The Objective

The objective of an SDRM is to facilitate the orderly, predictable, and rapid restructuring of unsustainable sovereign debt, while protecting asset values and creditors’ rights. If appropriately designed and implemented, such a mechanism could help to reduce the costs of a restructuring for sovereign debtors and their creditors, and contribute to the efficiency of international capital markets more generally.

Use of the mechanism would be for the debtor country to request; and not for the IMF or creditors to impose. If the debtor and creditors were able to agree a restructuring between themselves, they would of course be free to do so without having to invoke the mechanism. Indeed, the intention is that the existence of a predictable legal mechanism will in itself help debtors and creditors to reach agreement without the need for formal activation.

It is envisaged that a sovereign debt restructuring mechanism would be invoked only in very limited circumstances. Specifically, when the debt burden is clearly unsustainable. In other words, the mechanism would be invoked where there is no feasible set of sustainable macroeconomic policies that would enable the debtor to resolve the immediate crisis and restore medium-term viability unless they were accompanied by a significant reduction in the net present value of the sovereign’s debt. In such cases, the country concerned would probably already have been implementing corrective policies, but would have reached the point where financial viability could not be restored without a substantial adjustment in the debt burden. Countries that are judged to have sustainable sovereign debt burdens may on occasion need to approach their creditors for a reprofiling of scheduled obligations. But it is not intended that an SDRM should be used for such cases.

There are two key challenges to the successful design and implementation of an SDRM. The first is to create incentives for debtors with unsustainable debt burdens to address their problems promptly in a manner that preserves asset values and paves the way toward a restoration of sustainability and growth, while avoiding the creation of incentives for the misuse of the mechanism. The second is to design the mechanism so that, once activated, the relative roles assigned to the sovereign debtor and its creditors create incentives for all parties to reach rapid agreement on restructuring terms that are consistent with a return to sustainability and growth. The policies of the IMF regarding the availability of its resources before, during, and after a member seeks a restructuring of its debt currently play a critical role in shaping these incentives. This would remain the case under an SDRM, whatever shape it were to take.

If an SDRM were designed and implemented in a manner that achieved an appropriate balance of incentives, it would provide a number of benefits. Debtors would benefit from addressing their unsustainable debt burdens at an early stage, thereby avoiding the exhaustion of official reserves and unnecessarily severe economic dislocation. They would also benefit from a greater capacity to resolve collective action problems that might otherwise thwart a rapid and orderly restructuring. Most creditors would also gain if the debtor acted before it had dissipated its reserves and would benefit from the resolution of collective action problems that would otherwise impede a sustainable restructuring. Moreover, creditors would benefit from the creation of a predictable restructuring framework that provides assurances that the debtor will avoid actions that reduce the value of creditor claims. Finally, if an SDRM is sufficiently predictable, it will help creditors make better judgments regarding how any restructuring will take place and the recovery value of the debt. This should make sovereign debt more attractive as an asset class, increase the efficiency of international capital markets, and result in a better global allocation of capital.

The Problem

Developments in the composition of international sovereign borrowing over the past decade—notably the shift away from syndicated bank loans toward traded securities as the principal vehicle for the extension of financial credits to sovereigns—have improved the efficiency of international capital markets. In particular, they have broadened the investor base for financing to emerging market sovereigns and have facilitated the diversification of risk. But the increasingly diverse and diffuse creditor community poses coordination and collective action problems in cases in which a sovereign’s scheduled debt service exceeds its payments capacity. This leads to considerable uncertainty among all participants as to how the restructuring process will unfold, and contributes to reluctance by the sovereign, its creditors, and the official sector to pursue a restructuring, other than in the most extreme circumstances. This, in turn, increases the likely magnitude of the loss of asset values, which is harmful to the interests of both debtors and creditors.

During the 1980s debt crisis, collective action problems were limited by the relatively small number of large creditors, the relative homogeneity of commercial bank creditors, the contractual provisions of syndicated loans,¹ and, on occasion, moral suasion applied by supervisory authorities. Incentives for collective action were reinforced by banks’ interest in maintaining good relations as a means of safeguarding future business. Discussions between the sovereign and its creditors generally took place within a collective framework, with the major creditors negotiating through a steering committee. During the negotiations, the committee performed a number of functions, including the resolution of intercreditor problems, the assessment of the acceptability of the offers made by the sovereign, and the preservation of confidentiality. Moreover, the provision of new financing was facilitated by an agreement between the committee and the debtor that any financing provided after a specified date would be excluded from any future restructuring. This provided a basis for banks both to extend medium-term credits and to provide normal trade financing.

The move away from commercial bank lending as a source of external finance for emerging market sovereigns has made the coordination of creditors much more difficult than it was in the 1980s. Many creditors have no ongoing business relationship with the debtor to protect and are not subject to suasion by the official sector. The number and diversity of creditors has increased, with an associated increase in the diversity of interests and appetite for risk. These changes have been accompanied by an increase in the complexity of creditor claims. These developments have made creditor organization more complicated. A sovereign restructuring may require coordination across many bond issues, as well as syndicated loans and trade financing. This organization problem has been exacerbated by the repackaging of creditor claims in ways that separate the interests between the primary lender (the lender of record) and the end-investor (the beneficiaries that hold the economic interest).

Sovereigns with unsustainable debt burdens and a diffuse group of creditors can face substantial difficulties getting creditors collectively to agree to a restructuring agreement that brings the sovereign’s debt down to a sustainable level. In particular, it may be difficult to secure high participation by creditors in a debt restructuring that would be in the interest of creditors as a group, as individual creditors may consider that their best interests would be served by trying to free ride in the hope of ultimately receiving payments in line with their original contracts. Both fears of free riding and other issues of intercreditor equity may inhibit creditors from accepting a proposed debt restructuring, prolonging the restructuring process and making it less likely that a deal will achieve the objective of restoring sustainability.

The absence of a mechanism that provides for majority action among a diverse set of creditors is a primary source of difficulties with collective action. Currently, a sovereign that obtained the support of a qualified majority of its creditors for a restructuring that could restore sustainability would lack the ability to bind in a minority that may hope to free ride and continue to receive their contracted payments.

Ideally, a country with an unsustainable debt would be able to reach agreement with its creditors on a needed restructuring prior to suspending payments and defaulting. But, in the current environment, it may be particularly difficult to secure high participation from creditors as a group, as individual creditors may consider that their best interests would be served by trying to free ride in the hope of ultimately receiving payments in line with their original contracts. If more than a small proportion of creditors attempt to free ride, a restructuring would not succeed in bringing debt to a sustainable level, and a default may be unavoidable. These difficulties may be amplified by the prevalence of complex financial instruments, such as credit derivatives, which in some cases may provide investors with incentives to hold out in the hope of forcing a default (thereby triggering a payment under the derivative contract), rather than participating in a restructuring. Difficulties in securing agreement on a needed restructuring prior to a payments suspension also may undermine confidence in the domestic financial system (to the extent that domestic banks have significant holdings of government securities) and may even trigger an unmanageable deposit run.

If a restructuring cannot be achieved prior to a default, collective action problems may still arise as creditors may decide to hold out in hope of a more favorable settlement, possibly through resort to litigation. To date litigation against a sovereign has been relatively limited and there is inadequate evidence to suggest that the prospect of such litigation will invariably undermine the sovereign’s ability to reach an agreement with a majority of its creditors. Litigation is not an attractive option for many creditors. It is costly and may give rise to concerns relating to reputation damage. Potential holdouts face significant uncertainty regarding whether the debtor would be willing to make a more attractive offer to non-participating creditors. Nevertheless, the evolution of legal strategies has increased the uncertainties of postdefault restructurings. For example, the recent legal action against Peru may make potentially cooperative creditors nervous about participating in a future restructuring agreement. They may be worried that a holdout will be able to extract full payment from a sovereign by, for example, threatening the interruption of payments on the restructured debt.

In addition to difficulties securing collective action, creditors have identified other factors that they consider hamper the prospects for rapid progress toward predictable and orderly restructuring agreements. In particular, concerns about intercreditor equity stemming from debtors’ decisions to make payments to certain favored creditors after suspending payments on other creditors may introduce delays. Creditors have also pointed to the reluctance of debtors to participate in a collaborative dialogue to develop restructuring proposals. The design and implementation of more efficient mechanisms for resolving collective action could also catalyze the establishment of a more collaborative framework for debtor-creditor negotiations.