtor.
Delays are inefficient. Theymake recessionsmore persistent and decrease what isavailableforcreditorsifadefaultoccurs.16Inthepresenceofcross‐bordercontagion,
furthermore,thedelayiscostlynotonlytothegivencountry,buttothosewithwhichithaseconomicrelations(OrszagandStiglitz,2002).
Theobjectiveoftherestructuringprocessitselfmustnotbetomaximizetheflowsofcapitalortominimizeshort‐terminterestrates.Instead,theframeworkshouldensureoveralleconomicefficiency,acriticalfeatureofwhichisex‐postefficiency inabroader
sense:itshouldprovidetheconditionsforarapidandsustainedeconomicrecovery.A
13Importantly, italsodependsonthediscrepancybetweentheexpectationsonthefuturecapacityofrepaymentandtherealizationsthatdeterminetheactualcapacityofrepayment.SeeGuzman(2014).14Thenatureofthedistressalsodependsonactionsofthecreditors,i.e.theirwillingnesstorollover.15Thereissomecontroversyoverwhetheraftertheresolutionofthedebtthereisastigmathatmakesitmoredifficult for theborrower toborrow. There is theory (and someevidence) thatmarketsareforwardlooking, inferthatthecostofbankruptcyissufficientlyhighthatfewifanycountriesgointodefault if theycanavoidit—andthatthereforethereisnoinferenceofaflawed“charactertrait”thatcan bemade from a default; as a result of the cleaning of balance sheets, at least following a deeprestructuring,therewillbemoreaccesstocreditmarkets. Russia’s1998defaultfallsintothismodel.SeeStiglitz(2010).16That is, there are both macro‐inefficiencies and micro‐inefficiencies. In the chaos surroundingdisorderly debt distress situations, assets typically do not get used in the most efficient way, andcomplementaryinvestmentstothoseassetsarenotundertaken.
8
systemoforderlydischargeofdebtswouldpermitthedebtortomakeamoreefficient
use of its resources, whichmay be in the best interest both of the debtor and the
creditors. Normally,contractualandjudicialarrangementsshouldsupportthiskind
ofexpostefficiencythatisnecessaryforachievingParetoefficiency.17
Acuriousfeatureofthecurrentrestructuringprocessisthatcountriesthatareinthe
process of restructuring typically face massive underutilization of their resources.
This is because such countries cannot get access to external resources; financial
markets often become very dysfunctional in the midst of a crisis, with adverse
implicationsforbothaggregatedemandandsupply.Creditors,focusingnarrowlyand
short‐sightedlyonrepaymentforceacutbackingovernmentexpenditures(austerity),
and the combination of financial constraints and decreases in private and publicdemandbringonamajor recessionordepression. Theywrongly reason that if thecountryisspendinglessonitself,ithasmoretospendonothers—torepayitsdebts.But they forget the large multipliers that prevail at such times: the cutbacks inexpenditure decrease GDP and tax revenues. The underutilization of the country’sresourcesmakes it more difficult for it to fulfill its debt obligations—the austeritypoliciesarenormallycounterproductiveevenfromthecreditors’perspective.
Anothercriticalfeatureisex‐anteefficiency.Asystemthatdoesnotputanyburdenonthe lenders ex‐post does not provide the right incentives for due diligence ex‐ante.
Selection of “good” borrowers requires in general specific actions from the lenders,suchasscreening(beforelending)andmonitoring(afterlending).Theexistenceofamechanismforsovereigndebtrestructuringwouldactasasignalthatmoneywillbelostunlessduediligenceisapplied.
Notethatgoodduediligencewillresultinbetterscreeningandlendingpractices,sothatinterestratesmayactuallybeloweredasaresultofbetterbankruptcylaws(that
is,morepunitivebankruptcyproceduresmaysoadverselyaffectlendermoralhazard
thatfinancialmarketsbecomemoredysfunctional).Thisisespeciallythecasewhen,
as now, large fractions of lending aremediated through capitalmarkets, not banks.
Arguably,thatwasoneoftheconsequencesofthepassageofthecreditor‐friendlyUSbankruptcy law reforms in 2005 (through the Bankruptcy Abuse Prevention and
17Itisimportanttorealizethatthenormalpresumptionthatmarketsontheirownareefficientfailsinthiscontextforalargenumberofreasons: thereareimperfectionsandasymmetriesandincompleteriskmarkets (and in such situations, there is a strong presumption that markets are not efficient).Moreover,thecontextinwhichwearemostconcerned—wherethereissignificantunderutilizationofresources—isoneagaininwhichthereisapresumptionofmarketinefficiency.Finally,thebargainingthat surrounds debt resolution is itself evidence of the absence of perfect competition, anotheressentialassumptionifmarketsaretobeefficient.See,e.g.GreenwaldandStiglitz(1986).
9
ConsumerProtectionAct)whichmadethedischargeofdebtmoredifficult,andledto
asubstantialincreaseinbadlendingpractices.
2.2. Equityissues
Theframeworkforrestructuringdeterminestheincentivesforcreditors’behavior.A
system that favors holdout behavior creates a perversemoral hazard problem that
makesrestructuringsmoredifficult–onoccasion,evenimpossible.
It also creates inter‐debtor inequities, as it increases the borrowing costs for those
debtorsthataremorelikelytoneedarestructuring(whichisbothanefficiencyand
an equity issue, as the lack of proper mechanisms affect all countries but moreseverely those that are riskier). Of course, debtors that aremore likely to defaultshouldpayahigherinterestrate.Theproblemisthatiftherestructuringmechanismisinefficient—asthecurrentsystemis—itover‐penalizestheseborrowers,andtheexpost inefficiencyalsogetstranslatedintoanexante inefficiency,astheunnecessarilyhighpenaltydiscouragesparticipationinthecreditmarket.
A flawedsystem like thecurrentone that reliesmoreonmechanisms for “bailouts”(as the European Stability Mechanism) instead of providing mechanisms forrestructuringalsocreateslargeinter‐creditorinequities,asonlythecreditorsthatgetpaid with the resources of the “bailouts” benefit, while the expected value of the
claimsof theotherclaimants(suchas thecreditorswhosedebtsmature ina longerterm, or the workers and pensioners whose wages depend on the capacity ofproduction of the economy that decreases precisely as the consequence of theausterityoftenassociatedwiththoseplans)decreases.
Finally, there is a problem of equity between formaland informalcreditors—those
whohaveacontractandthosewhosebenefitsarepartofasocialcontract.Thisisone
of the important ways in which sovereign debt is different from private debt.Typically, therearea largenumberofsuchclaimants—pensioners, thosedepending
onthegovernmentforhealthbenefitsoreducation,etc.ThoughChapter9oftheUS
bankruptcy code (pertaining to the bankruptcy of public bodies) recognizes theimportanceoftheseclaimants,intheabsenceofaninternationalruleoflawthatgives
suchclaimsformalrecognition,theirclaimsareatriskofbeingmadesubordinateto
those of the formal creditors. And the recognition that this is somay itself have a
distortingeffectontheeconomy:itmayencouragetheformalizationofsuchclaims,even when such formalization may result in socially undesirable rigidities and
undesirableinstitutionalarrangements.
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3. TheCurrentProblems
The current non‐system doesn’t achieve the described objectives of restructuring.
Instead, it creates a host of inequities as well as inefficiencies. It over‐penalizes
debtors indistress,causingdelays intherecognitionoftheproblems. It leadstothe
“too little, too late” syndrome. In some cases, there is too much lending—and too
muchsufferinglateron;inothercases,theremaybetoolittlelending.Moreover,the
legal frameworks permit a situation inwhich a few specialized agents (the vulture
funds)canblockthefinalizationofarestructuring,imposinglargecostsonthedebtor
andonothercreditors.Thissectiondescribesavarietyof factorsthatareleadingto
theseproblems.
Thevulturefunds
Restructurings involve a public good problem: each claimant wants to enjoy thebenefitofthecountry’sincreasedabilitytorepayfromdebtreduction,buteachwantstoberepaidinfull.
Theexistingframeworksfailtosolvethepublicgoodproblem.Instead,theyprovidethe conditions for the emergence of vulture funds. The vulture funds are a class ofholdouts thatarenotreally in thebusinessofprovidingcredit tocountries. Instead,
theyareengagedin“legalarbitrage”.Theirbusinessconsistsinbuyingdebtindefault(orabouttobeindefault)insecondarymarketsatafractionoftheirfacevalue.Then,theylitigateincourts,demandingfullpaymentontheprincipalplusinterest(typicallyat an interest rate thatalready includes compensation fordefault risk).Avictory incourtsbringsexorbitantreturnsontheinitialinvestment.
Their modus operandi relies on a legal framework that has weakened sovereignimmunity, and on a flawed design of contracts. They resort to activities (many of
whicharesociallyunproductive)toincreasetheirbargainingpowerandtoinfluence
thedecisionsoftheactorsinvolved—includinglobbyingandthreatsabouteconomic
and political consequences of a failure to reach a settlement satisfactory to the
creditors (some liken it to extortion) to affect the debtor’s behavior. Economic
"extortion" isespeciallyeffective in influencingcountriesneedingtore‐entercapital
markets,andpoliticalextortionisespeciallyeffectivetoinfluencegovernmentswhose
officialshavebeenengagedinillegalactivitiesorwhoaremotivatedbyaconcernover
their"standing"intheinternationalcommunity.
11
Their presence creates huge inefficiencies and inequities in sovereign lending
markets. It can even lead to the total impossibility of debt restructuring. Recent
events—in particular, the Argentine debt restructuring, which pitted the country
againstNMLCapital(asubsidiaryofthehedgefundElliottManagement)—showthat
these inefficiencies are amajor issue. In that case, the presiding U.S. federal judge,
Thomas Griesa, ruled in favor of the vulture funds and ordered an injunction that
obliged Argentina to make payments to vultures and the holders of bonds
denominated in foreign currency issued by Argentina in the 2005 and 2010 debt
exchanges on a ratable basis, i.e. an interpretation of pari passu that requires
Argentina to pay to the vulture funds their full judgment whenever it makes any
paymentundertheexchangebonds,evenifitisjustacouponpayment—orotherwise
any holder of exchange bonds would be barred from receiving payments. Theinjunctionwasbasedonapeculiarinterpretationofparipassu,18acontractualclausethatissupposedtoensureequaltreatmentamongequallyrankedcreditors.19
Thedesignofcontractsalsofacilitatestheemergenceofvulturefunds.Manyexistingdebt contracts do not have collective action clauses (CACs)—clauses that allow amajorityofbondholderstoagreetochangesinbondterms(forexampletoreducethevalueoftheprincipal)thatarelegallybindingtoallthebondholders,includingthosewhovoteagainsttherestructuring.Somecontractsdoincludethembutthemajority
isdefinedatthelevelofeachindividualbond.20
Under a unanimity rule, vulture funds can emerge easily.With CACs at the level ofeachsecurity,vultures’behaviorismoreconstrainedbutitisstillpossible.Theycanstillbuytheminimumfractionthatwouldblocktherestructuringofauniqueseriesofbonds,andbydoingsotheywouldbeabletoblockthewholerestructuring.
A formula for aggregation of CACs (over different classes of bonds), as the one
proposedbyICMA(seesection4),wouldalleviatetheseproblems.Butitraisesother
questions:howaredifferentbondstobeaddedtogetherforpurposesofvoting(how
18The judge's decision was peculiar in other ways: it forced the trust bank into which funds weredeposited to enforce his decision, i.e. the trustee was forbidden from distributing funds that it hadreceived on behalf of the restructured bonds. Thus, to enforce one contract, it had to break othercontractual arrangements. There seemed to be little rationale for the Courts decision about whichcontractstorespectandwhichtoabrogate.Thus,thedecisionwasnot(asithassometimesbeenput)aboutthesanctityofcontracts.19Theupshotisthatvulturefundsarepoisedtogetreturnsontheir“investments”morethanfivetimesgreaterthantheholdersoftheexchangebonds.20Inthe1990s,bondsissuedintheLondonmarketundertheEnglishlawcontainedCACs,whilebondsissuedintheNewYorkmarketunderthelawofthestateofNewYorkdidnot(EichengreenandMody,2003).Mexicowas the firstcountry toput theseclauses in itscontractsunder the jurisdictionof thestateofNewYorkin2003.
12
doweadjustfordifferencesinprioritiesandexchangerates)?Itisclearlyconceivable
thatamajorityofjuniorbondscouldvotetodeprivemoreseniorbondsofsomeofthe
returns that they might have expected, given their seniority. There may even be
ambiguity about which claimants should be included in the aggregation: should
domestic,andnotonlyforeign,claimantsbeincluded?.21
Clearly,theissuesfacedinSDRsgobeyondthedesignofCACs.Theseclausesareno
panacea. If they were, there would be no need for bankruptcy laws that spell out
issues likeprecedenceand fair treatment.Evidenceshows thatnocountryhasrelied
onmarkets tosolvebankruptcies. Every country has a bankruptcy law. Theory also
shows that under realistic conditions markets are not able to provide efficient
restructuringson their own, as they areunable to reach efficient solutionson theirowningeneral,exceptunderveryrestrictiveandunlikelyconditions(GreenwaldandStiglitz, 1986). 22 There are important market failures that are present inrestructurings–eitherforcorporationsorforsovereigns.
WeakeningofsovereignimmunityandtheChampertydefense
The evolution of the legal frameworks has been instrumental for the emergence ofvulturesand thedebilitationof sovereign immunity. Sovereign immunityhad firstlybeen challenged with the sanction of the Foreign Sovereign Immunity Act in 1976
(Schumacher,Trebesch,andEnderlein,2014),andmorerecentlybylitigationoverthechamperty defense – an English common‐law doctrine, later adopted by US statelegislatures,thatprohibitedthepurchaseofdebtwiththeintentofbringingalawsuitagainstthedebtor(BlackmanandMukhi,2010).
The case ElliottAssociates,LPv.Bancode laNaciónand theRepublicofPeru was agame changer for the interpretation of legal frameworks affecting sovereign
immunity. Elliott hadbought Peruviandebt in default and sued the country for full
payment in theNewYork courts. TheUSDistrict Court for the SouthernDistrict of
New York ruled that champerty applied, dismissing Elliott’s claims. But the Second
Circuit of Appeals reversed the decision, stating that the plaintiff’s intent inpurchasing the Peruvian debt in defaultwas to be paid in full or otherwise to sue.
Then, according to the Second Circuit, Elliot’s intent did not meet the champerty
requirementbecauselitigationwascontingent.Suchaninterpretationisabsurd,asit21In aworld of globalization, thedistinction between foreign anddomestic bondsmaynot be clear.Moreover,therulesofthegamewouldbeexpectedtochangethemix.22This is especially truewhen there are largemacro‐economic disturbances. SeeMiller and Stiglitz(1999,2010).
13
wasnotreasonabletoexpecttobepaidinfulloverapromisethathadalreadybeen
broken. The exorbitant returns obtained based on an interpretation that was
unreasonable to expect constituted a case of “unjust enrichment” (Guzman and
Stiglitz,2014c).
In 2004, the New York state legislature effectively eliminated the defense of
champerty concerning any debt purchase above 500,000 US dollars. That decision
constitutedachangetotheunderstandingoverwhichhundredsofbillionsofdollars
ofdebthadbeenissued,redefiningpropertyrights.Thischangeinlegislationensured
thegoodhealthofthevultures’business.
DistortiveCreditDefaultSwaps(CDSs)
The problems are aggravated by the non‐transparent use of CDSs. A CDS separatesownershipfromeconomicconsequences:theseemingownerofabondcouldevenbebetteroffintheeventofadefault,asthepaymentsovertheCDSwouldbeactivatedinsuchevent.
The opacity of thismarketmakes unclear the real economic interests of thosewhohave a seat at the restructuring bargaining table. They provide another reason fordelayedrestructurings,withitsassociatedinequitiesandinefficiencies.
Theunbalancedbackgroundfornegotiations
ThelegalframeworksandthebailoutpoliciesoftheIMFdeterminethebackgroundofthe negotiations (cf. Brooks, Guzman, Lombardi, and Stiglitz, 2015). The currentarrangementsfavorshort‐termcreditorsagainstlong‐termcreditors,includinginthe
latter group the “informal creditors” (the citizens towardswhich the sovereign has
obligations,suchasworkersandpensioners).
IMFbailoutpoliciesonlyaimatensuringrepaymentintheshort‐run.Inpractice,they
havenotbeendesignedwiththepurposeoffavoringsustainedeconomicrecoveries.
In occasions they even undermined them (both as a result of counterproductive
conditionality and because of insufficiently deep restructuring), increasing the
probabilityofasubsequentrestructuringbeingneededdowntheroad.
In the case of Europe, the European Stability Mechanism (ESM) leads to the same
perverse effects. By construction, it’s not amechanism for debt restructuring but a
mechanismfor“bailouts”(BrooksandLombardi,2015),thatgivescreditorcountries
14
enormouspower in thenegotiationswithadebtorcountry. In thecaseofGreece, it
wasthemaininstrumentbywhichtheEurozonecountriesenforcedtheirdemandsfor
policydecisionsthatwerenotinthebestinterestofthecountry(atleastasjudgedby
thevastmajorityofpeopleinthecountry,asreflectedrepeatedlyinthepolls,andbya
largefractionofeconomists).
Politicaleconomyissues
SDR mechanisms must take political economy issues into account. The costs of
restructuring are usually bornebydifferent political actors than thosewho created
the problem. Political economy tensions increase in times of distress, when the
incumbentgovernmenthaslargerincentivestoachievedealswithshort‐termbenefitsbutlong‐termcoststhatwillbepaidbythenextgovernment.Oneofthestrategiesforbettershort‐termfinancingconditionsisgivinguponsovereignimmunity.
Every bad loan is equally the result of bad lending and bad borrowing: these arevoluntary agreements. But a system the puts the onus on the debtor (i.e.making itmore likely that more of the debt will be repaid) encourages bad lending—itencourages banks to encourage the government today to borrow too much,exacerbatingthealreadypresentdistortion.(Thereisafurtherargumentforputtingmoreoftheonusonthelenders:theyaresupposedtobetheexpertsinriskanalysis;
that is supposed to be their comparative advantage; government officials typicallyhave no expertise, and rely on the judgments of those in the financial marketconcerningreasonabledebtlevels.)
Politicalcostsarealsooftenbornedisproportionatelybythosewillingtotakeactions–thatis,toactuallydotherestructuring.Thusasystemthatmakesrestructuringstoo
costlyexacerbatesthesenaturalpoliticaleconomytensions,asitincentivizesdebtorstodelaytherecognitionofproblems.
Creditors’ behavior may also worsen these distortions, for instance, by providing
short‐termlendingathighinterestratestocountriesthatareobviouslyinneedofarestructuring,takingintoaccountthedistortedincentivesofthedistresseddebtorsto
makeuseofthosefunds,the“gamblingonresurrection”behaviorthatwedescribed
earlier.Suchshorttermlendingis,ofcourse,risky:whenthesituationisbadenough,
eventually therewill be a restructuring. But the short‐term creditors can typicallychargeasufficientlyhighinterestratetocompensatethemforthisrisk.
15
Therearealsopoliticaleconomyproblemsonthecreditors’side.Sovereignbondsare
animportantformofcollateral.Adecreaseinthevalueofbondsheldbybankswould
decrease the value of collateral, affecting lending and (reported) profits. Butwhen
bonds(loans)arenotmarked‐to‐market,23whatmattersistherecognitionoftheloss.
A debtwrite‐off forces the recognition of the loss.24Thus, banks have incentives to
resist debtwrite‐offs. The incentives turnmoreperversewhenmanagers’ relevant
horizon is short—as is typically the case, especially when, with bad corporate
governance,compensationislinkedtoshort‐termperformancemetrics.
4. Themarket‐basedapproachresponse
The International Capital Market Association (ICMA), with the support of the IMF,proposestoresolvethefailuresinsovereigndebtrestructuringbymodifyingthedebtcontracts’ language. The new terms include a formula for aggregation of collectiveactionclauses(CACs)andaclarificationoftheparipassuclause.
The formula for aggregation allows bondholders across different series of bonds tovote collectively in response to a restructuring proposal. The decisions of asupermajority (defined by acceptance of the aggregate principal amount25 ofoutstandingdebt securities of all of the affected series)would be binding to all thebondholdersacrossallseries.
Theclarificationofparipassuestablishesthat,unlikejudgeGriesa’sinterpretationinArgentina’s case, “the Issuer shall have no obligation to effect equal or rateablepayment(s)atanytime”withrespecttoanyotherExternalIndebtednessoftheissuer,andinparticulartheissuer“shallhavenoobligationtopayotherExternalIndebtedness
at the same time or as a condition of paying sums due on theNotes and vice versa”(ICMA,2014).Inotherwords,ICMAstatesthatparipassudoesnotmeanwhatjudge
Griesainterpretedittomean.23Evenwithmarkedtomarket, there isalwaysachancethat thecountrywill recoverandthebondswill pay off. If the write‐down is greater than the expected loss (recall, that if there is not arestructuring now, there is a chance, even a likelihood that matters will get even worse, and thenecessarywrite‐downwill be even greater) then thewrite‐downwill be associatedwith a decreasetodayinthevalueofthefirm.24Similarproblemsarise,ofcourse,withdomesticdebt,andplayedanimportantroleintheevolutionoftheU.S.financialcrisis.SeeStiglitz(2010b).25Thereisstillaproblemwhendebtisissuedindifferentcurrenciesandtherearemarkedchangesinexchange rates (as in the EastAsian crisis.) Depending on the rules, itmay be relatively easy for avulturefundtobuyenoughbondstoblockarestructuringortoobtainasettlementthatadvantagesitoverotherclaimants(theissueismoreextensivelyanalyzedinsection5).Similarproblemscanarisesimply when there are different maturities: long dated bonds might, for instance, sell at a markeddiscountrelativetoprincipalvalues.
16
Thesenewtermsareimprovementsoverthepreviousones,butleavesomeimportant
issuesunaddressed.Weanalyzetheseissuesinthenextsection.
5. Limitations of the private contractual approach: why a market‐based
approachwillnotsuffice
Sovereign debt restructurings are more complex than private debt restructurings.
They involve dealing with contracts issued under different terms, under different
legislationfromdifferentjurisdictions,anddifferentcurrencies,overwhichtheremay
notbeobviouswaysforcomparingvalueswhenthecontractsneedtoberewritten.At
those times, distributive conflicts getmagnified.26The private contractual approach
doesnotsolvetheseissuesaccordingtoefficiencyorequityconsiderations,butonthebasisofrelativebargainingstrength(related,forinstance,totheabilitytowithstandlarge litigationcostsanddelays).Outcomesaregenerally inefficientandinequitable.That is why no government relies on the private contractual approach within itsboundariesforprivatedebts.Theadvocatesoftheprivatecontractualapproachhaveneverexplainedwhy,ifitwereasgoodastheyclaim,ithasbeenuniversallyrejected.Andasthecomplexitiesofsovereigndebtrestructuringaregreater,theneedfortheruleoflawislarger.
Theproblemwithexistingcontracts
The IMFestimates that roughly30percentof the$900billion inoutstandingbondsissuedundertheoldtermswillmatureinmorethan10years.Approximately20%ofthosestocksdonot includeanykindofCACs,andvirtuallyallof the80%thatdoesinclude themhaveCACs thatoperateonly at the level of each security (IMF,2014).
What would prevent the current problems from arising if those debts had to be
restructured(eventswhich,unfortunately,areespeciallylikelytooccurinthecontextofananaemicglobaleconomy)?
Debt issuedunder theold terms could inprinciplebe exchanged for securities that
incorporate the new terms. But what would rule out holdout behavior if such aproposalwere carried out? The vultureswould have an incentive not to exchange
26That is, if thecountryhad issuedonlyonesetofbonds, therewouldbeaclearmeaningtoequity:repaymentsshouldbeproportionaltothefacevalueofthebonds.Thisisnotsoif,asitisthecaseinpractice,therearemanydifferentkindsofbonds.
17
existingbondsforthesenewbonds.Thereisnosolutiontothisquandarywithinthe
improvedcontractualapproach.
Inter‐creditorfairness
There are complicated bargaining problems among classes of creditors. A
supermajorityvotingdoesnotsolvethemall.
Asimplesupermajorityrulecould lead toasituationwhere juniorcreditorsvote to
havethemselvestreatedequallywithmoreseniorcreditors–andwheretheyimpose
theirpositionthroughasupermajority.Thiswouldmaketheseniorstatusconditional
ontheoutcomeofthebargainingprocess.Indeed,ifseniorcreditorsweresufficientlysmallrelativetothejuniorcreditors,thereisapresumptionthattheirsenioritywouldnot be fully taken into account, and under the proposed arrangements, there isnothingtheycoulddoaboutit.Seniorcreditorswouldanticipatethispossibility,andwould react by demanding different contract terms ex‐ante (for instance, an earlyseniorcreditmightlimittheamountofjuniorcreditorbondsthatcouldbeissuedsoasnot todilutevoting interests,but thatwouldhaveadeleteriouseffectongrowth;alternatively,hecoulddemandahigherinterestrate27).
Whencountriesissuedebtunderdifferentjurisdictions,establishingpriorityofclaimscould be a daunting task, with multiple contradictions. Contracts could become
inconsistent in crises times. For example, the terms of a bond issued under thejurisdictionA couldstatethat theholderof thatbondhaspriorityoverall theotherclaims.ButatthesametimeanotherbondissuedunderthejurisdictionBcouldstatethesame. If itwerenotpossible tosatisfybothclaimsat thesametime,howwouldprioritybedetermined?Whowouldultimatelyjudgeoverit?Itmightbeimpossibleto
ensuretheconsistencyofrulingsfromjudgesofdifferentjurisdictions.28
The same bargaining problems may arise when a default is accompanied by a
currency crisis, and the country issueddebtundermultiple currencies.Howshould
debtsthatmatureinthefuturebevaluedinthepresentintheeventofadefault?Whatnominal exchange rate should be used? The holders of debt denominated in a
currency that is rapidly depreciating would claim that they should be weighed for
27Moreover,thesetofcontractsinthemarketwillrespondendogenouslytotherulesofthegame.Forinstance,theseniordebtcontractcouldhaveaprovisionthatintheeventofadefault,thefacevalueofwhat isowedismultipliedsuchthat,undertheaggregationclause,thosebondholdershavesufficientvotestoblockanyproposalbyjuniorcreditors.28SeeGuzmanandStiglitz(2015b)foradescriptionoftheinterplaybetweenlegaljurisdictionsinthecaseofArgentina’srestructuringafterthe2001crisis.
18
purposes both of settlement and voting on the basis of a “normal” (i.e. strong)
exchangerate,whiletheholdersofdebtdenominatedintheothercurrencieswould
arguetheopposite,aseachpartyattemptstomaximizewhatshereceives.Itwouldbe
unfairtoeffectivelydeprivedomesticbondholdersoftheirvotingrightsintheevent
of a temporary currency crisis; and if that happened, opportunistic bondholders in
foreign denominated bonds would have an incentive to seize the opportunity to
effectivelydiscriminateagainstthedomesticbondholders.
Finally, how should the informal claimants (such as workers and pensioners) be
treated?Undercollectiveactionclauses,theywouldhavenovotingrights.Asolution
to this problem within the contractual approach is not easy. Governments could
decide togive full creditor rights to social security claimants.But then, governmentagencieswouldbefiduciaryforthoseclaimants,whichmight“drownout”traditionalcreditors–anissuethatwouldbeanticipatedandthatwouldalsobereflectedintheinterestratesandthecontractterms.
Under a decentralized private contractual approach, anticipating all of thesepossibilitieswouldresultinhighlycomplexcontracts,andsolvingthedisputeswouldrequire intricate and lengthynegotiations,with complex legal questions, andwouldalmost surely cast apallofuncertaintyoverwhatmighthappen in theeventof theneedforarestructuring.
Signalingequilibrium
Inthepresenceofimperfectinformation,debtorstrytoshowthattheyareofa“goodtype”byusingcostlysignals.
Inthecontextofsovereigndebt,debtorsmaychooseexcessively“tough”jurisdictions
to signal they are unlikely to default—jurisdictions that will make an eventualrestructuringverydifficult.Otherdebtors,byactingdifferently,wouldsignalthatthey
aremorelikelytorestructure.Hence,thenetpayoffofdeviatingtoamorereasonable
jurisdictionwouldbenegative.Theresultisaninefficientglobalequilibrium.29
Besides, bargaining models with imperfect information often result in excessive
delay—delayitselfisacostlysignal—againleadingtoaninefficientglobalequilibrium.
Politicaleconomyissues
29Thisisastandardresultinthetheoryofadverseselectionandsignaling.
19
As described in the previous section, sovereign lending markets are featured by
important political economy tensions both on the debtor and the creditors side. A
purelymarket‐basedapproachfordebtcrisesresolutionwouldonlyexacerbatethese
tensions,leadingtoinefficientsolutions.
On the debtors side, a free market solution will not internalize the negative
externalitiesofanincumbentgovernmentwillingtotakeactionsthatresultinshort‐
run benefits, like giving up on sovereign immunity to receive better financing
conditions,onsucceedinggovernmentsthatwouldpaythecostsoftheseactions.The
frameworks for sovereign debt restructuring should recognize these perverse
incentives, and should consequently make it impossible to sign away sovereign
immunity.
On the creditors side, a decentralized negotiation would face the opposition ofinvestors that use sovereign bonds as collateral, and that in a world of less thanperfectcorporategovernancewillopposetoseethevalueofthebondswritten‐downintheshortterm,evenifnotwritingdebt‐off leadstomoresustainabilityproblems,andlargerhaircutsinalongerterm.
6. Possiblefurtherimprovementstothecontractualapproach
There are other modifications to the standard contract that could improve the
workingsofthemarket‐basedapproach.Theyentailregulationsoncontracts,changesin domestic legislation, and the inclusion of clauses that make debt paymentscontingentontheeconomicsituationofthedebtor.
RegulationofSovereignCreditDefaultSwaps(SCDSs)
CDSshavebeenadvertisedashelpingtocompletemarkets.30Buttheyhavefailedtodoso,andinsteadhavemademattersworse.TheuseofSCDSsdistortsincentives.
30Arrow andDebreu have established that only if therewere a complete set of riskmarketswouldcompetitive markets be efficient. Some in the financial market thus argued that introducing newsecurities (such as CDSs) helps complete themarket, and thus improves societal welfare. But thatconclusionignoresthebasicinsightsofthetheoryofthesecondbest,whichdemonstratesthatinthepresence ofmultiplemarket failures, reducing the scope of one could actually (and under plausibleconditions, often would) lead to a decrease in societal welfare. Thus, Newbery and Stiglitz (1982)showedthateliminatingbarrierstotrade,inthepresenceofimperfectionsinriskmarkets,couldleadallindividualsinallcountriestobeworseoff.Inthiscontext,GuzmanandStiglitz(2014a,2015a,2015d)haveshownthat introducingthesenewinstrumentsforbettingmayactuallyincreaseeconomicvolatilityandloweroutputpermanently.
20
SCDSdistortincentiveswhentheyareusedforinsurancepurposes(asnotedabove).
But third parties can also demand SCDS for speculation purposes. This would not
necessarily be a problem if there were no connections between the actions of the
buyers and the interests of the sovereign. But the lack of transparency of these
marketsmakestheconnectionspossible(andprofitable).31
Toavoidconflictsofinterestthatcouldunderminethesuccessofrestructurings,and
consideringthattheopacityofCDSsmarketsmakesregulationtoodifficult,allCDSs
positions of parties involved in the restructuring negotiations should be fully
disclosed.32
Reinstatingvariantsofthechampertydefense
If investors that purchase debt in defaultwerewilling to settle under “reasonable”conditions, theywould just provide a liquidity service in themarkets for defaulteddebt,andcouldthuscontributetoavoidinganevenlargerdepressioninbondspricesinsuchcircumstances.But that isnotwhatvulture fundsdo.Reinstatingvariantsofthechampertydefensethatprohibitthepurchaseofdefaulteddebtwiththeintentoflitigating against the issuer, together with a clarification of the pari passu clause,would undermine the vultures’ business, correcting the numerous inefficienciesassociatedwiththeirbehaviorthatwehaveidentified.33
GDPindexedbonds
31TherecentcaseofArgentinedebtrestructuringillustrateshowperverseincentivescanturn.IntheaftermathofJudgeGriesa’sinjunctionthatblockedthepaymentsofthecountrytoitsbondholders,theInternationalSwapsandDerivativesAssociation(ISDA)classifiedthecrediteventasadefault.Interestingly,oneofthemembersofISDAcommitteewasElliotManagement,thesamevulturefundthatwaslitigatingagainstthecountry.(ThedebtcontractonlyspecifiedthatArgentinaturnovertherequisitefundstothe"agent"–whichArgentinadid.Argentinawasthusnotinbreachofthecontractswhichithadsignedintheprocessofrestructuring.Indeed,Argentinahadevenwarnedinvestorsinitscontractofthepossibilityofthesedifficulties.Thatiswhytheso‐calleddefaulthasbeenlabeledaGriesafault,todistinguishitfromanormaldefault,whereapartyactuallybreachesakeycontractprovision.SeeGuzmanandStiglitz(2014b)).32Some have suggested going further: banning the purchase of SCDSs by third parties (Brook,Lombardi,Guzman,andStiglitz,2015).33One could even imagine some variant of such a clause being inserted into the contract: that nosecondarypurchasersofthebondcouldmakeaclaimincourtforanamountgreaterthanthepriceatwhichhehadpurchasedthebond.Whilesuchaprovisionarguablymightlowerthepriceofthebondat issuance(requiring thesovereignborrower topayahigher interest rate), theeffect is likely tobeminimal:fewbuyabondontheexpectationthatitwillgointodefault.
21
WithGDPindexedbonds,theprincipalisindexedtothenominalGDPofthecountry.
Thecontingentelementinthecontractimprovesdebtsustainability,asitmakesdebt
obligations lessburdensomewhendebt repayment ismoredifficult, andviceversa.
Creditorsalsobenefitfromalowerprobabilityofdefault.
These securities may also be an effective part of sovereign debt restructuring.
Exchanging fixed‐couponbondsbyGDP indexedbondswouldbe theakintoadebt‐
equityswap.Theinclusionofthiscontingencyclausewouldaligntheincentivesofthe
debtorandthecreditors,aseachwouldbenefitfromthefastergrowthofthecountry.
(Similarbenefitsmightbeachievedthroughtheissuanceofordinarybondswhich,in
the extreme events associated with crises, automatically convert to GDP‐linked
bonds.)
Thecapacityforcountercyclicalfiscalpolicieswouldalsoimprove.Thenumbersmaybe significant: Bank of England economists (Barr, Bush, and Pienkowski, 2014)estimatethatGDP‐linkedbondscanincreasefiscalspace,thatis,theycanincreasethelevel of what is called “sustainable debt.”34 (Itmust be noted, however, that “debtlimit” is a subjective concept whose quantification requires taking a stance on theexpectations about the government’s capacity for generating revenues—acomplicated issue over which it’s relatively easy to make wrong assumptions,especially in the most volatile economies, that are the ones more likely to need
restructurings. The IMF itself has been systematically overestimating the speed ofrecovery of economies in crises, as well as the multipliers in response to theconditionalitiesimposedonthe“bailed‐out”countries.SeeGuzman,2014).
7. AmultinationallegalframeworkforSovereignDebtRestructuring
Amajorityofcountrieshasbecomeconvincedbothbyexperienceandtheforceofthe
argumentsof theprevioussectionsthat theprivatecontractualapproach,nomatter
howimproved,won’tsolvethebasicproblemofsovereigndebtrestructures. Thesecountries are advocating for institutionalizing amultinational statutory solution, as
reflected in the Resolution 68/304 passed by the General Assembly of the United
NationsonSeptember9,2014.
34Whendebtbecomestoohigh,then,dependingontherateofgrowthoftheeconomyandtherateofinterest, theratioofdebttoGDPincreaseswithoutbound. Barr,Bush,andPienkowski(2014)arguethatswitchingtoGDPlinkedbondsincreasesthecriticalthresholdbysome45%.
22
Guidelinesfortheframework
Theframeworkmustrecognizethelimitationsoftheprivatecontractualapproach.It
needs to solve the “too little, too late, too long” syndrome. Italsoneeds toensurea
reasonablyfairtreatmentofallparties.
Anyframeworkforsovereigndebtrestructuringmusttakeaccountoftheprimacyof
the functionsof thestate, itsobligations to its citizens,and the “social contract” the
statehaswithitscitizens(Stiglitzetal.,2015).
Although there are differences between sovereign debt and corporate debt
restructurings, there are also important analogies. Thus, some of the provisions of
chapters9and11of theUSBankruptcyCodeshouldbeconsidered(Stiglitz,2002a,
2010a).35
Deadlines. The sovereign should initiate the restructuring in a timely way. Theframework should provide the right incentives for avoiding delays in the initiationandinthefinalizationoftherestructuring.Therefore,itmustsetspecificdeadlinesforthe different stages of the process. This would make the whole process morepredictable.
Lending into arrears. The framework must recognize the macroeconomic
externalities associated with debt crises resolution. Thus, it should facilitatecountercyclicalmacroeconomicpolicies.Provisionsoflendingintoarrears,accordingtowhichcreditorswholendwhiletherestructuringprocessisbeingcarriedonwouldreceiveseniortreatment,shouldbecontemplated.
Stays.Litigationinducescostlydelays.Aspreviouslydescribed,italsocreatesamoral
hazard problem, as it negatively affects creditors’ incentives to enter intorestructurings. Therefore, the framework should incorporate clauses of stays for
litigation, which would prohibit litigation in courts between the initiation and the
finalizationoftherestructuringprocess.
Litigations could still occur in jurisdictions that do not endorse the framework,
remaining a problem as a largeproportion of debtswill still be issuedunder those
35Raffer (1990, 2015) explains that the essential points of the special insolvency procedure formunicipalitiesintheUS(Chapter9,Title11,USC)canbeeasilyappliedtosovereigns.
23
jurisdictions. However, judges of non‐participating jurisdictions could consider the
multinationalframeworkasareferenceonwhatgoodpracticeinSDRlookslike.
Hardlawvs.Softlaw.Thedesignoftheframeworkmustconsiderwhatconstitutes
the set of principles over which all the parties involved would agree on. One
possibility could be to follow a hard law approach, where countries adhere to an
InternationalBankruptcyCourt.IftherulingsoftheCourtwereenforceable,countries
wouldbegivinguponsovereignimmunity.Ofcourse,anyinternationaltreatyentails
giving up sovereign immunity. The benefitwould be amore orderly restructuring.
But countries would, at least initially, worry about the fairness of the tribunal.
Besides, geopolitical problems would be intense: How would the members of theinternational court be appointed?What interestswould they represent? Indeed, itmight even be difficult, at least initially, to define the principles that should guiderestructuring. The intense debateswithin countries over the design of bankruptcylawshouldmakeitclearthatresolvingtheseissuesinternationallymightbedifficult.Thecreditorcountrieswouldpushforcreditor‐friendlyprinciples,andconverselyforthedebtorcountries.
There is a single principle which countries could agree to which would restore asemblanceofordertotheglobalsovereigndebtmarket:therestorationofsovereign
immunity. Moreprecisely: thereisaconsensusthatthereshouldberestrictionsonwhatcountsasacceptablecontracts.Individualscannotsellthemselvesintoslavery.Manycountriesdonotallowcertainkindsofperpetuities. Thereshouldbeaglobalagreementthatnocountrycansurrender itssovereignimmunity(evenvoluntarily).Such a restriction is particularly important given the political economy problems
discussedearlier. It is tooeasy for a government today to surrender the sovereignimmunityofsomegovernmentinthefuture,inreturnformoneythatwouldenhance
itspopularityandthewealthofitssupporters.
Tothisshouldbeaddedaframeworkthatwouldfacilitaterestructuring.Thiswouldoccur throughwhat might be called a “soft law” approach, with the creation of an
OversightCommissionwiththemissionofmediatingandsupervisingtherestructuring
process. The Commission would also maintain a registry of the debt stocks. The
members of the Commission would be countries that endorse the multinationalframework.TheCommissionwouldnot ruleoverdifferentalternatives. Instead, the
sovereignwouldfinalizetheprocesswithafinalproposalandtheCommissionwould
producestatementsaboutthereasonabilityoftheprocessandthefinalproposal.This
24
approachwould serve to legitimate the restructuring, or alternatively, to legitimate
positionsthatspeakofillegitimaterestructurings.
8. Conclusions
Restructuringisnotazerosumgame.Themechanismsinplacecanhavelargeeffects
on the overall economic performance of the countries involved. The existing
institutionalarrangementsmakethesumtoonegative,astheydelaytheinitiationof
restructurings, and lead to “solutions” that do not promote economic recovery—
making recessions more severe and persistent overall. Deficiencies in the
restructuringprocessalsogetreflectedexanteinthetermsandvolumestransacted
insovereigndebtmarkets.
Theworld of debt restructuring needs tomove to a different equilibrium. There isconsensus on the necessity of this, but there are different views on how to moveforward.Ontheonehand,thebusinesscommunityandtheIMFadvocatefortweakingthe termsofcontracts.Although thesuggestednewterms(aggregationofCACsandclarificationoftheparipassuclause)areimprovementsovertheoldterms(termsthatclearly did notwork), they still leave a legacy of problems unaddressed. There arefurtherimprovementsthatcanbeimplemented,aswediscussedinsection6.
But with incomplete contracts, even with all those improvements, a variety of
problemswill remain. In times of default, debt contractswill need to be rewritten.Under a market‐based approach for restructurings, outcomes will be moredetermined by bargaining power than by considerations of efficiency and equity.Particularly disturbing is the fact that most countries that are entering debtrestructuringsareinaparticularlyweakposition,andthusparticularlyvulnerableto
pressure from creditors to agree to terms that are adverse to their long termsinterests. Andtheknowledgethatthisissogivesriseitselftobadlendingpractices,
especially in the context of the political economy problems we discussed earlier:
creditorsencouragemorelendingthanissociallyefficient,intheknowledgethattheycanusetheirmarketpowertoextractafavorableoutcomeforthemselvesintheevent
of a crisis. At least in the past, practices of the IMF, which provided funds to the
government to bail out the creditors – ensuring that they were paid in full – only
exacerbatedtheproblem.36
36Foramoreextensivediscussionofthisproblem,seeStiglitz(2002b).
25
Acomprehensivesolutionrequirestheimplementationofastatutoryapproachatthe
multinational level –an approach that helps “complete” contracts. The framework
needs to address the limitations of the current approach. It needs to redefine the
balance among theparties involved in thenegotiation. It should bebuilt respecting
theprinciplesoverwhichthedifferentactorsinvolvedwouldagreeon.
For now, the single most important change over which there is the possibility of
gettingagreementistherestorationofsovereignimmunity,andtherecognitionthat
no government can sign away the sovereign immunity either for itself or successor
governments.
A "soft law" approach that entails a more active role for a quasi‐judiciary can, we
believemitigatesome,perhapsmany,oftheinefficienciesandinequitiesnotedabove.
While this approach is not a panacea, we believe it represents a substantial stepforward—andasubstantialstepbeyondtheprivatecontractualapproach.
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