Key Issues in Sovereign Debt Restructuring - Group of Published by Group of Thirty Washington, DC 2002 A Working Group Report Key Issues in Sovereign Debt Restructuring

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<ul><li><p>1</p><p>Wor</p><p>king</p><p> Gro</p><p>up R</p><p>epor</p><p>t</p><p>Group of Thirty, Washington, DC</p><p>A Working Group Report</p><p>Key Issues in SovereignDebt Restructuring</p></li><li><p>2</p><p>All members of the Working Group served in their personal capacities. The viewsexpressed in this report do not necessarily reflect the views or policies of theirrespective institutions, nor does publication of the report by the Group of Thirtyimply an endorsement of the views expressed herein.</p><p>Copies of this report are available for $20 from:</p><p>Group of Thirty1990 M Street, N.W., Suite 450</p><p>Washington, DC 20036Tel.: (202) 331-2472 Fax: (202) 785-9423</p><p>E-mail - WWW -</p></li><li><p>3</p><p>Published byGroup of Thirty</p><p>Washington, DC2002</p><p>A Working Group Report</p><p>Key Issues in Sovereign DebtRestructuring</p></li><li><p>Page</p><p>Contents</p><p>Foreword 7</p><p>I. Introduction 1</p><p>II. Evaluating the options 7</p><p>IV. Conclusion 21</p><p>Tables 23</p><p>End Notes 25</p><p>References 27</p><p>Group of Thirty Members 29</p><p>Group of Thirty Publications Since 1990 31</p></li><li><p>Foreword</p><p>At its Spring 2002 plenary meeting hosted by the Banco de Espaain Madrid, the Group of Thirty discussed recent proposals aimed atstrengthening the framework for sovereign debt restructuring. Whileno consensus emerged on the issues, there was agreement on theneed to explore the issues more thoroughly and provide a balancedassessment of the various proposals. Therefore, the Group organizeda colloquium in New York on July 15, 2002 to identify the key issuesinvolved in sovereign debt restructuring .</p><p>Participants in the meeting included Geoffrey Bell of GeoffreyBell and Associates, Jack Boorman of the International MonetaryFund, Andrew Crockett of the Bank for International Settlements,Gerd Haeusler of the International Monetary Fund, John Heimannof Merrill Lynch, Peter Kenen of Princeton University, Jacques deLarosiere of BNP Paribas and Ernest Stern, recently retired from JPMorgan Chase, with written input provided by Guillermo Ortiz ofthe Banco de Mexico and David Walker of Morgan StanleyInternational. Zanny Minton Beddoes of The Economist served asrapporteur for the meeting; prepared a structured draft of thediscussion, which identified the issues to be addressed and theworking groups approach to them; and incorporated commentsfrom the working group to produce this paper.</p><p>The Group of Thirty wishes to thank the working group membersand Ms. Minton Beddoes for their work in preparing the draft;Merrill Lynch &amp; Co. for hosting the colloquium; and Gerald Corriganof Goldman Sachs, Mark Walker of Cleary, Gottlieb, Steen &amp; Hamiltonand Stephen Case of Davis, Polk and Wardwell for their advice andinput on aspects of the draft paper.</p><p>While the paper accurately represents the range of opinionsexpressed, consensus did not emerge on all points and it should notbe assumed that every participant agrees with every statement inthe working group report. Likewise, the report does not reflect anofficial view of the Group of Thirty, collectively or individually.</p><p>Jacob A. FrenkelChairman</p><p>Group of Thirty</p><p>i</p></li><li><p>Working Group on Sovereign Bankruptcy</p><p>Geoffrey BellPresident, Geoffrey Bell and Company Inc</p><p>Jack BoormanSpecial Advisor to the Managing Director, International Monetary Fund</p><p>Andrew CrockettGeneral Manager, Bank for International Settlements</p><p>Gerd HauslerCounsellor and Director, International Capital Markets Department,International Monetary Fund</p><p>John HeimannSenior Advisor, Merrill Lynch &amp; Co.</p><p>Peter KenenWalker Professor of Economics and International Finance, PrincetonUniversity</p><p>Jacques de LarosiereConseiller, BNP Paribas</p><p>Guillermo OrtizGovernor, Banco de Mexico</p><p>Ernest SternManaging Director(retired), JP Morgan Chase</p><p>David WalkerSenior AdvisorMorgan Stanley International, Inc.</p><p>John G. WalshExecutive Director, Group of Thirty</p><p>Rapporteur:Zanny Minton BeddoesThe Economist</p><p>ii</p></li><li><p>1</p><p>I. Introduction</p><p>Over the past decade, dramatic changes in international capital marketsparticularly the growth of bond financing have not been matched bya corresponding evolution in procedures for restructuring sovereigndebt. Todays typical sovereign borrower issues many types of bonds,often in several legal jurisdictions. These bonds are traded and held bya variety of market participants with different interests and timehorizons, from hedge funds to retail investors. As a result, a sovereignscreditors are numerous, diverse, and difficult to organize There is nocomprehensive framework for restructuring bond-based sovereign debt.</p><p>This situation is costly both for debtor countries and the globalfinancial system as a whole. Sovereign debt crises will always bepainful, but the lack of a comprehensive framework for restructuringsovereign debt can make them especially difficult to resolve. When asovereign debt crisis occurs, or seems imminent, the internationalcommunity has been faced with the unpalatable choice between largebailouts (Mexico 1995) or chaotic default (Russia 1998). The lack of aclear and predictable framework may also discourage debtors fromdealing with their problems promptly.</p><p>A clearer procedure for debt restructuring could therefore improvethe international financial system. Properly designed, it could ease theresolution of crises and might even help prevent them. Sovereignborrowers, in particular, might be more willing to address deterioratingdebt profiles promptly if they were more confident that debt workoutswould be negotiated rapidly and in an orderly manner. The pressure</p></li><li><p>for large official-sector crisis lending might be reduced. Greater certaintyabout how debt crises would be resolved could encourage higherprivate-sector flows to emerging economies. Badly designed debtrestructuring procedures, however, could have big negative consequencesfor the asset class of emerging-market debt. They could thereforediscourage future private-sector flows and substantially raise borrowingcosts for emerging economies.</p><p>In order to reduce the uncertainty surrounding sovereign debtcrises, a new framework for debt workouts must address the followingissues:</p><p> Who initiates a restructuring?</p><p>Should the decision to enter into workout procedures lie exclusivelywith a debtor government? Should the IMF have a role in determiningwhether a restructuring is necessary?</p><p> How are creditors organized?</p><p>Debt workouts require collective decisions by thousands of disparatecreditors. How should creditors be represented during therestructuring process? How should voting be organized and whogets to vote? How large should be the supermajority of creditorsrequired to approve a restructuring agreement that is binding onall creditors?</p><p> What prevents litigation by dissident creditors?</p><p>Orderly restructuring procedures need to protect a debtor fromcreditor litigation during the restructuring process. They mustalso protect the debtor from litigation by holdout creditors whoare unhappy with the outcome of a workout.</p><p> What debt is covered?</p><p>Sovereign governments issue a variety of debt instruments toseveral types of creditor. Should the procedure cover only foreigndebt or should it require equivalent treatment for domestic debt?Should it include only bonded debt or also syndicated loans andbank credits?</p><p> How is fair treatment between creditors ensured?</p><p>To be acceptable to creditors a debt workout procedure mustprovide equitable treatment to diverse creditors. That requires asystem for comparing debt instruments of different types andmaturities</p></li><li><p>3</p><p> How are disputes resolved?</p><p>Disputes could arise amongst creditors as well as between creditorsand the debtor. An effective workout procedure requires a meansof resolving them.</p><p> Will access to new financing be assured?</p><p>Sovereign debtors will need access to new capital during therestructuring process. Traditionally, this has been provided by theofficial sector. Ideally, workout procedures should offer thepossibility of obtaining such financing from the private sector tothe extent possible by ensuring that new capital is senior andexcluded from the restructuring. However, experience indicatesthat new money from private sources will probably not be sufficient.</p><p>While it would bring clear improvements, a debt workout procedurethat addressed these issues would not remove all the challenges anduncertainties involved in sovereign debt crises. Most important, itwould not resolve the basic problem of deciding whether a country hasan unsustainable debt burden and, if so, deciding the size of thecreditor haircut required to restore sustainability. In a corporatebankruptcy setting, the determination of a sustainable debt burden isrelatively easy. A companys capacity to pay its creditors can begauged from projections of future cash flow. In the case of sovereigndebtors, the decision is harder. Sovereign debt sustainability dependson more than simply economic criteria. A sovereign debtors fiscalresources, for instance, could be used to pay creditors or spent oneducation, health, and other basic social services. Judgements aboutdebt sustainability will always need to be made on a case-by-case basis.That is why debtors and creditors alike must look to the IMF forleadership in negotiating adjustment programs, determining balance-of-payments viability, and thus providing an overall framework for theresolution of sovereign debt crises.</p><p>Nor is an agreed restructuring framework likely to address alldebt-related problems facing an emerging-market borrower. Twoimportant types of debt stand out: official debts (those owed by anemerging-market sovereign to foreign governments and internationalfinancial institutions) and private debt (the foreign-currency debts ofprivate banks and firms in an emerging economy).</p><p>Procedures already exist for restructuring official debts owed toforeign governments (through the so-called Paris Club), but there is</p></li><li><p>currently no agreed framework for restructuring sovereign debt owedto multilateral institutions, except in the case of highly indebted low-income countries. The Paris Club process may need to be re-examinedin order to make it dovetail with the restructuring of privately-helddebt. The SDRM could also be structured to include bilateral officialdebt. The merits of restructuring multilateral debt is a more difficultissue. Multilateral financial institutions are currently preferred creditorssince they supply capital to emerging-market sovereigns when no oneelse will.</p><p>In some recent cases, debt owed by the private sector has playedan important role in triggering or compounding financial crises. In theAsian crises of 1997-98, for instance, there was little concern about thecountries sovereign debt, but much concern about the foreign-currencydebt owed by the private sector. In principle, effective domestic bankruptcylaws are the mechanism to deal with private-sector debts. But whilelocal currency debts are effectively covered, there may be issuessurrounding resolution of claims denominated in foreign currency.</p><p>Finally, a more satisfactory framework for restructuring sovereigndebt cannot decisively resolve the ongoing debate about what is theappropriate level of access to IMF resources. Better debt-restructuringprocedures may reduce the pressure for IMF lending to distressedsovereign debtors, but they will not remove it entirely. Nor is it alwaysappropriate to do so: IMF lending can prevent a short-term liquiditycrisis from developing into a full-fledged sovereign debt problem. Thequestion of whether to limit access to IMF lending more strictly, andunder what circumstances to permit exceptions, is an important, andseparate, issue in international financial reform. In short, debt workoutprocedures offer an improvement on the status quo, not a panacea.</p><p>The debate about how best to improve debt workout procedureshas been galvanized in recent months. The painful collapse of Argentina,the biggest sovereign default to date, has spurred discussion. So, too,has Anne Krueger, first deputy managing director of the InternationalMonetary Fund. In November 2001, Ms Krueger proposed a boldstatutory mechanism for sovereign debt restructuring that mimickedseveral provisions of domestic bankruptcy law. It would be introducedby amending the Articles of Agreement of the IMF, and would give theFund a central role in debt workout procedures.</p><p>After her initial proposal was greeted with considerable scepticism,Ms Krueger offered a revised version in April 2002. In this modifiedapproach, all important decisions in the debt restructuring processwould be made by a supermajority of creditors. Though the mechanism</p></li><li><p>5</p><p>would still be introduced through an amendment to the IMFs Articlesof Agreement, it would not statutorily enhance the powers of the IMF.</p><p>The main response to Ms Kruegers proposal has been a sharprevival of interest in contractual restructuring procedures based oncollective-action clauses. These clauses, which facilitate debt workoutsby providing for majority decision-making by bondholders, havetraditionally been included in bonds issued under British law. Bycustom, they are generally not included in bonds issued underNewYork law.</p><p>Also in April 2002, the United States Treasury proposed a reformstrategy that expanded upon traditional collective action clauses. Itcalled for the voluntary introduction of a new package of clauses intosovereign debt instruments. This package of contingency clauseswould not only provide for majority decision-making by bondholders(as traditional collective action clauses do), but would describe howdebtors could initiate a debt workout (an initiation clause) and whatprocedures should be followed thereafter (a procedural clause). InApril 2002, the G7 group of industrial countries endorsed a twin-trackapproach to reform. Contingency clauses should be developed and putinto place as soon as possible. Meanwhile, the IMF is to continuerefining its statutory reform proposal.</p><p>This twin-track approach makes sense. In principle, both thestatutory and contractual strategies are capable of introducing greatercertainty into the sovereign debt restructuring processthough, as thisreport makes clear, they would do so in different ways and withdifferent consequences. (That is why care must be taken that the detailsof the two reform strategies are complementary and do not undermineeach other).</p><p>In practise, there is little likelihood of rapidly introducing statutoryreform, as it would require the agreement of a large majority of theIMFs members. Moreover, even if it could be put into practise immediately,the statutory approach carries higher risks. A statutory change is morelikely to have unforeseen negative consequences on market participantsthan a contractual change that is designed in cooperation with marketparticipants, and introduced gradually and voluntarily. Given thisrisk, the immediate focus is, rightly, on making the contractual approacheffective.</p><p>Unfortunately, considerable legal and practical obstacles need tobe cleared before contingency clauses can constitute an effective procedurefor sovereign debt workouts. The contents of such clauses need to beagreed upon. Debtor countries must be persuaded to introduce th...</p></li></ul>


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