Restructuring sovereign debt in a crisis
As Enron prepares to file for bankruptcy under Chapter 11 of U.S. laws, the International Monetary Fund has proposed a mechanism somewhat similar to Chapter 11 for countries that find themselves unable to meet their obligations to foreign private creditors. The mechanism, to be discussed in the IMF's board later this month, will not provide for ``sovereign bankruptcy.'' What it will do is provide for a temporary standstill on debt repayments, possibly overseen by the IMF, during which time the debtor country and its private creditors will try to work out how much of the outstanding sovereign debt the country in trouble can and will repay.
The proposal will, if approved, take years to become operational and will possibly require fresh legislation in many countries to permit a moratorium on debt repayments. But the idea carries forward many proposals made by economists and other multilateral agencies for a process that would be superior to the present practice of IMF bailouts. (The United Nations Conference on Trade and Development more recently made such a proposal in its 2001 Trade and Development Report, pp 68-70). Efforts to devise a system to ``bail in'' the private creditors have been going on for some time at the IMF. Usually, when foreign confidence disappears - for whatever genuine or imaginary reasons - and lenders start pulling out, governments have to scramble to meet their sovereign debt obligations.
The IMF then steps in with a huge and expensive financial package and the Government uses the funds to repay the creditors. In addition to everything else, this system poses what is called a ``moral hazard'' problem. Foreign creditors never have second thoughts about lending to governments, whatever the purpose and whatever the conditions of the country, because they know that in the end the IMF will step in with a rescue package - on which the first charge will be theirs.
The new framework that was proposed earlier this week by Ms. Anne Krueger, Deputy Managing Director of the IMF, has the following features. When a country finds it has to restructure its sovereign debts,: (1) IMF assistance will be confined to providing liquidity for paying for imports, (2) the debtor country will commit itself to pursue ``good'' economic policies, (3) there will be a temporary standstill in debt repayments, which will be subjected to review, (4) the debtor government will work out with its creditors (may be domestic and foreign lenders) the terms on which it can repay its debts, (5) temporary controls will be imposed to prevent a flight of capital from the country and (6) once loan rescheduling agreements are worked out with a majority of the creditors, they will become binding on all lenders (otherwise the minority can demand full repayment though the majority may have accepted part servicing of the debt).
For this framework to be effective, two major changes will have to be made. Governments will have to enact legislation that will make a temporary moratorium possible - allowing for the possibility that creditors from their countries cannot in all circumstances demand enforcement of their contracts with their borrowers. Second, private creditors should not be able to locate national courts where they can demand full servicing of their lending contracts. Ms. Krueger, in her speech in Washington, referred to ``vulture funds'' that buy sovereign debt at heavily discounted prices and then demand full payment. In a recent example, one U.S. fund did precisely that with Peruvian sovereign debt and successfully got U.S. courts to rule in its favour.
The advantages of a new system to restructure sovereign debt are many. An orderly renegotiation, even if it imposes heavy costs on the debtor country, will be superior to the costs of a large IMF loan package. It should be the preferred choice of the debtors too since a disorderly renegotiation when everybody tries to exit from the country first, will send the price of the debt plummeting. However, the first reaction of the private sector creditors has not been positive. Their argument is that this will be a licence encouraging countries to dishonour their contracts because they know that they can obtain a moratorium and then restructure the debt. This is no argument because a restructuring will not be painless, the debtor country will find that at least for a while it is cut off from fresh finance or it will have to pay penal interest rates.
A more relevant question is who should administer this new framework/mechanism? The UNCTAD had suggested an international body, without specifying what kind. There is also the fear that if the IMF is in overall charge it will impose conditions on the debtor country that are not any lighter than what countries now have to pay for IMF assistance.
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