Mark Sobel is a former US Treasury official and IMF representative responsible for international monetary and financial affairs. He is now US Chair of OMFIF, a think-tank.
With severe sovereign debt distress now entrenched and more to come, many analysts and practitioners want to revamp the architecture for sovereign-debt restructurings. To do this they are offering reform proposals that are often incompatible with the facts on the ground.
The current architecture is undeniably a messy hodgepodge. But market practitioners shouldn’t expect major changes, and should focus instead on the improvements that can realistically be made.
One long imagined sweeping solution is to create a global bankruptcy regime, such as the IMF’s proposed Sovereign Debt Restructuring Mechanism of two decades ago. But the current world order is based on nation-states with differing legal political and economic systems, not global governance. Supranational bankruptcy enforcement requires a globally recognised supranational bankruptcy authority, and that does not exist. A global bankruptcy regime is a non-starter for further reasons, including possible politicisation of decision-making and that the US would not likely cede the sovereignty of US courts in core areas to a supranational body. Nor would others.
Today the debt of low-income countries — the poorest nations with per capita annual incomes often little more than $1,000 per year — is generally dominated by official debt, especially to bilateral creditors such as China, while emerging-markets debt is generally to private investors. Fair or not, it’s fanciful to think that the private sector would be elevated to have an equal seat at the table with international financial institutions, and the relative seniority of official and private creditors itself at times seems to be a jump ball. These differing circumstances, plus the diversity of private creditors, means that restructurings need to be worked out on a case-by-case basis.
Policymaking as a general rule is constrained by such realities as those above, so small steps, evolution and incrementalism are frequently all that can reasonably be expected. That means investors must likely work within the framework of the current sovereign debt architecture.
What then can be done?
The main debt-distress challenge now faces low-income countries themselves. The international community’s Debt Service Suspension Initiative provided some welcome, albeit temporary, breathing room. But deep and durable relief is essential from the G20 Common Framework. That blueprint for action has thus far been a flop, though recent developments in Zambia may offer hope.
Still, the main, but not only, hindrance is tackling large-scale Chinese official lending. Chinese debt is opaque; there are bogus Beijing arguments about whether credits are official or private; the authorities prefer to roll over debt rather than address overhangs through debt reduction; and given that China is often a dominant creditor, it has little incentive to follow co-operative Paris Club-like principles. Further, it would be unwise to underestimate the private sector’s willingness to hide behind Chinese inaction.
This problem has to be addressed politically. At this point, the G20 Common Framework, even if flawed, is the only game in town. The US lacks the leverage to prod China to move forward, given the current state of US/China relations. Nor does the World Bank, led by David Malpass, who is identified with US voices calling out China for “debt trap diplomacy”.
The IMF is the key actor. It has commendably and quietly been working step-by-step with China. But it needs to be more publicly outspoken in pressing China to quickly reach a concrete debt-relief deal with Zambia, and using such a deal as a springboard to sign up other low-income countries.
International financial crises are a staple of history and will remain so long past our lifetimes.
The messier the restructurings, the greater the damage and costs to issuers and creditors. Issuers — often with leaders who are in denial or covering up messes — are especially guilty of waiting too long to tackle woes and end up defaulting, rather than tackling stress preemptively and at less cost to society.
Under the current messy system, striking a fair balance between issuers and creditors can involve multiple approaches.
In recent decades, attention has focused on inserting collective action clauses (CACs) in foreign-law sovereign bonds overwhelmingly issued under UK or New York law. They allow a given majority of relevant bondholders to support a restructuring and bind all remaining holders. While they are no panacea, they were enhanced in 2014 to facilitate workouts and circumscribe holdout litigation, thus bolstering the orderliness and predictability of restructuring processes. (Full disclosure: I chaired the international working group that developed these enhancements.) CACs are now used in the vast bulk of such bonds and increasingly dominate the market. The enhanced features helped steer the recent Argentine and Ecuadorean restructurings to a successful outcome.
But CAC-type provisions are still needed in an array of other debt instruments, such as syndicated loans, subsovereign borrowings, and others. The international community should apply pressure to creditors and issuers to encourage the introduction of such provisions. This goal should be within reach if sleeves are rolled up. A G7 working group has focused on the matter, but appears so far to have little to show for its work.
Many analysts believe state-contingent debt instruments, linking a sovereign’s debt service more closely to its repayment capacity, could introduce greater flexibility into possible restructurings and better balance the interests of issuers and creditors. But such instruments have not taken off, despite decades of analysis, because of several issues — can one trust issuing authorities to provide accurate data; will such instruments cost issuers more than plain-vanilla paper; can such instruments be easily sold when liquid markets for them don’t exist? Perhaps they will become more popular in sovereign-debt restructurings, the way catastrophe bonds have. But the lifting required may be far heavier and uncertain than updating contracts for syndicated loans or subnational borrowings.
Debt data — both official lending and issuers’ debts — are opaque indeed. This terrain should be ripe for harvest. The private sector has a legitimate beef when it complains that it can’t trust official data and thus it is operating blindly when it has to contribute to restructurings. But it also uses this argument to hide behind official creditors and drag its feet in participating in restructurings. The IMF, World Bank and others should roll up their sleeves in their insistence on far greater public transparency from all borrowers. Key recent initiatives to enhance debt transparency seem to be bogged down.
The line-up of private actors who hold emerging-market debt now comprises banks, passive and active funds (the latter including distressed debt funds), and others, many with differing interests. Yet private-sector participants have one thing in common: they are self-declared experts in analysing and pricing sovereign credit risk. They tout their due-diligence work and argue that they understand and are ready to assume the risks they take in order to secure strong rewards for clients. Nonetheless, when “high-end” shirts are lost (or when expected payouts are not achieved), the first response is almost never for those wearing “designer” shirts to accept the consequences of their mistaken risk/reward assessments. Rather, it appears to be a visit to countries’ executive branches — including bureaucrats wearing cheap shirts — and legislatures to lobby furiously for smaller losses or greater returns, and even to litigate in courts with imaginative and inventive legal interpretations.
Shifting the current balance of power away from issuers to creditors in a restructuring — through rewiring bond architecture, limiting countries’ sovereign immunity and facilitating attachments, and imposing greater burdens on the already struggling vulnerable citizens of distressed countries — hardly seems to be a tenable path forward.
Further, the IMF — often the world’s debtor-in-possession financier — should re-examine its role in helping strike this difficult balance. The IMF sets the financing parameters for creditor payments in a restructuring through its programs and debt-sustainability work, which allocate the financing of gaps between country reforms, new money and debt relief. The outcome for sustainability depends heavily on future performance assumptions, especially around growth and the primary balance.
But excess IMF optimism can involve pretending that countries face illiquidity and not insolvency, letting creditors avoid significant upfront losses and blithely dissembling that debt can simply be rolled over and extended. In contrast, stricter and more steadfast realism (and less fear of haircuts) could avert harsher economic country restraint, help remove countries’ debt overhangs and pave the way for better country investment and growth outcomes.
The days of gunboat diplomacy are behind us. So are the days of locking a few bankers in a room to sort it out. Perhaps the world was tidier then. But the current reality of sovereign debt architecture is, for better or worse, a messy affair. And it’s one that is here to stay, even as marginal improvements are achievable.