Emerging-market bond investors are being caught in something of a pincer action. Impinging from one side is the IMF: hell-bent on destroying their contractual rights and making it easier for countries to default. Closing in on the other side are the countries they’ve been lending to, and the inevitability that they’re going to default increasingly frequently. International bonds, in the wake of Ecuador and Argentina, no longer have an aura of inviolability, and rating agency Standard&Poor’s says that sovereign bond defaults are going to rise steadily for the next decade.
More profoundly, bond investors have suddenly found themselves bereft of the power and influence they wielded throughout the 1990s. Back then they had no need of institutionalized creditors’ trade associations: everybody kowtowed to them. Creditor countries would happily default to banks and other sovereigns long before contemplating defaulting on their bonds; the official sector looked at the huge private-sector capital flows going into the emerging markets and saw a future in which development was funded by the market and merely catalyzed by the Bretton Woods institutions.
Now, however, a vicious cycle has started. Crises cause capital flows to dry up; as capital flows dry up, bondholders become less important; as bondholders lose importance, they lose power and influence; and, without that leverage, bondholders are likely to continue to exit, further diminishing capital flows. The Institute of International Finance says that private creditors funded emerging markets to the tune of $207.4 billion in 1996; by 2002, net funding was actually negative by $800 million. And the “sudden stop” of private capital flows, to use the term coined by Guillermo Calvo, chief economist of the Inter-American Development Bank, only serves to make further crises even more likely.
Some economists even welcome the decline in the importance of bondholders, especially considering that the huge private-sector capital flows of the mid-1990s seem to have had little beneficial effect on the populations of the countries that were the main recipients of that cash. If bondholders lose their status through whatever mechanism, says Jeffrey Sachs, director of the Earth Institute at Columbia University, “yes, the cost of borrowing is going to go up”. But, he says, something is needed to stop rapacious creditors from destroying lives in poor countries. “There probably isn’t a country in the world which doesn’t have the capacity to repay its debt right now,” he says. “But it would be through the mass death of people in these countries. When extreme events occur, there ought to be some partial release from indebtedness.”
The official sector, as represented by such institutions as the G7, the G10 and the IMF’s International Monetary&Financial Council, has come out in favour of two different ways in which it would like to change the way that sovereign debts are restructured. One is a contractual approach known as collective action clauses, CACs, the other is a statutory approach usually referred to as SDRM (sovereign debt restructuring mechanism). Both involve weakening bondholders’ contractual rights.
CACs will almost certainly come first, and only if and when they are shown to be inadequate are borrowers and investors likely to embrace SDRM. However, as Randal Quarles, assistant secretary for international affairs at the US Treasury, says: “It would be premature for us to put down our tools on the SDRM approach at this point, because we don’t know CACs will happen.”
Both CACs and SDRM are being debated in detail at the moment, and both, according to their proponents, are win-win propositions that will benefit both debtors and creditors. But neither sovereign borrowers nor lenders seem convinced by either and both groups are particularly opposed to SDRM.
In the background is another looming political battle over increased funding for the IMF, which is an institution not much favoured by the US Congress. An IMF quota would certainly benefit both debtors and creditors but it would also involve the official sector putting its money where its mouth is in terms of building a better financial world. The US administration doesn’t want to do that.
And when international banks and bond investors see the IMF putting together a system – the SDRM – that is aimed mainly at them, they wonder how useful that would be in a situation such as that of Nigeria, whose debts are overwhelmingly to the official sector. They are even doubtful about its applicability to Brazil, whose debt, while certainly verging on the unsustainable, is mainly domestic.
At this point, they note, emerging markets are in crisis, and, in the words of Mexican central bank governor Guillermo Ortiz, “when you’re building a new architecture for a hospital, you don’t start with the morgue” – it sends completely the wrong signals.
Jacques de Larosière, the former IMF managing director now at BNP Paribas, says: “It would most unwise for the international community to build legal systems that are based on the assumption of failure and default … I am afraid it is already having negative consequences on market appetite towards emerging economies.”
That’s something the White House is afraid of. Glenn Hubbard, chairman of the president’s Council of Economic Advisers, says that the reason for the introduction of CACs or SDRM “is the encouragement of private-sector growth and private capital flows that will lift the prospects of economies around the world.” The obvious conclusion is that if the White House sees that they would increase borrowing costs or reduce capital flows it might lose faith in CACs and SDRM.
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From the point of view of Brazil, there’s no doubt that de Larosière is right and that even talk about SDRM is causing real damage. “I think it’s a real bad time to discuss debt,” says Beny Parnes, director of foreign affairs at the Brazilian central bank. “I think the SDRM is going to be the straw that is going to break the camel’s back.”
But the fact remains that many countries have issued international bonds, and that if those countries’ debts are going to be comprehensively restructured there is going to have to be a way for bondholders to participate in the process.
And once bondholders get involved, any restructuring becomes much more complicated. When Brady bonds were first introduced, they were deliberately made as difficult to restructure as possible in an attempt to maximize the cost and minimize the probability of default. Any change in their payment terms has to be approved by 100% of the bondholders, which is a functional impossibility, and payments are made through fiscal agents, who work for the issuer and have very few powers, rather than trustees, who work for the bondholders and have much more freedom.
Timothy Geithner, director of the Policy Development and Review Department at the IMF, says: “There’s something anomalous that sovereign issuers can issue at levels which imply a very high risk of default without any established mechanism for workouts.”
Because of the way that bonds are structured, there is a general assumption that any attempt at a restructuring must necessarily be prolonged and painful, because of a set of difficulties known as the collective action problem. The main components of the collective action problem are the difficulty of getting thousands (sometimes hundreds of thousands) of bondholders to agree to the same restructuring plan and the holdout, or rogue creditor, issue: the risk that a small set of bondholders will refuse to join in, and take legal action to get repaid in full according to their contractual rights.
As well as the collective action problem, the IMF is trying to solve two related issues. The first is the risk – so far never seen – of a rush to the courthouse: a situation where, when a country defaults, bondholders fall over each other to get legal judgments against the sovereign in an attempt to be able to claim for themselves whatever assets might be available. The second is the problem of aggregation: getting the holders of all of a country’s different bonds to agree on the treatment of every other bond. (After all, bondholders are only going to agree to a restructuring if they have some kind of assurance that holders of other bonds aren’t going to get a better deal.)
The problems of the rush to the courthouse and of rogue creditors can be solved with some kind of stay on legal action: a mechanism that makes it impossible for bondholders to sue defaulted sovereigns in circumstances where the country is restructuring its debt. But those problems exist only hypothetically and while the IMF is worried that they could be a major issue in future workouts, private creditors are very reluctant to see any curtailing of their contractual rights in order to solve a problem which doesn’t yet exist.
After all, legislation such as the Foreign Sovereign Immunities Act (FSIA) in the US already makes it nigh-on impossible to successfully sue and win damages from foreign countries. “You may think your contract is clear, but against the background of the FSIA, the court may not let you enforce those rights,” says Mark Rosenberg, a bondholders’ lawyer at Sullivan&Cromwell in New York.
And the official sector does seem to be coming around to understanding this. The US Treasury’s Quarles, a former bankruptcy lawyer himself, says that “when we began, I certainly thought that the disruptive litigation problem was bigger than upon examination and reflection it actually turned out to be.”
When people talk about disruptive litigation, they normally think of Michael Straus. He is one of the few lawyers to have successfully sued a sovereign: he represented the vulture fund Elliott Associates in its highly publicized action against Peru. Straus himself doubts that he has set a precedent. “Litigation against foreign sovereigns is rare and ultimately unsuccessful despite the fact that concern about litigation against foreign sovereigns seems to lie behind attempts to change the international financial architecture,” he says. Received wisdom on the Elliott case seems to be that Peru only paid out because it was in political turmoil at the time, with then-president Alberto Fujimori being deposed, and the case was seen as a distraction that was best made to go away quickly. It would be very difficult to replicate, especially by a bondholder: Elliott held not bonds but loans, which had stronger protections built in.
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Ultimately, however, the litigation problems are sideshows to the collective action problem, which is the real driving force behind the official sector’s proposals. “The current process for restructuring the debt of a sovereign needs to be improved,” the IMF says in its latest paper on the subject. “The current process imposes undue costs both to the debtor country and its creditors, because it is prolonged and unpredictable.”
But there is actually very little evidence for that assertion. The current process is certainly unpredictable but that’s really just a pejorative way of saying that it’s worked out on a case-by-case basis, and tailored to each individual crisis according to its nature. And bond restructurings so far have been anything but prolonged: Ukraine, Pakistan and Ecuador all managed successful restructurings within a year of their defaults. In contrast, the bank loan restructurings following the wave of Latin American defaults in the 1980s took much longer to work out: well over 10 years in some cases.
Certainly, insofar as a restructuring is inevitable, both creditor and debtor benefit if it happens sooner rather than later. But against that has to be measured the cost to creditors of any increased risk of default.
When Anne Krueger and Paul O’Neill replaced Stanley Fischer and Lawrence Summers as first deputy managing director of the IMF and US Treasury secretary respectively, they were adamant that the age of moral hazard was coming to an end. The IMF and its biggest shareholder, the US, would not and could not continue to come up with ever-increasing aid packages for countries in crisis.
They knew that the way they invariably dealt with crises in the late 1990s – throwing huge amounts of money at them in a bid to restore confidence – is untenable in a world where crises are sure to become both more common and more expensive. And they were worried about moral hazard, the way in which the private sector would lend to highly risky countries simply because of the perceived probability of getting bailed out should things go wrong.
Right-wing think-tanks in Washington have one easy way of solving the problem of moral hazard: abolish the IMF altogether. They see moral hazard as applying not only to private investors but also to sovereign countries, which could feel that the international community will help bear the cost of any bad political or economic decisions.
And right-wing think-tanks have a lot more sway in Washington these days than they did during the Clinton administration. Although no members of the executive branch have yet come out calling for the Fund to be abolished, they do want to keep it on a tight leash. “Limiting official resources is a key tool for increasing discipline over lending decisions,” O’Neill has said. And there seems to be no chance that the IMF will get its way in its desire for a quota increase.
It’s a key difference between the US and the IMF: the Fund wants to facilitate debt restructuring as part of a broader effort that includes a quota increase and, presumably, a concomitant increase in IMF programmes. The US, on the other hand, sees a world where private-sector debt restructuring replaces, rather than augments, bailouts.
Even private-sector analysts worry about the IMF’s propensity to bail out countries in trouble, as it has done for Turkey, Uruguay and Brazil with the cooperation of the US Treasury. “Latin America is quickly becoming the new moral hazard trade. Investors are getting four digit spreads, with an implicit triple A guarantee,” says Walter Molano, chief economist at BCP Securities. “The IMF needs to find a way to reduce its financing cost for Latin America, without creating the mess associated with a disorderly restructuring.”
When the US opposes an IMF quota increase and simultaneously supports making bonds easier to restructure, private-sector creditors can be forgiven for reading that stance as an attempt to subordinate bondholders, rather than a purely high-minded attempt to restructure the international financial architecture for the betterment of all concerned.
But bondholders’ experience in Argentina might yet bring them round to some sort of formalized debt restructuring mechanism. The IMF’s Geithner says that “the optimal point of default is probably before the point where a government wants to do it.” At the end of 2001, bondholders had long realized that Argentina’s debt dynamics were unsustainable. It is conceivable that faced with a country in a similar situation, they might want to restructure their obligations early – and ultimately preserve more value – rather than face a potentially catastrophic default such as Argentina’s.
Mexican central bank governor Guillermo Ortiz says he was told by IMF managing director Horst Köhler that the Fund wanted to introduce SDRM in the form of a package, along with a quota increase. Ortiz adds that the G7 generally, and the US Treasury specifically, didn’t want that, and ended up separating the two issues.
In doing so, the G7 has lost a lot of goodwill with bondholders. “Relations between the private sector and the official sector are rotten,” says Lacey Gallagher, co-head of Latin American research at CSFB.
IMF and G7 officials often sound very frustrated with the private sector’s response to their proposals, saying that if only the bondholders understood the issues, they would come to see that they were in their best interests.
That’s where the academics come in. Barry Eichengreen, especially, of UC Berkeley, has published a series of papers with somewhat counterintuitive conclusions. Countries which have defaulted in the past don’t have any higher borrowing costs than those which have stayed current; instruments which are easier to restructure have lower borrowing costs than those without work-out mechanisms; and even building provisions for a complete stay on litigation into bond contracts reduces the yields on those bonds.
Few people in the bond markets really believe those conclusions, however, at least not to the point at which they’ll be willing to risk their livelihoods on them. It’s now up to the official sector to persuade the private sector of the desirability of debt restructuring mechanisms. For, as the IMF’s Geithner says, “it’s not going to happen unless we can be credible in convincing the major investors and the major issuers about the merits of this alternative.”
