Sovereign debt restructuring: the row rumbles on

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The IMF’s ambitious plan to flesh out new sovereign debt restructuring plans is laudable, but it faces strong opposition from EU policymakers, adding more uncertainty to the asset class, as fears grow of official sector restructuring in Greece.

With a Greek official sector involvement (OSI) potentially inching closer – you won’t hear EU policymakers admit that, of course – a split has emerged over IMF proposals to overhaul sovereign debt restructurings. The dispute underscores the perennial battle to flesh out ex-ante sovereign debt restructuring principles in a harmonized framework. What’s more, the mission sits awkwardly with the self-interest of many governments to operate under the twin principles of ‘constructive ambiguity’ and ‘benign neglect’ when it comes to telling market players about credit hierarchy norms and the legal redress in sovereign bond restructuring.

In a sense, the IMF is seeking to lead the debate, after coming under fire for mishandling its debt sustainability analyses on Greece, which gave EU policymakers the political cover to postpone restructuring of the country’s sovereign debt until last year – but at a much higher cost.

The European Commission and the European Central Bank feared that early restructuring would ease the pressure on Greece to reform and spark contagion in other heavily indebted eurozone economies. They were also worried about the impact of losses on European banks highly exposed to Greek sovereign debt.

What happened instead: the €107.3 billion Greek loan facility of 2010 and the March 2012 European Financial Stability Facility/IMF €130 billion financial assistance programme – bailouts that failed to produce the fiscal sustainability they were supposed to deliver.

As a result, the EU-IMF has been forced to extend by a further two years the time Greece has to meet the fiscal targets set by its bailout programme.

A private-sector involvement (PSI) deal last year, in which €197 billion of bonds were exchanged for discounted bonds with longer maturities, means that Greece’s mostly official-sector debt is one of the last barriers to it regaining market access. In December, official-sector loans were extended and interest rates modified.

And a possible OSI, in which countries that have lent to Greece or other economies accept losses, always something of a taboo issue, is now being openly discussed. That would expose the IMF itself to restructuring as eurozone countries are unlikely to accept write-downs while the IMF is paid in full.

The IMF has tried to distance itself from the debacle and has now made a number of proposals as to how sovereign debt crises should be handled in the future, for the official and private sector.

The most noteworthy is that, unlike with Greece, when there are liquidity or solvency problems, debt should be restructured before any bailout. Others include amending the European Stability Mechanism Treaty to suspend litigation by investors, a European crisis resolution mechanism, and flirting with the sovereign debt restructuring mechanism (SDRM), a statutory mechanism to deal with insolvencies that was scrapped in 2003 after US opposition.

One potentially powerful IMF recommendation is the use of single-step aggregation clauses in sovereign bonds to address holdout creditors in restructuring, compared with the eurozone model of two-step collective action clauses (CACs). In the IMF’s view, a one-step aggregation would allow modifications across multiple bond issues irrespective of the tranche, subject to voting thresholds, while CACs typically require an additional vote within each bond series subject to restructuring.
 
The IMF’s proposals have been largely greeted favourably by the market, but a few observers reckon they run the risk of being too prescriptive.

“There is definitely a good case for at least a framework for how to deal with these sovereign restructurings. Some of these, in my view, go a bit too far in terms of having a very strict structure,’’ says Raoul Ruparel, head of economic research at Open Europe. “I think one thing we learned from looking at different countries' debts in the euro crisis is that what’s right for Greece probably wouldn’t have been right for Cyprus. There are a lot of problems that aren’t captured by these solutions, so trying to push this strict structure forward might gloss over bigger issues that have caused dividing lines.’’

Ruparel says one glaring omission is that the framework does not address the legal distinction between bonds issued under domestic law and those issued under foreign law, which was an issue in Cyprus and might prove to be so for Slovenia, which is next in line for a Troika bailout.

“There needs to be more account taken of the nuances of each country’s bond market,” says Ruparel. “If you look at where the problems arose in the crisis a lot of what they’re trying to tackle here is tinkering around the edges of what was fundamentally a political issue and the nuances of each country such the amount of debt held in the banks and what law it was held under. These are practical obstacles that I don’t see these mechanisms solving.’’

According to research conducted by Exotix in London, earlier restructuring in Greece would have resulted in an earlier reduction in debt-service payments, a lower fiscal deficit, a shorter, milder recession, and smaller amounts required to recapitalize banks.

Bonds issued under domestic law can be easily written down through parliamentary decrees to facilitate restructuring. Greece’s parliament took the unprecedented step of legislating retroactively to implement collective CACs on the 90% of outstanding bonds issued under Greek law, paving the way for the PSI restructuring.

But countries that have issued under UK or US law must go through the courts in those jurisdictions, where they might be subject to legal challenge. Smaller economies often issue under foreign law to provide additional reassurance to international investors.

That can backfire for lenders. Holders of bonds issued under US law by Argentina have been challenging a restructuring in the courts since 2005, recently winning a judgment that holdout creditors must receive equal treatment to bail-ins. Pending appeals, this means creditors that agreed to restructuring, and their intermediaries, can no longer receive payments unless the holdouts are also paid – which Argentina has vowed never to do.

“The one thing we’ve learned is that you really need properly functioning CACs. If you look at a lot of the difficulties in getting coordination in the crisis – and also in Argentina – a lot of it is down to not having CACs in the bonds,’’ says Gabriel Sterne, senior economist at Exotix. “I think in Europe they were just too arrogant to bother with proper CACs on all of the domestic bond issues. In the case of Greece, the law was changed after the event at the recommendation of the IMF, which was pretty low down.”

Sterne adds: “The SDRM and the other proposals are all good ideas, but the bottom line is that the IMF procrastinated and did fantasy projections.’’

He concludes: “It’s all very well creating an infrastructure around making it easier to restructure, but what’s the point if you make up the numbers in the first place, say ‘Greece is not a restructuring situation’ as [former IMF chief] Dominique Strauss-Kahn did, and engage in quite reprehensible forecast massaging at the time.’’

Sovereign debt plans need to strike a balance between the rights of borrowers and creditors, but at a time when the asset class is in funk it’s easier said than done. 

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