REVISITING SOVEREIGN BANKRUPTCY Committee on International Economic Policy and Reform LEAD AUTHORS Lee C. Buchheit Ugo Panizza Anna Gelpern Beatrice Weder di Mauro Mitu Gulati Jeromin Zettelmeyer OTHER COMMITTEE MEMBERS Markus Brunnermeier Takatoshi Ito Dani Rodrik Barry Eichengreen Philip Lane Hyun Song Shin Mohamed El-Erian Eswar Prasad Andrés Velasco José De Gregorio Hélène Rey Yongding Yu OCTOBER 2013 TABLE OF CONTENTS Preface and Acknowledgments . iii Executive Summary . iv Chapter 1: Introduction . 1 Chapter 2: Pathologies in Sovereign Debt . 5 Chapter 3: Argentina and the Rebirth of the Holdout Problem . 15 Chapter 4: Euro Area Issues . 21 Chapter 5: Policy Proposals for the Euro Area and Beyond . 29 References . 47 RevisitiNG SOvereigN BANKruptcy ii PREFACE AND ACKNOWLEDGMENTS he Committee on International Economic Pol- Committee Members icy and Reform is a non-partisan, independent Tgroup of experts, comprised of academics and Markus Brunnermeier, Princeton University former government and central bank officials. Its Lee C. Buchheit, Cleary Gottlieb Steen & Hamilton objective is to analyze global monetary and finan- LLP cial problems, offer systematic analysis, and ad- Barry Eichengreen, University of California, vance reform ideas. The Committee attempts to Berkeley identify areas in which the global economic archi- Mohamed El-Erian, PIMCO tecture should be strengthened and recommend Anna Gelpern, Georgetown University solutions intended to reconcile national interests Mitu Gulati, Duke University with broader global interests. Through its reports, José De Gregorio, University of Chile it seeks to foster public understanding of key issues Takatoshi Ito, University of Tokyo in global economic management and economic Philip Lane, Trinity College Dublin governance. Each Committee report will focus on Ugo Panizza, Graduate Institute of International a specific topic which will emphasize longer-term and Development Studies, Geneva rather than conjunctural policy issues. Eswar Prasad, Cornell University and Brookings Institution The Committee is grateful to the Alfred P. Sloan Hélène Rey, London Business School Foundation* for providing financial support and Dani Rodrik, Harvard University to the Brookings Institution for hosting the com- Hyun Song Shin, Princeton University mittee and facilitating its work. Andrés Velasco, Columbia University Beatrice Weder di Mauro, University of Mainz Contributions by Elizabeth Broomfield and com- Yongding Yu, Chinese Academy of Social Sciences ments and suggestions by Richard Portes are Jeromin Zettelmeyer, European Bank for gratefully acknowledged. Quynh Tonnu provided Reconstruction and Development** excellent administrative support. **DuetohisofficialpositionatEBRD,Mr.Zettelmeyeris anhonoraryadvisortotheCommittee. *Brookings recognizes that the value it provides to any donor is in its absolute commitment to quality, independence and impact. Activities sponsored by its donors do not reflect this commitment and the research agenda, content, nor outcomes are influenced by any donation. REVISITING SOVEREIGN BANKRUPTCY iii EXECUTIVE SUMMARY overeign debt crises occur regularly and often that decline a restructuring offer the right violently . The recent debt crisis in Greece al- to interfere with payments to the creditors Smost led to the collapse of the Euro . Yet there that accept such an offer . This will compli- is no legally and politically recognized procedure cate efforts to resolve future debt crises on for restructuring the debt of bankrupt sovereigns . an ad hoc basis . Procedures of this type have been periodically de- • Sovereign debt crises are no longer just a bated—most recently, about a decade ago, when problem in emerging markets, but a core IMF management proposed a global sovereign concern in advanced countries as well— debt restructuring mechanism (SDRM) . They have particularly in the Euro area . If the Euro so far been rejected . Countries have been reluctant is to survive, this will require both better to give up power to supranational rules or insti- ways to resolve debt crises and stronger, tutions . Creditors and debtors have felt that there market-based incentives that prevent debt were sufficient instruments for addressing debt problems from occurring in the first place . crises at hoc . Importantly, there were also fears that making debt easier to restructure would raise To address these problems, the report presents the costs and reduce the amounts of sovereign policy proposals at two levels: for the Euro area, borrowing in many countries . This was perceived and globally . to be against the interests of both the providers of both creditors and major borrowers . The Euro area differs from other integrated re- gions both in that its members have fewer in- This year’s CIEPR report argues that both the struments to deal with debt crises—they cannot nature and our understanding of sovereign debt devalue or inflate—and because a crisis in one problems have changed in ways that create a much member can have catastrophic consequences for stronger case for an orderly sovereign bankruptcy others (by threatening the common currency) . regime today than ten years ago . This requires both a mechanism for the orderly • Pre-crisis policy mistakes—and in par- resolution of debt crises and stronger incentives to ticular, the tendency of domestic policy- prevent them . The current financial architecture in the Euro area is inadequate in this respect, because makers to overborrow or pay too little at- its main pillar—the European Stability Mechanism tention to private debt accumulation that (ESM)—is not set up to deal with unsustainable might turn public—are now recognized to debt . If it is used even when there are significant be a much more severe problem for bor- concerns about the ability of borrowers to repay rowing countries than the costs or limited their debts, it will become source of transfers, rath- availability of private financing . Far from er than just crisis lending . being a problem, proposals that would limit the ability to borrow for countries These problems could be addressed via an amend- with poor policies are a good thing . ment of the ESM treaty that encourages and legiti- • Recent court rulings—particularly a recent mizes—both legally and politically—debt restruc- U .S . ruling that gives “holdout creditors” turing in unsustainable debt cases . RevisitiNG SOvereigN BANKruptcy iv • First, assets and revenues of countries debt exchange offers, and bringing into question undertaking a debt restructuring would the IMF’s priority status, will make this problem be deemed immune from legal action by worse . To address this without allowing sovereigns holdouts if a restructuring is approved by to frivolously repudiate their debts, two alternative the ESM . mechanisms are proposed . • Second, the treaty would require a debt re- • A coordinated introduction of a strong structuring as a condition for ESM lending form of “collective action clauses” in sov- when national debts exceed a pre-set level . ereign bond contract, namely, provisions This should be higher than the Maastricht that allow for the restructuring of bonded limit of 60 percent of GDP, but not so high debt with the agreement of a supermajori- as to render the constraint meaningless . In ty of creditors across all bonds . the Euro area, this may mean a level about • The creation of a Sovereign Debt Adjust- 1 ½ times the Maastricht limit . The pres- ment Facility by the International Mon- ence of such a debt threshold would help etary Fund, which would combine IMF differentiate borrowing costs in normal lending with debt restructuring . A set times based on the strength of economic of clearly defined ex ante criteria, analo- policies . At the same time, it would pro- gous to those used in the HIPC initiative, tect ESM resources and Euro area taxpay- would need to be developed to steer high ers, and prevent extreme adjustments of debt countries towards this facility . An public finances at the expense of citizens amendment of the IMF articles would en- who usually have little control over poli- sure that the assets of countries using this cy mistakes leading to excessive sovereign facility would be shielded from holdouts debt . if a supermajority of creditors agrees to a restructuring . Importantly, Euro area countries must be given a chance to deal with legacy debt before this regime The main difference between the two proposals is is introduced . For countries significantly above that the second would do more to correct biases the future upper debt threshold, this will require that delay necessary debt restructuring . Further- a judgment of whether debt can be reduced below more, while both would deal with the holdout the limit within a reasonable time frame . Where problem in the long run, the IMF-based proposal the answer is no, the Euro area needs to make a would have immediate effects, while better collec- choice between an upfront restructuring – backed tive action clauses would become effective only by the ESM – and extra support, for example, in gradually, as existing debt is replaced by newly is- the form of providing a joint and several guarantee sued debt . on new debt issuance as long as countries adhere to an agreed fiscal consolidation path . The world is currently less equipped to handle problems of unsustainable debt than at any time At the global level, the relatively small size of the since the 1930s . At the same time, the extent of IMF, its de facto priority and its track