Speech

Sovereign Debt Restructuring and the International Financial Architecture, Speech by Thomas C. Dawson, Director, External Relations Department, IMF

January 28, 2003

XV REGIONAL SEMINAR ON FISCAL POLICY, CEPAL (ECLAC), United Nations
Santiago, Chile, January 27-30, 2003

Ladies and Gentlemen: Thank you for the invitation to participate in this discussion on reform of the international financial architecture. The IMF has been doing its share of work on architectural reform, as I'll describe in the first part of my remarks today. Our work on a sovereign debt restructuring mechanism, or SDRM, has drawn the most attention recently, but you'll see that we've been busy sprucing up other parts of the building as well.

In the second part of my remarks, I'd like to bring you up-to-date on the status of our work on the design of SDRM. Our revised proposal, which is still a work-in-progress, was posted on our website last month. I suspect that not many have had a chance to work through its 70-plus pages of single-spaced text. I'll confess that I haven't digested every single word of it myself, but I had the advantage of attending a conference the IMF hosted last week where the proposal was extensively discussed.

Let me begin by describing the IMF's efforts to contribute to architectural reform. Ever since the tequila crisis, efforts have been underway to find ways to ensure that "countries can drink from the waters of international capital markets without being drowned by them".¹

Countries that seek to attract foreign capital have learnt that reform of the international financial architecture begins at home.² Strong domestic institutions and strong policy responses are the first line of defense against the risks of financial crises. This may involve a number of steps:

• having more flexible exchange rate regimes;

• building stronger fiscal cushions in the boom years so that there is scope for counter-cyclical fiscal policy in periods of distress;



• having more resilient and diversified domestic financial systems;



• having legal institutions that can be counted on to credibly protect property rights.

And the list goes on. To their credit, many countries such as Chile have worked quite a ways through this long list of things to do.

Of course, these crisis prevention efforts at the national level have to be supported by steps taken by the international community. And, indeed, the list of reforms undertaken or underway at the international level is also quite long.

The 1988 Basel Accord is being revised, as you know, to make the capital set aside by international banks better reflect risk. Basel II rests on three pillars—capital requirements, supervisory reviews of internal bank risk assessments, and market discipline through better risk disclosure. Some 250 banks in 50 countries took part in the latest test of the proposed new rules.

Another noteworthy venture is the joint program by the World Bank and the IMF to conduct intensive health check-ups of the financial sectors of their member countries. Developed and developing country alike are being urged to sign up for this Financial Sector Assessment Program or FSAP. Canada and the United Kingdom have already had an FSAP and the program for Japan is underway.

Yet another area of progress is the development of internationally-recognized standards and codes in the economic and financial areas. The development and dissemination of such standards helps distill and spread best practice. Moreover, the IMF—together with several other international financial institutions—has been preparing assessments of countries' observance of these best practices. These reports on the observance of standards and codes, or ROSCs, are now available for many countries. They provide information on the extent to which countries are following best practices in prudential supervision and regulation, in the transparency of their monetary and fiscal policies, and in the provision of data and other information.

For those keeping score, the total number of ROSC modules completed is now 310 (for 84 economies). A study by Fitch Ratings found that, following publication of a ROSC, a country was more likely to receive an upgrade in its sovereign credit rating (or to retain its rating) than to receive a downgrade. This scrutiny of ROSCs from the private sector is welcome as it acts as a check on the their quality and keeps them from becoming, as some fear, merely an exercise in "ticking boxes".³

Despite this progress with crisis prevention efforts, we have to remain prepared to face financial crises in emerging markets, ranging from short-term liquidity problems to deeper and more protracted problems of solvency or sustainability. The IMF needs a strong and diverse set of instruments to help countries resolve financial crises across this vast spectrum of circumstances.

In some cases, financial assistance from the IMF—together with it effect on catalyzing finance from other sources—can be decisive in supporting economic programs that restore confidence. In other cases, IMF financial support would be futile or counter-productive without a reduction in the government's obligations to private creditors. In some contexts, therefore, the Fund's role is to provide confidence through its own finance and the policies supported by it. In other cases, the key may be to facilitate an orderly debt restructuring process.

To help us make the right decisions, progress is needed on a number of fronts. We need a sound debt sustainability analysis so that we can better distinguish cases of illiquidity from cases of unsustainability. In cases of illiquidity, we need to have a clear framework for determining access to IMF resources. And to ensure the effectiveness of our financial support, we have to make innovations, as needed, in our lending policies and in the design of IMF programs. In cases of insolvency or unsustainability, we need a framework to ensure a more timely and orderly restructuring of debts. The SDRM is an attempt to develop such a framework for cases of unsustainable sovereign debt.

The IMF has made progress on all these fronts over the last several years. Let's start with the sustainability analysis. Judgments about debt sustainability underpin the IMF's decisions. They help determine when financing is appropriate, what would be an appropriate amount of financing to provide, and whether a debt restructuring may be needed. Debt sustainability analyses also play an important role in supporting the Fund's advice on how a country needs to adjust its economic policies.

These judgments become critical—and in many cases, particularly finely balanced—in cases of emerging market countries that are highly integrated into global capital markets and may have large financing needs.

For this reason, IMF staff has been hard at work in developing a framework for assessing sustainability that builds on existing best practice. The aim is both to strengthen the elements that go into assessing sustainability and bring them into a common framework. We've now posted on our website a proposed framework for making judgments about sustainability—debt sustainability for the sovereign and external sustainability for the country.⁴ We are encouraging member countries to publish specific debt sustainability analyses we have done in individual cases. This will allow interested parties in the international community to get a better sense of how we go about making these very difficult judgments and it will foster a better discussion on how to improve the framework.

Second, we are developing a clearer framework for making judgments on how much financial support the IMF should be prepared to provide in crises. Under what conditions should the IMF be prepared to consider a financial package above the normal access limits? We are considering an approach that requires several substantive conditions to be satisfied for exceptional access—exceptionally large need; a sustainable debt burden under reasonably conservative assumptions; a judgment that the country will be able to return to the private capital markets in a reasonable period of time; and indications that the government has the will and the capacity to deliver on the agreed economic program.

Third, we continue to look for ways to improve the design of our loan facilities and the design of IMF programs. New IMF facilities created in the aftermath of the tequila crisis, in particular the Supplemental Reserve Facility (or SRF), have proved useful in subsequent crises in Asia and Latin America.⁵ The refinements to the design of IMF programs include: streamlining conditions attached to IMF-supported programs; designing fiscal strategies where the upfront adjustment is credible and thus bolsters confidence; and designing more effective financial sector resolution strategies.

So you can see that we have been busy on many different fronts to help strengthen crisis prevention. But, despite our best efforts, crises will occur. And it is in the context of improving crisis resolution that the proposal by our First Deputy Managing Director, Anne Krueger, for a sovereign debt restructuring mechanism should be seen.

Why is the IMF proposing such a mechanism? It's because we think there is a collective action problem in reaching agreement on a restructuring of sovereign debt. Some creditors, acting in their individual self-interest, may decide not to participate in a debt exchange in the hope of receiving payment on the original terms, even though the proposal may be in the interests of creditors as a group.

This problem is most acute prior to a default. Yet securing agreement on a restructuring before there has been an interruption in payments is the best way to minimize the economic dislocation and loss of asset values associated with restructurings that follow defaults.

The SDRM would overcome this collective action problem. It would establish a predictable and transparent restructuring process that respects creditors' rights. And it would create incentives for a debtor and its creditors to reach early agreement on a restructuring which, along with the implementation of the right policies, restores debt sustainability.

The SDRM proposal has undergone revisions since it was first put forward in November 2001. But the core feature is still a provision enabling a debtor and a qualified majority of its creditors to make a restructuring agreement binding on all creditors.

The SDRM would also include provisions to deter disruptive litigation by creditors during the debt restructuring negotiations. But, unlike previous versions of the SDRM proposal, the present proposal does not impose an automatic stay on enforcement of claims covered by the mechanism. Why have we made this change? After extensive consultations with experts, IMF staff is now of the view that while an automatic stay has its merits, it does not constitute a proportionate response given the magnitude of the risk.

Moreover, it may not fit comfortably with other features of the mechanism. In the corporate context, an automatic stay is normally accompanied by a moratorium on payments to all creditors—this ensures fair treatment of all creditors. In the sovereign context, however, it is unlikely that a sovereign will stop paying all creditors, in part because of the ramifications for the domestic financial system. Against this background, the IMF proposal describes two other measures designed to manage the risk of disruptive litigation without an automatic stay.

The latest proposal also places great emphasis on what are called transparency requirements. One important requirement is that creditors should be provided with information on how other creditors are being treated during the restructuring process. Persuading creditors of the need to accept some reduction in the contractual value of their claims, and achieving a solution that is accepted as fair to all creditors, is likely to be easier if there is transparency about how everyone is being treated.

The debtor country would also be expected to provide—and over time update—information on which claims are to be restructured under the mechanism; which claims are to be restructured in parallel with the mechanism; and which claims will be exempted from a restructuring altogether.

Creditors could agree to give seniority and protection from restructuring to fresh private lending, in order to facilitate ongoing economic activity through the continued provision of trade credit and other types of credit.

A forum would be established to resolve disputes that may arise during the voting process or when claims are being verified. This dispute resolution forum would have not authority to make judgments regarding the adequacy of a country's economic policies or the sustainability of a member's debt. While the forum would be established through an amendment of the IMF's Articles of Agreement, the design of the forum will ensure that it is independent, and is perceived as being independent, from the other organs of the IMF, in particular the IMF's Executive Board.

Indeed, the proposal does not envision any new legal powers for the existing organs of the IMF. Although it is likely that SDRM would be used in the context of an IMF program, its activation would not need to be approved by the Fund, nor would the Fund have a direct role in approving the terms of a restructuring. The decisions would be those of the debtor and a supermajority of creditors or of the independent dispute resolution forum. The IMF does not want to insert itself as judge or arbiter into the middle of a restructuring discussion between debtor and creditors.

At the same time, the IMF has a crucial role to play in enabling the international community to reach a judgment on the sustainability of a country's debt and the appropriateness of its economic policies. But the Fund plays this role right now, even in the absence of the SDRM. In cases where there is a IMF program, there has to be consistency between the Fund's judgments about a sustainable economic program and the feasible size of primary budget surpluses, on the one hand, and the extent of restructuring agreed to by the creditors and the debtors, on the other.

At the end of the day, things have to add up such that the agreed restructuring, financial support from the IMF, financial support from other sources catalyzed by the IMF program, and the country's own efforts at adjustment succeed in restoring the country to a sustainable situation.

So, in broad terms, the Fund's role will continue to be what it has been to date, namely that of signaling its willingness to support a country's economic policies and providing financial assistance to members implementing appropriate policies through an IMF-supported program.

Those are some of the main features of the SDRM proposal. As our Managing Director stated recently, the IMF welcomes "other proposals on the table on how to deal with unsustainable [sovereign] debt ... The SDRM is not the only possible solution."⁶

Two other proposals are to include collective action clauses (CACs) in bond contracts and proposals for a voluntary code of good conduct. The IMF is fully engaged also in the discussion of these proposals and regards them as complementary to the statutory approach taken by the SDRM proposal.

Collective action clauses apply to individual bond issues. They would permit a specified super-majority of holders of a particular bond issue to agree to a restructuring that would be binding on all holders of that issue. By preventing holdouts in individual bond issues, such clauses would thereby facilitate any needed restructuring.

The SDRM is a more comprehensive approach than CAC in a number of ways. First, SDRM would deal with the whole existing stock of debt, including instruments that do not explicitly provide for collective action. Even if CACs became more widely used in new bond contracts, the CAC approach would still fail to cover existing instruments that lack such clauses.

Second, the SDRM would allow a single vote to restructure multiple debt instruments by aggregating the votes of creditors holding participating debt instruments. In other words, the SDRM would permit the debtor and its creditors to act as if all of this debt were governed by a single collective action clause.

Third, the SDRM would provide an impartial dispute resolution process to protect creditors against fraud. The difficulty in providing such protection in the context of CACs has been a major impediment to developing a contractual approach.

Fourth, the SDRM would allow a super majority of creditors to approve new money that could help limit the scope of economic dislocation during the restructuring process. CACs do not have this feature.

And fifth, the SDRM would enter into force for all countries at the same time. In contrast, there could be a "first mover" problem associated with CACs. That is, emerging market economies might not want to be the first to introduce CACs in their bond issues for fear that investors will misinterpret this as a signal that restructuring is more likely and thus demand a higher risk premium.

Nevertheless, the use of CACs would be a big improvement, and the IMF is committed to promoting their use among its member countries. Likewise, we support the initiative to develop a code of good conduct. Transparent guidelines of best practice can be useful in making markets work more effectively. Indeed, this is the philosophy that guides the work on standards and codes, which I described earlier in my remarks.

Let me conclude. The financial crises that have buffeted the world economy over the last decade have led to reforms, both at the national and international level, to strengthen crisis prevention. The IMF remains committed to these efforts. The fact that our work on SDRM has drawn most of the attention in policy and media circles over the last year should not be taken as an indication that we have cut back our efforts on other fronts.

But we have to accept that not every crisis can be prevented and hence we also need to have better crisis resolution. There has been great diversity in the types of financial crises in the last decade, and no single instrument, the SDRM or any other, would have been able to resolve every one of them. This diversity is an argument for having more—not fewer—instruments in the tool-kit for crisis prevention and resolution. SDRM is intended to help in crises where sovereign debt restructuring is a necessary part of the solution.

As more countries gain access to private capital markets—which is an objective of the international community—a framework for the more orderly resolution of unsustainable debt situations (in those rare cases when they do arise) would be of immense help. In addition to SDRM, progress on collective action clauses and on developing a code of conduct would be valuable as well.

In short, we are not proposing SDRM in isolation, we are not proposing it as a solution to all problems, and we are not pursuing it to the exclusion of other needed reforms. Instead, as I discussed in the first part of my remarks, SDRM is part of the package of reforms of the international financial architecture. Better debt sustainability analysis; clarity on policies governing access to IMF resources; innovations in IMF lending facilities and program design—these remain important parts of the agenda for reform to help the IMF better serve its member countries.

Thank you.