Greater integration of capital markets and the shift from syndicated bank loans to traded securities have had a profound impact on the way that emerging market sovereigns finance themselves. Sovereigns increasingly issue debt in a range of legal jurisdictions, using a variety of different instruments, to a diverse and diffuse group of creditors. Creditors often have different time horizons for their investment and will respond differently should the sovereign encounter a shock to its debt servicing capacity. This is a positive development: it expands sources of sovereign financing and diversifies risk.

But the greater diversity of claims and interests has also made it more difficult to secure collective action from creditors when a sovereign’s debt service obligations exceed its payments capacity. This has reinforced the tendency for debtors to delay restructuring until the last possible moment, increasing the likelihood that the process will be associated with substantial uncertainty and loss of asset values, to the detriment of debtors and creditors alike.

During the past several years there has been extensive discussion inside and outside the IMF on the need to develop a new approach to sovereign debt restructuring. There is a growing consensus that the present process for restructuring the debts of a sovereign is more prolonged, more unpredictable and more damaging to the country and its creditors than would be desirable. Exploring ways to improve the sovereign debt restructuring process is a key part of the international community’s efforts to strengthen the architecture of the global financial system.

The absence of a predictable, orderly, and rapid process for restructuring the debts of sovereigns that are implementing appropriate policies has a number of costs. It can lead a sovereign with unsustainable debts to delay seeking a restructuring, draining its reserves and leaving the debtor and the majority of its creditors worse off. Perhaps most crucially, the absence of a mechanism for majority voting on restructuring terms can complicate the process of working out an equitable debt restructuring that returns the country to sustainability. The risk that some creditors will be able to hold out for full payment may prolong the restructuring process, and even inhibit agreement on a needed restructuring. The absence of a predictable process creates additional uncertainty about recovery value.

This paper seeks to outline the broad features of an improved sovereign debt restructuring process that would address these shortcomings. A sovereign debt restructuring mechanism (SDRM) should aim to help preserve asset values and protect creditors’ rights, while paving the way toward an agreement that helps the debtor return to viability and growth. It should strive to create incentives for a debtor with unsustainable debts to approach its creditors promptly—and preferably before it interrupts its payments. But it should also avoid creating incentives for countries with sustainable debts to suspend payments rather than make necessary adjustments to their economic policies. Debt restructuring should not become a measure of first resort. By the same token, however, when there is no feasible set of policy adjustments to resolve the crisis unless accompanied by a restructuring, it is in the interests of neither the debtor nor the majority of its creditors to delay the inevitable.

Of course, difficulty in securing collective action is only one of a number of factors that have made sovereigns extremely reluctant to restructure their debt. Even if mechanisms for debt restructuring are improved, concerns about economic dislocation, political upheaval and long-term loss of access to capital markets will make countries loath to default on their debt service obligations in all but the most extreme circumstances. As a result, it is very unlikely that alleviating the collective action problem somewhat would significantly weaken the credit culture or create moral hazard.

The paper begins by establishing the case for improving the present framework for sovereign debt restructuring and then sets out the core features that any new approach would need to include. It then discusses the relative roles that the International Monetary Fund and private creditors could play in an improved mechanism. Finally, before concluding, it discusses the circumstances when exchange controls may need to be relied upon in the context of the resolution of financial crises.