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Sovereign Debt Difficulties: Had Enough Yet?

Can the fragmentary and chaotic process of resolving sovereign debt crises be made fairer and more effective?

December 14, 2012

At various times since the developing country debt crises of the 1980s, proposals have been made to establish international processes to resolve sovereign insolvencies fairly and effectively.

None have been realized. This was largely due to the opposition of the creditors from the public as well as private sectors. Until recently, the underlying creditor strategy of deliberately operating in a space full of legal uncertainty worked to their benefit. But it is no longer reliable.

It is now in the creditors’ interest to join with other stakeholders in developing a mutually fair and beneficial international system. That also requires a process to build the political momentum to realize it.

At the root of the problem is a legal vacuum: When a sovereign nation in crisis declares itself unable to honor its payment obligations, no international bankruptcy court takes over. There is no impartial judge to oversee which creditors receive what share and when of whatever payments are deemed appropriate.

Rather, the debtor government undertakes a series of negotiations with different creditor groups. This can easily turn into a rather chaotic process, albeit usually eased by drawing on emergency funds provided under adjustment conditions from the International Monetary Fund and other multilateral financial institutions.

Populations of debt-crisis countries generally do not fare well under this system, as an insolvent government is usually not in a strong negotiating position. By the same token, until recently, private and official creditors have suffered little.

Indeed, emerging economy bonds in the 1990s and early 2000s paid excessive interest rates, as the risk premiums they embodied systematically exceeded the risks lenders actually faced given the rare instances of creditor losses.

However, recent developments, in particular involving Argentina and Greece, should give creditors pause. In several ways, normal creditor expectations have been disappointed.

Entangling uninvolved bondholders

Most of Argentina’s bondholders hold securities that had been swapped at a discount of about 70% for the defaulted bonds that were outstanding in 2001. The new bonds erased about 93% of the defaulted bonds. The remaining bondholders — in particular, certain so-called vulture funds — went to court to fully collect on them.

At the center of the action is Judge Thomas Griesa of the United States District Court in New York. He has been hearing the cries for payment by the vulture funds for almost a decade and recently decided in the favor of one of them based on a controversial interpretation of a term in the bond contracts.

Judge Griesa ordered Argentina to pay into an escrow account all the monies he would likely award to that fund. The money for escrow could be attached when banks transferred Argentina’s interest payment to its exchange bondholders.

The crisis was temporarily defused when an Appeals Court put a hold on the escrow account, but the damage has been done. Some creditors of a sovereign debtor can now possibly be penalized by the legal claims of other creditors against that nation.

Argentina’s President, Cristina Fernández de Kirchner, and her minister of finance, Hernán Lorenzino, feel wronged, and the rather extreme action by the New York judge has bought them a lot of sympathy.

Rather than accede to this, Argentina may default again. The key question is: That move would be punishing whom?

A diminishing Paris Club

The Argentine government still owes money from its 2001 default to the “Paris Club,” whose members represent government creditors (export credit agencies, aid ministries, etc.) that meet jointly to resolve the defaults of governments that borrow from them.

The main concerns of Paris Club creditors are equity among themselves and minimizing the relief given on funds owed to them.

The Club also claims a leadership role in shaping a debtor government’s overall relief by insisting it seek “comparable treatment” from its private creditors.

In cases like Argentina, this is silly. When the country defaulted at the end of 2001, it owed about $6 billion to Paris Club creditors, compared to about $62 billion to private sector bondholders. Argentina has largely ignored the Paris Club for a decade, which has not been an option for smaller and poorer countries or their private creditors.

But the Paris Club could increasingly be ignored by other sovereign debtors, as its members are responsible for a diminishing — albeit still large — share of government-supported international financing.

Over time, the Club must either take in more members (e.g., China, Venezuela, Brazil, India), a number of which would likely have different priorities than those of traditional members, or see its relevance increasingly shrink.

My preference is to see the Paris Club wound up and all government creditors folded together as one group in a comprehensive debt workout process.

A contract is a contract, except in Greece

Most investors expect the terms of financial contracts to be observed except in dire emergencies. The Argentine case revolved around different interpretations of a specific clause in the bond contracts. The Greek experience this year first involved different interpretations of reality and then outright ex post contract changes.

By any objective meaning of the term, Greece is insolvent. European governments are preventing an actual default through their financial support, although they have begun to impose burden sharing through a “voluntary” write-down on bondholders.

In March, Greece reduced the face value of its bonds by about 75% in a swap of its still-performing old bonds for discounted new bonds. The swap had to be voluntary, not only to avoid admitting that Greece was insolvent, but also because a large number of “credit default swaps” (CDSs) had been written on the bonds.

They would pay if Greece defaulted, but not if the exchange was “voluntary.” Any bondholder covered by a CDS would normally prefer to collect the face value of a defaulted bond rather than take a 75% write down.

The ruse worked, as 84% of the bonds were voluntarily swapped. So much for the insurance value of a CDS when major financial and political institutions have a stake in not acknowledging reality.

But then Greece was able to raise the total swap to 97% by invoking a law recently adopted in its parliament. It inserted a “collective action clause” into the bonds governed by Greek law, which forced the holdouts to take the swap.

This could no longer be deemed “voluntary,” and about $3 billion of CDS contracts had to be paid. That was down from $9 billion outstanding four months earlier, when holders probably felt it increasingly unlikely that a “credit event” would be called. One wonders whether this is a precedent.

No matter how hard the European governments may be trying to avoid such an outcome, the Greek debt problem may soon take the shape of unpayable obligations to multilateral creditors.

In the past, this was a measure contemplated only for the poorest countries. But the writing is clearly on the wall. The March bond swap did not put Greece in anything close to a sustainable situation and the new bonds quickly sank in market value.

Failed multilateral leadership

Any debt workout requires a credible economic recovery program as well as adjustment of debt obligations. This month, a second debt reduction was agreed, in this case taking the form of a partial Greek government buyback at a deep discount, using funds loaned by European governments.

Meanwhile, the acute suffering of the Greek population, capital flight by the rich, and repeated debt reductions do not signal sustainable economic policy. There is no denying that the multilateral system that assists countries in economic crisis has failed Greece.

What can be done? In my view (building on the ideas of others), the best way forward is to create an international forum charged with developing comprehensive workouts from insolvency.

The first thing such a forum would do is draw up a list of independent authorities who would be available to serve on evaluation committees. The forum would also spell out how the committees would operate.

If the Greek problem still existed (and it does not seem about to go away), Greece could be the first case. Greece needs a credible assessment of its adjustment and recovery requirements.

The IMF is supposed to provide this, but it has been compromised by its European members, who are overrepresented in the institution. They seem more intent on protecting their banks and punishing Greeks for their inadequate elites than overcoming the problems.

If the proposed system existed, Greece and its creditors would each be asked to appoint two people to an evaluation committee, drawing names from the aforementioned list. The four would then appoint a fifth.

These individuals would collect all relevant information, hold hearings or interview representatives of all relevant stakeholders, and propose a workout strategy. Part of that would be a comprehensive financing and debt relief package that aimed (once and for all) to put the country on a sustainable growth path.

Rather than continuing the current piecemeal approach full of legal uncertainty and surprises, such a body would far better concentrate the attention of policymakers and public creditors.

Responsibility for decision making on each component of the policy and its financing package would perforce remain where it is, but the credibility and comprehensiveness of the proposal should carry great weight.

Building a sovereign debt workout process

How realistic is this proposal? There was a brief time a decade ago, when the United States, Germany and a few other governments showed interest in developing a comprehensive debt workout mechanism.

At the time, the financial industry was inalterably opposed. And borrowing governments were afraid to pursue the idea in earnest, for fear that it might jeopardize their access to foreign financing.

In the end, a very flawed IMF proposal was rejected. Instead, the major international banks, acting through the Institute of International Finance, created their own creditor-friendly set of procedures.

Some of the IIF principles are valuable — such as on government transparency and facilitating creditor-debtor dialogue in good times as well as bad. However, the recommendations for debt renegotiations are only concerned with “fair” treatment of the creditors. This is not nearly good enough.

An encouraging sign is that some bond investors seem increasingly dissatisfied with the kinds of developments described here. Most do not talk about it publicly, but one comment quoted in the financial press is telling (albeit made after Ecuador’s 2008 selective default).

It was by Hans Humes, president of Greylock Capital in New York: “Maybe the solution is to go back to Anne Krueger’s model.” He was referring to the failed IMF initiative that the private sector had fought tooth and nail.

There have also been quiet discussions among financial, legal and policy experts that the United Nations has sponsored. (Yes, that United Nations!)

While investors may want unlimited “creditor rights,” what they actually need and deserve is to know their actual rights and what risks they are expected to share. An internationally agreed set of guidelines and processes to treat distressed sovereign debt would meet that need and help promote appropriate and more sustained international financial flows to sovereigns.

It would also free Judge Griesa to focus on other problems in his district.


Populations of debt-crisis countries generally do not fare well under this system, as an insolvent government is usually not in a strong negotiating position.

While investors may want unlimited "creditor rights," what they actually need and deserve is to know their actual rights and what risks they are expected to share.

Until recently, private and official creditors have suffered little. Recent developments, however, should give creditors pause.

Argentina may default again. The key question is: That move would be punishing whom?

The best way forward is to create an international forum charged with developing comprehensive workouts from insolvency.