SOVEREIGN DEBT RESTRUCTURING: PROBLEMS debt restructuring operations between private parties before turning to the criteria by which sovereign debt restructuring outcomes can be judged

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    SOVEREIGN DEBT RESTRUCTURING:PROBLEMS AND PROSPECTS

    MARK L. J. WRIGHT*

    ABSTRACT

    This Article reviews the history of sovereign debt restructuring operationswith private sector creditors with a view toward diagnosing the factors that leadto inferior outcomes. The Article also attempts to forecast potential problemsthat may arise in sovereign debt restructuring negotiations in the future andreviews possible modifications of existing institutions. The future potentialproblems range from the role of credit default swaps in discouraging creditorparticipation in voluntary exchange offers to the potential for manipulation ofaggregation clauses. Other potential issues include the possibility of de factosovereign default on state contingent debts through statistical manipulation,more widespread use of appeals to the notion of odious or illegitimate debts, andthe extent to which recent regulatory changes aimed at restricting litigationagainst sovereigns in default might reduce the incentive for sovereigns to repaytheir debts in the future.

    TABLE OF CONTENTS

    INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 RI. PRELIMINARIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 R

    A. What is Special about Sovereign Debt Restructuring? . . . 155 RB. Criteria for an Optimal Debt Restructuring Process . . 159 RC. Sovereign Debt Restructuring and Sovereign Default . . . . 162 RD. Institutions Governing Restructuring in History . . . . . . . . . 165 R

    II. SOVEREIGN DEBT RESTRUCTURING OUTCOMES . . . . . . . . . . . . . . . 167 RA. Data Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 RB. Delays in Reaching Agreement . . . . . . . . . . . . . . . . . . . . . . . . 169 RC. Creditor Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 RD. Debt Relief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 RE. Costs of Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 RF. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 R

    III. EXPLAINING SOVEREIGN DEBT RESTRUCTURING OUTCOMES . . . 171 RA. Creditor Coordination and Cooperation . . . . . . . . . . . . . . . . 172 R

    * Senior Economist, Federal Reserve Bank of Chicago; Assistant Professor, Department ofEconomics, University of California, Los Angeles; and Faculty Research Fellow, National Bu-reau of Economic Research. An early draft of this Article was prepared for the AdvisoryGroup on Dispute Resolution and Sovereign Debt convened by the Netherlands Governmentand the Permanent Court of Arbitration on May 12 and 13, 2011, at The Hague. I thank,without implicating, David Benjamin, Daniel Dias, Rohan Pitchford, and Christine Richmondfor allowing me to draw upon our joint work, as well as Nicole Bollen, Damien Eastman, MituGulati, Garth Schofield, and the members of the Advisory Group, for comments and illuminat-ing discussions. I also thank the National Science Foundation for research support under grantSES-1059829. The views expressed are the authors and do not necessarily reflect the views ofthe Federal Reserve Bank of Chicago or the Federal Reserve System.

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    154 Harvard Business Law Review [Vol. 2

    B. Coordinating Debtors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 RIV. LOOKING FORWARD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 R

    A. Alternative Mechanisms to Promote CreditorCoordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 R

    B. Aggregation Clauses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 RC. Derivative Securities and Debt Restructuring . . . . . . . . . . . 183 RD. State Contingent Sovereign Debt . . . . . . . . . . . . . . . . . . . . . . . 187 RE. Odious and Illegitimate Sovereign Debts . . . . . . . . . . . . . . . 190 RF. Coordinating on Denial of Market Access . . . . . . . . . . . . . . 192 RG. Is There a Need for an International Debt Referee? . . 193 R

    CONCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 R

    INTRODUCTION

    At the time of writing, Europe is in the early stages of a sovereign debtcrisis. Greece has already announced plans to restructure its stock of sover-eign debt, while the price of credit default swaps (CDS) indicates that finan-cial markets increasingly expect a number of other European sovereigncountries to follow in the near future. What is the likely outcome of theseEuropean debt restructuring operations? Can history act as a guide as towhat to expect of these operations? Is there room to improve upon the out-comes of the past? And what new problems are likely to arise in the future?In this Article, we review the history of sovereign debt restructuring opera-tions with a view toward diagnosing the factors that lead to inferior out-comes, proposing possible solutions to debt restructuring problems, andanticipating future problems that may arise with the continued evolution ofthe market for sovereign lending.

    After reviewing a number of important preliminary matters in Part I,including possible criteria that might be applied in the design of an optimalprocess for restructuring debts, in Part II we survey some of the recent evi-dence on the outcomes of sovereign debt restructuring. As the European cri-sis predominantly involves sovereign bonds, our focus will be on theexperience of sovereign debt restructuring operations with private sectorcreditors (including both bondholders and commercial banks), emphasizingthe lessons drawn from the experience of the emerging markets of LatinAmerica for the submerging markets of Europe. We show that outcomeshave typically been poor, with restructuring operations taking on average thebetter part of a decade to complete, resulting in creditor losses on the orderof forty percent of the value of their claims and leaving the debtor countriesequally or more indebted than they were when they entered default. Al-though restructuring outcomes are poor for almost all countries, they appearto be especially poor for the low-income countries of Sub-Saharan Africa.

    Part III then reviews possible explanations for these outcomes. The factthat the history of sovereign lending is associated with repeated attempts bycreditors to form institutions to promote coordinated action suggests that

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    2012] Sovereign Debt Restructuring: Problems and Prospects 155

    collective action problems may be an important determinant of these out-comes. We review some recent theoretical research on this topic that sug-gests that mechanisms such as the introduction of collective action clausesinto debt contracts have the potential to both reduce the costs of restructur-ing and improve the terms on which sovereigns will be able to borrow in thefuture. Importantly, this literature also suggests that such mechanisms arenot a panacea and may lead to worse restructuring outcomes when applied tocountries with poor debt management systems for which managing a restruc-turing operation is very costly. We also review a number of other potentialexplanations for poor restructuring outcomes.

    Part IV then draws a much longer bow and attempts to forecast poten-tial problems that may arise in future sovereign debt restructuring negotia-tions. We explore the extent to which the increased availability of derivativesecurities such as credit default swaps has the potential to discourage credi-tors from participating in a proposed debt restructuring operation and, in theevent that they do participate, from exerting the appropriate resources toensure an efficient restructuring outcome. We conjecture that increased issu-ance of state contingent debt securities will lead to the occurrence of a formof de facto sovereign default in which sovereigns manipulate their own sta-tistical data to reduce payments on their own bonds. We review the practicalproblems that are likely to arise with more widespread appeals to the notionof odious or illegitimate debts as a justification for imposing larger losses oncreditors. Finally, we consider the extent to which recent regulatory changesaimed at restricting litigation against sovereigns in default might reduce theincentive for sovereigns to repay their debts in the future. At each point, weemphasize the importance of carefully crafting solutions to these problemsso as to avoid creating perverse incentives for market participants.

    I. PRELIMINARIES

    In this Part, we outline some of the issues that arise when thinkingabout sovereign default and sovereign debt restructuring. We begin with adiscussion of the factors that make sovereign debt restructuring differentfrom debt restructuring operations between private parties before turning tothe criteria by which sovereign debt restructuring outcomes can be judged.We then discuss some concepts that arise from an attempt to quantify theextent of sovereign default and sovereign debt restructuring throughout his-tory. Finally, we provide a brief history of sovereign debt restructuring anddescribe the institutional environment within which restructuring negotia-tions have taken place.

    A. What is Special about Sovereign Debt Restructuring?

    The debts issued by sovereign governments differ from the debts ofprivate entities in at least two important respects. The first difference arises

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