Towards an integrated framework to restructure sovereign debt

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Sean Hagan (PIIE)

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It is time to transition to a sovereign debt restructuring framework that integrates the restructuring of private claims and official bilateral claims. By relying on a simultaneous-rather than sequential-decision-making process, an "integrated framework" would be designed to reduce the delays and uncertainty that characterize the current system. The current Global Sovereign Debt Roundtable (comprising representatives of sovereign borrowers, the official sector and the private sector) is well placed to lead discussions regarding the design of the rules that would govern this new approach, which would apply to both low-income and emerging-market sovereigns.

The existing restructuring process is a bifurcated one, where a sovereign's discussions with its official bilateral creditors take place separately from its negotiations with private creditors. History helps explain this. When official bilateral claims were restructured under the auspices of the Paris Club, agreement was typically reached at the outset of an adjustment program supported by the International Monetary Fund (IMF), while the private sector process was far more protracted.

Indeed, the speed at which official creditors provided financing-whether debt relief or new money-gave them a "halo" of seniority vis-à-vis private creditors in at least two respects. First, they had greater leverage in the process: While the IMF could approve a program without a private sector agreement (using its lending into arrears policy), an agreement with the Paris Club was a precondition for IMF support. Second, the "comparability of treatment" convention utilized by the Paris Club was designed to work in only one direction: While a debtor made a commitment to official bilateral creditors that it would not provide better treatment to private creditors, it generally made no such commitment to private creditors.

This differentiated process has become increasingly difficult to justify. First, the distinction between private and official bilateral claims is no longer an obvious one, particularly when one is dealing with the claims of China and its financial institutions. Moreover, the assumption that official creditors would always move expeditiously no longer holds. Indeed, the IMF had to introduce a policy of lending into official arrears in 2015 precisely because delays in the restructuring of official claims were holding up IMF support.

Relatedly, since it was always assumed that official creditors would move more quickly, these creditors traditionally were given earlier access to the information that underpinned the IMF's debt sustainability analysis. However, in recognition that private creditors may now sometimes move first, IMF staff recently issued guidance that allows for the sharing of information with private creditors at a much earlier stage in the process.

Finally, in terms of outcomes, the halo of official creditor seniority appears to have faded. A notable academic study found that the average haircut experienced by official creditors is higher than that suffered by private sector colleagues. Although methodological issues have been raised with this study, it poses the valid question as to whether, in fact, the principle of comparability has actually translated into reality.

Yet this fragmented approach continues to be relied on, even though it exacerbates delays and uncertainty. While it is true that the Paris Club has been unwilling to move without China, it is also true that China has often been unwilling to budge without the private sector-which, given the results of the aforementioned study, is hardly irrational. Moreover, the blurriness between official and private claims has undermined confidence in the system, as there is a suspicion-whether justified or not-that claims are being classified as "official" or "private" based on the perceived benefits of the classification from a restructuring perspective.

Of course, the real victims of this protracted and uncertain process are the indebted countries themselves. When debt is unsustainable, delays in restructuring exacerbate economic dislocation. Moreover, they threaten the viability of the government's reform process: Since an IMF-supported program can only be forthcoming when there are assurances that a debt restructuring will materialize, restructuring delays translate into delays in economic adjustment. And experience demonstrates that, as the adjustment process is held up and economic strife deepens, the political window for meaningful reform within the country begins to close.

In light of the above, the rationale for an integrated framework is based on two considerations.

First, there is a fundamental alignment of interests among both official and (most) private creditors regarding the benefits of a rapid process. Once the restructuring process is initiated, most private creditors have an interest in completingthe restructuring quickly. As I have indicated, a protracted process-especially one that causes greater economic dislocation in the country concerned-only results in a further depreciation of secondary market values. Moreover, for institutional investors, a rapid and predictable restructuring has the broader benefit of enhancing the value of sovereign debt as an asset class.

Of course, there will always be some creditors whose business model is to profit from delays and dysfunction. Fortunately, their leverage has been reduced by the development of robust collective action clauses. Indeed, the fact that these clauses were developed by both the private and official sectors serves to underscore this common interest in an orderly process.

Second, the process will accelerate if decisions are made simultaneously. A fragmented, sequential approach only engenders suspicion and paralysis. Having creditors around the same table with the same information does not necessarily mean that the terms everyone receives will be identical. Creditors understand that some differentiation may be needed. (For example, the scope of debt relief provided by domestic creditors will need to consider the financial stability implications of such relief.) But what is critical is that, before they decide to accept an offer, creditors will know what everyone else is being offered. This is the best way to ensure fairness-which, after all, is the whole point of comparable treatment.

Issues will need to be addressed, including the treatment of confidential information by private creditors. However, if representatives of private creditors have confidence that the process will accelerate, they may be more willing to sign nondisclosure agreements that restrict them from trading during the negotiations.

The idea of a single, integrated approach is not new; indeed, it was first floated over 20 years ago.[1] However, what was then an interesting concept should now be treated as a reform priority, given the inter-creditor coordination problems that have emerged. Indeed, having modified different aspects of the two processes over the years to address these problems (as discussed above), we should recognize that-as a matter of reality-we have been taking incremental steps towards convergence and integration for some time. And, as Alexander Hamilton recognized, it is helpful to use reality as a basis for formulating public policy.

Sean Hagan, nonresident senior fellow at the Peterson Institute for International Economics, is former general counsel for the International Monetary Fund, professor from practice at Georgetown Law, and advisor to Rothschild & Co.

Note

1. See reference to 2002 proposal for a Sovereign Debt Forum by Richard Gitlin in CEPAL Review 81.

This publication does not include a replication package.