Info Service on Finance and Development (Nov12/02)
22 November 2012
Third World Network
UN General Assembly special event on sovereign debt and debt resolution
mechanisms - Part 1/2
York, 22 November (Bhumika Muchhala) - The UN General Assembly's Second
Committee held a special event on 25 October on lessons learned from
debt crises and on the ongoing work on sovereign debt restructuring
and debt resolution mechanisms, with the participation of all relevant
stakeholders, including multilateral financial institutions.
This followed a decision adopted by the UN General Assembly (UNGA)
in February 2012, in paragraph 27 of resolution (66/189) on “external
debt sustainability and development”.
The UN’s debt sustainability resolution had specifically called for
the “intensification of efforts to prevent and mitigate the prevalence
and cost of debt crises by enhancing international financial mechanisms
for crisis prevention and resolution,” and to assess the ongoing work
on sovereign debt restructuring and resolution mechanisms so as to
guide policymakers in shaping the future global agenda on international
financial system reform. The event, titled “Sovereign debt crises
and restructurings: Lessons learnt and proposals for debt resolution
mechanisms,” held at the UN headquarters in New York on 25 October,
aimed to fulfill a first step towards the goals of the resolution.
Organized by the UN Conference on Trade and Development (UNCTAD) and
the UNGA’s Second Committee, the event highlighted five problems with
the current approach to sovereign debt restructuring, based on the
experiences and literature on sovereign debt and default. The first
problem is that of lengthy debt renegotiations which, in some cases,
do not restore debt sustainability. A study of 90 defaults and
renegotiations on debt owed to private creditors by 73 countries found
that debt renegotiations have an average length of over 7 years, produce
average creditor losses of 40 percent, and lead to limited debt relief.
The second problem is the need to coordinate the interest of dispersed
creditors and to deal with bondholders who have an incentive to hold
out from debt restructuring deals. Even if creditors could be
better off by writing off part of their claims, debt cancellation
requires a coordination mechanism that forces all creditors to accept
some nominal losses. In the absence of such a coordination mechanism,
each individual creditor will prefer to hold out while other creditors
cancel part of their claims. The third is the lack of access to
private interim financing during the restructuring process. In
the corporate world, interim financing is guaranteed by the presence
of debtor-in-possession financing provisions, but sovereign debt lacks
a mechanism able to enforce seniority. Lack of access to private interim
financing may amplify the crisis and further reduce the ability to
pay, because during the restructuring period countries may need access
to external funds to either support trade (trade credit) or to finance
a primary current account deficit.
The fourth issue is that of overborrowing caused by debt dilution,
which refers to a situation in which, when a country approaches financial
distress, new debt issuances can hurt existing creditors. And the
final area of priority is delayed debt defaults. While most
economic models of sovereign debt assume that countries have an incentive
to default too much or too early, there is evidence that countries
often try to postpone the moment of reckoning and may sub-optimally
delay the beginning of the debt restructuring process. A prolonged
pre-default crisis may reduce both ability and willingness to pay,
making both lenders and borrowers worse off.
This special event aimed to address the following five questions:
1. Do the issues listed above adequately reflect past experience with
the current system for the dealing with sovereign defaults?
2. Are there other problems with the current system for dealing with
3. Can the problems listed above be addressed with a structured mechanism
for the resolution of sovereign debt crises?
4. What would be the governance and organization of such a structured
5. Would the costs of a structured mechanism dominate its potential
Ken Rogoff, Professor at Harvard University, opened his remarks
by affirming that the UN is the appropriate forum to analyze issues
pertaining to sovereign debt resolution. Rogoff recognized that the
UN has played a significant role in sovereign debt proposals, including
the G77 proposal in 1979 on an “International Debt Commission.”
Since the advent of debt, sovereign debt crises have been a recurring
problem through history, he said. The first debt default in Europe
occurred in 1431, and cyclical debt crises have occurred from 1800-2009.
A historical spike in external debt default occurred in World War
II and the Great Depression, when almost 40% of sovereign states worldwide
were in debt default. Since then, debt defaults have decreased, and
comparatively speaking, are actually quite low today.
There is a salient question of where and how disputes and problems
of sovereign debt should be adjudicated. In 1995, Jeff Sachs made
a particularly influential proposal, arguing that the IMF would be
more effective if it functioned as an international bankruptcy court
rather than a lender of last resort. This debate culminated in the
2001 proposal for a Sovereign Debt Restructuring Mechanism, made by
Koehler and Krueger at the IMF, which led to the development of Collective
The Secretary General has rightly emphasized the importance of independence,
which makes the prospect of the IMF simultaneously lending money and
being a bankruptcy court very awkward. However, the trouble is that
the IMF is not viewed to be an honest broker by the international
creditor community because it is tantamount to a regulator proposing
a new regulatory structure that puts themselves at the center in a
lender role. Thus, Rogoff argued that it is the role of the UN body
to put forward a process toward formalizing sovereign debt adjudication.
What problems does an international bankruptcy regime aim to solve,
asked Rogoff. The “holdout problem” is one, as most recently seen
in a creditor instigated internment of an Argentine ship in Ghana.
Second, there is the idea of establishing seniority, which is very
hard to enforce, especially when the senior creditor is big. Europe
is going to soon realize that when there aren’t many junior creditors
below you, there will be further debt restructuring. The positive
aspect is that that the Europeans are trying to tackle this problem
and are talking of creating a European proposal for SDRM. In fact,
Europe shows how much debt resolution is a governance problem, and
how important it is to have a system that decides where and how transfers
should take place, among other things. Europe might be able to help
us with innovation and new ideas, Rogoff said.
The elephant in the room is that it is the advanced countries that
are in trouble today – US, Japan and Germany. Mechanisms for resolving
sovereign debt workouts have largely been envisioned for developing
countries. But as unlikely as a default in one of the largest developed
countries seems, it would be folly to build a mechanism that cannot
handle a default in one of the world’s largest economies.
Rogoff stressed that a deeper question remains of why such a large
percentage of international capital flows get channeled through debt,
and whether it can be shaped in the future in a more balanced way.
Equity and direct foreign investment are arguably somewhat more robust
than debt. Thus an international bankruptcy regime that weakens creditors
rights is not necessarily inefficient. Perhaps an ideal regime is
one with strong creditor rights but extensive indexation of debt to
GDP, commodity prices, etc., depending on country circumstances.
A big challenge in re-doing the international financial architecture,
Rogoff argued, is to try to redirect some of the financial flows that
currently go through loans (about 75% of the international tradable
market supply is funneled via debt), and instead channel it through
other instruments such as indexation, commodity prices and so on.
The Secretary-General of UNCTAD, Supachai Panitchpakdi, began
his remarks by recognizing the salience of this first special event
of the General Assembly on sovereign debt restructuring to the international
debate on debt resolution. He highlighted the increasing demand for
re-opening the discussion on the SDRM proposal, an insolvency mechanism
for sovereigns proposed by the IMF in 2002 but abandoned when opposition
was voiced by some large developed and developing countries.
As an alternative to the SDRM, countries started issuing bonds with
Collective Action Clauses, postulating that a majority of bondholders
(usually 75% of principal) can amend bond terms and conditions, including
payment terms. Recent debt restructurings were also facilitated by
the introduction of exit clauses which reduced the incentive to holdout
on a debt exchange offer by impairing defaulted bonds.
However, the April 2012 communiqué of the G20 stated the “the Euro
area crisis has also highlighted the need for further study of sovereign
debt restructuring mechanisms.” The UN Secretary General’s 2012 report
devoted special attention to debt restructuring and provides an outline
of key points of contention in this debate. Three of the most important
points are worth highlighting.
The first key objection to the creation of a structured mechanism
for solving sovereign debt crises is grounded in the economic concept
of “moral hazard.” It is the idea that by reducing the costs of default,
such a mechanism would reduce willingness to pay, make sovereign debt
riskier and ultimately result in higher borrowing costs.
Indeed, Supachai said, this fear of borrowing costs was one of the
key reasons why several developing countries were opposed to the IMF’s
proposal of an SDRM.
However, Supachai argued this fear of moral hazard is not compelling.
First, in economic theory it can also be argued that the current system
with its debt overhangs and delayed defaults leads to a loss of value
for both debtors and creditors and thus to higher borrowing costs.
From this perspective, a mechanism that addressed these problems could
increase recovery value and potentially lead to lower borrowing costs.
Second, and perhaps more importantly Supachai argued, empirical studies
have not found evidence of higher borrowing costs from improved debt
resolution mechanisms. For example, the introduction of Collective
Action Clauses (CACs) in certain bonds did not lead to an increase
in borrowing costs.
A second objection is based on the argument that such a mechanisms
is no longer necessary because CACs successfully address creditor
coordination and holdout problems. Indeed, CACs have helped to address
some of the issues, but it can also be argued that they do not completely
solve coordination problems, as they cannot aggregate the claims of
different classes of creditors, nor do they provide a more structured
mechanism that could increase the equity of burden sharing among different
classes of creditors.
Supachai said the third objection to the creation of a resolution
mechanism is the absence of well-defined criteria for establishing
the “capacity to pay,” subjecting assessment to political pressures,
making it a serious issue for any proponent of the creation of such
a mechanism. Any proposal should therefore include “capacity to pay”
criteria as well as safeguards guaranteeing the independence of a
body in charge of adjudicating sovereign claims.
Kiwanuka, Minister of Finance, Planning and Economic Development
for Uganda, said that the international financial architecture should
reflect a coherent set of processes for financial management. In today’s
interdependent economy every nation has a vested interest in managing
their sovereign debt problems. The proliferation of individual country
decisions disrupts unity and coherence.
These are times when both the demand and supply of sovereign debt
in developing countries is very high. On the one hand, the demand
side comes from financial pressures such as meeting MDG goals, infrastructure
investment and coping with the fallout from the global financial crisis.
Kiwanuka said Africa needs $93 billion per annum to address the infrastructure
The pressure governments face to increase financing has led to a proliferation
of non-concessional lenders where there is higher return for less
risk. This is especially true for countries like Uganda with many
natural resources. “We can all here echoes at the sovereign level
of what we hear on an individual level: ‘You have been pre-approved
for a credit card,’” said Kiwanuka,
A missing link in the international financial architecture is the
need for effective standard procedures in debt acquisition and management,
which would address increased systemic risks and spillovers, and debt
restructuring and difficulties, especially with multiple lenders who
all have different priorities. The UN should facilitate intergovernmental
discussions for guiding sovereign debt discussions based on global
linkages. The problems of lenders charging higher interest charges
and of low absorption capacity on the country level raises the cost
of debt in developing countries.
The Ugandan experience shows the need for a harmonizing framework
to address debt problems. Three of the biggest creditors to the country
have enabled debt reduction of almost 50%. However, Kiwanuka asked
pertinent questions as to what this debt reduction mean? Does lower
debt increase the stock of infrastructure financing? Or does it does
it add value to an economic product or process? Does it lower the
cost of doing business by the private sector, and if so by how much?
Kiwanuka argued that these questions must be answered in order to
build a debt process. Uganda restructured debt through the Highly
Indebted Poor Countries (HIPC) initiative with the IMF and World Bank.
However, debt must also be restructured for infrastructure financing
which will enhance agricultural and industrial activity.
A general uplifting of people and the state is necessary, Kiwanuka
said. Money that is coming in on commercial terms must go into commercial
ventures. For social initiatives, Uganda is looking increasingly toward
bilateral grants and soft financing.
“But we are not going to make the mistake again of using commercial
financing for social financing, it simply does not generate sufficient
returns,” Kiwanuka said, adding that “from the Ugandan perspective,
we are in a new era where sovereign nations are in a position of increased
power to manage debt.”
Arvinn Eikeland Gadgil, State Secretary for International Development,
Norway, said that current times are ripe for a serious discussion
on sovereign debt resolution mechanisms. The HIPC and Multilateral
Debt Relief Initiative (MDRI) are the cornerstones of Norway’s development
finance policies, and should not be dismissed from the debate. Norway
also has a broader idea of what a debt resolution mechanism should
First, it should cover all debt, both private and commercial. Second,
it should be an instrument that includes all creditors, including
the Paris Club, but is beyond that as well. It is now well known that
the Paris Club has a diminishing share of sovereign debt responsibilities.
A mechanism should be able to react quickly, so as to avoid situations
where defaults are being prolonged, as the costs of default are enormous.
A mechanism should also be able to follow the entire resolution process
from default to relief.
Gadgil stressed that the fairness or justice element of this process
is important as well, in that we have to end the current regime where
the only factor considered is debt sustainability. After all, debt
is not just technical, it is also very political. Looking at how the
debt originated in the first place is very critical.
The importance of an independent institution that can handle debt
arbitration in a neutral and credible manner cannot be stressed enough,
said Gadgil. Norway is eager to be an active part of this process,
and has thus decided to have a full debt audit to review if any of
Norway’s sovereign debt can be considered illegitimate. In so doing,
Norway aims to be a role model for other countries.
Norway is also signing a three-year contract with UNCTAD to frame
a process forward. Innovations are not easy, but history shows that
if there is political will, all sorts of things can go forward in
a short amount of time.