Too Little, Too Late

The Quest to Resolve Sovereign Debt Crises

Martin Guzman, José Antonio Ocampo, Joseph E. Stiglitz

• Publisher: Columbia University Press
• Year: 2016
• ISBN:
  9780231542029
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

The current approach to resolving sovereign debt crises does not work: sovereign debt restructurings come too late and address too little. Though unresolved debt crises impose enormous costs on societies, many recent restructurings have not been deep enough to provide the conditions for economic recovery (as illustrated by the Greek debt restructuring of 2012). And if the debtor decides not to accept the terms demanded by the creditors, finalizing a restructuring can be slowed by legal challenges (as illustrated by the recent case of Argentina, deemed as "the trial of the century").

A fresh start for distressed debtors is a basic principle of a well-functioning market economy, yet there is no international bankruptcy framework for sovereign debts. While this problem is not new, the United Nations and the global community are now willing to do something about it. Providing guidance for those who intend to take up reform, this book assesses the relative merits of various debt-restructuring proposals, especially in relation to the main deficiencies of the current nonsystem. With contributions by leading academics and practitioners, Too Little, Too Late reflects the overwhelming consensus among specialists on the need to find workable solutions.

PART I

General Issues of Sovereign Debt Restructuring

CHAPTER 1

Creating a Framework for Sovereign Debt Restructuring That Works

Martin Guzman and Joseph E. Stiglitz

Debt matters. In recessions, high uncertainty discourages private spending, weakening demand. Resolving the problem of insufficient demand requires expansionary macroeconomic policies. But “excessive” public debt may constrain the capacity for running expansionary policies.¹ Evidence shows that high public debt also exacerbates the effects of private sector deleveraging after crises, leading to deeper and more prolonged economic depressions (Jordà, Schularick, and Taylor, 2013).

Even if programs of temporary assistance (e.g., from the International Monetary Fund) make full repayment of what is owed possible in those situations, doing so could only make matters worse. If the assistance is accompanied by austerity measures, it would aggravate the economic situation of the debtor.², ³

Distressed debtors need a fresh start, not just temporary assistance. This is in the best interests of the debtor and the majority of its creditors: precluding a rapid fresh start for the debtor leads to large negative-sum games in which the debtor cannot recover and creditors cannot benefit from the larger capacity of repayment that the recovery would imply.

Lack of clarity for resolving situations in which a firm or a country cannot meet its obligations can lead to chaos. There can be extended periods of time during which the claims are not resolved and business (either of the firm or the country) cannot proceed—or at least cannot proceed in the most desirable way. In the meantime, assets may be tunneled out of the firm or country, or at the very least, productive investments that would enhance the value of the human and physical assets are not made.

Within a country, bankruptcy laws are designed to prevent this chaos, ensuring an orderly restructuring and discharge of debts. Such laws establish how restructuring will proceed, who will get paid first, what plans the debtor will implement, who will control the firm, and so on. Bankruptcies are typically resolved through bargaining among the claimants—but with the backdrop of a legal framework and with a judiciary that will decide what each party will get, based on well-defined principles.

Bankruptcy laws thus protect corporations and their creditors, facilitating the processes of debt restructuring. A more orderly process not only lowers transactions costs but precludes the deadweight losses associated with disorderly processes; in doing so, it may even lower the cost of borrowing.

Good bankruptcy laws facilitate efficient and equitable outcomes in other ways; for instance, in encouraging lenders to undertake adequate due diligence before making loans.

The benefits of a legal framework providing for orderly debt restructuring have also been extended to public bodies, for instance, through Chapter 9 of the U.S. Bankruptcy Code.

But there is no comprehensive international bankruptcy procedure to ensure proper resolution of sovereign debt crises. Instead, the current system for sovereign debt restructuring (SDR) features a decentralized market-based process in which the debtor engages in intricate and complicated negotiations with many creditors with different interests, often under the backdrop of conflicting national legal regimes. Outcomes are often determined on the basis not of principles but of economic power—often under the backdrop of political power. Restructurings come too little, too late.⁴ And when they come, they may take too long.⁵ The lack of a rule of law leads to ex ante and ex post inefficiencies and inequities both among creditors and between the debtor and its creditors.

Furthermore, unlike domestic bankruptcies, sovereign bankruptcy negotiations take place in an ambiguous legal context. Several different jurisdictions, all with different perspectives, influence the process. Different legal orders often reach different conclusions for the same problem. It may not be clear which will prevail (and possibly none will prevail) and how the implicit bargaining among different countries’ judiciaries will be resolved.

At the time we write this chapter, events are making the reform of the frameworks for SDR a major issue. Countries in desperate need of addressing profound debt sustainability issues, like Greece at the moment, are confronting the risks of a chaotic restructuring, and this discourages them from undertaking the restructurings that are now recognized as desirable or even inevitable.

Besides, the gaps in the legal and financial international architecture favor behavior that severely distorts the workings of sovereign lending markets. The emergence of vulture funds—investors who buy defaulted debt on the cheap and litigate against the issuer, demanding full payment and disrupting the whole restructuring process—as recently seen in the case of Argentine restructuring, is a symptom of a flawed market-based approach for debt crisis resolution.

Recent decisions⁶ have also highlighted the previously noted interplay among multiple jurisdictions, none of which seems willing to cede the right to adjudicate restructuring to the others (Guzman and Stiglitz, 2015b).

There is consensus on the necessity of moving to a different framework, but there are different views on the table about how to move forward.

The International Monetary Fund (IMF) and the financial community represented by the International Capital Markets Association (ICMA) recognize that the current system does not work well (ICMA, 2014; IMF, 2014). They are proposing modifications in the language of contracts, such as a better design of collective action clauses (CACs) and clarification of pari passu—a standard contractual clause that is supposed to ensure fair treatment of different creditors. These proposals are improvements over the old terms, but they are still insufficient to solve the variety of problems faced in SDRs. And it is almost surely the case that new problems will arise—some anticipated, some not—within the new contractual arrangements.

On the other hand, a large group of countries is supporting the creation of a multinational legal framework, as reflected in Resolution 69/304 of the General Assembly of the United Nations of September 2014, which was overwhelmingly passed (by 124 votes to 11, with 41 abstentions), and more recently in Resolution 69/L.84 of September 2015 that established a set of principles that should be the basis of a statutory framework for sovereign debt restructuring, passed with 136 votes in favor, 41 abstentions, and only 6 against (see Li, 2015).⁷ The framework should complement contracts, putting in place mechanisms that would establish how to solve disputes fairly. Building it on a consensual basis will be essential for its success. This in turn requires fulfilling a set of principles on which the different parties involved would agree, an issue that we analyze in this chapter.

While the importance of the absence of an adequate mechanism for SDR has long been noted (see also Stiglitz, 2006), five changes have helped to bring the issue to the fore and motivate the global movement for reform of existing arrangements. (1) Once again, many countries seem likely to face a problem of debt burdens beyond their ability to pay. (2) Court rulings in the United States and United Kingdom have highlighted the incoherence of the current system and made debt restructurings, at least in some jurisdictions, more difficult if not impossible. (3) The movement of debt from banks to capital markets has greatly increased the difficulties of debt renegotiations, with so many creditors with often conflicting interests at the table. (4) The development of credit default swaps (CDSs)—financial instruments for shifting risk—has meant that the economic interests of those at the bargaining table may actually be advanced if there is no resolution. (5) The growth of the vulture funds, whose business model entails holding out on settlement and using litigation to get for themselves payments that are greater than the original purchase price and of those that will be received by the creditors who agreed to debt restructuring, has also made debt restructurings under existing institutional arrangements much more difficult.⁸

The sections in the remainder of this chapter are organized around the following topics: the objectives of restructuring; the current problems; the solution proposed by the ICMA and the IMF; analysis of the limitations of the ICMA-IMF solution; a set of further reforms that could be implemented within the contractual approach; and the principles that should guide the creation of a multinational formal framework for SDR.

THE OBJECTIVES OF RESTRUCTURING

In absence of information asymmetries and contracting costs, risk-sharing (equity) contracts would be optimal; there would be no bankruptcy. But under imperfect information and costly state verification, complete risk sharing is suboptimal, and the optimal contract is a debt contract (Townsend, 1979).⁹

Information asymmetries and costly monitoring characterize the world of sovereign lending, which explains the widespread utilization of sovereign debt contracts. The optimal debt contract may be associated with partial risk sharing, including default in bad states and a compensation for default risk in the form of a higher (than the risk-free) interest rate in good states.

If default were never possible, the borrower would absorb all the risk. Under the assumptions of risk-neutral lenders who can diversify their portfolios in a perfectly competitive environment, the expected utility of each lender (who is compensated for the opportunity cost)¹⁰ would be the same, but the borrower’s would be lower than it would be with good risk-sharing contracts. Moreover, if the possibility of default were ruled out in every state of nature (for instance, through sufficiently high penalization of default), the amount of lending would be severely limited.

The probability of entering into situations of debt distress depends on a range of economic conditions¹¹ but also on the actions of the debtor.¹² And once the distress arises, the debtor’s capacity for production and repayment going forward will depend on how the debt situation is resolved. If the debtor defaults, he or she normally loses access to credit markets until a restructuring agreement is reached.¹³

The mechanisms in place for debt restructuring determine how all these tensions are resolved. A good system should incentivize lenders and debtors to behave in ways that are conducive to efficiency ex ante (i.e., the “right” decisions at the moment of lending) and ex post (i.e., at the moment of resolving a debt crisis). It should also ensure a fair treatment of all the parties involved.

EFFICIENCY ISSUES

A system that makes restructurings too costly induces political leaders to postpone the reckoning. When there are no mechanisms in place that would ensure orderly restructurings, the perceived costs of default to the party in power become too large. Therefore, “gambling for resurrection,” delaying the recognition of debt unsustainability, may be the optimal strategy for the debtor.

Delays are inefficient. They make recessions more persistent and decrease what is available for creditors if a default occurs.¹⁴ In the presence of cross-border contagion, furthermore, the delay is costly not only to the given country but to those with which it has economic relations (Orszag and Stiglitz, 2002).

The objective of the restructuring process itself must not be to maximize the flows of capital or to minimize short-term interest rates. Instead, the framework should ensure overall economic efficiency, a critical feature of which is ex post efficiency in a broader sense: it should provide the conditions for a rapid and sustained economic recovery. A system of orderly discharge of debts would permit the debtor to make a more efficient use of its resources, which may be in the best interests of both the debtor and the creditors. Normally, contractual and judicial arrangements should support this kind of ex post efficiency that is necessary for achieving Pareto efficiency.¹⁵

A curious feature of the current restructuring process is that countries that are in the process of restructuring typically face massive underutilization of their resources. This is because such countries cannot get access to external resources; financial markets often become very dysfunctional in the midst of a crisis, with adverse implications for both aggregate demand and supply. Creditors, focusing narrowly and shortsightedly on repayment, force a cutback in government expenditures (austerity), and the combination of financial constraints and decreases in private and public demand bring on a major recession or depression. They wrongly reason that if the country is spending less on itself, it has more to spend on others—to repay its debts. But they forget the large multipliers that prevail at such times: the cutbacks in expenditure decrease gross domestic product (GDP) and tax revenues. The underutilization of the country’s resources makes it more difficult for it to fulfill its debt obligations—the austerity policies are normally counterproductive even from the creditors’ perspective.

Another critical feature is ex ante efficiency. A system that does not put any burden on the lenders ex post does not provide the right incentives for due diligence ex ante. Selection of “good” borrowers requires, in general, specific actions from the lenders, such as screening (before lending) and monitoring (after lending). The existence of a mechanism for SDR would act as a signal that money will be lost unless due diligence is applied.

Note that good due diligence will result in better screening and lending practices, so interest rates may actually be lowered as a result of better bankruptcy laws (i.e., more punitive bankruptcy procedures may so adversely affect lender moral hazard that financial markets become more dysfunctional). This is especially the case when, as now, large fractions of lending are mediated through capital markets, not banks. Arguably, that was one of the consequences of the passage of the creditor-friendly U.S. bankruptcy law reforms in 2005 (through the Bankruptcy Abuse Prevention and Consumer Protection Act), which made the discharge of debt more difficult and led to a substantial increase in bad lending practices.

EQUITY ISSUES

The framework for restructuring determines the incentives for credi...

Table of contents

• Cover 
• Series Page
• Title Page
• Copyright
• Contents 
• Acknowledgments
• Introduction
• Part 1: General Issues of Sovereign Debt Restructuring
• Part 2: Two Case Studies: Argentina and Greece
• Part 3: Improvements to the Contractual Approach
• Part 4: Proposals for a Multinational Framework for Sovereign Debt Restructuring: Principles, Elements, and Institutionalization
• Contributors
• Index