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• Sovereign Debt - Background

© Kevin Davis/IILJ, a Creative Commons license for use is granted as detailed here.

 

FINANCING DEVELOPMENT

Sovereign Debt - Background

 

Overview

Developing countries often borrow the money needed to finance expenditures that will ultimately promote development.  Many countries are unable to raise sufficient revenue through taxation to pay for investments that will increase economic output.  Others require temporary assistance to pay for necessary social services during a period of economic downturn.  There are a number of different forms of debt financing available to a country seeking to raise funds, from issuing bonds to taking out loans from private banks.  Each method has its own advantages and disadvantages.   

 

Types of Sovereign Lending

Many states borrow from a variety of sources.  Here are the most important ones:

• Domestic creditors       
  • States may borrow funds from local banks or financial institutions, as well as issue bonds or treasury bills to local creditors.
• Private creditors
  • Banks (either individually or as part of a syndicate)            
  • Bondholders   
• Bilateral official creditors        
  • Many countries have state agencies that extend credit to other states. 
• Multilateral official creditors
  • IMF                  
  • Development banks   

Trends

Since the 1980’s, the composition of privately held sovereign debt has shifted from syndicated bank loans to bondholders.  This shift was accelerated in 1989 with the creation of Brady Bonds, which are tradable bonds that were issued in exchange for outstanding loans.  While Brady Bonds have not been issued in recent years, many of the innovations of Brady Bonds found their way into modern bond offerings.  As such, issuing bonds has become a more attractive and widely utilized option for developing countries wishing to raise funds.

Legal effects

Historically, private creditors had no direct legal recourse against foreign states, primarily as a consequence of the doctrine of sovereign immunity. In the United States the scope of the sovereign immunity has been restricted by statute since the 1950s. Moreover, sovereign borrowers have adopted the practice of waiving their entitlement to sovereign immunity.  But it is still not clear that litigation is an effective way of recovering sovereign debts.  Creditors typically cannot seize or sell assets of the state located within its borders and most states have few assets abroad (diplomatic assets such as embassies and consulates are protected from seizure).

Under these circumstances economists puzzle over why exactly countries repay their debts.  One of the leading theories is that countries wish to protect their reputations.  If a country fails to repay their debts, they will not only be viewed negatively by the international community, they will also lose the trust of creditors who could extend them credit in the future.

 

Conditionality

Sovereign debt often comes with strings attached, in the forms of prescribed conditions that the debtor must satisfy before it can obtain disbursements of funds.  Conditions that determine eligibility for an initial disbursement enable what financial economists call screening.  Meanwhile conditions that determine eligibility for subsequent disbursements or permit the lender to accelerate the debtor's obligations and demand immediate repayment put the teeth in monitoring. 

Conditionality -the practice of using conditions- in connection with sovereign debt is very controversial.  Defenders of conditionality claim that it is necessary to align the potentially divergent interests of creditors and debtors. As you review the materials on this topic you should consider how much of the debate surrounding these conditions revolves around the fundamental question of whose interests ought to be given priority.

IMF Conditionality

Perhaps the most controversial conditions associated with sovereign debt are the ones employed by the International Monetary Fund (IMF). 

The IMF’s original mandate was to provide financing in order to escape short-term economic difficulties while preserving the resources of the Fund.  Initially, therefore, the IMF focused on restoring balance of payments, such as an adequate supply of foreign currency to meet foreign obligations. Over the medium-term the main ways to accomplish this are to reduce the value of imports and increase the value of exports, or to attract foreign aid or net foreign investment. During the 1980s, there was a shift towards emphasizing growth as an objective.  Since the late 1980s concessional financing has been provided to countries undertaking long term structural reforms under the Structural Adjustment Facility (SAF) and the Enhanced Structural Adjustment Facility (ESAF).  Yet another form of financing has been designed to prevent capital account crises – a short term inability to meet foreign private sector obligations as a result of a currency depreciation caused by sudden shifts in market sentiment.  The current view is that the IMF’s objectives are to achieve “external viability at a satisfactory and sustainable rate of growth.”  This rejects notion that its objective is to “buy” particular policy reforms in borrower countries.  There remains debate about whether IMF objectives should be narrowed to immediate stabilization and/or to eliminate the objective of promoting growth.

IMF loans are disbursed in phases. Eligibility for the initial disbursement is subject to conditions known as prior actions, while eligibility for subsequent disbursements is conditional upon satisfaction of a variety of other types of conditions, including those known as performance criteria. The IMF also conducts regular performance reviews to monitor the debtor.

IMF conditions can vary considerably in terms of their specificity.  They also vary in the extent to which they are implemented by the IMF's Executive Governors as opposed to IMF staff.  Performance Criteria are approved by the Executive Governors (Board), but staff play an important role in drafting them and in making recommendations about continuation of arrangements. The staff also plays a key role in interpreting prior actions, in conducting and interpreting program reviews, and in creating and interpreting the structural benchmarks that guide program reviews.

Concerns about IMF conditionality

Among the concerns that have been raised about conditionality in general and IMF conditionality in particular are the following:

• Increased costs
  • Both monitoring and reporting costs increase if a country is expected to meet performance standards as a condition of financial support. 
• Inflexibility
  • The conditions may not allow the borrower to act quickly in the face of changing economic or political circumstances, even if such actions would be in the best interest of both the country and the IMF.
• Unclear Standards
  • If standards are not sufficiently clear they can create uncertainty.  Further, because the IMF staff plays a large role in determining when standards have been met, conflict could result between the staff, board, and members.  Increased agency costs are the likely result. 
• Illegitimacy
  • The IMF may not have the authority needed to impose economic policies on borrowing nations.  Alternatively, the IMF may have more legitimacy than the governments of many borrowing nations.
• Adverse impact on development, i.e. economic growth, health and educational outcomes and employment.
  • The IMF lacks expertise outside the field of macroeconomics.  Setting conditions with only macroeconomic policies in mind may in fact hinder development.  Once again, it is debatable whether the governments of many borrowing nations are more qualified to make such decisions.
• (Over)Reliance on international standards
  • International standards may not be appropriate in certain countries.  The implementation of such standards may depress development.
• Impinge on sovereignty
  • Many borrowing nations may resent having their economic policies dictated by foreigners. 
  • Conditions that undermine country ownership – presumably those that deviate significantly from governments’ preferred policies – may be ineffective.
    • Two thirds of program interruptions were caused by political upheavals or “flagging national commitment.”
    • A theoretical analysis of this issue is complicated by the fact that imposition of conditions can change the domestic political climate.  For example, IMF endorsement of a particular policy may, depending on the circumstances, either strengthen or undermine domestic groups espousing that policy.

Reforming conditionality

Several possible reforms of the IMF’s conditionality measures have been considered.  They are presented here along with potential drawbacks:

• Place more emphasis on outcomes rather than policies.
  • Many conditions focus on the policies of a country.  If the condition was instead based upon the desired outcome, the country could attempt to arrive at that outcome in the way that it believes is most appropriate for the country.  Given the government’s familiarity with peculiarities of their own economic and political systems, they could arguably make more efficient policy choices to bring about the desired result. 
  • Potential Problems – Many outcomes take a long time to materialize, so monitoring a country’s progress could become difficult or impossible.  Further, the IMF may have more expertise than the country’s government to make policy decisions that will bring about the intended outcome.
• Take collateral (e.g. export receipts).
  • Taking collateral would alleviate the need to impose conditions, as the IMF could recoup much of their loan in the event of nonpayment, and the existence of collateral would provide considerable incentive for the country to make reforms that would allow them to service their loans. 
  • Potential Problems – Most countries seeking IMF funds lack sufficient resources, such as export receipts, to provide adequate collateral.  Additionally, simply removing conditions may prevent the IMF from pursuing its goal of promoting sustainable economic growth.
• Having the country rather than Fund staff draft the Letter of Intent/increasing consultation about conditions.
  • Allowing for more input from the borrowing country could create conditions that are more appropriate for the specific circumstances facing the country. 
  • Potential Problems – This already is taking place with PRSP (Poverty Reduction Strategy Papers).  The country may not make efficient recommendations because they have political considerations that are at odds with simply maximizing economic potential.
• Limiting the scope of the IMF/relying on other authorities to draft conditions
  • Other authorities may be more qualified to draft conditions that will have effects beyond the sphere of macroeconomics.
  • Potential Problems - The IMF views cross-conditionality as inconsistent with its Articles of Agreement, and would therefore be unwilling to cede authority in this area.  There would also be issues regarding a potential lack of transparency, depending on the drafting process by the outside authorities.
• Place more emphasis on conditions to the initial disbursement.  Also known as increasing selectivity. 
  • Limiting lending to countries that are expected to make proper economic reforms will allow lending without rigid conditions and also encourage other nations that seek IMF funds to implement proper policies on their own. 
  • Potential problems:
    • Information available prior to disbursement may not be indicative of post-disbursement policies or outcomes.
    • Selectivity delays disbursement of funds to countries that are committed to but have not yet implemented good policies.
    • Experiences with aid suggest that commitments to exclude poorly qualified but needy or geopolitically important countries may not be politically feasible and so will not be credible.
    • Eliminating conditions to subsequent disbursements gives borrowers an incentive to renege on initial commitments.

 

Restructuring

For a variety of reasons, at some point in time a state may become unable or unwilling to continue servicing its foreign debts.  Two possible outcomes exist should this happen.  First, the state can simply go into default and discontinue payments.  This result prevents the creditors from recouping their investments, but also often disrupts the state's access to foreign capital, which typically has severe economic repercussions within the debtor country.  The second option is to restructure - meaning, modify the terms of - some or all of the country’s outstanding debts.  While this may mean that creditors give up their entitlement to be paid in full, they may be able recover more than they would in the event of default.  Meanwhile the debtor may benefit by avoiding the economic hardship often associated with protracted default.

Permitting sovereign debts to be restructured is not necessarily ideal.  The fact that parties know that a restructuring is possible creates undesirable incentives.  Debtor states that anticipate being able to avoid default or its consequences by restructuring may not adopt responsible economic policies to maximize their debt servicing potential.  Debtors may also seek to trigger restructuring by defaulting strategically or opportunistically, that is to say, defaulting even when they are actually capable of servicing their debts. Creditors who anticipate this kind of behavior on the part of their debtors will also expect to recover less from any given debtor than they would under a regime that did not permit restructuring.  Those creditors will in turn demand higher interest rates to compensate for the added risk. 

Purposes of debt restructuring mechanisms

The main purposes of any debt restructuring mechanism are to:

• Avoid a race among creditors to enforce their claims and the associated litigation costs.
  • If parties that initiate litigation will have priority rights in the event of default, this will provide an incentive to rush to court, even in situations where litigation could be avoided.  The granting of stays by the court may alleviate this problem.
• Provide interim financing for the debtor.
  • Priority for post-default financiers puts the pre-default lenders at risk of never recouping their investment.
  • An expectation that post-default financing (e.g. from the IMF) can be used to repay previous creditors may encourage excessive lending by private creditors. This is the moral hazard concern about IMF bailouts.
• Resolve disputed claims.
• Ensure that the resulting debt structure is sustainable - whether in economic, political or moral terms - for the debtor.
• Overcome the holdout problem that discourages parties from restructuring liabilities to preserve the debtor as a viable concern.

The holdout problem

Consider the following hypothetical.  Suppose a debtor owes $500 each to three creditors, for a total of $1500, but has found that a debt burden in excess of $1000 is unsustainable.  The debtor asks each of its creditors to agree to a restructuring that involves reducing the face value of each claim to $250.  Each of the creditors has an incentive to refuse and insist on their right to be paid in full while the other creditors accept the offer.  In other words, they have an incentive to 'hold out' for more favorable terms. 

Alternative approaches to sovereign debt restructuring

There is a long history of countries defaulting on their debts.  Over the years a number of approaches have been taken to countries that have defaulted or are on the verge of default.  The IMF often plays a leading role in coordinating these initiatives and providing interim financing for the sovereign.  Here are some other institutions/devices that have played a large role in managing debt crises:

• Great Powers
  • Before WWI great powers such as Britain and Germany intervened very directly in states such as Egypt, the Ottoman Empire and Haiti to ensure that debts owed to their nationals were repaid.
• Brady Plan
  • In 1982 Mexico declared a moratorium on its debt repayments, prompting defaults by a number of other Latin American countries.  This problem was resolved in 1989 by a restructuring led by the US called the Brady plan, which involved a combination of new lending by the IMF and the World Bank and exchanging outstanding bank debt for freely tradeable ‘Brady bonds’ that had a lower face value but were backed by collateral in the form of US bonds.
• Paris Club
  • The Paris Club is an informal organization of creditor countries.  They usually make debt relief conditional on compliance with an IMF stand-by arrangement. The Club also typically insists on implementing non-discrimination clauses.
• London Club
  • This informal organization, comprised of private creditors, restructures sovereign debt owed to commercial lenders, usually after agreement with the Paris club and the IMF.
• Private Compositions
  • This is particularly feasible if bond indentures allow their terms to be modified by a super-majority vote of the bondholders, thereby eliminating the ability of minority groups of bondholders to hold out.  Bonds issued under Japanese and British law have typically contained provisions known as collective action clauses, or CACs, which allow super majorities to make binding changes to the terms of bonds. Bonds issued under New York law have traditionally required unanimous consent to modifications ofthe key financial terms.  However, starting in 1999 bonds issued under New York law began to include CACs.
  • Market participants have managed to accomplish private compositions even of bonds that lack CACs by combining offers to exchange the old bonds for bonds with restructured terms - exchange offers - with terms known as exit consents.   This tactic is potentially effective whenever a bond indenture permits important non-financial terms to be modified without the unanimous consent of the bondholders.  The borrrower can exploit this fact by offering to exchange old bonds for new ones on condition that before effecting the exchange the bondholder consents to modifications to the non-financial terms of the original bonds that will significantly reduce their value.  Bondholders who fear being left holding the original bonds have an incentive to agree to participate in the exchange offer and accept the restructured bonds.
• Sovereign Debt Restructuring Mechanism (SDRM )
  • A regime proposed most recently by the IMF that would formalize the restructuring process.

Changing Boilerplate

Many questioned why it took so long for CACs to be widely implemented in bond offerings.  Major defaults had occurred throughout the 1990s, yet CACs only began to be used widely after 1999.  Part of the explanation is simply that unanimous consent agreements had been part of the boilerplate in bond offerings for an extended period of time.  The question then becomes, why do parties fail to invest in creating valuable new boilerplate?  Here are some standard explanations:

• Cost-benefit analysis
  • The status quo – such as the existing system of unanimous consent agreements, IMF bailouts, and exit consents – is not sufficiently bad to justify the investment in drafting new terms.
• Collective action problems
  • Learning externalities - Figuring out how to draft contracts – i.e. what contingencies to address and how to address them – requires investments of time and effort, which can be captured by others once the contract is drafted.  Contracts are easy to copy; difficult to copyright.
  • Network externalities – It does not make sense to adopt a contract unless a lot of other people have adopted it, because the more people who have adopted the contract, the more valuable it is.  Increasing the size of the network increases the number of counterparties who are familiar with the contract and the number of judicial precedents interpreting it.
• Lack of sophistication
  • It is possible that parties simply lack comprehension of the benefits of changing the boilerplate.  With regards to CACs, they had only been implemented a few times in the early 1990s, and their use was not widely noticed or commented upon.
  • Irrational myopia can result when one practice is dominant for an extended period of time.
• Asymmetric information
  • If a country indicates that it cares about restructuring provisions, it may be sending signals that it has a high probability of wanting to restructure.
  • Gelpern and Gulati suggest that at this point contractual innovation sent a positive signal.

These theories suggest a number of possible explanations as to why CACs ultimately came to be a part of bond offerings governed by New York law.  Gelpern and Gulati’s article offers a comprehensive discussion.  Here is a summary:

• Exogenous interpretive shock

• An exogenous shock – e.g. the threat of SDRM or Ecuador’s use of exit consents – may undermine the value of a standard form or demonstrate the value of alternatives.  All parties were so fearful of SDRM that they voluntarily adopted CACs to avoid public expropriation of the restructuring process.

• High-volume intermediaries

• Intermediaries who deal with a large number of transactions are in a position to adopt new terms without much fear of reprisal, even if collective actions discourage individual clients from changing terms unilaterally.  Choi and Gulati found that law firms but not underwriters played this role with regards to CACs, as a few large firms involved in many bond offerings were able to implement CACs.

• Individual norm entrepreneurs

• It has been argued that a few norm entrepreneurs were able to implement CACs because they felt it necessary and were in a position to advocate for them and implement them themselves.  Lee Buchheit, a partner at Cleary Gottlieb, is often cited as one such figure.

• Trade associations

• EMCA (buy-side), EMTA, and the Institute of International Finance, acting on behalf of interested parties, advocated for the use of CACs.  Parties involved with drafting bond agreements followed their advice.

• State actors

• State actors, such as the US Treasury and the IMF were involved in pushing for CACs.  Most governments wished to allow for easier restructuring as it was feared that large defaults would not only hurt the parties directly involved with the deal, but also could threaten the health of the entire world economic system.

• Parties who can send a positive signal by innovating

• Choi and Gulati suggest that small players have an incentive to innovate. Gelpern and Gulati suggest that Mexico tried to signal its sophistication to the market through innovation.  Being amongst the first to use CACs in their offerings allowed them to “show off” their financial and legal prowess and thereby increase their prestige in the international financial community.