Some Reflections on SDRM Yilmaz Akyuz

(Remarks made at the International Policy Dialogue: New Sovereign Debt Restructuring Mechanisms- Challenges and Opportunities-Berlin, 21 February 2003)

I would like to congratulate the organizers for bringing the debate on the SDRM to Europe, somewhat distancing it from the emotions of debtors and creditors in the Western Hemisphere, and to thank them for giving us an opportunity to express our views on this matter. In what follows I should like to comment on what the SDRM does and does not do, keeping in mind the questions posed by the organisers. It is, however, important to remember that we are shooting at a moving target. The proposal on the table a year ago was quite different from what we have in front of us today, and there may be further changes before anything is finally agreed.

I should like to start by pointing out that UNCTAD was the first international organisation calling for orderly workout procedures for international debt of developing countries, drawing on certain principles of national bankruptcy laws, notably chapters 9 and 11 of the United States law. We raised the matter during the debt crisis in the 1980s, noting in our 1986 Trade and Development Report that the absence of a clear and impartial framework for resolving international debt problems trapped many developing countries in situations where they suffered the stigma of being judged de facto bankrupt without the protection and relief which come from de jure insolvency. We returned to this issue in TDR 1998 after the East Asian crisis, making specific proposals, and then developed them further in TDR 2001.

In referring to bankruptcy principles in crisis management and resolution, we pursue two interrelated objectives. On the one hand, there is a need to prevent financial meltdown and deep economic crises in developing countries facing difficulties in servicing their external obligations – a situation which often results in a loss of confidence of markets, collapse of currencies and hikes in interest rates, inflicting serious damage on both public and private balance sheets and leading to large losses in output and employment and sharp increases in poverty, all of these being part of actual experience in East Asia, Latin America and elsewhere during the past 10 years. On the other hand, mechanisms are needed for an equitable restructuring of debt which can no longer be serviced according to the original provisions of contracts. Attaining these two objectives does not require full-fledged international bankruptcy procedures but the application of a few key principles:

A debt standstill whether debt is owed by public or private sector, and whether debt servicing difficulties are due to solvency or liquidity problems (a distinction which is not always clear-cut). The decision for a standstill should be taken unilaterally by the debtor country and be sanctioned by an independent panel rather than by the IMF because the countries affected are among the shareholders of the Fund which is itself also a creditor. This sanction would provide an automatic stay on litigation. Such a procedure would be similar to WTO safeguard provisions allowing countries to take emergency actions when faced with balance-of-payments difficulties. Standstills may need to be accompanied by capital controls in order to stop attacks on their currency and to gain greater autonomy in monetary policy.

Provision of debtor-in-possession financing, automatically granting seniority status to debt contracted after the imposition of the standstill. IMF should lend-into-arrears for financing imports and other vital current account transactions rather than for meeting the claims of creditors and maintaining convertibility. There should be strict limits to IMF crisis lending since otherwise it would be difficult to ensure private sector involvement.

Debt restructuring including rollover, write-off, etc., based on negotiations between the debtor and creditors, and facilitated by the introduction of automatic rollover clauses and CACs in debt contracts.

These principles still leave open several issues of detail, but they nonetheless could serve as the basis for a coherent and comprehensive approach to crisis intervention and resolution. How does the SDRM relate to such a framework and how effective would it be in responding to and resolving financial and debt crises in developing countries?

The SDRM is effectively a mechanism designed to facilitate sovereign bond restructuring for countries whose debt is deemed unsustainable. It concerns a handful of emerging markets, primarily in Latin America, and it has little interest for other developing countries which do not or cannot issue international bonds, as is generally the case in East Asia and sub-Saharan Africa respectively. The proposed mechanism is quite innovative in bringing debtors and bondholders together whether or not bond contracts contain CACs, in securing greater transparency, and in providing a mechanism for dispute resolution. Thus, it is a step forward in sovereign debt restructuring.

However, there is considerable room for improvement in its design even without extending its scope and objectives. First, compared to national bankruptcy principles, creditors are granted considerable leverage: there would be no generalized stay on the enforcement of creditor rights and hence no statutory protection for debtors against litigation; and creditor permission would be required in granting seniority to new debt needed to prevent disruptions to economic activity.

Second, the proposal could result in a significant increase in the role and power of the IMF even though this is supposed not to be the intention. A role for the Fund appears to be envisaged in decisions on debt sustainability. The Sovereign Debt Dispute Resolution Forum would have no authority to challenge decisions of the Board or make determinations on issues relating to debt sustainability. But the past record of the Fund in assessing sustainability (in Russia, Argentina and HIPC) is not very encouraging, suggesting that it may be facing political not just technical difficulties in making sound judgement on debt sustainability.

More fundamentally, the SDRM is designed to collect the debris rather than to put out the fire. Clearly it would not help countries facing liquidity shortages in servicing their public or private debt and runs on their currencies such as those witnessed in East Asia or more recently in Brazil and Turkey where current IMF programs are based on the assumption that debt is sustainable under feasible policies. But even for countries with unsustainable sovereign debt, the SDRM provides no new mechanism to stem attacks on their currencies and prevent financial turmoil. It includes a provision to discourage litigation by sovereign bondholders through the so-called “hotchpot” rule. Such a rule may not be very effective against litiginous investors (the so called “vultures”). More importantly, it does not address the problem of how to stop financial meltdown, since in a country whose debt is judged to be unsustainable currency runs would take place whether or not bondholders opt for litigation.

Finally, the current proposal does not fundamentally address the problems associated with IMF bailouts. It can reasonably be expected that countries would generally be unwilling to declare themselves insolvent and to activate the SDRM. Instead, they would be inclined to ask the Fund to provide financing in order to address their liquidity problems. In most cases it might be difficult for the Fund to decline such requests on grounds that the country is facing a solvency problem. Indeed, as part of its promotion of the SDRM the IMF has suggested that unsustainable debt situations are rare. Here lies the rationale for limits on IMF crisis lending whether the problem is one of liquidity or insolvency: with strict access limits creditors cannot count on an IMF bailout, and debtors will be less averse to activating the SDRM and standstills when faced with serious difficulties in meeting their external obligations and maintaining convertibility. This means that to encourage countries to move quickly to debt restructuring the SDRM should be combined with limits on crisis lending. But this could create problems unless private sector involvement is secured through a statutory standstill and stay on litigation.

The SDRM proposal has not elicited strong support from developing countries. Here, the cause for concern varies:

Many countries fear that the introduction of statutory and even contractual mechanisms for debt restructuring would impair their access to international capital markets and discourage capital inflows. This is often the reaction of countries which have become heavily dependent on capital inflows. There is some ambivalence in the IMF response to such concerns. On the one hand the Fund recognizes that the SDRM may prevent over-lending and over-borrowing but on the other they refer to some empirical studies to argue that CACs and spreads are not correlated. In reality the introduction of statutory standstills and restructuring mechanisms could indeed deter certain types of capital inflows but this may not be a bad thing. The appropriate response of developing countries should be to increase their domestic savings and investment efforts and to reduce their dependence on foreign capital. Such efforts would certainly help improve their credit ratings and reduce borrowing costs.

A second source of concern is that the proposed mechanism may give too much power to the IMF where participation of developing countries in decision making is highly restricted. This concern is expressed mostly by countries which do not depend on foreign capital to supplement domestic savings, but have nevertheless experienced boom-bust cycles in capital flows and speculative attacks on their currencies. Independent assessment of debt sustainability and expansion of powers of the SDDRF, as well as a fundamental revision of voting rights and procedures in the Fund could help meet their concerns.

In conclusion, despite the shortcomings in its design and objectives, the SDRM could bring improvements in sovereign bond restructuring. However, it does not constitute a coherent and comprehensive framework for crisis intervention and resolution. Not only would it not solve everything, a point conceded by its architects, but it would also not address the most important problems connected with financial and currency crises. Much of the work still remains to be done.

(Yilmaz Akyuz is the Director of Division on Globalization and Development Strategies, UNCTAD, Geneva. The opinions expressed here and the designations employed are those of the author and do not necessarily reflect the views of UNCTAD.)