Speech

Preventing and Resolving Financial Crises: The Role of Sovereign Debt Restructuring, Speech by Anne Krueger, First Deputy Managing Director, IMF

July 26, 2002

1. Introduction

Mr Chairman. Ladies and Gentlemen.

It is a great pleasure to be here today and a great honor to be giving the Carlos Diaz-Alejandro lecture, my colleague and friend from whom I learned a great deal. In an appreciation written shortly after Diaz-Alejandro's death in 1985, Charles Kindleberger recalled that he took pride in telling his fellow economists that he was a Populist. But, Kindleberger added, he did not blame the problems of the Third World exclusively on the north, the World Bank, or even the IMF. Coming from the north, and having worked for both, I take some comfort from that!

Diaz-Alejandro had a life-long interest in policy questions. The subject I want to talk about today is a policy question that Diaz-Alejandro was one of the first to address in the 1980s: namely how to help countries struggling under the burden of unsustainable debts.

I first mooted the possibility of a new approach to sovereign debt restructuring late last year, since when there has been a lively debate on the subject among policymakers, academics, non-governmental organizations, and the private creditor community. I have been gratified to find widespread agreement on the nature of the problem we have to tackle: namely that we lack adequate incentives for orderly and timely restructuring of unsustainable sovereign debts. Under the current unstructured arrangements, the international community is all to often confronted with a choice between accepting a disruptive and potentially contagious unilateral default, or bailing out private creditors and thereby contributing to moral hazard.

As Finance Minister Malan said at the spring meeting of the International Monetary and Financial Committee in April: "When an external debt restructuring cannot be avoided, it is important to minimize the costs of such a painful process for all involved — the country concerned, its creditors, the other debtor countries in the same class, and the international community". I very much agree.

At that meeting of the IMFC, the international community endorsed our view of the problem and backed further work on a twin-track approach to tackling it:

• First, a contractual approach involving more ambitious use of collective action clauses in sovereign bond contracts that limit the ability of dissident creditors to stand in the way of a widely-supported restructuring.



• Second, a statutory approach in which a super-majority of creditors — not the Fund — could be empowered to reach agreement with a debtor country and make the terms of a restructuring legally binding on all creditors.

Views differ on the relative merits of these two approaches. But we see them as complements rather than competitors — and we are pressing ahead with work on both in the run-up to our annual meetings in the fall. What I would like to do today is to discuss the rationale for reform, before turning to the key features of the contractual and statutory approaches. I will conclude by putting the topic in the broader context of our crisis prevention and resolution work. My bottom line is that emerging market countries have nothing to fear and much to gain from reform along these lines.

Before I start, I should emphasize that reforming the sovereign debt restructuring framework will not be a quick process. Much more work needs to be done on the details, and the statutory approach at least would likely need the formal approval of the international community through an amendment of the IMF's Articles of Agreement. So nothing I say today should be seen as a comment or recommendation on the handling of current sovereign debt problems in Argentina or elsewhere.

2. Why Emerging Markets Would Benefit from Reform

Let me begin by describing what we see as the problem and why in particular emerging market countries are disadvantaged by it.

The world of emerging market finance has changed dramatically since the debt crisis of the 1980s. Capital markets have become more integrated and countries have turned to bond issues rather than syndicated bank loans as their principal means of raising finance. Sovereign borrowers now issue debt in a range of legal jurisdictions, using a variety of instruments, to a diverse and diffuse group of creditors.

Emerging market countries have benefited from this evolution. It has widened the sources of finance available to them, helping to support investment and growth. Investors have benefited too, as it has made it easier for them to diversify risk.

But an increasingly diverse and diffuse creditor community has also created greater problems of coordination and collective action if and when it become necessary to restructure a country's debt. The change in the creditor base also hampers restructuring by exacerbating concerns about inter-creditor equity and by making it more difficult to establish a collaborative relationship between debtor and creditors.

During the debt crisis of the 1980s, collective action problems were limited: by the presence of a relatively small number of large creditors; by contractual provisions in syndicated loans that deterred litigation; by the desire of banks to maintain good relations with the debtor to secure future business; and, on occasion, by moral suasion from supervisory authorities. Restructuring took time, but was in most cases orderly. Nevertheless, debt problems contributed to a "lost decade" of economic growth for Latin America, with social consequences of which we are all too aware.

The move from commercial bank loans to bond issuance in the 1980s and 1990s has made creditor coordination much more cumbersome. This in turn has made it more difficult for all concerned to predict how the restructuring process will unfold. Many creditors now have no ongoing business relationship with the debtor to protect. Their interests are more diverse. They are less subject to moral suasion. And some now specialize in buying distressed debt cheaply and suing for full payment. Typically, a comprehensive sovereign restructuring may require coordination across many bond issues, as well as syndicated loans and trade financing. The task is further complicated by the repackaging of creditor claims, for example through mutual funds that separate the lender of record from the end-investor who holds the economic interest.

Even if restructuring is in the interests of creditors as a group, some may consider that their interests are best served by trying to "free-ride" in the hope that ultimately they can secure repayment in line with their original contracts. Credit derivatives may also give investors incentives to hold out in the hope of forcing a default, thereby triggering repayment under the terms of the derivative contract.

Using litigation to force repayment has never been a particularly attractive option for most creditors, but new legal strategies have been developed in recent years that have tilted the balance somewhat and made the outcome of post-default restructuring more uncertain. For example, recent legal action against Peru shows that holdouts can try to extract full payment from the sovereign by threatening to interrupt payments on the restructured debt, rather than by trying to seize its assets. This possibility may make potentially cooperative creditors more reluctant to participate in a restructuring.

The fear of disorderly resolution deters countries with unsustainable debts from seeking restructuring longer than they should. It increases the loss of official reserves and the ultimate economic dislocation that they suffer. It also pushes down the value of creditor claims on the secondary market and thereby further increases the cost of borrowing. A reform that shaved even a month or two off the time that it takes to achieve a necessary restructuring would yield significant benefits.

A more predictable framework would also help private investors and lenders distinguish between good and bad risks. By reducing moral hazard and ensuring that borrowing costs better reflect true risks, this should help countries with good policies attract capital more cheaply, and should help prevent countries with weak policies from building up excessive debts that might leave them vulnerable to potential crises. (Studies by Eichengreen and Mody of the impact that collective action clauses have on bond prices lend support to this conclusion.) I see no reason why a better framework for sovereign debt restructuring should result in a net decline in the volume of capital flowing to emerging markets, unless the flows deterred were not justified by economic fundamentals and we are therefore better off without them.

All in all, reform would result in a better allocation of global capital and make the international financial system stronger, more efficient, and more stable. In so doing, it would complement the valuable reforms that have already been undertaken in crisis prevention and crisis management in response to the market turmoil of the late 1990s.

Some commentators fear that alleviating the collective action problem will make default an easy way out. But the prospect of economic dislocation, political upheaval, and possible long-term loss of access to international capital markets will still make countries reluctant to renege on their debt service obligations in all but the most extreme circumstances. As a result, it seems hard to argue that facilitating orderly debt workouts would significantly weaken the credit culture or create moral hazard.

2. Core Features of a Sovereign Debt Restructuring Mechanism

The key to improving the current system is to allow a super-majority of creditors — across a broad range of instruments — to make the terms of a restructuring binding on the rest. This should help secure restructuring before a country feels it is forced to default. But, in case this proves impossible, it is also important to facilitate efficient restructuring after default. This requires the new approach to do three other things:

• First, to give the debtor legal protection from creditors while negotiating;



• Second, to give the creditor assurances that the debtor will negotiate in good faith and pursue policies that protect asset values and restore growth, and;



• Third, to guarantee that fresh private lending would not be restructured.

Finally, you also need a way to verify claims, oversee voting, and adjudicate disputes.

These are features familiar from domestic bankruptcy regimes. The parallel should come as no surprise. As Adam Smith wrote in 1776: "When it becomes necessary for a state to declare itself bankrupt, in the same manner as when it becomes necessary for an individual to do so, a fair, open and avowed bankruptcy is always the measure which is both least dishonorable to the debtor, and least hurtful to the creditor."

Some commentators fear that reforms would be used to force restructuring on unwilling sovereigns, undermining their access to private capital in the future. Let me be very clear on this point: use of the mechanism would be for the debtor to request, and not for the Fund to impose.

An important goal is to create as clear and predictable framework as possible. As in domestic bankruptcy regimes, predictability means that the formal mechanism should need to be activated only very rarely. Debtors and creditors will know what to expect, encouraging them to reach agreement voluntarily "in the shadow of the law".

4. The Twin-Track Approach

One way to give effect to the new approach is through the use of collective action clauses that restrain the ability of dissident creditors to stand in the way of a widely supported restructuring. (These are typical of bonds issued under English law.) This, then, is the first of our two tracks. But CACs have important drawbacks. To begin with, they only bind holders of a single bond issue. In most cases of unsustainable debt, a comprehensive restructuring will be required over a number of instruments simultaneously. To achieve this, CACs would have to be adapted to aggregate across all claims, including banks.

But "super collective action clauses" of this sort are problematic for three reasons:

• First, how do you persuade creditors and debtors to issue new debt and exchange existing debt for bonds that include these clauses, when they are already reluctant to include CACs in their current form?



Our Executive Board discussed this question last month. They noted that exhortation to adopt existing CACs by the official community had so far been ineffective. Most directors agreed that it would be appropriate to encourage the use of CACs through the Fund's bilateral and multilateral surveillance of member policies. But there was little support for making the adoption of CACs a condition of Fund lending. (This would come at the time at which the private sector is most reluctant to lend and when the debtor may be most reluctant to signal a greater chance of default by adopting them.) There was more support, though, for making the use of CACs in a debt restructuring a condition of lending to a country already in arrears to its private creditors.

Any efforts to encourage the use of CACs will certainly be more effective if accompanied by efforts to generate a consensus in their favor outside the Fund — among issuers, issuing houses and institutional investors.

• A second problem is that emerging market sovereigns typically borrow in several legal jurisdictions. (Argentina, for example, has 88 bond issues outstanding.) Not even identical restructuring language in CACs would necessarily guarantee uniform interpretation or application.



• Third, the domestic laws of some of our members do not provide a clear statutory basis that allows the rights of minority creditors to be modified without their consent.

We are working on ways to tackle these drawbacks, but in the end I am sure that we will need a statutory underpinning for the new approach as well. Hence the second track of our twin-track approach.

The statutory approach would use a treaty obligation to empower a super-majority of creditors to reach agreement with the debtor and bind in the rest. This would resolve the problem posed by different legal jurisdictions, as the treaty obligation would provide for uniformity in all jurisdictions. It would also allow for the establishment of a single dispute resolution forum that could ensure uniform interpretation.

An amendment to the IMF's articles of agreement might be the easiest way to enact such a treaty obligation, in part because it would be binding on all members once it had been approved by two-thirds of them with 85 percent of total voting power in the Fund. But I must emphasize that an amendment of the articles would be used only as a legal tool to empower the creditors and the debtor, not as a way to extend the IMF's legal authority. The Fund would only influence the restructuring process as it does now, through its normal lending decisions.

What about the debts owed by the sovereign to the Fund itself? Should these be included in any restructuring? It is important to remember that the IMF is not a commercial organization seeking profitable lending opportunities. We lend at precisely the point at which other creditors are reluctant to do so — and at rates well below those that would be charged by the private sector. Putting outstanding loans to the Fund together with commercial claims in a workout would fundamentally undermine our capacity to play that vital role in future. Members of the private creditor community have frequently pointed out that the case for excluding debt owed to other sovereigns is less clear cut. Typically, these claims began life as export credit guarantees, which were priced with the risk of default in mind. If Paris Club claims were to be included in the restructuring process, the framework would have to be constructed to pay due regard to the different nature of these claims.

There are several questions that we have to address as we continue to develop this two-track approach. For example:

• How should the member's initial request for a payment standstill be dealt with, given the time it would take for creditors to be in a position to vote on it?



• How should we treat sovereign debt owed to domestic creditors?



• How can we promote a collaborative interaction between debtors and creditors, rather than the use of take-it-or-leave-it exchange offers?



• Should we extend legal protection to viable firms prevented from servicing their debts by the imposition of exchange controls?

These are all important issues that are currently being analyzed and on which we will have proposals soon. But let me focus briefly on another important question: how best to secure the verification of creditor claims and the adjudication of disputes.

5. Dispute Resolution under a Sovereign Debt Restructuring Mechanism

For the new approach to sovereign debt restructuring to enjoy credibility and legitimacy, it must be possible to resolve disputes among creditors — and between creditors and the debtor — in a way that is demonstrably fair to all parties.

This role could not therefore be played by the Executive Board of the IMF. Not only do Executive Directors lack the necessary expertise, but their decisions could be thought to be influenced by the Fund's role as a creditor and by the representation of the debtor and bilateral creditors on the Board. Any dispute resolution forum would have to operate — and be seen to operate — independently not only of the Board, but also of the governors, management and staff of the IMF. The flipside of this independence is that the role of the dispute resolution forum should be strictly limited.

Our thinking on the dispute resolution forum is far from complete, but let me describe briefly what shape we think it could take. I will deal in turn with three aspects: the role of the forum; its composition, and; the legal status of its decisions.

Role

The first role of the forum would be the basic administration of creditor claims, similar to what a domestic bankruptcy court would do. Namely, notifying creditors that the debtor had requested activation of the mechanism; identifying the claims submitted by creditors; and publicizing dates, places and procedures for voting.

The forum would also administer the voting process, organizing meetings and recording the votes cast. The forum could also be given responsibility for administering a permanent sovereign claims registry. Registration would be voluntary, but a signal of commitment to prudent debt management. It would certainly make creditor coordination much easier in the event of a crisis.

The second main role of the forum would be the resolution of disputes among creditors, or between creditors and the debtor. These might arise in two areas:

• First, verification of claims. Creditors may be concerned that fictitious claims could be used to manipulate the voting process. There may also be disputes regarding the value of claims and the collateral that secures them.



• Second, integrity of the voting process. This is of critical importance if claims are to be aggregated across instruments for voting purposes, given the possibility of collusion between the debtor and certain creditors in the voting process. For example, some creditors could be offered undisclosed financial incentives to vote in a particular way. Creditors may also fear that the sovereign might try more subtle forms of influence, for example putting pressure on domestic creditors subject to government regulation or control. The statute setting up the mechanism would need rules to prevent these abuses. The forum would adjudicate their interpretation and application.

But this would be the limit of the forum's powers. It would have no authority to override the decisions of a qualified majority of creditors on such issues as the terms of a restructuring plan or the length of a stay. Its role would be essentially reactive.

Composition

Now let me turn to the possible composition of the dispute resolution forum. In order to command the credibility and legitimacy necessary to carry out its functions effectively, the setting-up and operation of the dispute resolution forum would have to be guided by four basic principles: independence, competence, diversity and impartiality. These principles could be achieved through a five step process:

• Step One: Each IMF member could nominate one candidate, who need not be a national of the nominating country. This would guarantee diversity of geography, legal tradition and professional experience, as well as making it possible to ensure the inclusion of members from both debtor and creditor countries. Soliciting nominations from members directly rather than from the Executive Board would also help ensure independence from the Fund.



• Step Two: An independent and qualified committee of eminent persons could be established by the Executive Board to vet the nominees and recommend a list of, perhaps, 21 for selection to the forum.



• Step Three: The names recommended by the committee could then be passed to the Board of Governors for approval. They would have to vote on the entire list as a package. If it was rejected the process would have to start again.



• Step Four: The appointed members of the dispute resolution forum would then elect a Presiding Member from among their own number, with specified duties to oversee the functions and operation of the forum. None of the members would be full-time employees of the forum. They would continue to work as normal in their own countries unless they were impaneled for a particular case.



• In the fifth and final step, when an actual case was submitted to the forum, three members would be impaneled by the Presiding Member. The Presiding Member would take good care to ensure that members with conflicts of interest in specific cases were not permitted to serve on them.

A process of this sort would provide the guarantees of independence, expertise, diversity and impartiality that the dispute resolution forum would require to secure the necessary credibility and legitimacy.

Legal Status of Decisions

In addition to resolving disputes, the dispute resolution forum would certify key decisions made by the debtor and a super-majority of creditors, including with respect to the final restructuring terms and the stay. These certifications of the dispute resolution forum would need a legal status making them binding on all member countries. In other words, they would need to be treated as though they were decisions of each member country's national courts. This means that each member of the Fund would need to comply with the forum's certifications and give effect to them in its territory — whether or not the member was a party to the particular case in question. The debtor or creditors would notify particular domestic courts or other authorities of a certification as and when it became necessary for them to enforce their rights.

But certifications would be based exclusively on the decisions made by a qualified majority of creditors. The dispute resolution forum would, in effect, only be certifying that the vote of the creditors had taken place in accordance with the procedural requirements and that there had been no evidence of fraud.

3. Conclusion

Let me conclude by putting this twin-track approach to the reform of sovereign debt restructuring into a slightly broader context. The financial crises that have afflicted emerging market countries since Mexico's devaluation in 1995 have triggered a far-reaching effort to strengthen the architecture of the international financial system. Much has already been achieved but more remains to be done.

Our efforts to strengthen crisis prevention are now focused on two goals: improving the quality of the IMF's advice, and increasing the impact of that advice. Among other things, the first involves: more candid and comprehensive analysis of exchange rate regimes; higher quality analysis of financial sector issues; greater attention to private sector balance sheets; and greater coverage of institutional issues, like public sector and corporate governance — drawing on outside expertise where necessary. Of course, advice is only useful when it is acted upon; hence the second goal of increasing our persuasiveness. Greater candor and transparency have a role here, as does the rewarding of good policies through contingent or precautionary financing.

Our efforts to improve crisis resolution also have a number of elements, of which the reform of sovereign debt restructuring is only one. Let me mention three others:

• A key challenge is to reinforce the analytical framework the Fund uses to judge debt sustainability, helping us judge how best to respond to a particular crisis. This can never yield unequivocal results, but we should be able to bring together in a more systematic fashion the different elements that go into such a judgment. For example: the initial stock of actual and contingent liabilities; expected external and internal developments that would affect the debt servicing burden; the likelihood of more adverse scenarios occurring; and the member's capacity to adjust policies in response to shocks.



• A second challenge is to clarify the policy on access to Fund resources for members facing financial crises. A clearer policy should help the Fund provide the financing needed to support members, while reinforcing incentives for sound policies and prudent assessment of risk.



• A third challenge is to strengthen the tools we have available for securing private sector involvement in crisis resolution within the current legal framework.

These various elements add up to a ambitious agenda that will help us prevent crises where we can, and manage them as effectively as possible where we cannot. They may be of little comfort to countries that are currently in difficulty (and whom we are determined to help as best we can), but making a long-term investment in the strength and stability of the international financial system remains essential. I believe that reforming the current framework for sovereign debt restructuring is a vital part of this agenda, and that emerging market countries — and the international community as a whole — have a big stake in its success.

Thank you.