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    FixingSovereignDebtRestructuring1July,2015

    MartinGuzman2andJosephE.Stiglitz3

    Abstract

    Recent controversies surrounding sovereign debt restructurings show theweaknesses of the current marketbased system in achieving efficient and fairsolutions to sovereign debt crises. This article reviews the existing problems andproposessolutions.Itarguesthatimprovementsinthelanguageofcontracts,althoughbeneficial, cannot provide a comprehensive, efficient, and equitable solution to theproblemsfacedinrestructuringsbutthereareimprovementswithinthecontractualapproachthatshouldbe implemented.Ultimately, thecontractualapproachmustbecomplemented by a multinational legal framework that facilitates restructuringsbasedonprinciplesofefficiencyandequity.Giventhecurrentgeopoliticalconstraints,intheshortrunweadvocatetheimplementationofasoftlawapproach,builtontherecognition of the limitations of the private contractual approach and on a set ofprinciples most importantly, the restoration of sovereign immunity overwhichtheremaybeconsensus.Wesuggestthatinacontextofpoliticaleconomytensionsitshouldbeimpossibleforagovernmenttosignawaythesovereignimmunityeitherforitself or successor governments.The framework couldbe implemented through theUnitedNations,oritcouldpromptthecreationofanewinstitution.Keywords: Sovereign Debt Crises, Sovereign Debt Restructuring, InternationalLendingJELCodes:F34,G33,H63,K12,K331WeareindebtedtoSebastianCeria,RichardConn,MatthiasGoldman,DanielHeymann,BrettHouse,Kunibert Raffer, Sebastian Soler, participants of the Conference on Frameworks for SovereignDebtRestructuringatColumbiaUniversity,theECON2014ForumatUniversityofBuenosAires,theRIDGEForumonFinancialCrisesatCentralBankofUruguay,theFirstSessionoftheAdHocCommitteeoftheUnitedNationsGeneralAssemblyonaMultilateralLegalFrameworkforSovereignDebtRestructuring,andseminarparticipantsatJaverianaUniversity(Bogota),theCentralBankofArgentina,theUNCTADConferenceonLegalFrameworkforDebtRestructuringProcesses:OptionsandElementsatColumbiaUniversity,theINETAnnualConferenceatOECD,theResearchConsortiumforSystemicRiskMeetingatMIT, and the International Instituteof Social Studies inTheHague foruseful comments,discussions,andsuggestions.WearegratefultotheFordandMacarthurFoundationsforsupporttotheRooseveltIPD Inequality Project, and the Institute for New Economic Thinking for financial support, and toDebaratiGhoshandInesLeeforresearchassistance.2ColumbiaUniversityGSB,DepartmentofEconomicsandFinance.3ColumbiaUniversity,UniversityProfessor.

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    Keywords:DebtCrises,SovereignDebtRestructuring,DebtContracts,Bankruptcy

    1. Introduction

    Debt matters. In recessions, high uncertainty discourages private spending,weakening demand. Resolving the problem of insufficient demand requiresexpansionarymacroeconomicpolicies.Butexcessivepublicdebtmayconstrainthecapacityforrunningexpansionarypolicies.4Evidenceshowsthathighpublicdebtalsoexacerbates the effectsofprivate sectordeleveragingafter crises, leading todeeperandmoreprolongedeconomicdepressions(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 economya 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 interestrateandborrowedatvery lowreal interestratesevenwhen its debt to GDP ratio was in excess of 130%borrowing for public investments that yieldsignificantlyhigherreturnsthanthecostofcapitalcanimprovethenationsbalancesheet.5The only situation inwhich the temporary assistance (bailout)mightmake sense is if there is aliquiditycrisis,e.g.marketsareirrationallypessimisticaboutthecountrysprospects,withtheevidencethattheyarewrongexpectedtoberevealedinthenottoodistantfuture.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,thecountrywouldbeworseoffoverthelongrununlesstherewascommitmenttoprovidethesefundsindefinitelywhichisineffectequivalenttoadebtwriteoff.

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    Distresseddebtors need a fresh start, not just temporary assistances. This is in thebest interestofthedebtorandthemajorityof itscreditors:Precludingarapidfreshstart for the debtor leads to large negative sum games, where the debtor cannotrecoverandcreditorscannotbenefit fromthe largercapacityof repayment that therecoverywouldimply.Lackof clarity for resolving situations inwhicha firmor a country cannotmeet itsobligationscanleadtochaos.Therecanbeextendedperiodsoftimeduringwhichtheclaimsarenotresolved,inwhichbusiness(eitherofthefirmorthecountry)cannotproceedoratleastproceedinthemostdesirableway.Inthemeantime,assetsmaybe tunneledoutof the firmor country, or at thevery least, productive investmentsthatwouldenhancethevalueofthehumanandphysicalassetsarenotmade.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,basedonwelldefinedprinciples.Bankruptcy laws thus protect corporations and their creditors, facilitating theprocessesofdebtrestructuring.Amoreorderlyprocessnotonlylowerstransactionscosts,butavoidsthedeadweightlossesassociatedwithdisorderlyprocesses;indoingso,itmayevenlowerthecostofborrowing.Goodbankruptcy laws facilitate efficient and equitable outcomes in otherways; forinstance,inencouraginglenderstoundertakeadequateduediligencebeforemakingaloan.Thebenefitsofalegalframeworkprovidingfororderlydebtrestructuringhavealsobeenextendedtopublicbodies,forinstancethroughChapter9oftheU.S.bankruptcycode.Butthereisnocomprehensiveinternationalbankruptcyproceduretoensureproperresolution of sovereign debt crises. Instead, the current system for sovereign debtrestructuring(SDR)featuresadecentralizedmarketbasedprocess,wherethedebtorengagesinintricateandcomplicatednegotiationswithmanycreditors,withdifferentinterests,oftenunderthebackdropofconflictingnationallegalregimes.Outcomesareoftendeterminedonthebasisnotofprinciples,butofeconomicpoweroftenunderthe backdrop of political power. Restructurings come too little, too late. And when

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    theycome,theymaytaketoolong.7Thelackofaruleoflawleadstoexanteandexpost inefficiencies,andinequitiesbothamongcreditorsandbetweenthedebtoranditscreditors.Furthermore,unlikedomesticbankruptcies, sovereignbankruptcynegotiations takeplace inanambiguous legalcontext.Severaldifferent jurisdictions,allwithdifferentperspectives, influence the process. Different legal orders often reach differentconclusionsforthesameproblem.Itmaynotbeclearwhichwillprevail(andpossiblynone of them would prevail), and how the implicit bargaining among differentcountriesjudiciarieswillberesolved.Atthetimewewritethisarticle,eventsaremakingthereformoftheframeworksforSDR 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.Theemergenceofvulturefundsinvestorsthatbuydefaulteddebtonthecheapandlitigateagainsttheissuer,demandingfullpaymentanddisruptingthewholerestructuringprocessasrecentlyseeninthecaseofArgentinerestructuring,isasymptomofaflawedmarketbasedapproachfordebtcrisesresolution.Recent decisions8have also highlighted the previously noted interplay amongmultiple jurisdictions, none of which seems willing to cede the right to adjudicaterestructuringtotheothers(GuzmanandStiglitz,2015b).Thereisconsensusonthenecessityofmovingtoadifferentframework,buttherearedifferentviewsonthetableaboutho

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