Recent examples of severe sovereign debt crises, such as those of Argentina and Greece, show that the failure to act early amplifies the social and economic consequences of the debt crisis and, when restructuring of the debt does arise, it often causes equity problems among different creditor groups.
Against this backdrop, consistent with its self-advocated role as the premier forum for international economic cooperation, the G20 should take a more proactive role in the regulatory architecture that underpins the management of severe sovereign debt crises by promoting a soft law approach to debt restructuring.
Various arguments both for and against reforming the approach to sovereign debt restructuring have been put forward. The main argument against reform is that the current arrangements work relatively well and that reforming the system would encourage debtor moral hazard: specifically, if a debtor country had access to a formal restructuring procedure, it might be inclined to choose bankruptcy over making its best efforts to exit a liquidity crisis by its own means. These dynamics would in turn raise sovereign borrowing costs and leave all parties worse off.
The proponents for reform reject this view and claim that creditor moral hazard, deadweight losses and distributional inequity are current problems that justify reform. For instance, creditors lend money to sovereigns expecting that the International Monetary Fund (IMF) will invariably bail out troubled debtors. This safety net encourages creditors to engage in excessive and risky lending, which in turn worsens the borrower’s debt structure and ultimately may lead the country into insolvency.
Deadweight losses are efficiency losses that arise from information and coordination problems among creditors and the debtor that reduce general economic welfare. As is evident in the Argentinian and Greek debt restructuring, one of the main ways in which coordination and information problems cause efficiency losses is by delaying the restructuring process. A delayed restructuring process postpones the country’s return to economic health, and can lead to a prolonged period of economic stagnation.
Restoring the balance
Distributional issues arise in all sovereign debt restructuring, as there is no holistic restructuring framework that adequately addresses all debt obligations equally in one formal procedure. The main sources of tension for inter-creditor equity lie in balancing the interests of short-term and long-term holders of sovereign debt on the one hand, and foreign and domestic creditors on the other. Depending on the specific circumstances, restructuring affects only holders of a particular bond issuance, rather than all bondholders, which can cause inequity between creditors of different bond issuances. In addition, for political reasons foreign creditors may achieve a better restructuring than domestic creditors, or vice versa.
Attempts to create a binding, statutory framework for sovereign debt restructuring have a long history. In 2001, the IMF initiated a discussion among stakeholders in major financial centres, when it proposed the creation of a sovereign debt restructuring mechanism (SDRM). The core feature of the proposal was to give the IMF power to approve payment standstills for distressed debtor countries. As such, the SDRM would address the problem of creditor moral hazard, and facilitate a speedier and more orderly resolution of sovereign debt crises. Although a number of countries within the G7 initially supported the SDRM, voices opposing the proposal took on greater significance. The opposition mainly argued that the IMF, being a creditor of most distressed debtors, would not be the right institution to exercise decision-making power over a debt standstill, and that countries would abdicate sovereignty if an outside institution could decide with binding effect when a debt standstill has to occur. Eventually, the SDRM proposal was abandoned.
In 2014, the United Nations General Assembly passed a resolution to create a “multilateral legal framework for sovereign debt restructuring”. Although the resolution was opposed by all countries hosting major financial centres, the vote received broad support from the G77 caucus of developing countries. As it stands, it is unclear whether the resolution will lead to the formulation of a new, comprehensive proposal for a sovereign debt restructuring framework.
Yet, the most effective changes affecting sovereign debt workouts have been on the contractual level. In 2014, the International Capital Market Association (ICMA) – a private industry standard-setting body whose members include banks, asset managers, and securities issuers and brokers/dealers – proposed standardised sovereign bond contract clauses to facilitate debt restructuring.
Other proposals to improve the conditions of sovereign debt restructuring have been to formulate soft law rules. A soft law instrument establishes rules that are acceptable to market players, which, however, do not develop any binding legal force. In other words, soft law may serve as a guideline for market actors who choose to voluntarily adhere to these rules. The Institute of International Finance (IIF) – an interest group whose members include banks and other private financial institutions – published the Principles for Stable Capital Flows and Fair Debt Restructuring. The principles aim to promote better debtor behaviour for preventing as well as resolving crises through adherence to four broad principles: data and policy transparency, open dialogue and cooperation, good-faith negotiations, and fair treatment of all creditors. In 2012, the United Nations Conference on Trade and Development (UNCTAD) developed and published its Principles on Responsible Sovereign Lending and Borrowing. The UNCTAD principles differ from the IIF principles in that they include a more balanced emphasis on the responsibilities of both debtors and creditors and are, moreover, open to stakeholder input and revision.
Developing soft law principles
The G20, through joining the efforts of major creditor countries and major financial centres, should play an important role in sovereign debt restructuring. Given that statutory proposals for a formal sovereign debt workout process historically have failed, and that contractual reforms have a limited scope as they only apply to new bond contracts, the G20 should commit to improving the sovereign debt environment by taking the lead on the soft law approach.
Specifically, the G20 should mandate the Financial Stability Board (FSB) to promote a broad consultative effort within its membership and facilitate agreement on a set of soft law principles. Such principles, upon receiving broad acceptance, should be included into its Compendium of Standards as a way to promote the principles themselves and improve sovereign debt restructuring by voluntary adherence to soft law. As a subsequent step, the G20 could mandate the FSB to monitor how its members implement the principles into their negotiations with distressed borrowing sovereigns. The insights from these reviews would help further develop the principles and promote acceptance for them among a larger group of market players.
Entrusting the FSB with the regulatory umbrella of sovereign debt restructuring would help the management of world crises as a whole, as well as improve prevention.