As previously argued, a case can be made that the international financial institutions (IFIs) have not yet fully adjusted to the post-Bretton Woods world of massive private capital flows that dwarf the limited resources of the official sector. Lacking the instruments and frameworks to fully assist their members strike the right balance between financing and adjustment, the institutions have been less than fully credible and effective in dealing with the capital account crises of today. The result has been disenchantment with the IFIs, whose legitimacy is questioned. Viewed in this perspective, improving the framework for the resolution of financial crises and promoting the timely, orderly restructuring of sovereign debt are critical objectives in international architecture reform.
Two previous posts discussed a potential source of failure in the “market” for timely, orderly sovereign debt restructuring and the use of debt buy backs to reduce the outstanding stock of debt.
The first post argued that the absence of complete state contingent contracts and the inability of sovereign borrowers to credibly bind themselves to upside growth potential prevents efficient re-contracting of sovereign debt. Now, some will argue that state contingent contracts already exist in the form of GDP-linked instruments that reduce payments under bad states of the world when growth falls below some threshold. While such contracts have indeed been issued, there are limits on their potential use. My reservations do not reflect limitations on contract design, but uncertainty regarding the monitoring, verification and enforcement of such debt: a government will always want creditors to share in “bad” states; it is less clear that governments will be equally prepared to share in good states. In this respect, the feasibility of these instruments hinges on enforceability and sovereign immunity. I could well be proven wrong, but I suspect that once we have a full cycle experience with these instruments, they will be viewed, in effect, as insurance contracts for “bad” states; being insurance contracts, investors will price ex ante them so as to extract the necessary premium. As a result, they will carry a fairly substantial premium over plain vanilla instruments, which may be subject to ex post re-contracting. Governments may be unwilling to issue bonds that carry high premiums today to insure against possible bad states tomorrow, particularly when another government may be in charge!
The second post noted that debt buybacks, which sound like a good idea, can have unintended effects, including the transfer of risk from private creditors (who implicitly assumed higher risk as the quid pro quo for higher interest payments) and inadequate risk mitigation measures. Buybacks could also undermine the efficiency of global bond markets. As luck would have it, shortly after that post was written the Greek government undertook a debt buyback as part of its end-November agreement with the “Troika.” That being said, the debt buyback could be justified on two grounds: first, if the bonds are purchased from Greek banks, it could make the system more robust to future shocks (including another round of debt reduction that pulls in official sector claims?) and foster expanded lending to the private sector; and, second, that progress on reducing the debt/GDP level buttresses confidence and leads to higher investment. While the first may have merit, given the continuing depressed state of the economy and the very considerable uncertainty regarding the sustainability of the adjustment effort, the second argument seems something of stretch.
But if debt buybacks are problematic, what else can be done to improve the framework for the restructuring of sovereign debt?
One possible option is a loan guarantee offered in the context of an exchange of old debt for new, restructured debt with a lower net present value (NPV). This approach has been used in the case of a debt restructuring by St. Kitts, with the loan guarantee provided by the Caribbean Development Bank. The role of the guarantee is to “grease the wheels” of the debt restructuring process by providing an assurance to creditors taking a haircut (or NPV reduction) that the restructured debt is less risky. Providing this assurance could induce creditors to accept a larger haircut, either in the form of a greater reduction in the face value of the claim or a lower coupon rate.
No Risk Transfer
Given the nature of the intended use — to support a timely, orderly debt restructuring that returns a country to sustainability — and the fact that there is an issue of "willingness" as well as "ability" to service debts, access to the facility would clearly have to be rigorously controlled. The objective, after all, is not to allow the transfer risk or undermine the bonding role of debt by allowing recalcitrant borrowers to evade payments discipline. The goal, rather, should be to facilitate the timely, orderly restructuring (or “re-contracting”) of debt that is not state contingent.
The choice of quantum or size of the guarantee is critical. Securing the public policy objective requires a judicious balancing between providing incentives to participate in a debt restructuring, on the one hand, and the need to guard against the transfer of risk, on the other. In the case of St. Kitts, the CDB provided a $100 million guarantee, in total, but it was on a revolving and renewable basis. Essentially, if a coupon payment is missed the rest of the guarantee is immediately voided. And, even if there is no missed payment, the guarantee must be renewed every 24 months. This ensures that the guarantee is subject to cancellation if the outlook was sufficiently negative, or the authorities have failed to follow through on important policy adjustments. As a result, despite the “headline” figure of $100 million, the rolling exposure of the CDB is capped at $7-10 at any point in time, determined by the interest and amortization schedule.
An obvious means of preventing risk transfer is to require the sovereign to post collateral. (But most distressed debtors lack collateral — err, that’s why they are borrowers.) Some, with steady income streams from natural resources for example, could collateralize the income stream by allocating revenues to an escrow account accessible by the IFI providing the guarantee.
Of course, not all countries have the resources or the capacity to bind themselves in this manner, while the collateralization of a revenue stream may be too great an infringement on national sovereignty. In these cases, an IMF Fund program is clearly the starting point. The goal of IMF engagement is to identify a set of policy measures that raise the potential growth rate of the economy, raising the debt-servicing capacity and thereby ensuring a positive debt sustainability analysis (DSA). Beyond that, however, it might be sensible for a program supporting a debt reduction guarantee to be subject to a higher standard—for want of a better term, call it a "super-sustainable" DSA. This would be a program that, rather than balancing on some knife edge of sustainability with respect to expected growth, interest rates, etc., is robust to much greater shocks (think in terms of standard deviation confidence intervals) in lower growth or higher interest rates. Absent a debt restructuring, such a program would clearly run counter to the objective of the IMF in assisting its members strike the right balance between financing and adjustment. But, with a sizeable enough debt restructuring, the implicit adjustment required of the member would be reduced commensurately.[1]
The member would also have to earmark revenues to a debt servicing fund (either held in escrow or over which sovereign immunity to creditor attachment is specifically waived). Of course, if the program works and realized shocks are not as severe as factored in the “super-sustainability” DSA exercise, excess revenues would be freed up for social spending, investment, etc. (perhaps only after a stockpile of two-years’ interest payments as been accumulated).
Risk Mitigation
The role of the trust fund is to guard against risk transfer — creditors would be bearing risk, through the NPV reduction, while the sovereign borrower would be undertaking adjustment effort sufficient to protect the balance sheet of the IFI providing the guarantee. At the same time, the guarantee could be designed to further the goal of risk mitigation.
In particular, the debt restructuring guarantee could be written so that payments made by the IFI under a guarantee contract automatically convert to a loan subject to the preferred creditor convention, by which IFIs enjoy a senior status over other unsecured creditors. At the same time, the guarantee should be priced at the same rate as a loan on amounts extended, but with a higher commitment fee charged to create an incentive to make scheduled payments.
Principles of Debt Restructuring
A debt reduction guarantee can also be used to advance key principles of efficient debt reduction — debt reduction operations that preserves the bonding role of debt while providing incentives to the sovereign borrower to implement sound policies that preserve asset values and “grow the pie” to the benefit of taxpayers and private creditors alike. In this respect, one way to think about the use of the guarantee is as a credit enhancement to meet thresholds in collective action clauses. Perhaps of most importance is the need to preserve inter-creditor equity — similar creditors should receive similar treatment — in the context of voluntary debt exchanges. This does not imply equal treatment to all creditors. The rights of senior creditors should not be subordinated to junior creditors. But, because the guarantee would be offered in the context of voluntary exchanges, the rates at which different classes of debt are exchanged for the new debt would reflect these differences in seniority.
Discussion
If thoughtfully designed so as to avoid risk transfer, to facilitate effective risk mitigation and to promote sound principles for debt restructuring, a debt reduction guarantee may not pose any more risk than the status quo; indeed, it likely poses the same risk to the IFI but yields a Pareto improvement: under the status quo, with insufficient debt restructuring, the IFI would be “catalyzed” to provide policy-based lending in order to close the financing gap. But because debt owed to an IFI is still debt, the net result would be increased IFI indebtedness, without enhancing fundamental growth prospects, thereby increasing the likelihood of a subsequent debt problem, while subordinating remaining private sector exposure through the preferred creditor convention. The country could be unambiguously worse off, while private creditors are (possibly) harmed — I’d argue certainly no better off — and the IFI is indifferent (assuming its preferred creditor status is upheld). If someone is made better off and nobody is made worse off, we have a Pareto improvement with the guarantee.
As I see the concept, the goal is to help “complete” financial markets or, alternatively, bridge a contracting divide that results from a sovereign borrower’s ability to credibly pre-commit to sharing upside outcomes. Absent that gap, a sovereign could ask its creditors to provide bigger up front debt relief today in return to sharing in upside potential in the future. And, of course, if the market for state-contingent contracts does develop sufficiently, the need for a debt restructure guarantee would diminish.
For IFIs that are looking to remain relevant in a world of large private capital flows and middle-income members that are ‘graduating’ from a traditional borrower relationships, an instrument that allows them to better assist their members deal with the vagaries of the global capital market might be attractive.
The effectiveness of a limited guarantee of the kind considered here could be questioned. What would a limited, two-year rolling guarantee do to improve the efficiency of the ‘market’ for the timely, orderly restructuring of sovereign debt? The answer, I think, is that such a facility would greatly assist in the renormalization of credit market access by restoring the liquidity and allowing investors unwilling to assume the risk to sell their asset to investors that are prepared to accept the risk. This should promote more stable financial market conditions, with beneficial effects for the economy as spreads narrow, confidence is restored. Moreover, there is a basic question to be addressed: would a creditor be prepared to voluntarily accept a bigger haircut for certainty of income stream (even if it is a revolving two-year guarantee)? Any risk adverse investor will be prepared to accept a lower, more certain income stream for a higher, less certain one. This point bears emphasis: for creditors contemplating a debt restructuring exercise, there is always uncertainty about future outcomes.
But not all investors are risk adverse. There are investors with a higher tolerance for risk that are prepared to act opportunistically to extract higher payments. For this reason, work should continue apace on efforts to construct a better framework for the timely, orderly restructuring of sovereign debt.
The next installment in this series will explore a proposal to develop a Sovereign Debt Forum that would help facilitate voluntary restructurings by promoting full information and building up a ‘quasi-jurisprudence’ of best practice.
To be continued…
[1] A possible beneficial effect of this approach is that the reduction in the stock of debt, combined with the dissipation of uncertainty regarding future sustainability, could have a felicitous effect in reducing the option of value of waiting and stimulating private sector investment.
