The ongoing European crisis and the recent ruling (see, for example, Gelpern 2012) of the United States Court of Appeals for the Second Circuit in NML Capital Ltd. versus Republic of Argentina reignited the debate on sovereign debt restructuring. This post uses the rules of engineering to make the case for the creation of a structured mechanism for managing sovereign debt crises (for more details, see Panizza 2013).
The rules of engineering
Reforming the international financial architecture is a complex task. Engineers have six rules of thumb for managing complex problems with conflicting needs and constraints:
- If it ain't broke, don't fix it.
- Always know what problem you are working on.
- Avoid needless complexity.
- Don’t do something stupid.
- Every decision is a compromise.
- Don't panic!
The rules of engineering can also be useful to frame the discussion on the desirability of a structured mechanism for solving sovereign debt crises. Therefore, would-be reformers need to start by describing the problems with the status quo.
What's broken? (First rule)
Sovereign debt is non-enforceable (see Panizza and Borensztein 2010; Panizza et al. 2009), and there are at least four problems with the current non-system for the resolution of sovereign debt crises:
- Creditors' coordination and incentives to holdout from debt renegotiations
In the presence of debt overhang, a reduction in total debt could benefit both debtors and creditors. However, in the absence of a mechanism that forces all creditors to accept some nominal losses, each individual creditor will prefer to hold out while other creditors reduce their claims. As a consequence, debt restructurings tend to be lengthy, have uncertain outcomes, and may not end up restoring debt sustainability.
- Lack of private interim financing
During the restructuring period, the defaulting country may need access to external funds to support trade or finance a primary current account deficit. Lack of interim financing may amplify the crisis and further reduce ability to pay.
- Over-borrowing caused by debt dilution.
Debt dilution refers to a situation in which, when a country approaches financial distress, new debt issuances can hurt existing creditors (Bolton and Jeanne 2009). In the corporate world, debt dilution is not a problem because courts can enforce seniority rules. After a sovereign default, all creditors – old and new – receive the same treatment. A resolution mechanism capable of enforcing seniority may prevent debt dilution and thus reduce over-borrowing.
- Delayed defaults
While standard models of sovereign debt assume that countries have an incentive to strategically default, there is now evidence that policymakers often try to postpone necessary defaults (Borensztein and Panizza 2009; Levy Yeyati and Panizza 2010; Zettelmeyer et al. 2012). Delayed defaults can lead to a destruction of value because a prolonged pre-default crisis reduces ability and willingness to pay. In my view, this is the most important problem with the status quo.
Can the solution be worse than the problem?
Those who oppose the creation of a structured mechanism for the resolution of sovereign debt crises argue that any attempt to address the problems listed above would end up making things worse. A structured mechanism for managing sovereign debt crises would thus violate the first principle of emergency medical services (primum non nocere) and the fourth and fifth rules of engineering (“avoid needless complexity”, and “don’t do something stupid”). There are four common objections to the creation of a structured mechanism for the resolution of sovereign debt crises:
- It would raise borrowing costs
According to this view, the distortions listed above create willingness to pay and are thus optimal ex ante (Dooley 2000). This argument carries a lot of weight in policy discussions (a group of emerging market countries opposed the creation of the IMF-sponsored Sovereign Debt Restructuring Mechanism because of the spectre of higher borrowing costs). However, the hypothesis that the creation of a crisis resolution mechanism would lead to higher borrowing costs does not have strong empirical foundations. We can indirectly test this hypothesis by checking whether other mechanisms that facilitate sovereign debt restructuring have an effect on borrowing costs. One candidate is the introduction of collective action clauses. There is overwhelming evidence that collective action clauses do not have any negative effect on borrowing costs.
- We don’t need it anymore
According to this objection, the introduction of collective action clauses has solved all problems. The mechanism would thus be useless, and only add complexity to the international financial architecture. This argument is flawed because collective action clauses can, at best, address one of the four problems listed above (creditors’ coordination). Moreover, collective action clauses are mostly defined at the bond level and, in the absence of aggregation clauses, cannot solve coordination problems for countries with many types of outstanding bonds, or for countries that have different classes of creditors (bondholders, syndicated bank loans, bilateral and multilateral creditors). The October 2012 ruling in NML Capital versus Republic of Argentina may allow holdout creditors to interfere on payments on restructured debt and jeopardise any future attempt of sovereign debt restructuring that does not reach full unanimity.
- It is too difficult
The steering committee that drafted the ‘Arbitration and Sovereign Debt’ Report (The Steering Committee of the Netherlands Government and the Permanent Court of Arbitration 2012) concluded that “…the wider use of arbitration in the context of sovereign debt would not be a simple undertaking”. It is indeed true that building a structured mechanism for dealing with sovereign insolvency would be a difficult endeavor. This is not a good reason for not trying. Many tasks that seemed impossible then, are considered trivial now. This applies to technology, but also to policies, initiatives, and institutional innovations.
- As there are no well-defined criteria for establishing capacity to pay, the mechanism would always be subject to political pressures dictated by geopolitical considerations
This is indeed a formidable challenge. However, the WTO is often called to rule on issues for which there is no precise technical solution. In some cases, the financial and political implications of the WTO’s decisions are larger than those related to the adjudication of a sovereign default. And yet, these rulings are normally respected and deemed to be free from political pressures. Geopolitical considerations will always play a role. It is an open question whether a simpler and faster process might be worth the price of additional political influence (remember the fifth rule of engineering, “every decision is a compromise”). The fact that debt restructuring exercises conducted under the coordination of international organisations tend to work better than uncoordinated defaults seems to provide a positive answer to the above question.
What problem should the mechanism address? (Second rule)
Most proposals for reforming the sovereign insolvency process concentrate on creditors' coordination. However, creditors’ coordination is not the main problem with the status quo. Delayed defaults are the main problem. Postponing a necessary default prolongs the economic crisis in the debtor country. Delayed defaults reduce recovery value because of their negative effects on ability and willingness to pay. They hurt both creditors and debtors. The pain in the debtor country is not compensated by anybody else’s gain (while this pain without gain could be optimal ex ante, I do not think that this is the case, see above on the effects of collective action clauses on borrowing costs).
Delayed defaults often come with a sense of urgency, panic (violation of rule six), and the impression that policymakers have no idea of what they are doing. Consider the recent European experience. It started with “European countries don’t default”. Then, we moved to, “OK, Greece needs to restructure, but its case is unique and exceptional. No other Eurozone country will default”. At time of writing, European policymakers are now considering the potential consequences of a sovereign default in Cyprus. In Panizza 2013 and a subsequent Vox column, I discuss a mechanism aimed at mitigating the delayed default problem.
Bolton, Patrick and David Skeel (2004), “Inside the Black Box: How Should a Sovereign Bankruptcy Framework Be Structured?”, Emory Law Journal 53: 763-822.
Borensztein, Eduardo and Ugo Panizza (2009), "The Costs of Sovereign Default", IMF Staff Papers 56(4): 683-741.
Dooley, Michael (2000), "International financial architecture and strategic default: can financial crises be less painful?", Carnegie-Rochester Conference Series on Public Policy 53(1), 361-377.
Gelpern, Anna (2012), “Pari Passu Wipeout in the Southern District”, blog, available at http://www.creditslips.org/creditslips/2012/11/pari-passu-wipeout-in-the-southern-district.html.
Levy Yeyati, Eduardo and Ugo Panizza (2011), "The elusive costs of sovereign defaults", Journal of Development Economics 94(1): 95-105.
Panizza, Ugo (2013) "Do We Need a Mechanism for Solving Sovereign Debt Crises? A Rule-Based Discussion", IHEID Working Papers 03-2013, The Graduate Institute, Geneva.
Panizza, Ugo and Eduardo Panizza and Borensztein (2010), “The costs of sovereign default: Theory and reality”, VoxEU.org.
Panizza, Ugo, Federico Sturzenegger, and Jeromin Zettelmeyer (2009), "The Economics and Law of Sovereign Debt and Default", Journal of Economic Literature 47(3): 651-98.
The Steering Committee of the Netherlands Government and the Permanent Court of Arbitration (2012), “Arbitration and Sovereign Debt”, 11 July, available at http://www.slettgjelda.no/filestore/ArbitrationandSovereignDebt.pdf.
Zettelmeyer, Jeromin, Christoph Trebesch, and Mitu Gulati (2012), “The Greek Debt Exchange: An Autopsy”, unpublished, Duke Law.