As described in Section II, the absence of explicit seniority is a striking difference between sovereign and corporate debt. This section argues that explicit seniority in sovereign debt—and, more generally, contractual innovations that help protect creditors from the consequences of future additional borrowing by the debtor country—could potentially play a useful role by promoting safer debt structures, discouraging overborrowing, and lowering interest costs for countries with moderate debt levels. However, this section is only a first pass at the issue, and a more thorough analysis of its consequences in different situations as well as its practical feasibility and impact on crisis resolution is warranted.1
Economic Role of Seniority
The traditional argument for the existence of senior debt is that it prevents debt dilution (Fama and Miller, 1972). Debt dilution is analogous to the dilution of equity through new equity issues. When new debt is issued, the recovery value of the debt has to be shared among more creditors in the event of insolvency; thus, dilution leads to a reduction in the repayment expected by each claim holder. New creditors are compensated for this effect through higher interest rates. But the initial creditors are not: for them, dilution means a capital loss. Anticipating this possibility, they may either require higher interest rates at the outset or refuse to lend altogether. Thus, the possibility of debt dilution may ultimately backfire on the debtor. But if the original creditors were senior—in other words, if creditors that lent earlier had priority over those that lent later—they would be less concerned about subsequent debt issues, because in the event of bankruptcy they would be repaid first. Thus, first-in-time seniority may serve as an antidote to debt dilution.
At the corporate level, the case for senior debt is particularly strong when managers pursue their own agendas (Hart, 1995; Hart and Moore, 1995). Self-interested managers may have incentives to over-borrow—for example, to finance projects that give them private benefits, to make the firm as large as possible, or to keep their jobs in a situation when it would in fact be efficient to liquidate the firm. If existing debt can be diluted, it is easy to overborrow, because new capital receives a share of the debt recovery value corresponding to its share in total debt outstanding. This is not the case when the new debt is junior: the presence of senior debt can thus serve as a disciplining device.
The dilution problem has become increasingly relevant to emerging market debt. For dilution to play a role, two conditions must be met. First, there must be a substantial chance of default or restructuring: as long as repayment remains safe, new debt issues are not a cause of concern for existing creditors. Second, debt must be issued to different groups of creditors over time. This would not be the case, for example, if emerging market governments kept borrowing from essentially the same group of banks, as happened during the 1970s and 1980s. However, in a case such as Argentina in the 1990s, which issued 156 bonds to a wide base of customers, dilution of earlier debt by later issues may have been intense. The same is true for other recent default or restructuring cases. For example, in the first half of 1998, Russia and Ukraine continued accessing capital markets through new debt issues at rapidly rising interest rates, thereby sharply diluting the existing debt stock.
One sign that the dilution problem is relevant in emerging market debt is that creditors seem to be making efforts to protect themselves against dilution. For example, one of the two Eurobonds that creditors were offered in Ecuador’s 2000 debt exchange contained a “principal reinstatement” clause, which provided for an automatic upward adjustment in principal in the event of a default. The face value of the bond-holder’s claim was to increase by a given amount in the event that Ecuador defaulted on the new bonds after the restructuring (30 percent if a default occurred in the first three years after issuance, and gradually declining to zero after 10 years). Thus, incumbent bondholders received (temporary) protection from dilution that might result from new debt issuance.
The dilution problem could be eliminated if, in the event of a debt restructuring, creditor claims were served in the order in which the debt was issued. With this “first-in-time” seniority, initial creditors would be repaid (possibly in full), whereas the most recent creditors would receive much less, and possibly nothing.2 If credible and enforceable, this could have desirable effects on the structure, cost, and amount of public borrowing. Explicit seniority could benefit the debt structure by reducing the incentive to issue debt forms that are hard to dilute, such as short-term foreign-currency debt. It could also lower the costs of borrowing at moderate levels of debt, because creditors would not have to worry about debt dilution in the future. Finally, by eliminating the possibility of issuing debt at the expense of previous creditors, seniority could reduce the incentives to overborrow. This said, countries with high levels of debt would find tighter market access and higher costs if they were to adopt a first-in-time seniority rule. This is an inherent drawback of any mechanism that reduces debt dilution and needs to be taken into consideration when evaluating the possible adoption of a seniority rule.
The following subsections elaborate on these points before turning to the question of how seniority-like features could in practice be introduced into sovereign debt. A number of obstacles and difficulties are discussed. While it is too early to say whether such difficulties could be resolved, the section suggests that consideration could be given to creating an international debt registry that would make it easier to monitor both total indebtedness and the contractual terms under which public debt is issued. This would be a necessary (albeit not sufficient) step for the development of an explicit seniority structure based on debt contracts, and may also have benefits of its own.
Effects of Seniority on the Quantity and Price of Debt
The benefits of making incumbent sovereign debt senior are most obvious when governments are biased toward excessive borrowing.3 Diluting existing debt makes it easier for politicians to finance activities that may not be in the taxpayer’s best interest. Examples include consumption or investment that benefit special interests, fiscal expansions ahead of elections, or—instead of politically costly reforms or restructurings—“gambles for redemption,” whereby the dilution of existing debt may allow new government borrowing even when it is generally known that the country is insolvent. This may postpone a crisis, but the default, when it finally happens, will be much larger.
Seniority could also help curb overborrowing that arises even without a political bias toward excessive borrowing, purely as a consequence of the inability of the debtor to commit to not dilute the existing debt (Sachs and Cohen, 1982; Kletzer, 1984; Detragiache, 1994; and Eaton and Fernandez, 1997). Suppose that a country would like to borrow up to a given debt level. Once it has done so, it will generally have an incentive to borrow some more, because the dilution effect implies that new debt can be placed relatively cheaply. This will lead to excessive borrowing from the country’s original perspective and—as it is anticipated by creditors—to higher interest rates. As a result, the country is worse off than if it had been able to commit to the original debt level. Seniority can rectify this problem by acting as a substitute for commitment: the debtor can credibly promise to the initial creditors that it will refrain from additional borrowing, because seniority eliminates the possibility of dilution.
Senior debt could also reduce borrowing costs for countries with low levels of debt; these countries might end up borrowing more. At present, the possibility of future debt dilution makes emerging market countries’ debt relatively expensive even at moderate levels. As a result, governments that want to “play it safe” and keep their borrowing costs down have an incentive to borrow less than desirable, that is, below the level at which they would want to borrow if they could commit to not dilute (Bolton and Jeanne, 2004; and Zettelmeyer, forthcoming). With debt seniority acting as a binding promise to not dilute, countries with levels of debt that are low relative to sustainable levels would be able to borrow more, at equal or lower interest rates than would prevail in the absence of seniority.
As suggested above, any mechanism that limits debt dilution could impede debt dilution when it is in fact desirable. Consider a situation in which a (solvent) country suffers an adverse shock that would require large additional financing. Issuing junior debt could be prohibitively expensive, because the probability of a debt crisis is now higher. In such a case, it might be in the interest of the incumbent creditors to allow dilution—in other words, allow new debt issues at the same, or even a higher, level of seniority as the existing debt—in order to provide the liquidity that might stave off a debt crisis. This is similar to the logic of “debtor in possession” financing mechanisms in corporate bankruptcy, whereby creditors may waive their seniority in order to allow the firm to access new money. A mechanism for waiving seniority in such situations could be useful. However, coordinating creditors on waiving seniority may be difficult in practice.
Collateralized debt shares some features with legally senior debt, but also suffers from some specific—and potentially serious—disadvantages. Like legally senior debt, fully collateralized debt cannot be diluted and may discourage overborrowing and lower the costs of responsible borrowing.4 However, issuing collateralized debt is possible only for countries that have assets abroad or large cash flows originating in other jurisdictions. More important, promoting collateralized debt may be counterproductive if the basic problem is an inherent government bias to overborrow. With standard debt, the possibility of default would deter investors from lending to an irresponsible government. In contrast, collateralized debt could make it possible for lending to continue, effectively at the expense of future governments and generations.
Effects of Seniority on Debt Structure
Introducing seniority could have an impact not only on the quantity and price of debt but also on its structure. In the absence of explicit seniority, creditors may have an incentive to seek “de facto seniority” by opting for debt instruments that are hard to dilute, such as short-term debt (Sachs and Cohen, 1982; Kletzer, 1984; Chamon, 2002; Bolton and Jeanne, 2004). If maturities are short, lenders can refuse to roll over (or roll over at higher interest rates) as soon as they perceive an attempt to dilute. In contrast, if maturities are long, lenders are captive, and will suffer a capital loss.
Dilution fears could also create an incentive to borrow in debt forms that are relatively difficult to restructure, for example, through international bonds rather than domestic bonds or bank loans. If a country is able to repay some debt, but not all, it may default selectively on the instruments that can be renegotiated more easily. Once everyone has realized this, however, it will only be possible to issue hard-to-restructure instruments (Bolton and Jeanne, 2004; Lipworth and Nystedt, 2001).5
The implication of the bias toward short maturities is to make debt more crisis prone. The bias toward debt instruments that are relatively hard to restructure deepens crises when they occur and impedes restructurings that could have avoided major defaults. Seniority could help prevent costly crises by removing these biases.
Approaches and Obstacles in Implementing Explicit Seniority
An explicit, first-in-time seniority structure could arise through one of three mechanisms. First, new statutes at the international level, created by an international treaty or an amendment of the IMF’s articles (IMF, 2002b; and Bolton and Skeel, 2003). Second, national legislation whereby debtor governments would commit to repay debt—in the event of default—in the order in which it was issued. For such commitment to be credible in the eyes of investors, changes to the law would have to be hard to make, and the domestic judiciary would need to be strong and independent. Third, contractual provisions protecting bondholders from dilution by future debt issues; such provisions would be enforced by the courts of the country where the debt was issued. The remainder of this section focuses mainly on the third approach, because it seems promising and raises complex issues that have not been analyzed before.
The contractual approach would loosely follow the example of creditor protections in corporate bond covenants. Specifically, the debt contract between an initial creditor and the debtor could contain a covenant prohibiting the debtor from issuing any subsequent debt unless future creditors agreed to be contractually subordinated to the initial creditor’s claim. To enforce this covenant, senior creditors would need to be given the power to declare a default and accelerate if debtors fail to ensure that future creditors are subordinated. The next creditor’s contract would then include a similar clause with respect to future debt, and so on. This sequence of contracts might generate a priority structure that gives senior creditors a legal basis to sue junior creditors in the event that seniority is violated in a default (Box 4).6
Enforcing Contractual Seniority
Establishing a feasible contractual priority structure based on time of issue requires solving two enforcement problems. First, assuming that outstanding claims define a consistent legal priority structure, this structure must be enforceable in the event of a restructuring. Second, a mechanism must be found that ensures that the priority structure is defined consistently. In particular, debtors have to be prevented from issuing new claims in contravention of earlier contracts, that is, claims that are not explicitly subordinated to those of previous creditors. The resolution of both these problems will most likely require the establishment of both debtor-creditor and intercreditor obligations.
Resolving the first problem—enforcing contractual priority in a default—requires giving senior creditors the legal basis to sue junior creditors who receive payments in contravention of their order of priority. To provide certainty, this legal basis is likely to require privity of contract between the senior creditor and the junior creditors. Specifically, the junior creditor would need to enter into a contract with the senior creditor that provides that the junior creditor will not receive any payments from the debtor until the senior creditor is paid in full.
Making sure that the above framework is established also presents some challenges. Contrary to the case in which existing creditors agree to subordinate themselves to future creditors, as in the case of debtor-in-possession-type financing (Buchheit and Gulati, 2002), existing contracts must contain covenants that ensure that future creditors subordinate themselves in a way that gives senior creditors comfort that their priority can be enforced. The basic instrument for achieving this would be to give senior creditors the power to declare a default and accelerate if debtors fail to ensure that future creditors are subordinated to them. However, this is a fairly blunt instrument. Notably, if new creditors are not subordinated and previous creditors accelerate, they will not be able to enforce the seniority of their claims with respect to the most recent group of new creditors. This said, the threat of acceleration and technical default may conceivably provide sufficient discipline to the debtor for a consistent contractual priority structure to get off the ground.
An explicit first-in-time seniority structure in sovereign debt could conceivably be undermined by debt issues that are formally subordinated but have shorter maturities and thus require earlier repayment. Indeed, to the extent that this is possible, first-in-time seniority might have perverse effects on the debt structure at high levels of debt, as it may lead sovereigns in distress to issue debt of even shorter maturities than under the present system. In the contractual approach, a possible solution could be an intercreditor provision to relinquish payments received 90 days prior to a formal default to the senior creditor. Alternatively, bond covenants could stipulate the suspension of payments to junior creditors—or their redirection to a trustee—prior to a formal default, upon observing prespecified signs of debt distress (e.g., when debt service capacity indicators cross certain thresholds). Finally, covenants could be added that effectively give senior creditors veto power over the issuance of short-term debt, by granting them the right to ask for early repayment.7
As is often the case with financial innovation, first-in-time seniority would add complexity to the debt instruments. Financial market participants would need to keep track of the seniority status of the various bonds when pricing them. Methods to price bonds with different degrees of seniority would have to be developed. It is possible that this additional complexity would make sovereign debt less attractive and raise borrowing costs, at least until markets became accustomed to the new system.
A further caveat is that highly indebted countries might not benefit from a switch to a first-in-time seniority regime. A new creditor would rank junior to all preexisting claims, and would hence need to be compensated by a higher interest rate, or could even refuse to lend at all if the risk of default were sufficiently high (Box 5). A similar problem might apply to countries that are liable to suffer from large adverse shocks that would increase their financing needs significantly. For many countries, however, this would be just a transitional problem. Under a pari passu regime, countries tend to over-borrow because dilution lowers the costs of obtaining additional debt. Under a seniority regime, countries would have an incentive to maintain lower debt levels but, in some cases, they may need to reduce their debt levels before they are able to secure a reduction in their borrowing costs. These countries would have to gradually reduce their debt burdens to levels that are viewed as reasonably safe before issuing senior debt. Alternatively, they could incorporate seniority clauses that do not become effective immediately, but instead stipulate that the debt will become senior to new debt issued after a specified time interval (say, five years). This would allow time to adjust from high debt levels, and provide a commitment to doing so.
Effect on Borrowing Costs of a Switch to First-in-Time Seniority
As argued earlier, the main effect of first-in-time seniority on the quantity of countries’ borrowing would be to reduce incentives to overborrow. After countries and markets have adjusted to the new regime, one would expect to see fewer countries at or close to unsustainable debt levels. In addition, borrowing costs would be lower, because spreads would no longer reflect the risk of future debt dilution.
However, the effect of a switch to first-in-time seniority on impact—for given outstanding debt stocks—might be to either raise or lower borrowing costs, depending on the size of countries’ existing debt stocks. Countries with low debt levels would see their borrowing costs fall, whereas countries with high debt levels would see borrowing costs rise, and might even be cut off from additional net borrowing altogether. This is because at low debt levels, a creditor buying an extra unit of debt under first-in-time seniority would expect to be senior in the event of a default (because default would only occur after substantial accumulation of subsequent debt). In contrast, under the present regime this creditor would expect to rank equally, in the event of default, as the holders of debt issued subsequently. For very large outstanding debt levels, and a correspondingly high probability of a debt crisis in the near future, the opposite is true: a new creditor would expect to rank junior to most outstanding debt, and would consequently want to be compensated by higher interest rates than under the present system.
The argument is illustrated in the figure below. This assumes that the country in question has a minimum recovery value of debt, denoted D, and a maximum sustainable debt level of
As D approaches
Marginal Borrowing Costs
Before concluding, it is worth emphasizing that there may be alternative contractual ways of reducing the dilution problem while not establishing a full-fledged legal priority structure in the event of default. One possibility would be to give creditors contractual options that provide them with some control over the debtors’ subsequent borrowing behavior or allow them to renegotiate in the event of new borrowing. At the most basic level, contracts could include put options allowing debtors to ask for early repayment in the event that certain limits on total debt are exceeded. Alternatively, future debt issues could trigger changes in the payment terms of existing bonds in a way that offsets the loss of value inflicted upon their holders by the new borrowing. These alternative approaches may go a considerable way toward addressing the dilution problem without raising the legal difficulties of full-fledged first-in-time seniority. Because they do not have the effect of making the outstanding debt stock legally senior relative to future debt issues, they might also avoid possible transitional problems associated with full-fledged first-in-time seniority.
Conclusions
Explicit seniority in privately held sovereign debt, or other possible enhancements in debt contracts that significantly reduce the scope for debt dilution, could have benefits in terms of discouraging overborrowing, lowering the debt costs of responsible borrowers, and reducing the incentives to adopt risky debt structures. These benefits would need to be balanced against a potential cost, namely, the possibility that countries with high levels of debt would find it more difficult to access international capital markets than they do under the present system. Countries with more moderate debt levels—but which nevertheless pay a substantial risk premium—could thus stand to gain the most from adopting a seniority regime. Other countries might need to find ways to reduce their debt to safer levels before the benefits could be secured.
This said, the analysis of both the feasibility and overall effects of seniority-like features in sovereign debt would need to be extended before reaching a more definitive judgment on the issue. In particular, further analysis would be needed in three areas: (1) the impact of seniority on crisis resolution (an aspect not addressed in this paper); (2) the legal and operational feasibility of a contractual seniority structure; and (3) the desirability and feasibility of enhancements in bond contracts that might protect bondholders from dilution without the need to create a legal seniority structure.
One possible step that would not seem to depend on how the verdict on the usefulness and practicality of explicit seniority ultimately turns out is the creation of an international official debt registry publishing the terms of all public debt contracts.8 While such a registry might be a necessary step toward a contractual seniority structure, it could also be of value more generally. Greater transparency in the level and structure of sovereign debt might contribute to the efficiency of the debt market, and would play a helpful role in the context of debt restructuring operations. Although the costs of establishing a debt registry should be evaluated carefully, the public good aspect of information is an argument for officially sponsoring such a registry.
Gelpern (2004) argues that explicit seniority may result in a more predictable and less complicated debt restructuring process. Establishing a fixed priority ranking among creditors eliminates one aspect of the creditor collective action problem: the “race to the courthouse,” whereby creditors seek an advantage by being the first to litigate. However, it can also be argued that an explicit seniority ranking would complicate debtor-creditor negotiations, because senior creditors have an incentive to agree quickly to a large haircut that leaves junior creditors with nothing (see Zettelmeyer, forthcoming, for a discussion).
In a variant of first-in-time seniority, time units could be calendar years, for example. All debt issued within a given year would have equal priority. Debt issued in year t would have absolute priority over debt issued in year t–1.
The IMF’s World Economic Outlook (September 2003, Chapter 3) suggests that overborrowing—defined as public debt that is higher than what can be repaid based on a country’s fiscal track record—is widespread among developing countries and emerging market borrowers.
On public sector collateralized borrowing, see IMF (2003d); and Chalk (2002).
Debt restructurings in the 1990s seemed to reflect an implicit, though evolving, de facto seniority structure (Zettelmeyer, forthcoming).
The IFIs (and possibly other official creditors) would be excluded from an explicit priority structure for privately held debt. This would not imply giving them legal seniority—rather, their seniority status would remain legally indeterminate with regard to the debt instruments whose seniority was governed by the new system. First-in-time seniority in privately held sovereign debt would thus have no bearing on the issue of IFI seniority.
An analogous problem is that first-in-time seniority could be undermined through collateralized debt issues. Again, this problem would have to be dealt with by explicitly limiting or ruling out such issues through provisions in bond contracts.
Such a registry has been proposed on several occasions in the past—for example, by Allen (1988); Kaeser (1990); and Eaton (2002).
