Financial Times; Apr 24, 2002
By MARTIN WOLF

COMMENT & ANALYSIS: Debt to the world: The crisis in Argentina lends support to calls for better sovereign bankruptcy procedures. But reform of debt restructuring is long overdue, believes Martin Wolf

Argentina hung like a dark cloud over the spring meetings of the International Monetary Fund and World Bank in Washington last weekend. But it also made one of the topics under discussion particularly relevant. That question was how to design a better bankruptcy procedure for countries. The intractability of the renegotiation that lies ahead for Argentina makes the case for reforms even more compelling than before.

Adam Smith wrote: "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 dishonourable to the debtor, and least hurtful to the creditor." Much has changed since 1776. But one thing has not: a fair, open and avowed sovereign bankruptcy remains beyond our reach.

Yet in Washington last weekend, genuine progress was made. There, the finance ministers and central bank governors of the Group of Seven leading industrial countries endorsed a twin-track approach to improving the tractability of debt restructuring.

The first track is to be what their communique calls "a market-oriented approach to the sovereign debt restructuring process in which new contingency clauses would be incorporated into debt contracts. These new clauses . . . should include super-majority decision-making by creditors; a process by which a sovereign would initiate a restructuring or rescheduling - including a cooling-off, or standstill period; and a description of how creditors would engage with borrowers."

The second track is to be "further work by the International Monetary Fund on proposed approaches to sovereign debt restructuring that may require new international treaties, changes in national legislation or amendments to the articles of agreement of the IMF". Both tracks are to be followed, because the second one is bound to take far longer than the first.

Never before have the countries with a preponderant voice in the international financial system so clearly endorsed the case for a more efficient, expeditious and orderly procedure for dealing with sovereign bankruptcies. This reflects their deepening dissatisfaction: crises have been too frequent; the procedures used to handle them have been too ad hoc; what has been expected of private sector creditors has been too ill-defined; and, in consequence, debtors and creditors have found it too easy to "game" the official sector into lending too much.

A better route needs to be found, argue reformers, towards what is known as "private sector involvement". Anne Krueger, the IMF's first deputy managing director, has become the most influential and articulate proponent of the proposed answer - a "sovereign debt restructuring mechanism" (SDRM).* Over the course of the 1990s, argues Ms Krueger, the creditor community has become "increasingly diverse and diffuse". This creates severe problems of co-ordination and collective action. These exacerbate uncertainty and contribute to the reluctance of the borrower, its creditors and the official sector "to pursue a restructuring other than in the most extreme circumstances. This, in turn, increases the likely magnitude of the loss of asset values, which is harmful to the interests of both debtors and creditors."

Ms Krueger suggests a new international legal framework designed to replicate the features of domestic bankruptcy proceedings in private sector insolvencies for sovereign debtors. It could be enacted via an amendment to the IMF articles of agreement. The new mechanism would allow a qualified majority of creditors to approve a restructuring agreement and make that decision binding on a minority. It would also contain three other features: a stay on litigation; mechanisms to protect creditor interests; and provision of seniority to new creditors. These procedures would be triggered by request of the debtor and be subject to agreement of the IMF or some proportion of creditors. It would, suggests Ms Krueger, be invoked only to deal with a debt burden that is "clearly unsustainable", not with temporary illiquidity.

Ideas for such a sovereign bankruptcy procedure have been around for some time. But only now has it been proposed by someone in Ms Krueger's position and endorsed by both the G7 and the IMF's monetary and finance committee. The ideas of academics have become respectable. Yet all is not agreed. At least six objections can be made. A first is that the new mechanism would make it too easy for debtors to default. Lending would become riskier and so smaller, possibly making crises more frequent. Against this, the costs of a loss of access to capital markets would remain daunting for any sovereign defaulter. Furthermore, appreciation of the greater risks by lenders should increase the differentiation among sovereign borrowers that has been a welcome feature of the past few years.

A second objection is that the mechanism is unnecessary. The US administration, in particular, prefers what Paul O'Neill, Treasury secretary, has called the "decentralised, market-oriented approach" of inserting new clauses into sovereign debt contracts. This is peculiar since bankruptcy laws exist not as an alternative to market mechanisms but to make them work better. Moreover, when there are hundreds of debt contracts, governed by the laws of many jurisdictions, collective action clauses in individual contracts would fail to ensure co-ordination among creditors. The proposed SDRM would, in contrast, force creditors to co-operate.

A third objection is that a well-flagged insolvency, such as Argentina's, is an exception, not the rule. Panic and illiquidity have been more normal. The answer to this is that the mechanism could also be used to make a temporary halt on payments and then negotiate a rescheduling.

A fourth objection is that, unlike in a standard domestic bankruptcy (though not when the bankrupt is deemed "too big to fail"), the official community is known to be prepared to make money available. The role of official lending must be clarified in advance. Otherwise, there would be insufficient pressure on creditors and debtors to reach agreement, since, by failing to do so, they can hope for a bigger bail-out. This is not an argument against the new mechanism but, rather, one in favour of it. The reforms would force transparency on the limits and conditions of potential official financing. Fear of this is, no doubt, the chief reason for the opposition of private creditors to the proposal. Furthermore, clarity on the limits of official finance is a necessary condition for any debt restructuring, including one initiated by collective action clauses in contracts.

A fifth objection is that it is going to be hard to delimit the scope of the debts covered by the mechanism. Would it cover domestic currency debt, official debt, or foreign currency debts by private parties who are prevented from servicing their debts by official actions? The answer is that coverage should be as comprehensive as possible. Again, these dilemmas do not vanish in an alternative to the formal mechanism. They must be answered in any sovereign debt restructuring. A final objection is that the new idea would take far too long to agree and implement. Such delays justify the decision to pursue the alternative of inserting collective action clauses into new contracts. But pursuing the legal changes would, at the very least, be an invaluable spur for movement on the idea of inserting these new clauses.

The objections to this proposal are unpersuasive. They are either a matter of timing, or incorrect, or apply equally to any less formal alternative. Nobody would now envisage domestic lending without a formal bankruptcy procedure. The same logic applies to lending to sovereigns. The time to recognise this fact is now. Indeed, it is decades, perhaps even centuries, overdue.

* Anne O. Krueger, A New Approach to Sovereign Debt Restructuring, 2002, www.imf.org  martin.wolf@ft.com 
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