Sovereign debt architecture is messy and here to stay
Mark Sobel is a former U.S. Treasury official and IMF representative with responsibility for international monetary and financial affairs. He is now the US chairman of OMFIF, a think tank.
With severe sovereign debt entrenched and more to follow, many analysts and practitioners are looking to renew the architecture for sovereign debt restructuring. To do this, they come up with reform proposals that are often inconsistent with the facts on the ground.
The current architecture is unmistakably a messy mishmash. But market practitioners should not expect major changes and should instead focus on the improvements that can realistically be made.
A long-thought sweeping solution is to create a global bankruptcy regime, such as the IMF’s proposed sovereign debt restructuring mechanism two decades ago. But the current world order is based on nation states with different legal political and economic systems, not on global governance. Supranational bankruptcy enforcement requires a globally recognized supranational bankruptcy authority, which does not exist. A the global bankruptcy regime is a non-starter for other reasons, including possible politicization of decision-making and that the US is unlikely to relinquish sovereignty of US courts in core areas to a supranational body. Neither do others.
Today, the debt of low-income countries – the poorest countries with annual per capita income often no more than $1,000 a year – is generally dominated by official debt, especially to bilateral creditors such as China, while emerging market debt is generally goes to private investors. Fair or not, it’s fanciful to think that the private sector would be elevated to an equal seat at the table with international financial institutions, and the relative seniority of official and private creditors themselves sometimes seems to take a leap of faith. to be. These different circumstances, plus the diversity of private creditors, mean that restructurings have to be worked out on a case-by-case basis.
Policy making is generally limited by realities like those above, so small steps, evolution and incrementalism are often all that can reasonably be expected. That means investors will likely have to work within the framework of the current sovereign debt architecture.
Then what can be done?
The greatest challenge of the debt crisis now lies with the low-income countries themselves. The international community Debt Service Suspension Initiative offered some welcome, albeit temporary, breathing space. But deep and durable relief is essential of the G20 Common Framework. That blueprint for action has so far been a flop, although recent developments in Zambia may offer hope.
Still, the main, but not the only, barrier is tackling large-scale Chinese official lending. Chinese debt is opaque; there are false Beijing arguments about whether credits are official or private; authorities prefer to roll over debt rather than deal with overhang through debt reduction; and since China is often a dominant creditor, it has little incentive to follow co-operative Paris Club-esque principles. Furthermore, it would be unwise to underestimate the willingness of the private sector to hide behind Chinese inaction.
This problem needs to be tackled politically. Right now, even if it’s flawed, the G20 Common Framework is the only game in town. The US does not have the leverage to push China 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 for “debt trap diplomacy” from China.
The IMF is the protagonist. It has cooperated with China commendably and quietly step by step. But it needs to be more overt to pressure China to quickly come to a concrete debt relief deal with Zambia, using such a deal as a springboard to sign other low-income countries.
International financial crises are a staple of history and will persist for so long after our lives.
The messier the restructuring, the greater the damage and costs for issuers and creditors. Issuers — often with leaders in denial or covering up clutter — are mostly guilty of waiting too long to address issues and ultimately failing, rather than addressing stress preemptively and at a lower cost to society.
In today’s messy system, finding a fair balance between issuers and creditors can require multiple approaches.
In recent decades, attention has been focused on the insertion of class action clauses (CACs) in foreign-law government bonds issued largely under UK or New York law. They enable a given majority of relevant bondholders to support a restructuring and bind all remaining holders. While not a panacea, they were improved in 2014 to facilitate training and reduce procrastination processes, enhancing the orderliness and predictability of restructuring processes. (Full disclosure: I chaired the international working group that developed these improvements.) CACs are now used in the vast majority of such bonds and increasingly dominate the market. The improved functions helped the recent restructuring in Argentina and Ecuador lead to a successful outcome.
But CAC-like provisions are still needed in a range of other debt instruments, such as syndicated loans, subordinate loans, and others. The international community must exert pressure on creditors and issuers to encourage the introduction of such provisions. This goal should be within reach when the sleeves are rolled up. A G7 working group has focused on the matter, but appears to have shown little for its work so far.
Many analysts believe that sovereign debt instruments, which tie a state’s debt service more closely to its repayment capacity, can introduce more flexibility in possible restructuring and better balance the interests of issuers and creditors. But, despite decades of analysis, such tools have failed to take off due to various problems – one can rely on the issuers to provide accurate data; such instruments will cost publishers more than ordinary vanilla paper; can such instruments be sold easily if there are no liquid markets for them? Perhaps they will become more popular in sovereign debt restructuring, as catastrophe bonds have done. But the required liquidation can be much more burdensome and uncertain than updating contracts for syndicated or sub-national loans.
Debt data – both official loans and debt from issuers – is indeed opaque. This terrain must be ripe for harvest. The private sector has a legitimate asset when it complains that it cannot trust official data and thus acts blindly when it has to contribute to restructuring. But it also uses this argument to hide behind official creditors and get involved in restructuring. The IMF, World Bank and others should roll up their sleeves in pushing for much greater public transparency from all borrowers. Important recent initiatives to increase debt transparency seem to have stalled.
The line-up of private players holding emerging markets debt now includes banks, passive and active funds (the latter including emergency funds) and others, many with different interests. Yet private sector participants have one thing in common: they are self-proclaimed experts at analyzing and pricing sovereign credit risk. They tout their diligence and claim that they understand the risks they are taking and are willing to take to secure strong rewards for customers. Nevertheless, when “high-end” shirts are lost (or when expected payouts are not met), the first reaction for those wearing “designer” shirts is almost never to accept the consequences of their wrong risk/reward assessments. Rather, it seems like a visit to countries’ executives — including bureaucrats wearing cheap shirts — and legislatures to lobby furiously for smaller losses or larger returns, and even litigate in courts with imaginative and inventive legal interpretations.
Shifting the current balance of power from issuers to creditors in a restructuring — by rewiring the bond architecture, limiting sovereign immunity of nations and facilitating foreclosures, and imposing greater burdens on the already struggling vulnerable citizens of ailing nations — hardly seems to be a tenable path forward.
Furthermore, the IMF – often the world’s debt-owned financier – should re-examine its role in helping to strike this difficult balance. The IMF sets the financing parameters for creditors’ payments in restructuring through its debt sustainability programs and work, which allocate financing for gaps between land reform, new money and debt relief. The outcome for sustainability strongly depends on future performance assumptions, especially around growth and the primary balance.
But excessive IMF optimism can involve pretending that countries are dealing with illiquidity, not insolvency, allowing creditors to avoid significant start-up losses and allow debt to be easily shifted and extended. By contrast, stricter and more steadfast realism (and less fear of haircuts) could prevent harsher economic restraint from countries, help remove countries’ debt burden and pave the way for better investment and growth outcomes.
The days of gunboat diplomacy are behind us. So are the days when you lock a few bankers in a room to solve it. Maybe the world was a nicer back then. But the current reality of sovereign debt architecture is, for better or for worse, a messy affair. And it’s one to stay, even if marginal improvements are achievable.