Joseph Stiglitz and Hamid Rashid
FORCE MAJEURE, NECESSITY AND RELATED LEGAL DOCTRINES
It is reasonable for debtor countries in the current pandemic to invoke force majeure – a catchall phrase for the breaking of a contract in the presence of unforeseeable circumstances beyond the control of parties in a commercial contract. Governments clearly could not foresee the pandemic. Even if they could foresee a pandemic, they could not possibly foresee its widespread and devastating economic impacts, including those brought on by lockdowns, closure of borders and the collapse of exports and remittances.
Most sovereign bonds do not include automatic force majeure protection, which is why it has to be written in within the legal framework. Even if a force majeure clause is missing in the debt contract, a debtor can demand temporary relief on the ground of the impossibility or impracticability of performance. New York contract laws, for example, accepted the global financial crisis in 2008 as an unforeseeable event, which made the performance of a contract commercially impracticable in some court cases (Encinas, 2011). Legal experts believe that the pandemic can qualify as a force majeure event, even if a contract does not explicitly include it as such (Marmins, 2020; Weiss et al, 2020). The fact that most of these countries introduced a state of emergency or some form of lockdown measures to fight the pandemic can be seen as extraordinary and impractical circumstances for servicing debt.
Regardless of whether a bond contract includes force majeure clauses, a sovereign can invoke the doctrine of necessity – requiring an emergency response to an unprecedented crisis – to suspend debt payment. Some experts view that the doctrine of necessity played a role in forcing private creditors to accept 46.5% of the face value during the restructuring of Greek sovereign bonds in 2012 (Xafa, 2014).
Under the doctrine of necessity, developing country governments could temporarily suspend current and capital account convertibility, which would apply to a broader set of external flows, including payments on debt and portfolio investments. A temporary suspension of current and capital account convertibility will give some reprieve to developing countries and help to reduce the global demand for dollars, which would otherwise lead to a significant depreciation of the dollar vis-à-vis local currencies during the crisis period. This will lower the local currency cost of external debt for developing countries.
While countries can restrict capital account convertibility anytime, Article VIII, Section 2(a) of the IMF Article of Agreement stipulates, “a member may not impose restrictions on the making of payments and transfers for current international transactions without the (prior) approval of the Fund”. Such measures are not unprecedented. In September 1998 – one year into the Asian financial crisis – Malaysia imposed a 12-month waiting period for repatriation of investment proceeds (Sundaram, 2005). It also introduced an exit tax on capital repatriation to prevent capital flight. At that time, critics of these measures warned that investors would never trust Malaysia again and that international capital would forever stay away from the country. These warnings were proved false; international investors returned to Malaysia in no time. Argentina had currency controls for most part of the 21st century until the previous government scrapped them in 2015, only to reintroduce them in September 2019. The currency controls did not prevent capital inflows into Argentina. In fact, Argentina managed to issue a 100-year 7.125% bond for $2.75 billion in 2017 – less than two years after it defaulted – which was more than three-times over-subscribed by investors.
In the aftermath of the 2008 crisis, the IMF recognised the advisability of adopting “capital account management” regimes under certain circumstances (IMF, 2016). Under an IMF programme, Iceland had capital controls in place during 2008-2018 as it pushed for recovery from the global financial crisis. Cyprus introduced capital controls to minimise the fallout of the Greek debt crisis. Several large developing countries – notably Brazil, Indonesia and the Republic of Korea – have some form of capital controls aimed at stemming volatile capital flows.
The pandemic is clearly a set of circumstances under which such interventions should be considered by a wide array of countries. If many introduce such measures in concert, it will reduce the adverse signal that might result if only one or two countries were to adopt such actions. The IMF might help coordinate the appropriate set of interventions.
The pandemic is clearly a set of circumstances under which such interventions should be considered by a wide array of countries. If many introduce such measures in concert, it will reduce the adverse signal that might result if only one or two countries were to adopt such actions. The IMF might help coordinate the appropriate set of interventions.
REDUCING THE DEBT BURDEN BY BUYING BACK SOVEREIGN BONDS
Earlier we explained why, in spite of the seeming desirability of an orderly debt restructuring, achieving such a restructuring under current institutional arrangements is difficult. It is why, domestically, we have bankruptcy courts that sort out competing claims in an orderly way. If debt restructurings could always be done efficiently and fairly on a voluntary basis, courts would not be required; at most, what would be required is standardisation of debt contracts that would facilitate the desired debt restructurings. No country relies just on voluntary negotiations, with or without the kinds of collective action clauses that have been inserted into international debt contracts in recent years.
Most debt restructuring involves debt swaps, retiring existing debt with some reduction in face value, issuing new debt often with longer maturity and lower interest rates, sometimes with a grace period, sometimes paying creditors some cash up front (often with proceeds from the issuance of new bonds) and other incentives to accept the terms of the restructuring. A grace period is especially important during a major economic downturn, such as that associated with the pandemic; without a grace period, the country cannot recover (or in this case, fight the pandemic). But as we mentioned earlier, creditors often try to impose more difficult and costly provisions. For example, the restructuring of the Latin American debt in 1989 – under the Brady Pan – required the debtor countries to buy US treasuries to hold as collateral to guarantee repayment of principal. This collateral requirement implicitly increased the cost of debt for these countries, although they received some haircut on the uncollateralised debt they owed to US commercial banks. The Latin American countries used a combination of their own foreign reserves and new borrowing from the IMF to buy the collateral. The Argentine debt restructuring in 2005 involved debt swaps, with Argentina paying 4.35% coupon interest rate for the first five years, 5.0% for years 6-10, and 8.52% for the remainder of the new 30-year bond (Congressional Research Service, 2006).
The restructuring offered Argentina a 75% write-off on a net present value basis.32 To sweeten the deal for the creditors, Argentina also offered GDP-linked warrants – paying a premium on coupon rates when its GDP growth exceeded a pre-determined level. The restructuring package gave Argentina room to grow when in needed it (i.e., in the years immediately following the crisis). Argentina quickly rebounded, with GDP growth rate averaging 8.6% during 2005-2007. By 2006, it was able to repay its loans to the IMF. Because of improved growth performance facilitated by the restructuring of the bonds in 2005, holders of these bonds are likely to receive a good deal, even with these bonds being restructured again, some 55 cents on the dollar, in the current Argentine debt restructuring workout (Setser, 2020). The second round of debt restructuring in 2010 proved costlier for Argentina, as it agreed to an 8.28% coupon rate (Hornbeck, 2013) when the benchmark interest rate on US treasuries was close to zero. The write-off on the face value of the debt was smaller than was received by Argentina in 2005.
The restructuring of Greek debt is perhaps even more instructive. In the largest ever debt restructuring, Greece issued €62 billion in new bonds and took €30 billion in new loans from European institutions and the IMF in 2012 to retire €198 billion of its old bonds. While the 53.5% haircut was large – though significantly smaller than that which Argentina received during the 2005 and 2010 restructuring – Greece was required to issue all new bonds under English law, entailing a substantial strengthening of creditor rights. For reference, 86% of Greek bonds outstanding in 2012 were governed by Greek law. The debt swap clearly favoured creditors, which prompted the Greek government to buy back their newly issued bonds in less than six months. In December 2012, Greece bought back 50% (€31.9 billion) of its €62 billion of its new bonds for only €$10.8 billion, receiving a significantly larger haircut than it received from the debt swap six months earlier.in 2005, holders of these bonds are likely to receive a good deal, even with these bonds being
A voluntary sovereign debt buy-back programme may thus be useful in overcoming costly holdout and coordination problems, while avoiding harsher terms that typically come with debt swaps. Debt buy-back is widespread in the corporate world (Yadav, 2019).33 There are also some good examples of sovereign debt buy-backs besides that of Greece. In 1988, donor countries gave Bolivia, which was facing a debt crisis, $34 million so that it could buy back its sovereign debt, which had a face value of $670 million. These Bolivian debts were trading for 6 cents on the dollar in the secondary market. Using the money from donors and its own money, Bolivia bought back $302 million of its debt for $40.2 million.
The experience of the Bolivian debt buy-back encouraged other sovereign debtors to follow. A number of Latin American countries repurchased Brady bonds with cash – or swapped for new debt – to reduce their debt servicing costs, reduce risks and manage their liabilities. Bond buy-backs and swaps reduced the total value of Brady bond holdings from US$154 billion in 1994 to US$10.7 billion in 2006 (Medeiros et al., 2007). (These were mostly 30-year par and discount bonds that would have matured sometime around 2020.) Developing country governments have yet to use bond buybacks as a pre-emptive strategy for averting a debt crisis.
Some critics (Bulow and Rogoff, 1988; Claessens et al., 2011) have considered sovereign bond buy-backs as inefficient because they push up the price of remaining debt. Assuming market efficiency, they argue that the market price reflected the true value of these bonds, including the likelihood that they would not be paid. In their view, the buy-back artificially inflated the market price of the bond. Others have argued that buy-backs improves the bargaining power of sovereign borrowers (Rotemberg, 1991). While buy-backs typically do drive up the prices of remaining debt, this is not always the case. In the Greece buy-back described earlier, only about 50% of the creditors participated while yields on Greek bonds actually fell after the announcement.
In normal times, this controversy would merit some debate. We know that credit markets are seldom efficient. Bond prices do not always reflect the fundamentals, whatever that means. Irrational exuberance and panic sell-offs often drive swings in bond prices. During these extraordinary times, bond buy-backs present a highly attractive solution, offering substantial debt relief at a relatively low cost. Moreover, a major determinant of market price is the market’s subjective judgement of domestic and international politics – how much the debtor country is willing to pay and how much pressure the creditor country is able and willing to put either on the debtor country or the international institutions upon which the debtor country might be dependent, and the rationality/irrationality of market players.There is no ‘scientific’ basis for these judgments. They are guesses, that’s all; the earlier literature may have put too much store on these judgments. Subsequent research has highlighted the importance of disparities in judgements leading to situations where, say, the debtor believes he is (on average) going to pay far more than the creditor believes (on average) he is going to receive. In such situations, a reduction in indebtedness can be welfare increasing.
SECURING DONOR BUY-IN
New loans from the IMF and the Europe Financial Stability Fund (EFSF) enabled Greece to buy back its bonds held by private creditors, but this support from the IMF and EFSF required Greece to implement stringent austerity measures. Lower levels of spending plunged the economy into a deeper recession for several years. Greece is yet to fully recover from the debt crisis. It is important that we keep the Greek tragedy in mind, while finding ways for securing financial support for buying back sovereign bonds of developing countries.
One way of enhancing donor interest in supporting the buy-back – beyond the humanitarian concerns of the disaster that such buy-backs might avert with potential global consequences – is for the debtors to agree to spend the savings on creating and promoting global public goods. Instead of imposing self-defeating austerity measures on developing countries, the financing support for the proposed buy-back initiative could impose conditions of green and long-term investments that will boost real output. The savings from bond buy-back should not only finance public health expenditures to fight the pandemic but also contribute to minimizing climate risks, with money invested in climate change mitigation and adaptation. Recent research (e.g., Hepburn et al., 2020) has shown that such expenditures can be an effective part of pandemic rescue and recovery programmes – timely, labour intensive, with high multipliers, and delivering a large bang for the buck.
A DETAILED DESIGN PROPOSAL
There are many ways in which a coordinated effort at bond buy-backs might be organised. The following proposal puts the IMF at the centre. We propose the immediate establishment of an international facility within the IMF to buy back outstanding sovereign bonds. Developing countries – participating voluntarily and seeking to restructure their debt – will identify the sovereign bonds they would like the facility to buy back on their behalf. The IMF is perhaps the best option for managing the bond buy-back operation on behalf of the developing countries. The IMF is mandated to take such responsibility as stipulated in its Article of Agreement, “making the general resources of the Fund temporarily available to …[its members] under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.” The IMF is mandated to “shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members”.
The IMF has the technical expertise to manage sovereign bond buy-backs from private creditors. Its website states that “[t]he IMF’s current total resources amounting to about SDR 978 billion translate into a capacity for lending or ‘firepower’ of about SDR 715 billion (around US$ 1 trillion), after setting aside a liquidity buffer and considering that only resources of members with strong external position are used for lending”. The IMF can also use its New Arrangements for Borrowing to fund the bond buybacks, which would substantially reduce the likelihood of a debt crisis. These funds could be supplemented by those provided by a global consortium of countries and multilateral institutions. Countries not needing their full allocation of special drawing rights (SDRs) could donate or lend them. To achieve the maximum debt reduction for a given expenditure, the bond repurchase facility may conduct an auction, announcing that it will buy back only a limited amount of bonds.
The debt buy-back programme could reduce the debt burden of developing countries by a substantial amount, restoring debt sustainability and averting at least some debt crises. Obviously, the extent to which it can do so will depend on the magnitude of funds that are made available, and on the cooperation of creditors whose bonds have not been bought back to accept a debt reduction.41 As we suggested earlier, as a condition of this debt relief measure, countries receiving the relief should be required to invest, in local currencies, the equivalent of these savings in public health and climate change efforts.42 The pandemic and its economic aftermath are likely to be with us at least until 2022. Countries need a grace period during which they are freed from servicing the new debt undertaken to finance the bond buyback programme, both to meet the health demands of Covid-19 and to resuscitate economies that may be devastated by the pandemic.
A DETAILED DESIGN PROPOSAL
There are many ways in which a coordinated effort at bond buy-backs might be organised. The following proposal puts the IMF at the centre. We propose the immediate establishment of an international facility within the IMF to buy back outstanding sovereign bonds. Developing countries – participating voluntarily and seeking to restructure their debt – will identify the sovereign bonds they would like the facility to buy back on their behalf. The IMF is perhaps the best option for managing the bond buy-back operation on behalf of the developing countries. The IMF is mandated to take such responsibility as stipulated in its Article of Agreement, “making the general resources of the Fund temporarily available to …[its members] under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.” The IMF is mandated to “shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members”. The IMF has the technical expertise to manage sovereign bond buy-backs from private creditors. Its website states that “[t]he IMF’s current total resources amounting to about SDR 978 billion translate into a capacity for lending or ‘firepower’ of about SDR 715 billion (around US$ 1 trillion), after setting aside a liquidity buffer and considering that only resources of members with strong external position are used for lending”. The IMF can also use its New Arrangements for Borrowing to fund the bond buybacks, which would substantially reduce the likelihood of a debt crisis.39 These funds could be supplemented by those provided by a global consortium of countries and multilateral institutions. Countries not needing their full allocation of special drawing rights (SDRs) could donate or lend them. To achieve the maximum debt reduction for a given expenditure, the bond repurchase facility may conduct an auction, announcing that it will buy back only a limited amount of bonds.40 The debt buy-back programme could reduce the debt burden of developing countries by a substantial amount, restoring debt sustainability and averting at least some debt crises. Obviously, the extent to which it can do so will depend on the magnitude of funds that are made available, and on the cooperation of creditors whose bonds have not been bought back to accept a debt reduction.41 As we suggested earlier, as a condition of this debt relief measure, countries receiving the relief should be required to invest, in local currencies, the equivalent of these savings in public health and climate change efforts.42 The pandemic and its economic aftermath are likely to be with us at least until 2022. Countries need a grace period during which they are freed from servicing the new debt undertaken to finance the bond buyback programme, both to meet the health demands of Covid-19 and to resuscitate economies that may be devastated by the pandemic.
Rethinking debt sustainability
Recent attempts to enhance the debt sustainability of developing countries focused narrowly on fixing the behaviour of the debtor, that is, ‘solving’ what we referred to earlier as the payment and transfer problems. The standard advice on debt restructuring revolves around cutting government spending and improving fiscal balance. Only if a debtor government is more prudent – i.e., if a debtor will reduce its fiscal excesses – will debt become sustainable. Fiscal tightening has been promoted as the universal solution to avoiding a debt crisis. According to this conventional wisdom, as soon as a debtor government tightens its belt and minimises its ‘payment problems’, its credit ratings improve and creditors offer to lend more, which then helps the government to service its existing debt. Of course, this ‘solution’ seldom works: the fiscal tightening induces an economic downturn, which leads to even less government revenue, though the painful economic contraction often does lead to a reduction in imports, thus improving the balance of payments and providing foreign exchange to service the debt. But as the experience of Greece so vividly demonstrates, austerity can exacerbate a debt crisis. Besides, the idea that the problem of excessive debt could be solved by taking on more debt seems, on the face of it, odd.
The solution to excessive debt is debt restructuring. The problem with debt restructurings in the past, though, is that they have typically been too little, and too late. ‘Too late’ because as creditors strive to avoid recognising their losses, the country is forced into a limbo situation; the extended uncertainties. They have also been ‘too little’, with about half of the restructurings being followed by another restructuring within five years.44 (Delays often have intercreditor effects, with private creditors selling their bonds and thus escaping the consequences of their imprudent lending. A delay in restructuring Greek debt, for example, helped private creditors as they managed to off-load their holdings.)
Effective debt restructurings also have to be comprehensive – including all debt, both official and private. There will obviously be a reluctance among some creditors to take a haircut if they believe that the main effect will be to provide less of a haircut to others.
There are a couple of important exceptions to this general principal. In the case of private debtors, some creditors may be senior to others, some may be more ‘secured’ with a collateralised asset than others. In the case of sovereigns, some debt is backed by the ‘full faith’ of the government, while the debt of some government agencies may not be so backed.
Most importantly, the IMF and the World Bank have traditionally been given preferred creditor status, with the obligations to these institutions being fully fulfilled (though often with a delay in repayments) even when private creditors take a haircut. This longstanding presumption is (or should be) understood by private creditors when they lend to developing countries and emerging markets; it is part of the implicit contract. Accordingly, private creditors should not complain when this occurs. There are good reasons for this arrangement, the justification of which would take us beyond the scope of this Policy Insight. Formalising this preferred creditor status would be an important part of the establishment of an international framework for sovereign debt restructuring, to which we alluded at the beginning.
MITIGATING RISKS ASSOCIATED WITH PRIVATE CREDITORS
Any successful new debt sustainability framework needs to recognise the differential risks posed by different kinds of debt. As we discussed earlier, private sector debt and private creditors present significant macroeconomic externalities that must be taken into account. Moreover, short-term debt which has to be rolled over is a particular risk, and especially so when it is denominated in a foreign hard currency. There can be sudden stops in which financial markets refuse to roll over this debt, and this can quickly precipitate a crisis. While sudden stops can result from an inexplicable change in expectations, a shock such as the current pandemic might even rationally bring about such an adverse turn of events.
Even when debt is not short-term, the attempt by private creditors to pull their money out of a country can have severe impacts on exchange rates, with the untoward effects described earlier. On the other hand, such destabilising speculative behaviour does not arise from debt associated with the official creditors (including the multilateral institutions), although indications on their part of a reluctance to extend credits that were expected (for example, as a result of a change in politics or economics in either the creditor or debtor country) can trigger similar destabilising responses from private creditors. More importantly, lack of coordination among all creditors can result in over-indebtedness; and in some cases, the lines between official and private credits become blurry, as when governments provide insurance to private creditors (often related to exports or construction projects), which can encourage excessive indebtedness.
The large increase of indebtedness to China has recently been the subject of some concern. With more than $3 trillion in international reserves, China is surely the largest creditor nation in the world. It is the largest holder of sovereign bonds of the governments of the United States, Germany, the United Kingdom and other developed countries. China is also the largest bilateral creditor to developing and emerging country governments, with outstanding credits estimated at $370 billion (Reinhart et al., 2020). Nearly half of these debts are owed by governments of other developing G20 countries, including Argentina, Brazil, South Africa and Turkey. The Government of Argentina, for example, owes $17 billion to China.
Much of the recent Chinese debt has been project-related. Collateralised projectrelated debt poses fewer systemic risks to debt sustainability, as it often includes debt-to-equity conversion options. Such conversions may have political (including geo-political) implications and may affect long-run debt sustainability, especially if they would affect government revenue flows in future.
Debt crises have been a regular part of the global financial system ever since the era of financial market liberalisation some half a century ago. They have imposed enormous costs on the afflicted countries, and sometimes enormous costs on whole regions and the global economy. As we argued earlier, there has been a tendency for excessive indebtedness – short-sighted lenders interacting with short-sighted political processes are a toxic combination, and especially so in an era of super-low interest rates. There is no simple way of preventing such excessive indebtedness, other than to encourage greater prudence on the part of lenders. Creditor country bailouts (often engineered in the past with the assistance of the IMF) have lowered the costs of bad lending practices. So too have creditor friendly courts, which have reduced the losses that creditors would otherwise have faced, as do legal frameworks (for example, which enable creditors to get 9% pre-judgment interest, as noted earlier).
One way to reduce the likelihood of future debt crises, and their depth and duration, is to design better debt contracts and put in place a predictable and rules-based sovereign debt restructuring mechanism. In the next three sub-sections, we discuss briefly three aspects which have received considerable attention in recent years.
COLLECTIVE ACTION CLAUSES
Collective action clauses (CACs) facilitate debt restructuring by making it more difficult for ‘holdouts’ to prevent such restructurings – exemplified by vulture funds’ behaviour not only against Argentina in the well-known court case but also against Panama, Ecuador, Peru, Cote d’Ivoire, Poland and Vietnam (Sassen, 2014). The CACs mark an improvement in sovereign debt restructuring workouts. They typically allow for a qualified majority of bondholders (75%) to change the terms and conditions of a single bond, including a standstill on payments, and make new terms binding on all bondholders. A minority of bondholders can still block a CAC-led standstill if they can muster the support of more than 25% of bondholders.
Most governments, however, have multiple series of sovereign bonds, each with separate covenants, terms and maturity structures. A debt restructuring requires a restructuring of each of these and doing so frequently raises questions of intra-creditor equity; it also gives rise to intra-creditor bargaining, precisely the kind of thing that can prevent the required overall debt restructuring. There has been innovation to address this problem across different bond issuance. Nearly half of all sovereign bonds now include aggregated CACs, which allow a qualified majority across various bond issues to amend payment terms. But because many countries still have bonds without these provisions, CACs are unlikely to resolve the problem of debt restructuring during the current pandemic – even if they might eventually do so.
STATE-CONTINGENT DEBT CONTRACTS
A key problem with debt is that a country’s obligations are fixed, even though the country’s ability to meet those obligations can change dramatically, as in the course of this pandemic. Moving to state-contingent debt contracts, such as GDP-linked bonds (Shiller et al, 2018), where what the country has to pay is related to what it can pay, will be a step in the right direction.
The key challenge in state-contingent debt agreements is securing an agreement between creditors and borrowers on the ‘state of the world’ that would trigger the contingency. Some countries have issued GDP-linked bonds,49 making bond payments contingent on the rate of GDP growth. But creditors do not always have full confidence in the GDP growth data reported by a debtor government, though the one instance in which this has been the most concern was one where the government reported an overly high real GDP, as it tried to suppress data on the extent of inflation. While real GDP is manipulable – i.e., it is affected by government policy – using real GDP as a basis of a debt contract is typically incentive compatible, since both creditor and debtor want GDP to increase.
Export numbers, unlike GDP or inflation, are perhaps more exogenous and more easily verifiable, through data from the importing country. With debt obligations in dollars (foreign exchange), it makes sense to index debt servicing to the ability to service that debt, which depends heavily on export earnings. Similarly, developing countries – especially those dependent on commodity exports – may make debt servicing contingent on key commodity prices, which are determined by international demand. Issuing export or commodity price-indexed sovereign bonds would enhance the debt sustainability of low- and middle-income countries. This might even create an incentive for creditor countries to increase imports from these countries. The higher the volume of export, the higher will be the volume of debt servicing from low and middle-income countries.
SOVEREIGN BANKRUPTCY PROCEDURE
A fundamental deficiency in the global international financial architecture is the absence of a rules-based sovereign debt restructuring mechanism (Stiglitz, 2010). Many hoped that such a mechanism would not be needed, if only we had better designed contracts. That belief always seemed foolish: if that were the case, why has every country adopted a legal framework, with courts resolving disputes when creditors and the debtor cannot reach a timely agreement? Resolving disputes across borders is far more difficult than within a country, because there are often different norms, expectations and even underlying legal frameworks. If one can’t just leave it to the market domestically, why should one expect that one could do so internationally? After years of working to design an optimal debt contract – or at least a collective action clause that was acceptable to both creditors and debtors and had some promise of working – in their first big test (that of Argentina), the new debt contracts are not working as hoped. Worse, the creditors are using their financial muscle to change the collective action clauses. The creditors are also demanding payments that are well beyond the levels that the IMF believes are sustainable.
The pandemic is likely to further expose the high costs of not having such a mechanism in place. The Chapter 9 bankruptcy procedures in the US – which protect municipalities and other public authorities against creditor claims while they restructure their debt – can guide us in the right direction. Although similar to other bankruptcy procedures, Chapter 9 bankruptcy is significantly different. We discuss some of the more salient differences in the following paragraphs.
Unlike the bankruptcy procedures designed for private borrowers, the Chapter 9 procedures give significant protection and power to public entities to restructure their debt in the public interest. The idea is simple: social obligations of a public entity – providing basic services to the citizens and honouring commitments to pensioners, among others – should have priority over financial claims of the private creditors.
Not surprisingly, Chapter 9 provides automatic protection of its assets and revenues against collection efforts by creditors. There is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors. The rationale is stright-forward: if private creditors are allowed to liquidate the assets of a democratically constituted entity of a state, it would undermine the sovereignty of a US state as stipulated in the US Constitution. There have been calls along these lines to protect debtor countries’ assets from attachments by private creditors (Buchheit et al., 2013).
Creditor rights are quite limited in Chapter 9 bankruptcies. The municipality under bankruptcy protection can undertake new debt, without the consent of its creditors, to meet provide services to its citizens or meet its other financial obligations, including payment of salaries and pension. Under Chapter 9 procedures, a municipality facing difficulty in making payments is afforded considerable flexibility to initiate a bankruptcy process. While it is expected to obtain the agreement of the majority of its creditors, the creditors may not propose competing debt restructuring plans. And while it is expected to make good faith efforts to negotiate debt restructuring, if certain requirements are met, the debtor’s plan is binding on all creditors, including those that find the restructuring offer less than acceptable. As such, the ‘holdout problem’ is virtually non-existent in Chapter 9 bankruptcy procedures. Within the United States, Chapter 9 has proven effective. Its procedures guided the restructuring of $18 billion debt that the city of Detroit owed to bondholders, for instance, securing steep haircuts while protecting the city’s assets and obligations to its pensioners.
A debt restructuring mechanism – a sovereign bankruptcy procedure modelled on Chapter 9 provisions – should not need universal agreement and participation of all governments to become effective, so long as key creditor countries were willing to participate. So long as there is a critical mass of creditor and debtor countries joining the initiative, other countries will follow suit. As we noted earlier, in 2015, the UN General Assembly adopted a set of principles that should underlay such a framework. The framework could also facilitate rewriting the standard contracts governing sovereign debt in ways that might reduce the likelihood of over-indebtedness, and when such over indebtedness occurs, that help promote timely and equitable restructurings.
It will take time to establish a sovereign debt restructuring mechanism, and the pandemic is already upon us. But the process should begin now. Meanwhile, we must do what we can within the existing institutional framework to prevent and resolve the numerous debt crises that, in the absence of international action, are likely to occur. In this Policy Insight, we have proposed several policy measures to reduce the likelihood of these debt crises and the costs they impose.
There may be resistance to some of these measures by some creditors and, where these creditors have sufficient influence on their governments, from those governments as well. There are often outcries that such measures will destroy the international capital market. Lessons from the past shows that such measures do not kill markets. Investors and creditors return to the market as soon as governments manage to mitigate underlying risks. It will be no different this time. If they temper some of the excessive lending, that will almost surely be for the better. The measures we have proposed may in fact improve market behaviour, encouraging lenders to do a better job in assessing debt sustainability.
Governments of creditor and debtor countries must remember the consequences of the dismal failure of the London debt conference in 1933 that prolonged the severity of the Great Depression for half a decade. To put the world economy back on a trajectory of growth, the world must avoid a devastating debt crisis. The cost of collective failure to avert the debt crisis will be too high for all. We know what should be done. There should be a debt standstill, and there should be comprehensive debt restructurings. This Policy Insight provides some ideas on what can be done, in a timely way, in the midst of this pandemic.
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