Magazine article The International Economy

The Next Step Forward: Building a System for Sovereign Debt Restructuring

Magazine article The International Economy

The Next Step Forward: Building a System for Sovereign Debt Restructuring

Article excerpt

Every advanced country has a bankruptcy law, but there is no equivalent framework for sovereign borrowers. That legal vacuum matters, because, as we now see in Greece and Puerto Rico, it can suck the life out of economies.

In September, the United Nations took a big step toward filling the void, approving a set of principles for sovereign debt restructuring. The nine precepts--namely, a sovereign's right to initiate a debt restructuring, sovereign immunity, equitable treatment of creditors, (super) majority restructuring, transparency, impartiality, legitimacy, sustainability, and good faith in negotiations--form the rudiments of an effective international rule of law.

The overwhelming support for these principles, with 136 UN members voting in favor and only six against (led by the United States), shows the extent of global consensus on the need to resolve debt crises in a timely manner. But the next step--an international treaty establishing a global bankruptcy regime to which all countries are bound--may prove more difficult.

Recent events underscore the enormous risks posed by the lack of a framework for sovereign debt restructuring. Puerto Rico's debt crisis cannot be resolved. Notably, U.S. courts invalidated the domestic bankruptcy law, ruling that because the island is, in effect, a U.S. colony, its government had no authority to enact its own legislation.

In the case of Argentina, another U.S. court allowed a small minority of so-called vulture funds to jeopardize a restructuring process to which 92.4 percent of the country's creditors had agreed. Similarly, in Greece, the absence of an international legal framework was an important reason why its creditors--the troika of the European Commission, the European Central Bank, and the International Monetary Fund--could impose policies that inflicted enormous harm.

But some powerful actors would stop well short of establishing an international legal framework. The International Capital Market Association, supported by the IMF and the U.S. Treasury, suggests changing the language of debt contracts. The cornerstone of such proposals is the implementation of better collective action clauses, which would make restructuring proposals approved by a supermajority of creditors binding on all others.

But while better collective action clauses certainly would complicate life for vulture funds, they are not a comprehensive solution. In fact, the focus on fine-tuning debt contracts leaves many critical issues unresolved, and in some ways bakes in the current system's deficiencies--or even makes matters worse.

For example, one serious question that remains unaddressed by the ICMA proposal is how to settle conflicts that arise when bonds are issued in different jurisdictions with different legal frameworks. Contract law might work well when there is only one class of bondholders; but when it comes to bonds issued in different jurisdictions and currencies, the ICMA proposal fails to solve the difficult "aggregation" problem (how does one weight the votes of different claimants?).

Moreover, the ICMA's proposal promotes collusive behavior among the major financial centers: The only creditors whose votes would count for the activation of collective action clauses would be those who owned bonds issued under a restricted set of jurisdictions. …

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