End of the road for sovereign debt consensus

The nature of sovereign debt reschedulings is changing as private sector bail-ins of diverse groups of bondholders replace the Brady-style deals that used to be negotiated between borrowers and tight groups of creditors. Lawyers have their work cut out.

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Brady bonds and disintermediation have transformed the sovereign debt market and, as a result, sovereigns Wnding themselves in diYculties have had to engage in a process of dialogue with as wide an investment community as possible. Unfortunately, parallel shifts in this market mean that the opportunities for dialogue in sovereign reschedulings are being eroded and the future for these deals is hard to predict.
By the mid-1990s, it would be fair to say that the
Brady process of resolving government debt defaults had been successfully established. Brady deals, which were enthusiastically taken up by non-bank bond market investors, had become the expected restructuring package. Poland, Bulgaria, Mexico, Brazil and Argentina were all examples of countries where, to a greater or lesser extent, this technique had proved successful. These deals were put together by committees, with discussion and negotiation underpinning their entire framework (much as their predecessors, Baker deals, had been handled). CliV Godfrey, partner at CliVord Chance with some 20 years' experience advising creditors' committees in debt reschedulings, says: "In a typical Brady deal, discussions were held between the lenders and the debtors on the process to be followed and the desired solution. Term sheets are drafted, roadshows put together and the deal documented and sold." But all that is changing. "We are now deWnitely beginning to see the fragmentation of that consensual approach."The roots of this fragmentation can be found in the Mexican crisis of 1995. Mexico, which had itself been the Wrst and most public Brady deal, had run up a substantial short-term debt position in the international capital markets, which alongside its peso/dollar peg, had given rise to a volatile cocktail. The public sector met this head-on with a new approach - instead of following the consensual Brady approach, a massive bail-out package was assembled, funds were pumped in and all the most important and immediate contractual obligations were satisWed. Basically, private creditors were paid oV. In short, a rapid (and politically expedient) Wx had been achieved. A couple of years later, in the fallout from the Asian Wnancial crisis, when the South Korean debt crisis blew up, the public sector once again came up with a cash bail-out package - but this time around, it included a "bail-in" of the private sector. The short-term exposure of foreign banks to the South Korean banks was initially rolled over and eventually exchanged for longer-dated Wnancial instruments with a South Korean government guarantee. "'And herein lies the genesis of the position we see today," says Godfrey. "South Korea was followed by Thailand and Indonesia, both of which were approached in the same way by the IFIs, attempting to bind in the private sector investors who now comprised a signiWcant proportion of those exposed to each new crisis".Debate had turned to the best way of "bailing in" the private sector, or as Godfrey says: "How can the public sector induce the private sector into restructuring deals and how can the majority of the private sector force deals onto the minority?"This marked a radical move away from the previous, market-driven approach to resolving these deals, wherein negotiation with the major creditor groups - that is to say, with the Paris Club (governments); the London Club (private sector Wnancial institutions); trade suppliers; and international Wnancial institutions (IFIs) such as the EBRD, the World Bank and the ADB - had been the established method. Post-1995, the market had changed - the categories of private-sector creditors had diversiWed and the change in identity of the economic holders of government bonds had become the key issue. Put bluntly, commercial banks are relatively malleable - the position with respect to private investors is not yet clear.Instead of Wnancial institutions being able to follow the traditional route of resolution through negotiation, the changed proWle of the bondholders meant that governments and IFIs were beginning to require solutions. Discussion alone would not win the day, as Andrew Yianni, Godfrey's fellow partner at CliVord Chance specializing in sovereign debt reschedulings, goes on to say: "If the creditor community is not to be alienated, it is still necessary that there should be an early engagement in constructive dialogue. That process needs now, even more so than in the 1980s, to be conducted on as inclusive an approach as is practicable."The new climate is a precarious one. Defaulting governments need to restore credibility, but they will be unlikely to do so without discussion with their creditors - and it is exactly this discussion-based process that is in danger of being eroded by the new public-sector approach evidenced in some recent reschedulings. This trend sits uneasily with the sea change in the Wnancing of emerging market infrastructures - from the public to the private sector. Private sector conWdence has to be there before inward investment will take place - and if debt reschedulings are not handled through discussion, this is unlikely to be encouraged. CliV Godfrey goes on to say: "If the future Wnancing needs of emerging market countries are to continue to be met by the private sector, the IFIs and the Paris Club could usefully devote more attention to restoring credibility." It is hard for banks to predict where this is all heading - the market is deWnitely in Xux. Other deals, ongoing or recently resolved, have been falling midway - in 1999 Pakistan was resolved partly by unilateral oVer and partly through discussion, but, in contrast, Ukraine was recently resolved commercially by a group of banks between themselves. And it is equally hard for the debtors themselves. With a market in active evolution, they should be mindful of the fact that trying to reach a point where they can negotiate with a creditor committee that is representative of the disparate interests involved will be increasingly challenging.And, of course, the future will be no more clear-cut for the lawyers - both those advising the debtors and those advising the creditors. Besides Eurobonds, the range of obligations owed to private-sector participants has proliferated as new types of instrument have come into the restructuring debate (including debt-repackaging arrangements and various types of credit derivatives). Each raises intricate legal considerations and could considerably complicate the voluntary resolution of sovereign Wnancial crises, so far as the private sector is concerned. For example, with repackaging so well established among Wnancial intermediaries, the resulting layering of structures creates economic interests in favour of other investors, which creditors must then take into account in any future rescheduling. Concludes Yianni: "This is just one more issue in a changing market which will aVect creditor behaviour, and will - as a consequence - need to be thoroughly understood by sovereign obligors and others."

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End of the road for sovereign debt consensus

The nature of sovereign debt reschedulings is changing as private sector bail-ins of diverse groups of bondholders replace the Brady-style deals that used to be negotiated between borrowers and tight groups of creditors. Lawyers have their work cut out.

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