Remarks to the UNCTAD Expert Group Meeting on Sovereign Debt Crises and Restructurings

October 25, 2012
United Nations Headquarters, New York

By Otaviano Canuto
Vice President, Poverty Reduction and Economic Management
The World Bank

Sovereign Debt Restructuring Mechanism (SDRM)

The current global crisis, mounting debts in the Euro area and the US along with the resulting uncertainties that have emerged in the world today have led to a growing risk aversion among creditors to lend anew, even to firms and households, as well as calls for debt restructuring by highly leveraged and overexposed countries.

We agree that the international community is still far from a consensus on the costs and benefits of a structured mechanism for dealing with sovereign insolvencies.  However, discussions like the one we are having today are very timely and could help find an orderly way out of this mess.

The debate on the creation of an insolvency mechanism for sovereigns took center stage again when the IMF advanced a proposal to create a Sovereign Debt Restructuring Mechanism (SDRM) in the wake of the Argentinean default of 2002/2005.  The SDRM project was abandoned when it became clear that the initiative lacked the necessarily political support to undertake the creation of such a mechanism.  It is not clear even today, as being witnessed by ongoing discussions in Europe, that we have this consensus yet.  One will require a “miracle of law, economics and politics” for this to happen (see Canuto, Pinto and Prasad 2012).

As an alternative to the SDRM, countries began issuing bonds with Collective Action Clauses (CACs), postulating that a majority of bondholders can amend any of the terms and conditions of the bonds.  With the onset of the global financial and economic crisis, there are calls from various fora to consider more structured approaches to resolving debt problems.  The IIF has set up a “Joint Committee on the Strengthening of the Framework for Sovereign Debt Crisis Prevention and Resolution” and have released a statement at the recent Bank’s Annual Meetings in Tokyo.

The Concept Note that UNCTAD has prepared for today’s event has rightly identified five problems with the current approach to sovereign debt restructuring from a survey of recent experience and literature on sovereign debt and sovereign default, namely:

• Lengthy debt renegotiations which, in some cases, do not restore debt sustainability.
• Need to coordinate the interest of dispersed creditors and to deal with bondholders who have an incentive to holdout from debt restructuring deals.  Coordination problems and the possibility of free riding are particularly serious in the case of bonded debt and are exacerbated by the presence of “vulture funds” who buy the debt at deep discount on the secondary market with the explicit intention of litigating after the majority of creditor has reached a settlement with the defaulting country.
• Lack of access to private interim financing during the restructuring process.  In the corporate world, interim financing is guaranteed by the presence of debtor-in-possession (DIP) financing provisions, but sovereign debt lacks a mechanism able to enforce seniority. Lack of access to private interim financing may amplify the crisis and further reduce ability to pay because during the restructuring period countries may need access to external funds to either support trade (trade credit) or to finance a primary current account deficit.
• Over-borrowing caused by debt dilution.  Debt dilution refers to a situation in which, when a country approaches financial distress, new debt issuances can hurt existing creditors.  In the corporate world, debt dilution is not a problem because courts can enforce seniority rules.
• Delayed defaults.  While most economic models of sovereign debt assume that countries have an incentive to default too much or too early, there is evidence that countries often try to postpone the moment of reckoning and may sub-optimally delay the beginning of the debt restructuring process.  A prolonged pre-default crisis may reduce both ability and willingness to pay making both lenders and borrowers worse off.

With the experience the World Bank has had with our Heavily indebted poor country (HIPC) and Multilateral debt relief initiatives (MDRI), the Debt Reduction Facility (DRF) whereby these special groups of low income countries have received comprehensive debt relief from multilateral, bilateral creditors and commercial creditors, as of mid-2012, the debt stocks of 36 post-decision point HIPCs have been reduced by over 90%.  A few lessons are in order:

We are focusing on building debt management capacity wherever we can.  This is very crucial in order for governments to stay away from debt problems in future even after they have received debt relief.  This includes debt and fiscal risk management at subnational levels.

• Given countries need to grow and create jobs, the investment-growth nexus is key and we have now more explicitly incorporated it in the analyses of debt sustainability in all LICs.  A significant number of countries in Africa have found natural resources.  To benefit from these one will require large infrastructure investments upfront that need to be financed by prudent borrowing.  Any orderly debt resolution mechanism that one chooses cannot jeopardize these future financing flows.
• To restore debt sustainability, fiscal consolidation needs to be proactively pursued and measures to boost competitiveness and growth are needed.
• In countries that are taking proactive measures towards the needed adjustment, efforts may be wiped out in the event that another external shock or a more prolonged global crisis debt continues, as fiscal buffers are no longer available for developing countries.
• Access to capital is expected to be limited in the current global environment anyway and the recent experience with some of the Caribbean countries that undertook significant reschedulings have found it difficult to access international financial markets in recent times.