Unfortunately, some who address this issue of dealing with unmanageable debt situations have offered advice that, while emotionally appealing, is not operationally helpful. I will describe and justify the rationale and design of the proposal put forward by the International Monetary Fund for a Sovereign Debt Restructuring Mechanism (SDRM). Its major goal is to help reduce the unacceptably large costs associated with disorderly defaults by sovereign governments whose debt burdens have become unsustainable. The SDRM aims to get the countries’ debts to sustainable positions and deal with the broader needs of the countries through the full array of aid and other mechanisms that are available—and, indeed, to enlarge and enhance these initiatives. I will also explain my misgivings about some of the other proposals, including the ones coming from the NGO community.
The Need for a Formal Mechanism
The dislocation and disorder that occurs when governments default is often the result of reluctance on the part of the countries’ authorities to confront the underlying policy problems or to approach the countries’ creditors for relief when their debts have become unsustainable. In too many cases, the authorities gamble for redemption through ill-devised policy measures rather than face the uncertainty of approaching the countries’ private-sector creditors for the needed relief. Argentina in the summer and fall of 2001 is all too dramatic an example of this phenomenon.
And why are these countries hesitant to approach creditors? One reason for this is reputation: no government official likes to admit the true nature of his or her country’s debt problem. Indeed, these officials are often the same people who were partly responsible for the policies that led to the accumulation of that debt. Ministers are also concerned about undermining their countries’ future access to capital markets. But, importantly, it is also because at present there is no mechanism to assure that countries that approach their creditors will be able to reach a negotiated settlement with them to restructure the countries’ debts in a way that is consistent with their capacity to pay it. Moreover, they have no assurance that the process of negotiating with creditors will be orderly, predictable, and transparent.
In order to address these problems, a proposal was developed in the IMF that has come to be known as the Sovereign Debt Restructuring Mechanism. Five principles guided its development. First, the mechanism should only be used to restructure debt that is determined to be unsustainable. It should neither increase the likelihood of restructuring nor encourage defaults. It must not unduly inhibit the capacity of markets to provide appropriate financing to indebted countries in the future by undermining the presumption of the validity of contracts.
Second, any interference with contractual relations should be limited to those measures that are necessary for resolving the collective action problems that can complicate the process of reaching agreement on a restructuring. The danger is that individual creditors will decline to participate in a voluntary restructuring in the hope of recovering payment on the original contractual terms, even though creditors, as a group, would be better served by agreeing to such a restructuring. This problem increases the likelihood of defaults and the large economic and social dislocations that usually follow.
Third, the framework should promote greater transparency in the restructuring process, and encourage early and active creditor participation in it. It should not increase the role of the Fund in this regard.
Fourth, the integrity of the mechanism’s decision-making process should be safeguarded by an efficient and impartial dispute-resolution process.
Finally, the SDRM should not expand the Fund’s legal powers.
The Sovereign Debt Restructuring Mechanism
Guided by these principles, the Fund’s SDRM proposal was designed with five major features. First, the sovereign debtor would, if needed, have protection from disruptive legal action by creditors during negotiations. This could be provided, in appropriate circumstances, through a stay on litigation, preventing creditors from seeking court decisions for repayment while negotiations are under way. The possible automaticity and the triggers for such possible stays have been widely discussed in the debate on the SDRM. Some favor, similar to the process of domestic bankruptcy, an automatic stay at the time the SDRM is activated. Others see this as both unnecessary and possibly counterproductive in certain cases where it would be preferable to continue to service some of the outstanding debt, such as that held by domestic banks.
Second, the creditors would be provided with assurance that debtors will negotiate in good faith and will pursue policies—which will most likely be designed in conjunction with seeking financial support from the IMF––that help to protect the value of creditor claims, to limit the dislocation in the economy, and to limit the likelihood of contagion to other countries. The Fund’s policy on lending into arrears is key in this regard.
Third, creditors would be permitted to protect and prioritize fresh private lending during the restructuring process in order to facilitate ongoing economic activity through the continued provision of, inter alia, trade credit (something akin to Chapter 11 debtor-in-possession financing).
Fourth, a supermajority of creditors could vote to accept new terms under a restructuring agreement. If new terms were adopted, minority creditors would be prevented from blocking such agreements or enforcing the terms of the original debt contracts.
Fifth, a dispute-resolution forum would be established to verify the claims of different parties to the negotiation. This forum would assure the integrity of the voting process, and adjudicate disputes that might arise.
A Response to the Critics
Some have faulted the proposal because “only private creditors would have to reduce their claims.” 1 This is not correct. It is true that the proposal assumes continuance of the preferred creditor status of the IMF and some other multilateral organizations, but bilateral official creditors would be expected to provide relief on their claims on the country. It was always foreseen in the proposal that bilateral official creditors would share the burden, and the Paris Club has been actively examining the implications of this.
A second point that critics make is that the “SDRM would not return poor, indebted countries to viability/sustainability.” 2 I believe there is some confusion here: the SDRM is not aimed at the poorest countries. It may be relevant to a few of them that have large amounts of debt outstanding to private creditors (such as Nigeria), but for the low-income countries, generally, there is the Highly Indebted Poor Countries initiative—criticism of it notwithstanding.
There are also those in the NGO community who fault the proposal for not including a process through which countries can be discharged of their obligation to repay what they call “odious” debt. While I have no illusions about the existence of odious debt, focusing on it shifts attention away from the real issue: how to deal with the total stock of unpayable debt. The international community has shied away from mechanisms built on concepts such as odious debt and has concentrated on the broader issue. There are various reasons for that. On the political side, some governments, I suspect, may not want to recognize or defend the consequences of lending decisions they have taken in the past and, moreover, may want to protect their future ability to pursue geopolitical ends through international lending. The seriousness of this obstacle is evident from the way in which the initial calls for invoking the concept of odious debt for loans made to Iraq during Saddam Hussein’s regime have quickly subsided. On the economic side, dealing with debt in this way could introduce a new source of risk that could seriously affect the workings of the secondary market, where investors exchange government securities among themselves, and hence the ability of sovereigns to mobilize new money. If purchasers in the secondary market had to assure themselves of the integrity of the process through which the claim was originally created, that market would cease to operate.
In addition, there are many questions to be asked about the practicality of the NGO approach with regard to odious debt. Who decides which debt falls into this category? What are the values or criteria to be applied in deciding who ought to bear the costs of dealing with odious debt? For example, if the odious debt deals were cut between one government and another, who should decide, and by what criteria, what balance should be struck between the wronged citizens of the debtor country and the taxpayers of the creditor country who would absorb the cost of the debt relief?
The SDRM has a specific purpose: to help deal with the problems of market-access countries whose debt has become unsustainable, and to establish a system for more orderly and coordinated negotiation between the country and its creditors for debt relief in such circumstances. Interestingly, neither private creditors, who presumably would have to give less relief if odious debt were set aside, nor the emerging market countries themselves have voiced support for this proposal to write off odious debt.
Questions and challenges have also been raised about the role of the IMF under the SDRM. One relates to the appropriate procedure through which the SDRM is to be institutionalized. The IMF has proposed that it be created through an amendment to its articles of agreement rather than through a new international treaty. The rationale is straightforward: Helping countries to manage their debt problems and the economic and certain institutional aspects of their interface with international capital markets falls squarely under the IMF’s mandate. The SDRM fits within the boundaries of that mandate. p>Moreover, creating a new international treaty would likely be a much more complicated and uncertain undertaking. The articles of agreement have been amended before and it is therefore a process familiar to the organization’s members. An amendment can take effect immediately when three-fifths of the members having 85 percent of the voting power have voted for it––as opposed to an international treaty, which would require unanimous vote and ratification by domestic parliaments. Amending the IMF’s articles of agreement would also provide the framework with greater stability. Withdrawing from a freestanding treaty may have little cost to the withdrawing country. Withdrawing from the Fund, however, deprives the country of the benefits of membership provided for under the articles of agreement.
The amendment would create no new legal powers for the Fund itself. The integrity of the process would be ensured through the Sovereign Debt Dispute Resolution Forum––and this forum would be independent of the Fund.
Apparently most controversial in the eyes of some NGOs and other critics of the proposal is that the Fund would continue to play a role in assessing the sustainability of the country’s external position, including its debt. Some criticize this on the grounds that it puts the Fund in the position of dictating the terms of any settlement between the country and its creditors. Others claim that it is incompatible with the role of the Fund as a creditor itself, and, indeed, a preferred one.
However, the Fund has traditionally been treated as a preferred creditor by debtor countries and by other creditors, such as private banks, capital markets, and bilateral official creditors. It is widely accepted that, as the institution providing financing to a country in times of crisis and when other sources of credit have often disappeared, it is appropriate for the Fund to have preferred status. The reason for this is that crisis financing would likely not be forthcoming without that protection. This means that when debt relief is sought, the other creditors must provide a greater share of the needed relief than would be the case if the IMF comparably reduced its own claims. It seems odd that this preferred status of the Fund is accepted as appropriate by most private and official creditors affected by it, while NGOs (which are not so affected) have been opposed to it.
The Fund has also been criticized for its role in policy formulation and, thus, judgments regarding debt sustainability. Ann Pettifor, for example, claims that the Fund “would play a preemptive role in shaping the outcome of the debt crisis resolution negotiations by setting the country’s level of debt sustainability. . . . In addition, the Fund will continue to play a substantial role in shaping the debtor’s economic policies. . . . the IMF disempowers the debtor, all other creditors, and civil society” (p. 5). This supposed role of the Fund would certainly surprise anyone who has negotiated a Fund arrangement with a member country. Negotiations are inevitably difficult. They involve extensive discussions, lots of give-and-take, and many concessions from all sides before an agreement is finally reached. The Fund does not ride in with the parameters defining sustainability chipped in stone. There is also no single set of macroeconomic policies dictated by a country’s particular condition, even in a crisis situation. There are temporal trade-offs regarding the extent and speed of adjustment, and trade-offs concerning those who need to make the necessary adjustments and sacrifices.
This brings in an important related point rightly emphasized by NGOs: the call for civil society to have a role in the discussions leading to a debt relief plan. The issue, however, is not whether civil society should participate, but through what fora and mechanisms its participation should be organized. In turn, this relates to how policies and debt sustainability are determined. The government budget is the key instrument of policy in this regard, since it is the basis on which debt service capacity will be determined. And, contrary to the views of some in the NGO community, the country’s budget is not dictated by the IMF. Increasingly, the countries with which the IMF has arrangements are democracies in which the budget comes out of a process of consultation between the government and the national parliament that determines the overall framework of the budget, spending priorities, judgments about taxing capacity, and all the other aspects of the final budget presentation. The Fund is part of that process through its discussions with the government. Civil society should certainly be part of that process as well, through representations to the government, participation in parliamentary debate, the giving of testimony, lobbying, and all other means traditional to the specific culture of each country. Effective participation and transparency for civil society are thus required in the domestic system. If these are assured, the process of establishing the trade-offs that ultimately help to determine debt sustainability holds the promise of being fair and effective.
The Prospect of the SDRM
If the world is going to deal justly with debt, it needs to prevent debt crises from occurring in the first place––and many of the initiatives in the Fund and elsewhere are aimed precisely at that objective. Stronger economic and financial policies combined with improving the environment for private-sector decision-making in ways that facilitate the assessment and management of risk offer the best prospect for allowing countries to reap the potential gains from globalization, while minimizing the likelihood, and potential severity, of crises. Robust assessments of the strength and soundness of banking systems and a country’s financial system more generally; encouragement of the adoption of internationally recognized standards and codes and of best practices in numerous areas of economic policy-making and institution building; and better surveillance or monitoring of country policies by the authorities themselves, as well as by the IMF, are all part of these efforts. Nevertheless, crises will occur, and we need to find a way that allows for dealing with them at an early stage in order to alleviate the enormous costs they involve for the citizens of the debtor country and its creditors. I believe the SDRM holds that promise.
The SDRM proposal has been formulated in rather specific terms in a statement from the managing director to the Fund’s governing body, the International Monetary and Financing Committee, and has evolved as a result of the most ambitious consultative process that the Fund has ever engaged in, including the official sector, bankruptcy practitioners, the international legal community, NGOs, and many others. These consultations have led to many important modifications in the proposal. They have also contributed to a greater understanding of the legal and institutional complexities involved in debt restructuring. Even if the SDRM is never implemented, which would be regrettable, it has advanced the debate concerning debt restructuring in important ways. It has given new impetus to the push in the official community that began in the mid-1990s with the Rey Report to encourage the use of collective action clauses (CACs) in sovereign debt issues. Similarly, there is now widespread agreement—at least in principle—on the desirability of agreeing on a voluntary code of good conduct. Although it would not solve collective action problems, such a code would, among other things, foster greater transparency, provide guidance to debtors and creditors regarding procedures for contact and negotiations, and help to provide greater predictability to the restructuring process under any legal framework. Such a code could be made applicable to a broad set of circumstances, ranging from periods of relative tranquility to periods of acute stress, and could constitute an established set of best practices. In that way, it would enhance the proposals for strengthening arrangements for debt restructuring, which have the more limited scope and purpose of facilitating the resolution of financial crises.
These discussions are already generating change in the financial markets. For example, Mexico, South Africa, and Korea, among other emerging market countries, have recently included collective action clauses in sovereign bond issues. A system with reasonably comprehensive and robust CACs and a well-defined code of conduct with broad support among debtors and their creditors will be an improvement on the system that currently exists. Nevertheless, I believe the role of these initiatives should be complementary to the SDRM. They are not sufficiently powerful by themselves to provide what is needed to deal with the more complex and potentially damaging crises that may occur. The past few months have seen a number of news articles speculating on the future of the SDRM. Some have hinted––in my view, prematurely––at its death. However, it took many years to enact bankruptcy legislation in the United States and I believe more work and more thinking is called for—and that is what has been requested by the International Monetary and Financing Committee.
1 Ann Pettifor and Kunibert Raffer, “Report of the IMF’s conference on the Sovereign Debt Restructuring Mechanism, 22nd January, 2003, IMF Headquarters, Washington, D.C.” (Jubilee Research at the New Economics Foundation, January 23, 2003); available at www.jubileeresearch.org/latest/sdr220103.htm. [BACK]