Under the current system, when a country such as Argentina ceases making payments on its debts, its obligations are eventually rescheduled by a committee of its creditors, which agrees to accept lower payments of interest and principal, at least in the early years. In the Latin American crisis of 1982-86 this worked quite well, because nearly all the debt was international, and held by a relatively small group of large international banks. Although theoretically a bank could hold out at the last moment and stop a rescheduling deal, in practice any bank that did so would find itself subject to intolerable pressures from its peers.
It got more difficult in the 90's, for two reasons. First, emerging market countries such as Argentina started issuing international bonds. Under the traditional British bond issue structure, a trustee represented bondholders, who were not allowed to sue the borrower unilaterally. However, since the majority of 1990's bond issues were made either in New York or using the continental European fiscal agency system, this protection was not available, making rescheduling deals very much more difficult if lawsuits are to be avoided.
Second, domestic debt markets, denominated in local currency, became much more important. In the 1998 Russian default, the government simply ceased payment on domestic debt, resulting in moderate losses for foreign buyers of such debt, but the collapse of the domestic banking system. Because its citizens distrusted the peso (rightly, as it turned out) Argentina had only a modest quantity of domestic debt outstanding. In Brazil however, the next country lurching into trouble, the domestic debt market is larger than the international (non-international financial institution) debt market, and so default would have very serious repercussions for the domestic economy.
Anne Kreuger, First Deputy Managing Director of the International Monetary Fund proposed in November 2001 a sovereign debt restructuring mechanism (SDRM), under which a debt reorganizer (probably but not necessarily the IMF) would be appointed for defaulting countries and, by modification of the IMF Charter, all international banks would have to submit to the reorganizer's edicts.
As an alternative, U.S. Treasury Under Secretary John Taylor proposed that British-style collective action clauses (CACs), under which bondholders in a bond issue would submit to the jurisdiction of a trustee for that issue, should become more widely used.
At the September World Bank/IMF meeting, it was agreed that the IMF would put forward formal proposals for an SDRM by the time of their spring meetings (April 2003) at which time a decision would be taken on which way to go.
Jack Boorman, Special Advisor to the IMF's Managing Director, explained the rationale behind the SDRM. This would have five major features:
-- The sovereign debtor would have legal protection from disruptive legal action by creditors while negotiations were underway, through a vote by a supermajority of creditors to approve a stay on litigation
-- The creditors would have some assurance that the debtor would negotiate in good faith and pursue appropriate economic policies
-- Creditors would give seniority and protection from restructuring to fresh private lending (especially trade credit) to facilitate ongoing economic activity
-- A supermajority of creditors could vote to accept terms of a restructuring, and minority creditors would then be prevented from blocking such agreements or enforcing the original debt contracts
-- A dispute resolution forum would be established to verify claims, insure the integrity of the voting process and adjudicate disputes
In Boorman's view, the SDSM offers the advantage of being immediately feasible (through a change in IMF statutes, which would then be binding through national laws on private sector banks and investors.)
Randall Kroszner, of the U.S. Council of Economic Advisors, pointed out that another feature of the SDSM proposal would be that it would add enormously to the power of the IMF, and of the international financial institutions in general, even if the administrator of the SDSM's was not technically the IMF. CACs on the other hand offered a private sector solution to the problem of rogue bondholders that could be implemented immediately; he called for managers of emerging market bond issues to begin putting such clauses in their agreements forthwith.
Anna Schwartz, of the National Bureau of Economic Research, co-author with Milton Friedman in 1962 of the seminal work on U.S. monetary policy, said that the SDSM would affect all existing debt contracts and bring the IMF into debt restructurings, when the free market had shown no such demand. While CACs could be helpful in international debt agreements, the market had shown no demand for them and it remained to be seen what additional cost the market would demand for a bond issue that included such a clause. The danger of such proposals is that they may result in investors "redlining" emerging market countries, and refusing to buy their bonds.
Jeffrey Sachs, director of the Earth Institute at Columbia University, called strongly for an international bankruptcy law, to resolve collective action problems and provide a risk sharing mechanism that relieves the debtor from extreme outcomes in which domestic economic activity is severely damaged. His model is Chapter 9 of the U.S. bankruptcy code, which protects municipalities from their creditors, preserves their political viability and ensures that essential municipal functions continue.
Alan Reynolds, Senior Fellow of the Cato Institute criticized the effects of IMF programs on the borrowing countries' economies. In general, such programs were needlessly deflationary, raised taxation entirely inappropriately, and by stifling growth, increased the debt burden. In a number of cases, countries such as South Korea, Chile, Mauritius and Jamaica that had tried the IMF approach and then thrown it out had seen economic growth surge and debt service problems reduce after the IMF approach had been reversed.
In my view, the SDSM represents an even greater approach to the IMF's "command and control" public sector model of the world economy that has failed repeatedly in the past. CACs, while desirable, are not in themselves sufficient because they would not cover domestic debt.
At the same time, I agree with Sachs that some legal basis for country bankruptcy must be found, to make negotiations more orderly and reduce collective action problems.
The best approach, in my view would be an international treaty, signed by all countries with significant international borrowings or lending banks, that would provide for a committee of the major creditors, both international and private sector domestic, to act as administrator of defaulting countries.
The committee, on which voting would be by volume of outstanding obligations owned or for which proxies were held, would have by the treaty clear and strong powers against both creditors and the defaulting debtor, but would be governed by a code of conduct containing clear rules on the need to act collectively, prevent frivolous lawsuits, and protect the defaulting country's international trade.
The makeup of the committee would be derived from the volume of credits outstanding. The IMF and World Bank would be represented as creditors, but would have no special role or veto.
This is fairly close to the 19th Century position, under which the London merchant banks (or in some cases, J.P. Morgan) managed the affairs of defaulting countries, whose economic policies were set depending on the merchant bank of which the country was a client.
Naturally, to make this system work today, institutions similar to the London merchant banks would be mandated by the committees to act on the creditors' behalf. As in the nineteenth century, the existence of several such institutions, all in the private sector, would ensure a useful competition between alternative economic policy recommendations.
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