TWN Info Service on Finance and Development (Nov12/03)
22 November 2012
Third World Network

UN General Assembly special event on sovereign debt and debt resolution mechanisms - Part 2/2

New York, 22 November (Bhumika Muchhala) - A UN General Assembly (UNGA) event in New York on 25 October, titled “Sovereign debt crises and restructurings: Lessons learnt and proposals for debt resolution mechanisms,” outlined some concrete steps that could be taken toward a viable debt resolution mechanism.

The UNGA has over the last year channeled a greater amount of its focus on the debate surrounding a sovereign debt resolution mechanism, which has been particularly timely in the wake of the sovereign debt crises in many European countries. The most recent discussion in late October followed the resolution 66/189 on “external debt sustainability and development,” which was adopted by the General Assembly in February 2012.

The above UNGA resolution marks a renewed effort to review ongoing work on sovereign debt restructuring and debt resolution mechanisms, and to intensify efforts to prevent and mitigate the prevalence and cost of debt crises. An overall goal of the UN’s intergovernmental negotiations on sovereign debt is to guide policymakers in shaping the future global agenda on international financial system reform.

The second part of the day-long panel event included speakers from Argentina’s Finance Ministry, the intergovernmental organization, the South Centre, the World Bank and the UN Department of Economic and Social Affairs.

Adrian Cosentino, Secretary of Finance in Argentina, said that debt rescheduling has to carefully ascertain the sovereign capacity to pay in a context where sovereign debt complicates the ability of countries to normalize its economic relationship with the rest of the world.

In the Argentine experience, organizing debt swap offers required as a reference point an evaluation of debt sustainability, which in turn looked at fiscal and external surpluses as reference points. Starting in 2005 Argentina has continuously worked on a debt management strategy which has vigorously pursued the goal of clearing non-performing liabilities and solving outstanding problems.

Cosentino said that Argentina has restructured 92% of its total debt default, where the proportion of holdouts was not even 40%. Argentina has not only restructured but has also carried out debt reduction processes based on financial policies that used internal resources. This allowed Argentina to lower the debt-to-GDP ratio to a present figure of 43%. Half of the total sovereign debt is held by the public sector, including public agencies whose financial risk capacities are very broad. In comparison, the private-debt-to-GDP ratio of 12%.

Cosentino said that unstable macroeconomic policies are a key driver of debt crises, which has to be taken into account particularly in the aftermath of the recent global financial crisis. “In Argentina,” he said, “we have understood that we need to ensure a path to the use of resources that could otherwise be affected by debt payments. We have also understood that we have to give priority to building macroeconomic sustainability, before starting to work on proposals for debt repayment.”

Perhaps a conclusion we can reach, especially by looking at what is happening in the Euro region which is facing a liability restructuring process, is that the lessons learned from Argentina are significant. One key lesson is to prioritize macroeconomic stability, because debt default is economically destructive and leads to a protracted debt resolution process over time.

Another lesson is that fiscal policy has to be very responsible in its allocation of resources, which requires serious parliamentary discussion on how this has to be carried out. A central problem that has emerged from the Argentine experience is that of the “legal vacuum.” The importance of making progress on dispute settlement mechanisms cannot be overstated. Such mechanisms must lead to innovations where rules and procedures place creditors and debtors on an equal footing.

A lot remains to be done, Secretary Cosentino concluded, although there are many good initiatives which already exists and which will hopefully quickly become real measures and options that all countries can use.

A day after Secretary Cosentino’s remarks at the UN General Assembly, on Friday 27 October the Second US Circuit Court of Appeals in New York declared that Argentina had discriminated against bondholders who refused to take part in the nation’s two large debt restructurings.

The Court of Appeals said that Argentina’s decision to pay holdout bondholders later than bondholders who agreed to participate in the 2005 and 2010 debt swaps violated provisions that required the country to treat bondholders equally.

Argentina vowed to fight the court’s decision, and Secretary Cosentino told the state news agency Telam, “Today’s ruling is not in any way the end of litigation” on the relative treatment of bondholders, and that it had no immediate impact on debt payments. However, prices of Argentine government debt fell on that day, and the cost of protecting the debt against default surged higher.

Former Argentine finance secretary Guillermo Nielsen, who helped oversee the 2005 debt swap, said that the court action “corners Argentina into a new default, potentially forcing the country to pay holdouts while it services restructured debt.”

The court proceeding was steered by NML Capital and the Aurelius Capital Management funds, both holdout bondholders who owned $1.4 billion of defaulted debt. Earlier in October, NML Capital won a court order to detain the Argentine naval ship ARA Libertad in a Ghana port, demanding that it be paid some of what it is owed.

A Reuters report on the case concluded that the court decision against Argentina could make it harder for other countries to extricate themselves from sovereign debt crises and fend off angry creditors that may sue the country from United States courts.

Martin Khor, Executive Director of the South Centre, said there is an urgent need for an internationally coordinated system of debt workout today, which is a key missing pillar of the international financial architecture. The world has now seen all the weaknesses in the present system and all the ways in which it doesn’t work. The need to make new efforts for an international solution has never been more important.

What are the features of an international sovereign debt workout system? Some of the features can be borrowed from the US Bankruptcy Chapter 11 law as well as Chapter 9 relating to public sector municipalities.

Khor outlined six major pillars or elements of such a system:

First, a temporary standstill on external debt servicing which will provide breathing space for debtor countries to formulate a viable debt servicing plan. Such a plan should cover all debt servicing, including those due to solvency problems in which the debt has to be reduced, or liquidity problems in which the debt has to be rolled over.

There should also be an automatic stay on litigation during the standstill in order to avoid problems for both debtor country and creditors, and in particular to avoid a scenario where creditors are scrambling for exit or to sue the debtor. The process should be similar to the World Trade Organization (WTO) feature, in that if there is a balance of payment difficulty in the country that can be demonstrated, the country can unilaterally suspend its tariff obligations in the WTO while receiving assurance that other WTO member states cannot take it to court.

Second, an independent panel of legal and economic experts should be established, and independence should be safeguarded by ensuring that panel members are neither debtors or creditors. The IMF, in particular, cannot sit on such a panel because the institution is itself a creditor, which compromises the independence of such a panel.

Third, selective capital controls should be implemented in order to prevent capital flight. Fourth, new loans should be provided to the debtor country, in a process of lending into arrears. This enables countries to continue their trade, and in particular to be able to import essential items. Possible lenders for new loans are the IMF, the WB and other donor and lender countries. However, such lenders should not finance debt payments, which should be discussed strictly in the debt workout reorganization and mechanisms. If new money is lent to the debtor in order to repay old creditors, the whole point is moot.

Fifth, new debt contracted after the standstill should not be counted in the original debt amount. If the problem is primarily a liquidity problem, there should be a rollover of existing loans. If it is a solvency problem there should be a partial debt writedown. The precise method of such workouts should be the result of negotiations between the debtor and the creditor, and the negotiations process should be guarded by a statutory mechanism. Operationalizing the Collective Action Clause should be part of the entire exercise. When creditors and debtors cannot reach an agreement, an independent panel should arbitrate.

Elements of such a process were in the Sovereign Debt Restructuring Mechanism proposal by the IMF.

Recently, South Korea expressed support for a debt standstill and restructuring process when it said to the G20 that “Many who have analyzed Korea’s 1997 and 1998 financial crises have found that Korea could have solved its liquidity problem sooner had a debt standstill programme been in place at the time Korea requested IMF assistance at the end of 1997.”

Khor stressed that the UN can take the lead in the debt restructuring exercise. In watching the Euro area debt crisis, there is an evolution of many ideas, especially from political leaders who are recognizing that there are far more efficient and effective processes and mechanisms than the ‘muddling through’ process the world is currently witnessing.

What is important for developing countries, especially Least Developed Countries that have experienced the Highly Indebted Poor Countries program, is that they do not become complacent when sovereign debt is low and sustainable, when times are good.

Khor highlighted that many factors indicate that the favorable global economic conditions that led to high capital inflows and high commodity prices are going to phase out in the coming years. Most economists are currently predicting that in the next 3-5 years there are very difficult times ahead for most developing countries. There may be shocks to export and remittance earnings, and this may cause difficulties for debt sustainability.

This is why, Khor emphasized, the current time is an opportune time to set up a debt restructuring mechanism. When countries are in the middle of a crisis, it will be much harder to establish a large-scale internationally coordinated mechanism.

Shamshad Akhtar, Assistant Secretary-General for the Department of Economic and Social Affairs (UN DESA) in the United Nations, outlined the proposals, perspectives and collective wisdom towards a sovereign debt resolution framework. Parallel to UNCTAD’s “Principles on Promoting Responsible Sovereign Lending and Borrowing,” the private sector has started discussing amendments to the “Principles for Stable Capital Flows and Fair Debt Restructuring.” The private sector’s objective is to incorporate the new developments associated with debt restructuring into the capital flows regime.

Meanwhile, UN DESA has launched a range of multi-stakeholder consultations on sovereign debt restructuring to solicit views of distinguished experts from academia, policymakers and private sector representatives. At the October meetings of the World Bank and IMF in Tokyo, experts acknowledged the virtues of a statutory debt restructuring mechanism but also recognized the complexity of designing an acceptable and enforceable framework.

The magnitude of the recent financial crisis might explain a perceived general willingness, including among private sector representatives, to entertain a more rules-based approach. Such an approach, while constraining private sector creditors, would also protect them from arbitrary actions by sovereigns, said Akhtar. The hope is that the recent round of debates might result in a balance etween contractual and statutory instruments.

Akhtar highlighted that an important and cross-cutting issue is that of transparency and availability of data. One proposal to enhance transparency and data access is the creation of an international registry of debt, reported by creditors and reconciled with debtors. Another perhaps more ambitious option would be the creation of a neutral Sovereign Debt Forum, which would help assuage the information and analytical issues associated with the question of debt sustainability, as well as provide a space for negotiations and consultations.

In situations of debt distress borrowers would benefit from “breathing space,” which is not available currently, before identifying a sound policy framework to promote “sustainable adjustment, preserve asset values and support growth, to the mutual benefit of both debtors and creditors.” In practice, sovereigns can impose de facto standstills through the exercise of ‘force majeure,’ given the absence of credible means to enforce judgments under sovereign immunity.

A fundamental issue, Akhtar stressed, is whether a more formal process for the declaration of a standstill, in conjunction with lending into arrears by the IMF, would enhance the debt resolution framework. Such a process would provide a stay on all litigation by individual creditors, preventing a panicked rush to the exits that usually triggers a rollover crisis and a race to the courthouse.

Two proposals have been discussed in this regard. First, the inclusion of terms for standstills in bond and loan contracts under the voluntary approach and second, the amendment of article VIII 2b of the IMF Articles of Agreement to include capital account transfers under the statutory approach.

Otaviano Canuto, Vice-President of the Poverty Reduction and Economic Management Network in the World Bank, said that various World Bank studies have concluded that sovereign debt restructuring tends to be disorderly and prolonged. Official interventions can sometimes help, but sometimes it can worsen sovereign debt situations.

This conclusion was consistent across countries with striking similarities such as fixed exchange rates, open capital accounts, weak growth prospects and concerns about fiscal solvency. A common sovereign narrative is that fiscal fundamentals play a crucial role. Even though all these crises typically involve abrupt economic disruptions, their seeds were sown over long periods, and reflect policies in national and global political economy.

A common thread across sovereign debt crises is the rise of a relatively new set of complications, namely that of private capital flight moving from the core to the periphery and now back to the core. In the 1980s there was a proliferation of black market premia for hard currency, and the rising risks of convertibility have become a serious concern. However, despite the disorderly nature of some debt writedowns, at the end of the day there is some acknowledgement for the need to write down debt.

Canuto compared the 1980s debt crisis in Latin America, after the Brady Plan was formulated, to the debt crisis in Russia and Argentina, where the usefulness of official intervention was questionable. Financial engineering occurred in the form of voluntary debt swaps and the lesson was learned that procrastination is costly for all stakeholders.

For any official intervention to be catalytic, Canuto said that private holders of government debt must get involved, fiscal and structural reform must take place, and the interest rate must come down after risk stress declines. “Intuition is simple,” he said, “There is an understanding that solvency means that the present value of primary fiscal surpluses must be less than outstanding debt.”

With regard to the Greek debt crisis, bond spreads in the country continued to rise even as the interest stayed stagnant. The debt had to be adjusted even higher and a haircut has to come to the fore. Against this backdrop of recent experiences in the Euro area, there are many desirable features underpinning any orderly debt restructuring when a fiscal solvency problem is detected and when the market is in significantly high default risk.

First, private creditors receive an upfront haircut; second, vulnerable systemic banks are protected to get back on track; and third, the official money is loaned at risk-free rates which reflect its senior status. The question would arise whether an upfront haircut for private creditors would incur more hazard.

What the data in the World Bank shows, according to Canuto, is that the supposed moral hazard risk on the debtor country has been overestimated starting from the various debt crises in the 1980s. The kind of smoothing required in a debt restructuring mechanism is one that would avoid the aspects of disorderly and procrastinated debt restructuring.

Nigeria said that defaulting countries are not focusing enough on the ways in which creditors can behave more responsibly. There is a lot of discrepancy in the figures presented by the IMF, the World Bank and the countries themselves.

The international community also has to address the important question of how these sovereign debts have been amassed by developing countries in the first place. Has the debt been used for the purpose originally stated? There are often no proper records, no statements and no evidence as to the actual use of the debt. For some developing countries, sovereign debt becomes deeper and deeper because they don’t export industrialized goods.

How will developing countries stimulate exports of higher value added manufactured and industrial goods? Many African countries have a taste for imported goods from abroad, and do not put the priority on building a deeper domestic industrial base. But, Nigeria stressed, if developing countries have nothing to export there is nothing with which to pay the debt.

The International Monetary Fund stated that when discussing issues countries currently face in debt sustainability, there are successful examples of how the international community effectively cooperated to establish the Multilateral Debt Relief Initiative and the Highly Indebted Poor Countries initiative.

Since the Sovereign Debt Restructuring Mechanism (SDRM) proposal, the IMF has been involved in many national debt restructuring initiatives, where the IMF is guided by its policies on debt restructuring and private sector involvement. The mandate given to the IMF by the international community is to provide an independent assessment of the economic reform programme of the government to ensure debt and economic sustainability analyses.

The Fund is also mandated to provide financing and more importantly play a catalytic role to help unlock financing from other countries. Even though the SDRM discussion was stalled at the IMF’s Executive Board, the Fund has been involved in a number of sovereign debt restructuring processes, and within each of these, the IMF has been following international protocols.