Bail-Ins, Bail-outs, Burden Sharing and Private Sector ...
Preliminary draft
Do we need a new international bankruptcy regime?[1]
Comments on Bulow, Sachs and White
by
Nouriel Roubini
Stern School of Business
New York University, NBER and CEPR
April 4, 2002
Recently, the debate on the reform of the international financial architecture has centered on the issue of the appropriate mechanism or regime to be developed to ensure orderly sovereign debt restructurings. While recent sovereign bonded debt restructuring cases (Pakistan, Ecuador, Ukraine and Russia) have been successfully completed with the use of unilateral exchange offers (at times complemented by a system of carrots and sticks such as exit consents to ensure successful deals), many have expressed dissatisfaction with this “market-based” status quo approach. Also, the recent default by Argentina suggests that we need to reconsider the issue of optimal debt restructuring regimes. And recently, Anne Krueger, the First Deputy Managing Director of the IMF, has proposed the creation of an international debt restructuring mechanism (SDRM) that would have many of the features of an international bankruptcy regime[2]. The three papers by Jeremy Bulow, Jeffrey Sachs and Michelle White are all interesting contributions to this debate on the appropriate sovereign debt restructuring regime.[3] They all address the question of whether we need an institutional change in the international financial system that would lead to a new way to provide for orderly sovereign debt restructurings/workouts when they become necessary.
So, the difficult policy question to address is: when sovereign debt restructuring/reprofiling/reduction becomes necessary and unavoidable, what is the appropriate regime that provides an orderly restructuring while safeguarding the balance of rights of both the creditors and the debtor?[4] Is it better to continue with the “market-based” status quo regime where exchange offers have been used to do bonded debt restructurings? Or should we move to the wholesale introduction and use of collective action clauses (a “contractual approach”)? Or should we consider creating an international bankruptcy mechanism (as “statutory approach”) such as the one proposed by the IMF.[5]
The issue in this debate is which restructuring regime is most efficient in cases in which the country’s debt path is deemed to be clearly unsustainable (cases of “insolvency”). Subject to the caveats that the concept of insolvency is problematic in the sovereign context (as “inability to pay” may be combined with “unwillingness to pay”) and that the assessment of unsustainability is always probabilistic (as a sharp primary adjustment could in principle make an unsustainable debt path sustainable), there is a general consensus that in cases of “insolvency” further official finance is not warranted and that the sovereign should suspend debt payments and restructure/reduce its debts, while at the same time undertaking serious and credible domestic fiscal adjustment and structural economic reform.[6] The debate is not on whether the sovereign should restructure its debt in these unsustainable situations. It is instead on the appropriate regime for orderly sovereign debt restructurings in these unsustainable debt cases. There are essentially three alternative options/regimes that one may want to implement and use.
First, continue with the current “market-driven” status quo regime where sovereign bonded debt restructurings (Pakistan, Ecuador, Ukraine and Russia) have been successfully completed with the use of unilateral exchange offers (at times complemented by the use of exit consents),
Second, move to a “contractual approach” regime where collective action clauses (CACs) are introduced in most bond (and possible other debt) contracts and used to achieve debt restructurings.[7]
Third, design a new “statutory regime” where an international bankruptcy regime for sovereigns is created and used to achieve sovereign debt restructurings. The latter regime has been recently re-proposed by the Anne Krueger, the Deputy Managing Director of the IMF.
So, when sovereign debt restructuring/reprofiling/reduction becomes unavoidable, what is the most efficient regime that provides orderly restructuring while safeguarding the balance of rights of both creditors and the debtor?
Each of these three approaches to sovereign debt restructuring has some pros and cons. One way to think about the relative merits of these three regimes is to first ask what are the market failures that may prevent and orderly and efficient restructuring of sovereign debt when such orderly restructuring is beneficial to both debtors and creditors. One can think of several externalities that prevent orderly restructurings but there are three of them that are crucial and they all have to do with collective action problems among creditors[8] [9]:
1. The “rush to the exits”: this is the collective action problem of creditors in the run up to a crisis. As a sovereign debt crisis is unfolding, creditors may try to rush to the exits and cause a disorderly crisis that has real and avoidable costs; an example is the one of liquidity or rollover runs. But, as discussed below, a debt suspension/standstill (including capital/exchange controls and/or deposit freezes) may avoid such a destructive rush to the exits.
2. The “rush to the courthouse” externality. While a unilateral debt standstill may take care of the inefficiencies of a “rush to the exits”, such standstill may cause a “rush to the courthouse”. Creditors may start litigation and this potential externality can become a serious problem if creditors can attach assets, i.e. have a first claim on the assets of the debtor if they move first (“rush to the courthouse” or “grab race”). But as discussed below, there are important differences between the corporate paradigm and the sovereign one on this matter as the ability of creditors to seize/attach sovereign assets is very limited.
3. The “free rider” or “holdout” or “rogue creditors” problem (another collective action problem among creditors). This is an important obstacle to orderly restructuring. In situations where unanimity may be required to restructure debt, minority holdout creditors may scuttle a restructuring that is advantageous to the majority of creditors. While the unanimity problem may be sidestepped with exchange offers, the holdout problem may potentially remain serious. If an holdout does not accept the offer and then receives (via post-deal litigation or its threat) the full amount of his/her claims while those who accept the offer receive a lower amount than their full claim, there is a strong incentive to hold out (“free riding”) with the consequence that an otherwise mutually advantageous deal may fail because many/most creditors will decide to hold out. If this coordination problem among creditors cannot be solved, a disorderly and costly workout will be the outcome even if it would have been in the interest of all creditors to achieve a cooperative solution (i.e. a non-cooperative Nash equilibrium with holdouts is inferior to the cooperative/coordinated one). In this regard, the ability to have a restructuring plan approved by a majority of creditors made binding on the entire creditor body (a “cram-down” or majority enforcement provision) would solve this holdout externality.
In addition to these three collective action problems among creditors, any efficient mechanism has to deal with a fourth potential market failure on the side of the debtor:
4. The “rush to default” or the debtor’s incentive to do “opportunistic defaults”. As the literature on sovereign debt suggests, a default decision may be due not to “inability to pay” but to “unwillingness to pay”. There is always the possibility of opportunistic defaults given that a sovereign benefits from (not full but significant) sovereign immunity and thus attaching/seizing sovereign assets is difficult. Thus, an efficient international debt workout mechanism needs to tradeoff two objectives: not to make workouts too costly as default may at times be due to inability to pay and restructuring can thus benefit both the debtor and its creditors; and not to make workouts too easy as otherwise the temptation to have opportunistic defaults may increase.
I will first analyze how the three regimes being considered address the three collective action problems of creditors. I will at the end of my remarks address the question of the “rush to default”; this issue is essential to the views of Bulow on the desirability of an international bankruptcy regime and on his proposal for granting full immunity to sovereigns.
Let us consider first the pros and cons of each regime in terms of the collective action problems of creditors.
Supporters of a new statutory regime[10], an international bankruptcy mechanism, stress the fact that, while the above collective action problems always existed, they have become more severe in the last few years given development in international financial market.
First, in the 1980s most of sovereign debt was held in the form of medium-long term syndicated bank loans; the covenant of these loans included sharing clauses and other limits to initiation of litigation that made the “rush to the courthouse” less serious. They also had implicit or explicit majority clauses that allowed to deal with holdout banks; also moral suasion, deriving from repeated interaction among banks was more likely to rein in holdouts.
Second, in the 1990s most of the flows to emerging markets sovereign have taken the form of bonds. The number, heterogeneity and differences of interest of this wider group of creditor makes the holdout problem much more severe.
Third, the emergence of new bond creditors with no ongoing relations with the debtor or other creditors, suggests that the presence of aggressive holdouts, i.e. “vulture” creditors, who are willing to hold out and aggressively pursue their claims in court may have increased. Indeed, the recent Peru-Elliott case is seen as major threat to orderly debt restructuring as the creditor successfully pursued a litigation strategy and ended up being paid in full.
In summary, the variety of claims (bank loans of various maturity, different types of bonds under different legal jurisdiction and with or without collective action clauses) and types of creditors (retail investors, investment and commercial banks, real money fund, hedge funds and other highly leveraged aggressive creditors, dedicated emerging market funds and cross-over investors) makes the collective action problem of coordinating the interests and action of such an heterogeneous world of claims and claimants almost impossible: investors may rush to the exits in a destructive panic; they may rush to the courthouse and start litigation if the debtor suspends payments and they may free ride /holdout even if a majority of creditors could reach an agreement advantageous to all. If this view is correct a new international bankruptcy mechanism could allow an orderly restructuring. The main advantage of such a mechanism is that it would solve the three collective action problems by:
1. allowing the imposition of a suspension of debt payments that stops the “rush to the exits”;
2. imposing a “stay of litigation” following the debt suspension that is legally binding on all creditors and thus prevents disruptive litigation (the grab race);
3. allowing for a majority vote on a restructuring agreement that is binding on all creditors, thus eliminating the “free riding” or “rogue creditor” problem.
Supporters of the second option[11], the “contractual approach (the universal introduction and use of collective action clauses in bond and debt contracts) would argue that most of the benefits of the “statutory approach” could be obtained with the use of collective action clauses (CACs). Such clauses usually do not allow individual bondholders to start litigation (litigation has to be voted by a majority of creditors) and/or include sharing clauses that reduce the benefits of being an holdout and litigate. Also, CACs would include majority "cram-down clauses" so that an agreement reached by a majority of creditors can be binding on all holdouts, thus solving the free rider problem. Thus, all the collective action problems that prevent an orderly restructuring could be solved with the use of CACs. And relative to an international bankruptcy regime that could potentially give new judicial powers to the IMF and/or to some “bankruptcy court”, the contractual solution could be more market friendly and rely on an agreement to be reached between the sovereign debtor and its creditors.
However, it is important to note that the sovereign debt restructuring regime proposed by the IMF (at least its last incarnation as in Krueger (2002)) would not be substantially different from a contractual approach as it would be “creditor-centered” rather than being “IMF-centered”: specifically this latest SDRM proposal would provide to creditors all the rights related to approving by a majority vote an initial stay of litigation (and its continuation) and approving by majority a restructuring deal that would be binding on minority holdout creditors. Thus, this “IMF-lite” SDRM would not be substantially different from a beefed-up contractual approach in terms of being creditors, rather than “court”, driven.
Moreover, supporters of the “statutory” approach would counter-argue that the statutory solution is superior to a contractual regime for several reasons.
First, there is a transitional problem as many outstanding bonds, those issued under New York law, do not have CACs. So, even if new bonds included them, the past stock of outstanding bonds would not have them.
Second, under traditional CACs the vote to start litigation or cram down by majority an agreement is taken bond-by-bond rather than by a majority of all creditors in the asset class (all bondholders). So, holdout problems and litigation problems may reemerge if a majority of bondholders in one issue decides not to cooperate. While one may think of some super-clauses that would imply a super-majority vote by all creditors in a particular credit class (all bonds), these clauses do not exist so far and are not likely to be introduced in a uniform way any time soon.
Third, while collective action clauses could be eventually included in all bond covenants, many other claims on the sovereign (banks loans, various other credit instruments) may or may not have them. Also, over time financial innovation may lead to the creation of new financial instruments, such as various credit derivatives, that may not include such clauses. The statutory approach has the advantage that, regardless of what current and other future claims on the sovereign are, they would all be included in the same restructuring mechanism and be subject to the same overall majority vote to initiate or withhold litigation and vote to approve a restructuring agreement.
Fourth, achieving uniformity of CACs (their wording and interpretation) issued in very different legal jurisdictions may be very hard to achieve. Messy, costly and protracted legal issues of interpretation and adjudication may result. While an uniform international bankruptcy regime would codify a standard set of rules, case law and interpretations.
While some of these difficulties could be surmounted in a contractual approach via the use of superclauses, arbitration and other meta-clauses, such a beefed-up contractual approach ends up becoming very close to a creditor-centered statutory one.[12]
Supporters of the status quo regime[13] start from the observation that, while ideally a “statutory approach” or a “contractual approach” would solve these collective action problems and thus be welcome institutional developments, they are both unlikely to emerge for a complex set of political-economy issues. The U.S. will not agree to have an international legal regime overrule US security laws and its protection of creditor rights; many emerging markets may resist the bankruptcy regime based on a concern that it would make it easier for the IMF to cutoff lending to crisis countries, thus “dumping” them into the bankruptcy court; and the other G7 (while being in principle more sympathetic to the idea of an international bankruptcy regime)[14] will not aggressively push for it. A “contractual approach” is also unlikely to see light as, while rhetorically supported by the G7/G10 since the times of the Rey Report in 1996, there is no system of carrots and sticks to ensure that both creditors and debtors include them in new bond issues. Thus, progress on adoption of CACs has been dismal so far.[15] Thus, if neither the statutory nor the contractual approach are likely to see light in the foreseeable future, one has to try to make the most of the status quo regime to achieve orderly restructuring.
In this regard, recent experience suggest that bonded debt restructurings are feasible and have been successfully achieved, even in the presence of hundreds of thousands of heterogeneous creditors, with the use of unilateral exchange offers (cum exit consents when available) in several episodes: Pakistan, Ukraine, Ecuador, Russia.
Moreover, the collective action problems emphasized by many may be exaggerated in reality. First, any sovereign faced with a “rush to the exits” can stop it with a unilateral debt suspension; thus, this collective action problem has already a solution available in the current status quo: a unilateral debt suspension/standstill/default. It is true that this debt suspension, in the absence of a stay of litigation, may lead to a “rush to the courthouse”. But the collective action problem of a “rush to the courthouse” is not severe in the case of sovereign debtors. This market failure (also referred to as the “grab race”) is certainly important and severe in the corporate bankruptcy context where rushing to litigate may allow a creditor to attach assets. Thus, bankruptcy regimes such as Chapter 11 or 7 prevent such a grab race via a stay of litigation once the debtor has applied for the bankruptcy protection. And the stay is mostly about protecting creditors rights (i.e. avoid the unfairness of some creditors attaching assets to the disadvantage of other creditors) in a corporate context.
In the sovereign context, the rush to the courthouse is much less of a problem as sovereign immunity implies that creditors have trouble finding assets worth rushing to claim. The ability to attach asset via early litigation is severely limited. In fact, there is a scarcity of assets under the jurisdictions of foreign courts that can be potentially available for creditors to seize/attach. And, indeed, there is little evidence of a rush to litigate in sovereign debt crisis when a country suspends debt payments. For example, in the recent case of Argentina, creditors threatened litigation but they have not so far started it.
Then, if the rush to the exits and the rush to the courthouse are not real issues in the current status quo, one is left with the “holdout /free rider” problem as the main collective action problem that may not be as easily solved in the absence of majority cram-down clauses. But, in the reality of the current status quo regime, even the free rider problem (and the related litigation threat) has not been as severe as initially thought. There are plenty of sensible ways to overcome and minimize the rogue creditor problem even without majority cram-down clauses. Here are ten reasons why the holdout problem is not a big problem in practice.
First, the unanimity problem (as when bond contracts do not have majority cram-down clauses) can be bypassed with the use of unilateral exchange offers. While these offers do not eliminate the holdout problem, they allow for a great majority of cooperative bondholders to accept new bonds with new payment features even when the old bond required unanimity to change their terms. And indeed, in cases where there were thousands of bondholders (Ukraine, Pakistan, Ecuador, Russia) such unilateral exchange offers have had overwhelming success with 99% plus of creditors accepting the offer.
Second, as it is well known “exit consents”, to change by majority vote the non-financial terms of the bond covenant, have been successfully used (see Ecuador) to dilute the benefits of being a holdout.
Third, a system of carrots (sweeteners in the form of cash, collateral release, seniority upgrade) and sticks (threat of default, ex-post use of CACs, exit consents) has been used and can be used to ensure a successful completion of deals.
Fourth, the “free rider” or “holdout” problem is predicated on the assumption that, in a debt restructuring, a creditor that holds out would receive a financial benefit that is greater than the one he/she would receive by participating in an exchange offer. But this assumption is flawed in a number of ways that significantly reduce the risk of having many rogue creditors and the litigation risk. Note that the simple assumption that a holdout would automatically receive the full value of his/her claims rather than the value offered in an exchange is false. Moreover, in any market based exchange offer, any mark-to-market investor should accept the offer (or be at the margin be indifferent) – rather than holdout - as long as the value of the new claims is at least as large as the value of the market value of the old claim. Since no creditor would want to accept an exchange offer where there is not at least mark-to-market neutrality, a successful exchange offer must provide a new claim whose market value is at least as high as that of the exchanged instruments. And indeed in all previous debt exchanges (Pakistan, Ecuador, Ukraine, Russia) creditors have enjoyed mark-to-market gains (20-30% on average); such gains increased the likelihood that the offer will be accepted by a majority of creditors.
Fifth, a creditor may decide to hold out, even if the offer has neutral value (mark-to-market neutrality) or a mark-to-market gain if the risk-adjusted expected discounted net value of its original claim, if he/she holds out, is greater than that of the new claim. But all the underlined elements are fundamental in determining whether a creditor will hold out and litigate. Litigation is costly (especially for small creditors); some creditors (the small retail ones) are more risk averse than others and the outcome of litigation is uncertain; some have a high rate of time preference and may not want to wait for the delay costs of protracted litigation. Thus, a majority of creditors are likely to rationally accept an offer that is mark-to-market neutral or slightly positive, rather than holdout and incur the costs and risks of litigation.
Sixth, large financial institutions that have ongoing business relations with a sovereign debtor (through the franchise value of their commercial banking operations in the debtor country and/or the fees/commissions from their investment banking services to the debtor) are unlikely to hold out and fight. They may actually be the leader/catalytic agents that would contribute to coordinate the actions of the many creditors, apply moral suasion on holdout and, if necessary, bribe them into accepting a deal. The desire to gain the large fees/commissions involved in a successful deal leads the intermediaries to design workout packages that minimize such “deal risk”.
Seventh, the holdout problem can be minimized through side payments (“bribes”) offered by creditors who have a lot to gain from a successful deal; or by the debtor (that “ex-post” buys out a limited number of holdouts); or official creditors (via extra amounts of official finance that provide enhancements and/or sweeteners to a deal).
Eighth, the Elliott-Peru decision was, from a legal standpoint, highly controversial and unusual and, most likely, its logic would not stand if challenged in other legal cases. A legal doctrine that interprets “pari passu” allowing to block payments to creditors that have accepted an exchange offer is highly controversial and very likely to be successfully challenged in court.
Ninth, creative variants of the status quo regime of exchange offers can be designed to provide market based orderly restructurings that reduce the risks of litigation and/or free riding.[16]
Tenth, rogue creditors and vulture are often part of the solution rather than part of the problem. Low risk aversion vultures tend to buy low, when default has occurred and debt prices have collapses and get large mark to market gains from a successful deal; thus, they may accept an exchange offer rather than litigate. For example, the infamous Elliott who successfully sued Peru was holding Ecuador debt and decided, with 99% plus of creditors, to accept the exchange offer rather than holdout as the offer provided significant mark to market gains. Morover, even “rogue creditors” who will eventually sue will not jeopardize the completion of an exchange offer: their incentive to start litigation are triggered by a successful, not a failed offer; only after a majority of creditors accepted a deal, a rogue will have the incentive to litigate and attempt to obtain his/her full claim.
Thus, while one cannot fully solve the free rider problem in the absence of a majority cram-down clause (that is available in the contractual and statutory regimes), there are creative ways to minimize its risks and consequences in the current market based status quo. And, indeed, recent experience has shown that holdout problems have not prevented the successful achievement of orderly bonded debt restructurings. In most cases, the status quo may still work and allow successful exchange offers where the holdout problem becomes only a post-deal nuisance.
This view in favor of the market-based status quo does not mean that a contractual or statutory regime would not be beneficial if implemented; the latter regimes would provide cleaner and potentially more efficient ways to solve the free rider problem. But, as long as these regimes are not in place and unlikely to be in place in the foreseeable future, my argument is that one can creatively use the market-driven status quo to achieve orderly restructurings.
“The Rush to Default” problem
I will finally consider the “rush to default” problem on the part of the debtor as this is a main concern of those, like Bulow, who worry about debtor moral hazard. In a world where countries benefits of sovereign immunity and creditors have very limited ability to attach/seize sovereign assets, there is always a possibility that a sovereign would “opportunistically” default, i.e. default may be driven by unwillingness to pay rather than inability to pay. And indeed, the large literature on sovereign default has studied the incentives of a sovereign to default and the factors (costs/punishments) that may limit the temptation to have such opportunistic defaults.
Of course, since sovereign debt has always the potential to lead to “opportunistic defaults” (unwillingness to pay as opposed to inability to pay), a restructuring that is too “easy” or “orderly” (i.e. with little or no cost to the debtor) may not be socially efficient. Indeed, given the pervasiveness of sovereign immunity, the appropriate costs (in terms of loss access to international capital markets, output and trade losses) that creditors can impose on the debtor are an important component of a well balanced regime that minimizes the moral hazard of opportunistic default. But while “default” that is too “easy” may not be efficient, a “disorderly” default (triggered by an inability to pay) can impose losses that are socially inefficient and thus can hurt both the debtor and the creditors. Thus, subject to the caveat that defaults should not be too easy (to prevent opportunistic defaults), an orderly debt restructuring should be the objective of an international regime that allows countries with unsustainable debt profiles to restructure their liabilities.
How would the three restructuring regimes deal with the “rush to default” issue? Supporters of the status quo regime would argue that the “rush to default” is not a big issue in the first place. In this view, even in the current regime with limited sovereign immunity, sovereign have strong incentives not to opportunistically default as such action has severe reputational costs and punishments in the form of protracted loss of access to international capital markets, output and trade losses and other punishments, including litigation and attempts to seize assets, that creditors can impose on the sovereign.[17] In this view, a healthy and balanced regime is similar to the current one where the incentives of sovereign to opportunistically default are already limited by the consequences and costs of such default. Thus, making it easier for the debtor to default via a statutory regime that provides greater legal protection against creditors’ actions in case of default may tip the balance in favor of debtors and trigger opportunistic default that would ultimately reduce the ability of emerging markets to access capital markets.
At the other extreme, a well designed SDRM regime would provide legal protection of the sovereign against creditor litigation but it would have safeguards against the abuse of this protection by opportunistic debtors. In one variant of the SDRM, access by the debtor to this SDRM legal protection would be conditional to an IMF assessment that the country has an unsustainable debt position; without such sustainability test, the country would not receive such legal protection. In another variant, closer to a majority enforcement clause, a majority of creditors would take the decision on whether approve and extend a stay or instead to start litigation. Thus, as in the current regime, opportunistic defaults could be dealt with the threat of litigation if creditors believe that the debtor is behaving in “bad faith”.
In the contractual approach, opportunistic defaults would again be addressed by the threat of litigation on the part of a qualified majority. Unlike the current status quo where any creditor can start legal action if he/she desires so, in the contractual approach the decision to start litigation would be made by a majority of creditors (to avoid disruptive litigation by a small minority of creditors).
An interesting but radical view of debtor “moral hazard” and the merits of a bankruptcy regime is presented by Jeremy Bulow in his paper. Bulow starts from the view that debtor moral hazard is pervasive in two ways: first, emerging market policy makers have a bias towards socially inefficient budget deficits (as the are “corrupt” or “malevolent” policy makers that will borrow for inefficient reasons and transfer the debt burden to future policy makers and taxpayers); second, the “unwillingness to pay” problem (rather than the “inability to pay”) is severe in emerging market economies where a sovereign (benefiting from partial sovereign immunity) has a strong incentive to do opportunistic defaults. So, the problem of emerging market sovereigns is that they borrow too much to begin with and the ability to borrow internationally distorts this initial bias towards budget deficits and debt accumulation.[18]
Thus, Bulow believes that the way to reduce or eliminate this bias is, paradoxically, to provide sovereigns full sovereign immunity, rather than the partial sovereign immunity coming from debt issuance in major financial centers; sovereign debtors should be allowed to borrow only in their own legal jurisdictions where sovereign immunity is close to full. In his view, the partial legal protection of creditor rights in international jurisdictions exacerbates the debt/deficit bias of reckless emerging market policy makers. Since their ability to issue debt (purchased by foreign investors) when there is full sovereign immunity in local jurisdictions would be severely limited, this reform may altogether shut down or severely restrict the ability of “reckless” sovereign debtors in to borrow internationally. Only good and responsible sovereign policy makers following sound policies and devoid of the temptation to default would be able convince foreign investors to lend them in securities issues in domestic jurisdictions. If, after this reform, most sovereign debtors are unable to borrow from international investors, this would be a better world in Bulow’s view.
Then, again paradoxically, in the Bulow view the only potential benefit of an international bankruptcy court is that, by making it easier for a sovereign to default and restructure its debts (assuming that the regime is designed in such a way that the relative power of the debtor is increased), it would severely shrink the amount of international capital lending to emerging market sovereign debtors, an outcome that he finds to be socially efficient. So, the international bankruptcy court is good as it would effectively destroy the market for international issuance of new sovereign emerging market debt. While granting full sovereign immunity would be his first best policy to achieve this goal, the international bankruptcy court could be a second best policy that would reduce the initial excessive borrowing distortion of debtors.
I am not convinced by his arguments for a number of reasons.
First, reputational mechanisms and output/trade costs of default do significantly restrict the willingness, even of otherwise “malevolent” policy makers, to default. Governments try to avoid as much, and as long as possible, defaults as they are politically, socially and economically costly.
Second, the empirical evidence on moral hazard (both debtor’s and creditors’) in international lending is extremely thin; for example, Jeanne and Zettelmeyer (2001) show that domestic tax payers, rather than the IMF/IFIs (i.e. the international tax payers) or creditors, pay for the costs of official support packages. Thus, the idea that emerging market economies borrow too much and follow reckless economic policies in expectation of being bailed out by the IMF has little basis. The idea that countries would willingly follow policies that lead to currency crises, banking and financial crises and possible default in expectation of bail-out is not supported by evidence. The costs of crises are severe and crises lead (good and bad, democratic and autocratic) policy makers to be booted out of power.[19]
Third, a side implication of the point above (i.e. IMF support is not in reality a “bail-out” of the debtor as it is an unsubsidized loan, not a grant) is that Bulow’s aversion towards lending by the IMF/IFIs (the IMF should not make loans because it leads to gaming between debtors and private creditors to extract resources from the official sector) does not have a strong empirical basis. Also, there are many other arguments in favor of IMF loans and conditionality and against the “aid but no loans” view.[20] Even the authoritative views of Jeffrey Sachs on the issue of IMF loans appear to have changed over time. While in his 1995 paper first he made the argument that the IMF should become an international lender of last resort (ILOLR) to deal with liquidity crises, he then argued that, even better than large bailout packages, liquidity runs could be addressed by turning the IMF into an international bankruptcy court with the power to declare standstills and restructure sovereign debts and thus avoid the destructive effects of a “rush to the exits”. But his later analysis of the Asian crisis as being driven mostly by self-fulfilling liquidity runs suggested again that large IMF liquidity packages would be necessary to deal with such destructive liquidity panics and runs. Thus, his later support, within the work of the Meltzer Commission, of turning the IMF into a quasi ILOLR that would lend very large amounts to well-behaved countries that experience liquidity runs, panics and contagion.[21] Also, while some (as Sachs in 1995) may argue that, even in the case of liquidity runs one could use - as an alternative to large official support - capital controls, standstills, debt suspensions and debt reprofiling/restructuring as a way to prevent the effects of such panics, this approach would be seriously counterproductive and destabilizing in practice. In a world with uncertainty, risk aversion and imperfect policy credibility expectations of standstill to solve liquidity runs may trigger an early and destructive “rush to the exits” that would have serious consequences even if all international financial transactions (including sovereign and private ones) were subject to a standstill.[22] Thus, at least for cases closest to illiquidity runs, there is a broad intellectual and policy consensus that large IMF loans, rather than standstills and defaults, may be the way to resolve such crises. This is also way central banks mostly use lender of last resort liquidity support, rather than bank holidays (deposit freezes), to deal with pure liquidity runs and panics.
Fourth, restricting the ability of sovereign policy makers to borrow in foreign jurisdictions may not restrict significantly their ability to borrow and the risk of crises. Of the financial crises of last decade (Mexico, Korea, Thailand, Indonesia, Russia, Brazil, Turkey, Argentina) only one (Argentina) had to do with the foreign issued debt of a sovereign.[23] In some crises (Korea, Thailand, Indonesia), private rather than public liabilities, were the source of the vulnerabilities. Even in crises where public debt was at the source of the liquidity or currency mismatch that triggered a crisis, most of the borrowing that was at risk was issued at home (Tesobonos in Mexico, GKOs in Russia, domestic local and foreign currency short term debt in Turkey and Brazil, domestic debt of Argentina).[24] Even in these sovereign crises, the foreign currency liabilities of a private financial system were often subject to a run or rollover crisis, on top of the run on sovereign claims.
Fifth, as long as the ability of the private sector to borrow internationally is not restricted, restricting the ability of a sovereign to borrow internationally will not affect its ability and cost of accumulating debt: the sovereign will borrow at home and the private sector will in turn borrow abroad to indirectly finance the borrowing needs of the sovereign.[25] For example, in many recent crises (Mexico, Russia, Brazil, Turkey, Argentina) a large fraction of the government debt was issued domestically and purchased by domestic banks; these, in turn, borrow short term and in foreign currency from abroad to indirectly finance the government’s budget needs.
Sixth, while it is conceptually obvious that the existence of a third player, the IMF or official sector providing funds, may lead to a delay game between the debtor and its creditor aimed at extracting further official resources, the empirical relevance on this problem is very weak. As long as the subsidy component of IMF loans is small (as shown by Jeanne and Zettelmeyer (2001)) and as long as IMF loans are senior to private claims (as they are), such gaming would not be beneficial to the debtor (whose tax payer eventually repays those loans) nor to the creditors (as further debt senior to private claims at some point may end up hurting the servicing of private claims). Thus, this specific critique by Bulow of IMF loans is conceptually correct but policy-wise of minor relevance.
Seventh, the international bankruptcy court, as designed and proposed by the IMF (see Krueger (2002)) would not provide any new powers to the IMF or to the debtor country, relative to the current status quo or a contractual regime with collective action clauses. Thus, it will not tip the balance in favor of the debtor relative to the current status quo and thus it will not affect the debtors’ incentives to default and, thus, it would not affect in principle the amount of flows to emerging market sovereigns. Thus, as proposed by the IMF, the international bankruptcy regime would not severely restrict (as otherwise hoped by Bulow) the amount of lending to emerging market governments.
Thus, in conclusion, Bulow’s view of the evils of international sovereign borrowing and of IMF lending seems extreme and not warranted by the facts. And his solution to this alleged problem/distortion would not, most likely, solve the distortions that it is meant to address.
Conclusion
The debate on which one of the alternative debt restructuring regimes is better at achieving orderly restructurings is still open; all three regimes provide different creative solutions to the collective action problems inherent in debt restructurings. While the statutory approach provides the cleanest way to solve in a consistent and coherent way all the collective action problems involved in an orderly restructuring of sovereign bonds, it is unlikely to be implemented in the near future. Similarly, the contractual approach has some appeal, as being more market based than the statutory one, but transitional problems and incentives to implement it may be insurmountable. Thus, for the time being, working with the status quo remains the dominant option. And I have argued that using the current market based regime (or non-regime) thus allow to minimize collective action problem and provide for orderly restructurings.
In part, the verdict on the appropriate regime will depend on the experience with the Argentine restructuring. This is a most complex case given the heterogeneity of both the claims and the claimants. If the Argentine debt restructuring becomes messy, disorderly, protracted and causes avoidable loss of economic value that hurts both the debtor and the creditors, the political pressure to reform the current regime and move towards the adoption of an international bankruptcy regime or a contractual approach will increase. If, instead, the creative use of exchange offers with various carrots and sticks allows to achieve an orderly restructuring, the incentive and pressure to create a new statutory or contractual regime would disappear.
References
Bulow, Jeremy and Kenneth Rogoff (1989) “Sovereign Debt: Is to Forgive to Forget?” American Economic Review, Vol. 79, No.1, March.
Corsetti, Giancarlo and Nouriel Roubini (1997) “"Politically Motivated Fiscal Deficits: Policy Issues in Closed and Open Economies," Economics and Politics, March 1997.
Eichengreen, Barry (1999) Toward a New International Financial Architecture Institute for International Economics, Washington, D.C. 1999.
Frankel, Jeffrey and Nouriel Roubini, “The Role of Industrial Country Policies in Emerging Market Crises,” NBER WP No. 8634, December 2001; forthcoming in M. Feldstein (ed.) Economic and Financial Crises in Emerging Market Economies, volume published by NBER and Chicago University Press, 2002.
Jeanne, Olivier and Jeromin Zettelmeyer (2001) “International Bailouts, Moral Hazard, and Conditionality,” Economic Policy 16, issue No 33, October.
Krueger, Anne (2001a) “International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring,” IMF November 26, 2001.
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Krueger, Anne (2001b) “A New Approach to Sovereign Debt Restructuring,” IMF, December 20, 2001.
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Krueger, Anne (2002) “New Approaches to Sovereign Debt Restructuring: An Update on Our Thinking,” Conference on "Sovereign Debt Workouts: Hopes and Hazards" Institute for International Economics, Washington DC, April 1, 2002
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Rogoff, Ken and Jeromin Zettelmeyer (2002) “Early Ideas on Sovereign Bankruptcy Reorganization: A Survey,” IMF Working Paper 02/57, March.
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Roubini, Nouriel (2000) “Bail-In, Burden-Sharing, Private Sector Involvement (PSI) in Crisis Resolution and Constructive Engagement of the Private Sector. A Primer: Evolving Definitions, Doctrine, Practice and Case Law,” September 2000.
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Roubini, Nouriel (2001) “Why should the foreign creditors of Argentina take a greater hit/haircut than the domestic ones: On the economic logic, efficiency, fairness and legality of "discriminating" between domestic and foreign debt in sovereign debt restructurings” December 14, 2001 ()
Roubini, Nouriel (2002a) “Do we need a new international bankruptcy regime? Alternative regimes for orderly sovereign debt restructurings”, April 2002, New York University.
Roubini, Nouriel (2002b) “Private Sector Involvement in Crisis Resolution and Orderly Sovereign Debt Restructurings: The G-7/IMF Framework and the Open Unresolved Issues,” March 2002, New York University.
Sachs, Jeffrey (1995), “Do We Need an International Lender of Last Resort,” Frank D. Graham Lecture at Princeton University 8, April 20, 1995 (unpublished manuscript.
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Taylor, John B. (2002a) “Grants and Sovereign Debt Restructuring: Two Key Elements of a Reform Agenda for the International Financial Institutions,” Testimony of John B. Taylor Under Secretary of the Treasury for International Affairs before the Joint Economic Committee, February 14, 2002
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Taylor, John (2002b) Sovereign Debt Restructuring: A U.S. Perspective” remarks at Conference on "Sovereign Debt Workouts: Hopes and Hazards" Institute for International Economics, Washington DC, April 1, 2002.
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Wright, Mark (2001) “Reputations and Sovereign Debt,” unpublished, MIT.
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[1] Discussion of papers by Jeremy Bulow, Jeffrey Sachs and Michelle White for the Brookings Panel on Economic Activity “Symposium: A Bankruptcy Court for Sovereign Debt”, April 5, 2002, Washington D.C. The usual disclaimer applies.
[2] Krueger (2001a, 2001b, 2002)
[3] Sachs (1995) was an early advocate of an international bankruptcy court for sovereign debtors while his current contribution concentrates on the debt crisis and the debt reduction needs of low income countries. In my remarks here I will concentrate on the Sachs (1995) arguments in favor of an international bankruptcy regime and the related issues in his most recent paper. See Rogoff and Zettelmeyer (2002) for a survey of the literature on sovereign bankruptcy ideas.
[4] When debt becomes unsustainable and the country has to restructure its sovereign (and possibly private sector) external liabilities, it is in principle in the interest of all parties to have an orderly debt restructuring process, one that can minimize losses of value that are socially inefficient and allow the country to adjust and return to a sustainable debt path. The need for an orderly restructuring derives from the observation that a “disorderly” default can impose losses that are socially inefficient and thus can hurt both the debtor and the creditors. Thus, subject to the caveat that defaults should not be too easy (to prevent opportunistic defaults), an orderly debt restructuring should be the objective of an international regime that allows countries with unsustainable debt profiles to restructure their liabilities.
[5] I discuss these issues in more detail in Roubini (2002).
[6] There is an open issue of whether an international debt workout regime should also be used to address financial crises that have an “illiquidity crisis” nature and other cases where debt restructuring may be necessary but the country is not obviously insolvent. The IMF thinks of applying the SDRM to insolvency cases only but, as discussed below, an SDRM could be used to address collective action problems and other obstacles to orderly workouts in a broader range of crises, including liquidity cases. This application of a debt restructuring regime also to liquidity cases appears to be the view of Sachs (1995).
[7] This “contractual approach” based on introduction and use of CACs has been long supported by a number of academics (see Eichengreen (1999) and Eichengreen and Portes (1995)). It has recently also received the support of the U.S. administration (see John Taylor (2002a, b). Support for the progressive introduction of CACs in bond contracts can also be found in other official reports, like the Rey Report issued after the Mexican Peso crisis and in several past G7 communiques on how to reform the international financial architecture.
[8] See Sachs (1995) for an early statement of these market failures as the basis for the need for an international bankruptcy regime.
[9] In Roubini (2002) I discuss of a number of other potential market failures in addition to the four discussed in my remarks here. Specifically, I consider the “rush to the exits” and the “rush to the courthouse” on non-sovereign claims (and the ensuing need for capital and exchanger controls); the risk of debtor actions (such as preferential treatment of some creditors) that damage creditor interests; the risk of asset stripping by the debtor; how to provide senior private “new money” (debtor in possession - DIP - financing) during a default. Sachs (2002) states that, in addition to the collective action problems among creditors, another motivation of bankruptcy law is to provide a “fresh start” to insolvent debtor, i.e. avoid situations of a “debt overhang” and provide some fairness, in addition to efficiency, to the workout process. I interpret this “fresh start” as the need to provide debt workouts that are beneficial to both debtors and creditors when a disorderly and costly and lengthy workout would lead to a loss of value that is not beneficial to either side. Thus, this issue is which regime (statutory, contractual, market-based) can provide such orderly workout.
[10] See Krueger (2001a,b, 2002).
[11] See Eichengreen (1999), Taylor (2002a, b).
[12] The main difference remains that a statutory approach requires an amendment of the IMF’s Articles of Agreement or an international treaty while the contractual approach could evolve over time without such a radical institutional change. But even a contractual approach would require changes in legislation in some major legal jurisdictions, thus taking some institutional/statutory features rather than being purely market-driven.
[13] Roubini (2002).
[14] See the very cautious endorsement of the idea of an international bankruptcy regime in the latest (February 2002) communiqué of the G7 Finance Ministers.
[15] Even the latest remarks by Taylor (2002) in favor of the contractual approach appear to be so far toothless in terms of the system of incentives (carrots and sticks) that may lead to real progress towards the wholesale adoption of CACs.
[16] Se for example the recent JPMorgan proposal by Bartholomew and Stern (2002).
[17] There is a broad literature on whether reputational mechanisms and which type of costs of default are able to sustain an equilibrium without opportunistic defaults. See for example Bulow and Rogoff (1989) and Wright (2001).
[18] See Corsetti and Roubini (1999) for a model of how a political bias towards budget deficits is exacerbated when policy makers can borrow in international capital markets.
[19] A side implication of this observation is that Bulow’s aversion towards lending by the IMF/IFIs (the IMF should not make loans) as a source of gaming between debtors and private creditors does not have a strong factual basis
[20] See the critique of similar views by the Meltzer Commission in Frankel and Roubini (2001).
[21] This is in principle the role of the current CCL facility within the IMF.
[22] See Frankel and Roubini (2001), Roubini (2000, 2002b) for various arguments against standstills as a tool to prevent runs.
[23] Ted Truman has recently stressed this point.
[24] See Roubini (2001) for a discussion of how to treat “domestic” and “external” claims in sovereign debt restructurings.
[25] See Corsetti and Roubini (1997) on this conceptual point.
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