Sovereign Debt Developed by Written by Professor Rodrigo Olivares-Caminal, Principal, Pari Passu Consulting Ltd. (in collaboration with Willkie Farr & Gallagher, LLP). All opinions are personal. 2 TABLE OF CONTENTS CHAPTER 1: KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE 1. Introduction 11 1.1. The Financial System and Types of Financing 11 1.2. Capital Markets 13 1.3. Money Markets 13 1.4. Derivatives Markets 14 1.5. Loan Markets 14 2. What is sovereign finance? 15 2.1. Taxation 15 2.2. Debt Finance 16 3. Domestic and External Debt 16 3.1. Governing law 16 3.2. Choice of jurisdiction 17 3.3. Currency 17 4. Bonds and Loans: What is the difference? 18 4.1. Liquidity 18 4.2. Customisation 18 4.3. Repayment 19 4.4. Investor base 19 4.5. Private or public nature 5. Bills, Notes, and Bonds: Different Maturity, Similar Terms 19 6. Coupons and Zero-Coupon Bonds 20 7. Fixed and Floating Interest Rates 20 8. Secured and Unsecured Debt 21 9. A Relatively Recent Innovation: GDP-linked warrants 21 10. The Principal Actors in Sovereign Finance 22 10.1. Debtor / Issuer 22 10.2. Central Bank 22 10.3. Arranger / Underwriter 22 10.4. Agent Bank / Fiscal Agent / Trustee 23 10.5. Credit Ratings Agencies (CRAs) 23 10.6. Creditors / Lenders 23 10.7. Clearing Houses 25 11. Conclusion 25 3 SOVEREIGN DEBT TABLE OF CONTENTS References 25 CHAPTER 2: FUNDAMENTAL PRINCIPLES OF SOVEREIGN DEBT 1. Introduction 27 2. Sovereign debt as an interdisciplinary problem 28 3. Sovereign insolvency: is it possible? 29 3.1. Definitions of insolvency 29 3.2. The sovereign’s assets 30 3.3. Reasons for default 31 4. The bank-sovereign nexus 32 5. Different definitions of default 33 5.1. The contractual definition 33 5.2. Credit events under a credit default swap 34 5.3. The Credit Rating Agency definition 34 6. An ongoing debate: the costs of default 34 7. The role of sovereignty in contracting and structuring debt 36 7.1. The law-making power of governments 36 7.2. The dynamics of sovereign debt restructuring and the lack of a legal regime 36 8. Conclusion 37 References 37 CHAPTER 3: THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT 1. Introduction 40 2. Multilateral debt 42 2.1. The IMF 42 2.2. Regional Development Banks 43 2.3. The European Stability Mechanism 45 3. Sovereign debt and restructuring in bilateral loans 46 3.1. The Paris Club 46 3.2. China 46 3.3. Russia v. Ukraine: An anomaly in official sector lending 47 4. Private sector lending: a process shaped by national law 47 4 SOVEREIGN DEBT TABLE OF CONTENTS 4.1. The London Club 48 4.2. Sovereign immunity: the initial hurdle 48 5. Proposals for reform 51 5.1.The Sovereign Debt Restructuring Mechanism (SDRM) 51 5.2. The United Nations Conference on Trade and Development (UNCTAD) Principles 51 5.3. The United Nations (UN) Draft Principles 51 5.4. Principles for Stable Capital Flows and Fair Debt Restructuring 52 5.5. The contractual approach to reform: Collective Action Clauses (CACs) 52 6. Conclusion 53 References 53 CHAPTER 4: INTRODUCTION TO CREDIT FACILITIES AND PRINCIPAL DOCUMENTATION 1. Introduction to Credit Facilities 54 2. Single or Multicurrency 56 3. Pari Passu or Subordinated 57 4. Secured, Partially Secured or Unsecured 57 5. Guaranteed, Partially Guaranteed or Unguaranteed 57 6. Bilateral or Multilateral 58 6.1 Bilateral 61 6.2 Multilateral 58 6.3 Syndicated Loans 58 7. Conclusion 66 References 67 CHAPTER 5: INTRODUCTION TO BOND ISSUANCES: PROCESS AND PRINCIPAL DOCUMENTATION 1. Introduction 69 1.1. A Note on Medium Term Notes (MTNs) 70 1.2. Subordinated Bonds 70 2. Parties involved 71 3. A note on underwriting 72 5 SOVEREIGN DEBT TABLE OF CONTENTS 4. Overview of Key Documents 76 5. Procedure 75 6. Listing of Bonds 77 7. Rating of Bonds 77 8. Trustees and Fiscal Agents 79 9. Conclusion 80 References 81 CHAPTER 6: UNDERSTANDING RISKS AND CHALLENGES 1. Introduction 83 2. Sovereign Risks 85 2.1 Non-Financial Sovereign Risks 6 85 3 .Debt-to-GDP Ratio 92 4. Outlining and monitoring the use of funds 95 5. Predecessor debt 95 6. Conclusion 96 References 97 CHAPTER 7: INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT 1. Introduction 99 2. Choosing Where to Sue 100 3. Enforcing the Judgment 101 4. Using a Fiscal Agent or a Trust Structure 102 5. The History of the Pari Passu clause 103 6. Pari passu litigation: Prominent case studies 104 6.1. Peru 104 6.2. Argentina 105 6 SOVEREIGN DEBT TABLE OF CONTENTS 7. Debtor strategies to neutralise holdouts 108 7.1 Contractual sweeteners 108 7.2 Collective Action Clauses (CACs) 109 7.3 Exit consents 110 8 .Conclusion 110 References 111 CHAPTER 8: SOVEREIGN DEBT IN AFRICA 1. Introduction 114 2. Sovereign debt crisis in Africa 114 2.1. A History 114 2.2. The HIPC initiative 115 2.3. Post-mortem: African debt today 117 3. Case Studies 118 3.1. Case Study 1: Kenya’s Eurobond 122 3.2. Case Study 2: Ecuador 124 3.3. Case Study 3: Grenada 125 3.4. Case Study 4: Seychelles 4 .Conclusion 126 References 127 7 CHAPTER 1 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE 1. Introduction 5. Bills, Notes, and Bonds: Different 1.1. The Financial System and Types of Maturity, Similar Terms Financing 1.2. Capital Markets 6. Coupons and Zero-Coupon Bonds 1.3. Money Markets 1.4. Derivatives Markets 7. Fixed and Floating Interest Rates 1.5. Loan Markets 8. Secured and Unsecured Debt 2. What is sovereign finance? 2.1. Taxation 9. A Relatively Recent Innovation: GDP- 2.2. Debt Finance linked warrants 3. Domestic and External Debt 10. The Principal Actors in Sovereign 3.1. Governing law Finance 3.2. Choice of jurisdiction 10.1 Debtor / Issuer 3.3. Currency 10.2 Central Bank 10.3 Arranger / Underwriter 4. Bonds and Loans: What is the 10.4 Agent Bank / Fiscal Agent / Trustee difference? 10.5 Credit Ratings Agencies (CRAs) 4.1. Liquidity 10.6 Creditors / Lenders 4.2. Customisation 10.7 Clearing Houses 4.3. Repayment 11. Conclusion 4.4. Investor base 4.5. Private or public nature Reference 9 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE 1. INTRODUCTION For all the talk of sovereignty, countries and their governments are not omnipotent. They have limitations just like the citizens that compose them. Much like its citizens, a country will face pressures in paying all of its bills on time, and in creating wealth through sound investments. Much of this is handled through fiscal policy, which is the discipline of what government revenues to collect, from whom to collect them, and how to spend them. However, much like with a person living day-to-day from a salary, fiscal policy has its limitations, in that a government that has to spend in services what it raises in taxes will never be able to save money for large expenditures of the sort that are sometimes required for necessary public investment. Thus, countries, like corporations, turn to the financial markets for their financing needs. When countries use debt as a financing tool, the debt is termed sovereign debt, and the country is known, in its status as a borrower, as a sovereign debtor. The lender, for its part, will be known as a creditor, and as will be seen, both creditors and sovereign debtors come in all shapes and sizes, and can be either public or private in character. While these Modules will concentrate on how to issue sovereign debt, the legal and economic aspects for sovereign debt, and what to do when things “do not go as planned” (sovereign debt restructuring), any discussion of sovereign finance must be grounded, first, in an introduction to the financial markets. While governments principally access the bond and loan markets to satisfy their financing needs, they also occasionally engage in transactions in other markets, such as the money markets and the derivatives markets, when they require the liquidity or risk management offered by these markets. Thus, in understanding the wide gamut of markets in existence, policymakers increase the tools at their disposal for addressing the myriad needs of government. In particular, this specific Module will focus on the basic characteristics that underlie sovereign finance, such as the distinction between domestic and external debt, and the similarities and differences between the two financial instruments that governments use to incur procure financing, bonds and loans. While both are forms of debt, their legal terms, market treatment, and investor-base/lenders are entirely different. The Module finishes with a discussion of the principal actors in sovereign finance, the relevance of which will be clearer in subsequent Modules dealing with loan and bond documentation and debt restructuring. 1.1 The Financial System and Types of Financing The financial system is divided into different types of markets, each catering to a broad class of financial instruments. Any entity in search of financing will consider its particular needs in deciding what market to turn to. Broadly speaking, these markets may be defined as the capital markets (consisting of the stock markets and the bond markets), the money markets, the derivatives markets, and the loan markets. 1.2 Capital Markets The international capital markets are typified by two main characteristics: 1) their main purpose as fundraising sources for entities, and 2) the negotiability of the instruments it encompasses. 9 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE Tradeable financial instruments are known as “securities”, but not all securities are used for fundraising.