A Bankruptcy Court for Nations?

By Evan Abrams

The global financial crisis of 2007-08 may have begun in the private sector, but it quickly spread to the public sector as well, with countries like Greece, Portugal, and Italy making headlines for months. The crisis exposed these countries’ inability to finance their debt and left the specter of a Eurozone breakup battering financial markets across the world. Argentina has also made news of late due to its long running legal battle with so called “vulture funds.” The situation with Argentina is not that they are unable to pay their debts, but that they are unwilling to reward holdouts from an earlier restructuring after its 2001 default. These holdouts claim they are simply trying to recover what they are contractually owed. However, developing countries view such recalcitrant creditors as taking advantage of economic crises and undermining nations’ recovery efforts in the wake of financial turmoil.

Both the Argentine court battles and European restructurings have prompted renewed calls for a better system to deal with sovereign debt crises. Such calls have come from a group of 130 developing countries at the UN, leading economists including Joseph Stiglitz, and prominent IMF officials. The proposed debt restructuring system is typically referred to as a sovereign debt restricting mechanism or SDRM. The SDRM was first floated in 2003, in response to the East Asian financial crisis and has been periodically revived since then. According to the Economist, “the IMF would evaluate a state’s capacity to pay, institute a reform programme and determine a haircut for creditors.” This would prevent the lengthy and somewhat ad-hoc process that currently exists, which typically entails prolonged negotiations between creditors and debtors and often devolves into years-long litigation in New York or London. This creates uncertainty and means economic recovery could easily be delayed or frustrated. The SDRM should in theory fast track this process while making it more transparent and predictable.

However, not everyone is a fan of the SDRM. Developed countries and private sector financiers are particularly weary of it. They argue that the SDRM would give additional leverage to the debtor states that already hold outsized bargaining power. Because any restructuring mechanism would likely lack real enforcement power, a country could pursue restructuring under the SDRM and then decide to default anyways if it did not like the terms the SDRM set out. Since lenders would have to surrender their right to litigate when purchasing debt issued under the SDRM model, creditors would have very limited means to try to force compliance. 

Detractors also contend that the SDRM would harm debtors. They see the systems implementation littered with practical problems, including the lack of an independent body to run the mechanism (since the IMF is itself a lender and thus an interested party). They further contend that the SDRM might inadvertently raise borrowing costs by making the prospect of a default somewhat more palatable for borrowers and diminishing trust in the markets by placing bureaucrats and institutions between creditors and debtors. A rise in borrowing costs would ultimately hurt the very countries advocating for the SDRM.

Finally, it is argued that the need for the SDRM has largely been eclipsed by the introduction of collective action clauses, which allow a supermajority of bond holders to bind all holders to an agreed upon restructuring. These clauses were introduced following Argentina’s first default in 2001 and have gained further traction since the global financial crisis of 2008. Their introduction has been viewed as a success by many observers; however, they are not included in all new debt issuances. The clauses also apply to specific bond issues rather than all outstanding debt that includes a clause. This means a majority of just one issue could create havoc on an entire restructuring.  Further, merely reaching the required supermajority to trigger the clause could be a challenge in many situations.

Where does all of this leave us? There are clearly legitimate arguments for and against an SDRM. A clear answer will likely remain elusive, but if the recent global financial crisis taught us anything, it is the potential for a disorderly default to have devastating financial consequences across the world and across all sectors of the economy. The creation of the SDRM would certainly present many challenges (a binding enforcement mechanism being foremost), but if the SDRM can provide additional transparency and predictability for the world’s financial markets it must be seriously considered.