Article - What future for sovereign debt crisis resolution?
- May 5, 2014
- 7 min read
The “Greece and Griesa”[1]: A call for a new framework for debt restructuring
One of the striking lessons from the Greek crisis is that the topic of sovereign debt restructuring is no longer just an emerging markets-related issue. This statement contrasts with discussions around sovereign debt crisis resolution over the last decades, which assumed that the subject was only a matter for developing economies.
The Greek debt exchange stands out in the history of sovereign default by setting new world record in terms of restructured debt volume (€200bn) and aggregated creditor losses (59-65%). While successful on many levels, the Greek restructuring can be subjected to criticisms as it failed to clearly restore Greece’s debt sustainability. According to Zettelmeyer & al. (2013), the timing and design of the restructuring is highly questionable as it “left money on the table” for Greece and put European taxpayers at risk. With the benefit of hindsight, the conclusions on Greek episode and the way it has been handled leaves room for further improvement in sovereign debt crisis resolution.
A recent ruling in New York on the ongoing dispute between Argentina and holdout creditors put the current global framework of orderly sovereign debt restructurings based on a market based/contractual approach to the test. The case traces its roots back to 2001, when Argentina defaulted on $80 billion of government bonds. By reinterpreting the pari-passu clause in bond documentation (through which it is specified that investors cannot be treated differently), the ruling gives further legal remedies for creditor holdouts to interfere with payments to the creditors that accepted the restructuring offer in first place. The case is now in the hand of the US Supreme Court that is expected to review the federal court ruling. If this new principle prevails, that would set a precedent that will have serious consequences for Argentina but also every sovereign debt restructuring in the future. Such a conclusion will complicate efforts to resolve future debt crises on an ad hoc basis even if both the debtor and a large majority of creditors agree to step-up. Joseph Stiglitz expresses its concerns in a Project Syndicate column of September 2013. The Nobel laureate calls for a new system to limit the emergence of “vulture funds”.
The current debate: from radical overhaul to status quo
For the International Monetary Fund, recent developments are significant enough to rethink the current framework on debt restructuring. In a paper released in May 2013, the Fund states that “the current contractual, market-based approach to debt restructuring is becoming less potent in overcoming collective action problems”. Rather than calling for a statutory approach à la SDRM,[2] the IMF advocates for the strengthening of the current contractual framework through the introduction of more robust aggregation clauses[3] into international sovereign bonds. The institution explores new solutions to address the “too little, too late” pathology, identified as the main cause of failure when it comes to recover debt sustainability.
More radical initiatives have been put forward with a view to establishing statutory or institutional frameworks to overcome collective action problems and facilitate a timely and orderly debt restructuring. Among them, the Committee on International Economic Policy and Reform and the think tank Bruegel’s proposals are of interest since they provide specific schemes for the Eurozone, as discussed below.
Roubini, on the contrary, argues that existing market instruments are well sufficient to achieve orderly restructuring of sovereign debt. A new crisis resolution mechanism is seen as unnecessary and unlikely to solve the main shortcomings of the current system. He argues that a large part of the sovereign bond restructurings has been successful so far and that fear of litigations is exaggerated. The needs for flexibility in restructurings is also perceived as well suited to the diversity of debt crisis.
Moving towards a statutory framework: a stronger case for the Eurozone.
In a monetary union, the lack of monetary policy autonomy leads to greater exposure to sovereign default for its members since they have fewer instruments to deal with excessive debt. Without the leverage of inflation and devaluation, a highly indebted member is left with three solutions: austerity, default and bailout.
Another specificity of a monetary union is its relation to debt crisis resides in the market uncertainty that may emerge from spillover risks. The strong volatility of Euro financial markets during the 2010 euro-area sovereign-debt crisis reflected the high level of uncertainty of market participants at different levels: the willingness of members to bring their financial support to countries in need, the possible outcome of a default on Greece and the future of the Euro currency. A debt-restructuring mechanism that clearly defines the steps of the resolution process, as well as its possible outcomes would reduce uncertainty.
In terms of feasibility, the implementation of debt restructuring mechanism as a complement to the existing European Stability Mechanism (ESM) would be straightforward compared to an international effort. While the IMF’s SDRM proposal was rejected on the grounds that it would interfere with national sovereignty, this objection is less valid at European level. Europe is well positioned to be at the leading edge of institutional and legal innovation in the field of sovereign debt crisis resolution.
Reforming the restructuring process in the Eurozone: a set of new targeted proposals.
A large numbers of statutory proposals and theoretical contributions have attempted to tackle sovereign debt crisis resolution at a global level since the early 80’s. Most of them drew their inspiration from existing corporate procedures or even Chapter 9, the US bankruptcy code for municipalities. Despite the fact it has never been implemented, the most famous project to this day remains the SDRM elaborated by the IMF in 2002.
A set of new detailed proposals, purposely calibrated for the Eurozone, has emerged. The two main euro-targeted proposals include the European Crisis Resolution Mechanism (ECRM), a fully fledged statutory framework suggested by the think-tank Bruegel (Gianviti et al. 2010) as well as the European Sovereign Debt Restructuring Regime (ESDRR) initiated by the Committee on International Economic Policy and reform (CIEPR) in October 2013.
Bruegel’s statutory approach requires the enactment of a treaty among the euro-area countries that would legally govern all debt issued or contracted by a euro-area sovereign entity. It would consist of three separate bodies: a legal one in charge of sorting out disputes, an economic one to provide the necessary economic expertise and judgment, and a financial one responsible with financial assistance—ideally, the European Court of Justice, the European Commission and the European Financial Stability Facility (EFSF).
Christoph Trebesch et al (2012) enumerate three main differences between ECRM proposal with the rejected IMF’s SDRM: automatic payment suspension, implementation through existing supranational legal bodies (rather than through a Dispute Resolution Forum to be created in the initial SDRM proposal), and no formal IMF participation. The SDRM logically envisaged a substantial role for the IMF for interim financing, debt sustainability assessment as well as for assisting the restructuring process.
Despite those distinctions, both mechanisms share a key feature: the possibility of binding potential holdouts by giving a supermajority of bondholders (from a defined threshold) the right to outvote a minority in order to enter into negotiations and conclude an agreement with a debtor country. Such an automatic aggregation clause among all creditors’ claim would be a powerful way to overcome the collective action clause (CAC’s) limitations.
A second prominent proposal to improve sovereign debt workouts within the Euro area deserves a close examination: the European Sovereign debt-restructuring Regime (ESDRR) by the Committee on International Economic Policy and reform (CIEPR). The main purpose of the ESDRR is to create ex-ante incentives against excessive public debt accumulation, with pre-conditions for ESM lending. Above the Maastricht limit of 60% per cent of GDP, a country will have to enter a debt restructuring in order to access to ESM funding. The two expected outcomes are, on one hand, the differentiation of borrowing costs among euro-area members and, on the other hand, the protection of ESM resources and Euro area taxpayers by preventing extreme adjustments of public finances. The new vehicle would take the form of a change in the ESM treaty and features measures to prevent legal actions by holdouts.
Using a particular debt threshold to define the restructuring regime also comes with problems. A debt threshold is far from being a perfect measure of solvency and simple rules are not necessarily associated with credibility. Aware of that, the CIEPR considers that, “given the biases that currently exist against any form of debt restructuring, pure discretion would lead to bigger errors than simple rules.” An argument that becomes increasingly popular these days.
Conclusion
Recent sovereign debt restructurings highlighted the need for more adequate resolution frameworks. It is fair to say that the current global architecture for sovereign debt restructurings, which has developed since the late 1990s through a mix of market-based and contractual tools, has worked reasonably until now. However, it does not eliminate potential collective action problems in the short run, nor does not protect from moral hazard or provides enough incentives to prevent overborrowing ex-ante.
While the implementation of a statutory framework in near-term seems highly improbable at a global scale, we argue that it could make sense in a monetary union with close political, financial and economic linkages such as the Eurozone. At this stage, though, the Eurozone has taken a more moderate, contractual approach by making compulsory the inclusion of collective action clauses in all Eurozone government bonds[4].
Notes:
[1] Expression referring to both Greek crisis and the court ruling on Argentina’s default granted by the judge Thomas Poole Griesa, federal judge for the United States District Court for the Southern District of New York.
[2] SDRM stands for “Sovereign Debt Restructuring Mechanism” and refers to a proposal of the IMF to implement a global resolution mechanism based on a statutory approach. The proposal was intensely debated and finally rejected by the IMF shareholder in April 2003.
[4] In accordance with of the ESM Treaty (Paragraph 3 of Article 12) the model CAC became mandatory in all new euro area government securities with maturity above one year issued on or after 1 January 2013.
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