The Bankrupt Sovereign
The Sovereign Debt Restructuring Mechanism (SDRM)
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
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Written January 24, 2003
Updated April 2005
In a little noticed speech, given in January 2003 at an IMF conference in Washington, Glenn Hubbard, then Chairman of President Bush's Council of Economic Advisers, delineated a compromise between the United States and the International Monetary Fund regarding a much mooted proposal to allow countries to go bankrupt.
In a rehash of ideas put forth by John Taylor, then Treasury Undersecretary for International Affairs, Hubbard proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees. The substitution of old debt instruments by new ones, replete with "exit consents" (the removal of certain non-payment clauses) will render old debt unattractive and thus encourage restructuring.
In a sop to the IMF, he offered to establish a voluntary sovereign debt resolution forum. If it were to fail, the IMF articles can be amended to transform it into a statutory arbiter and enforcer of decisions of creditor committees. Borrowing countries will be given incentives to restructure their obligations rather than resort to an IMF-led bailout.
In conformity with the spirit of proposals put forth by the Bank of England and the Bank of Canada, Hubbard insisted that multilateral financing should be stringently conditioned on improvements in public sector governance and the legal and regulatory frameworks, especially the protection of investor and creditor rights. He rejected, though, suggestions to strictly limit official financing by international financing institutions.
Yet, these regurgitated schemes suffer from serious flaws.
It is not clear why would creditors voluntarily forgo their ability to extort from other lenders and from the debtor an advantageous deal by threatening to withhold their consent to a laboriously negotiated restructuring package. Nor would a contractual solution tackle the thorny issues of encompassing different debt instruments and classes of creditors and of coordinating action across jurisdictions. Taylor's belated proviso that such clauses be a condition for receiving IMF funds would automatically brand as credit risks countries which were to introduce them.
The IMF is, effectively, a lender of last resort. When a country seeks IMF financing, its balance of payments is already ominously stretched, its debt shunned by investors, and its currency under pressure. The IMF's clients are illiquid (though never insolvent in the strict sense of the word).
The IMF's First Deputy Managing Director, Anne Krueger, proposed in November 2001 to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.
Today, sovereign debt defaults lead to years of haggling among bankers and bondholders. It is a costly process, injurious to the distressed country's future ability to borrow. The terms agreed are often onerous and, in many cases, lead to a second event of default. The experiences of Ukraine and Ecuador in the 1990s are instructive. Russia - another serial debt restructurer, lastly in 1998 - was saved from a recurrent default by the fortuitous surge in oil prices. Argentina and its emasculated debtors were not as lucky.
Moreover, as Hubbard observed in his speech, both creditors and debtors have a perverse incentive to aggravate the situation. The more calamitous the outlook, the more likely are governments and international financial institutions to step in with a bailout package, replete with soft loans, debt forgiveness and generous terms of rescheduling. This encourages the much-decried "moral hazard" and results in reckless borrowing and lending.
A carefully thought-out international sovereign bankruptcy procedure is likely to yield at least two important improvements over the current mayhem. Troubles now tackled by a politically-compromised and bloated IMF will be relegated to the marketplace. Bailouts will become rarer and far more justified. Moreover, the "last man syndrome", the ability of a single creditor to blackmail all others - and the debtor - into an awkward deal, will be eliminated.
By streamlining and elucidating the outcomes of financial crises, an international bankruptcy court, or arbitration mechanism, will, probably, enhance the willingness of veteran creditors to lend to developing countries and even help attract new funding. The creditworthiness of lenders increases as procedures related to collateral, default and collection are clarified. It is the murkiness and arm-twisting of the current non-system that deter capital flows to emerging economies.
Still, the analogy is partly misleading. What if a developing country abuses the bankruptcy procedures? As The Economist noted wryly "an international arbiter can hardly threaten to strip a country of its assets, or forcibly change its 'management'".
Yet, this is precisely where market discipline comes in. A rogue debtor can get away with legal shenanigans once - but it is likely to be spurned by lenders henceforth. Good macroeconomic policies are bound to be part and parcel of any package of debt rescheduling and restructuring in the framework of a sovereign bankruptcy process.
Addendum - Vulture Funds
Vulture funds are financial firms that purchase sovereign debt at a considerable disaggio and then demand full payment from the issuing country. A single transaction with a solitary series of heavily discounted promissory notes can wipe out the entire benefit afforded by much-touted international debt relief schemes and obstruct debt rescheduling efforts.
Also Read:
The IMF Deconstructed - A Dialogue
The Washington Consensus - I. The IMF
The Washington Consensus - II. Washington and Sarajevo
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