Wednesday, November 26, 2014

Sovereign Debt at Square One

CAMBRIDGE – Argentina and its bankers have been barred from making payments to fulfill debt-restructuring agreements reached with the country’s creditors, unless the 7% of creditors who rejected the agreements are paid in full – a judgment that is likely to stick, now that the US Supreme Court has upheld it. Though it is hard to cry for Argentina, the ruling in favor of the holdouts is bad news for the global financial system and sets back the evolution of the international regime for restructuring sovereign debt.

Why is it so hard to feel sympathy for a developing country that can’t pay its debts? For starters, in 2001, Argentina unilaterally defaulted on its entire $100 billion debt, an unusual step, rather than negotiating new terms with its creditors. When, in 2005, the government finally got around to negotiating a debt swap, it could almost dictate the terms – a 70% “haircut.”

In the intervening decade, President Cristina Fernández de Kirchner and her late husband and predecessor, Néstor Kirchner, have pursued a variety of spectacularly bad economic policies. The independence of the central bank and the statistical agency have been severely compromised, with Fernández forcing the adoption, for example, of a consumer price index that grossly understates the inflation rate. Contracts have been violated and foreign-owned companies have been nationalized. And when soaring global prices for Argentina’s leading agricultural commodities provided a golden opportunity to boost output and raise chronically insufficient foreign-currency earnings, Fernández imposed heavy tariffs and quotas on exports of soy, wheat, and beef.

Some might counter that the holdout hedge funds that sued Argentina deserve no sympathy, either. Many are called “vulture funds” because they bought the debt at a steep discount from the original creditors, hoping to profit subsequently through court decisions.

But the problem with the Argentine debt case has little to do with the moral failings of either the plaintiffs or the defendant. The problem is the precedent that the case establishes for resolving future international debt crises.

The most common reaction to the recent rulings is pro-holdout. After all, the judge is only enforcing the legal contract embodied in the original bonds, isn’t he? As President Calvin Coolidge supposedly said of the American loans to the World War I allies, “They hired the money, didn’t they?”

If only the world were so simple. If only a regime of consistent enforcement of all loan contracts’ explicit terms were sufficiently practical to be worth pursuing. But we have long since recognized the need for procedures to rewrite the terms of debt contracts under extreme circumstances.

The British Joint Stock Companies Act of 1856, for example, established the principle of limited liability for corporations. Indentured servitude and debtors’ prisons have also been illegal since the nineteenth century. And individuals and corporations can declare bankruptcy. There will always be times when it is impossible for a debtor to pay.

As for corporate bankruptcy, it is recognized that a poor legal system is one that keeps otherwise viable factories shuttered while assets are frittered away in expensive legal wrangling, leaving everyone – managers, workers, and shareholders – worse off. A good legal system permits employment and production to continue in cases where the economic activity is still viable; divides up the remaining assets in an orderly and generally accepted way; and makes these determinations as efficiently and speedily as possible, while discouraging future carelessness by imposing costs on managers, shareholders, and – if necessary – creditors.

No such body of law exists at the international level. Some believe that this vacuum is the primary difficulty with the international debt system. Ambitious proposals to redress it, such as a Sovereign Debt Restructuring Mechanism (SDRM) housed at the International Monetary Fund, have always run into political roadblocks.

But incremental steps had been slowly moving the system in the right direction since the 1980s. In the international debt crisis that began in 1982, IMF country adjustment programs went hand in hand with “bailing in” creditor banks through “voluntary” coordinated loan rollovers. Eventually, it was recognized that a debt overhang was inhibiting investment and growth in Latin America, to the detriment of debtors and creditors alike.

Subsequent programs to deal with emerging-market crises featured an analogous combination of country adjustment and “private sector involvement.” Voluntary debt exchanges worked, roughly speaking, with investors accepting haircuts.

After Argentina’s unilateral default in 2001, many investors saw more clearly the need to allow explicitly for less drastic alternatives ahead of time, and so incorporated so-called “collective action clauses” into debt contracts. If the borrower runs into trouble, CACs make it possible to restructure debt with the agreement of a substantial majority of creditors (usually around 70%). The minority is then bound by the agreement.

Such incremental steps gave rise to a loose system of debt restructuring. To be sure, it still had many deficiencies. Restructuring often came too late and provided too little relief to restore debt sustainability. But it worked, more or less. By contrast, the US court rulings’ indulgence of a parochial instinct to enforce written contracts will undermine the possibility of negotiated re-structuring in future debt crises.

Time will run out for Argentina at the end of July. Unable to pay all of its debts, perhaps it will be forced to default on all of them. The more likely outcome is that it will manage to come to some accommodation that the holdouts find more attractive than the deal accepted by the other creditors. Either way, future voluntary debt-workout agreements have just become more difficult to reach, which will leave debtors and creditors alike worse off.

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    1. CommentedJames Edwards

      Argentina pursued a policy of looking at the next big thing which end it spectacularly forcing it to borrow more to fix the mistake. I'm in an agreement that a sovereign debt restructuring is needed to resolve the issue of possible default by a country unable to pay its debt because it pursued an economic policy that did not panned out they way they wanted.

    2. CommentedAdrian Lucas

      Davy V. H. Nguyen, in the paper 'Too Big to Fail? Towards a Sovereign Bankruptcy Regime', Cornell International Law Journal, Volume 45 (2010): 697-722 (available at has discussed the issue with intelligence. Nguyen shows that free-market approaches (CACs, and pari passu clauses) are not sufficient, and that a sovereign bankruptcy regime needs to be established. There is no excuse for political leaders to procrastinate, and to keep putting free trade talks (TTIP) before more urgent sovereign bankruptcy regime talks. With regard to Argentina's debt restructuring, Nguyen recounts (p.713) how: "In 2001, Argentina had 152 types of bonds, issued in seven different countries and governed by the laws of eight different countries. The result was that failure to approve the debt-restructuring plan in one agreement made disagreeing parties holdout creditors". It is the holdout creditors who have now been upheld by the US Supreme Court. This legal precedent means that the private-market approach (CACs and pari passu clauses) to sovereign debt restructuring, an approach that Jeffrey Frankel nostalgically claims "worked, more or less", is itself utterly bankrupt: yet another promise of self-regulating free-markets in shambles, and exactly as various scholars (Patrick Bolton, Olivier Jeanne, Steven L. Schwarcz, Philip Wood) predicted. When is scholarship going to be respected, and ideology (the ideology of private-market solutions) put where it belongs?

    3. CommentedRoger Houghton

      We need to level the playing field between the people represented by their government on the one hand and the capitalist operating through a limited liability company on the other.

      We should also take the opportunity to review the concept that a company is a person, independent of its directors and shareholders. That has to go.

    4. CommentedPranjul Bhandari

      Very insightful article! I worry that for both companies and countries, if voluntary debt workout agreements become the norm, wouldn’t risk premiums rise and wouldn’t the good guys with sound company/country policies be the eventual losers? Of course one may say that there will be a premium attached to having a good ‘reputation’. But ample experience has shown that public memory is short and bad reputations are forgotten quickly ...

        Portrait of Jeffrey Frankel

        CommentedJeffrey Frankel

        To Pranjul Bhandari:
        Thank you for your comment, and for your question. The notion is that having in place a workable international system of resolving debt problems in extreme circumstances should REDUCE the default risk premium. It should avoid full defaults (like Argentina's in 2001) by making a more moderate alternative available. It should avoid prolonged legal battles in which both creditors and debtors lose due to high legal costs and due to the destruction of value from a debt overhang that discourages production. In some circumstances a good bankruptcy regime can even reduce the frequency of restructurings, by avoiding the bank-run-like episodes where creditors race to grab assets out of fear that they may be left with nothing. I realize it is a bit counter-intuitive, but the idea is that making debt restructuring easier should encourage more lending.