IMF reveals proposals for sovereign debt restructuring
Regional, Economics, 1/27/2003

Establishing a strong sovereign debt restructuring mechanism is a "formidable" task that will take many years to develop and implement, the International Monetary Fund (IMF) says in a January fact sheet outlining preferred features of such a mechanism. The Fund and major stakeholders in global financial markets are seeking a legal framework to make restructuring of debts owed by countries in financial distress more orderly and expeditious.

Following is the IMF fact sheet:

(begin fact sheet)

International Monetary Fund

Proposals for a Sovereign Debt Restructuring Mechanism (SDRM) A Fact Sheet

January 2003

The IMF's crisis prevention efforts are aimed at reducing the number of financial crises over time, but it is unrealistic to expect that all member countries will be able to avoid all crises all of the time.

In rare instances where countries amass unsustainable debt burdens, they must restructure their obligations. Currently, the international financial system lacks a strong legal framework for the predictable and orderly restructuring of sovereign debt, which drives the cost of default even higher. The IMF is trying to create a framework for an equitable debt restructuring that restores sustainability and growth, without including incentives that unintentionally increase the risk of default.

In September 2002, the International Monetary and Financial Committee (IMFC) endorsed the Fund's work and requested the IMF to develop a concrete SDRM proposal for consideration at the April 2003 Spring meetings.

What is the problem?

In recent years countries have turned increasingly from bank loans to bond issues to raise capital. As a result, the international capital markets are more diversified and function more efficiently.

Specifically, there is a broader investor base available to provide financing for emerging market sovereigns, which has helped diversify risk. But there is a serious downside if a country faces unsustainable debt. Private creditors have become increasingly numerous, anonymous and difficult to coordinate. This problem is exacerbated by the variety of debt instruments involved and the range of legal jurisdictions in which debt is issued. When faced with a restructuring, individual creditors, unlike banks, have more incentives to hold out for the best possible terms, or to sue for better terms. Also, disagreement over the relative treatment of different types of creditors are more likely.

Countries facing severe liquidity problems go to extraordinary lengths to avoid restructuring their debts to foreign and domestic creditors because they know that even an orderly debt restructuring can damage their economy and banking system. Moreover, a disorderly restructuring can sever access to private capital for years, leading to crisis. As a result, countries with unsustainable problems wait too long before confronting them, which is harmful to the country, its citizens and the entire international community.

What is the solution?

Better incentives for debtors and creditors to agree on prompt, orderly and predictable restructuring of unsustainable debt are needed. Domestic bankruptcy law serves as a useful model in the insolvency context, but the applicability of the corporate model is limited by the unique characteristics of a sovereign state.

Considerable work has been done to identify "best practices" in core areas. Properly adapted, many of the following key features could be incorporated into the design of a sovereign debt restructuring mechanism ("SDRM").

Majority restructuring -- The mechanism would allow a sovereign and a qualified majority of creditors to reach an agreement that would then be made binding on all creditors that are subject to the restructuring.

Deter disruptive litigation -- The mechanism would discourage creditors from seeking to enhance their position through litigation during the restructuring process. The current SDRM proposal does not include an automatic stay on the enforcement of creditor rights.

Rather any amounts recovered by a creditor through litigation would be deducted from its residual claim under an approved restructuring agreement (through the application of the so-called "Hotchpot rule").

Protecting creditor interests -- An SDRM would need to include safeguards that give creditors adequate assurances that their interests are being protected during the restructuring process.

Priority financing -- As a means of inducing new financing, an SDRM could exclude a specified amount of new financing from the restructuring, if such exclusion were supported by a qualified majority of creditors.

Going forward

In April 2002 the IMFC endorsed the IMF's view of the problem and encouraged it to investigate a "twin-track" approach to solving it.(1) The first, a statutory approach, would create a legal framework that would allow a qualified majority of a country's creditors to approve a restructuring agreement which would be binding on all. In order to make the agreement binding on all creditors, enactment of a universal statutory framework would be necessary. The second approach would incorporate comprehensive restructuring clauses, so-called "collective action clauses," in debt instruments. Collective action clauses, found in sovereign bond contracts, limit the ability of dissident creditors to block a widely supported restructuring on an individual bond issue.

Both approaches have been subject to intense and constructive debate, within the Fund and in other fora, throughout 2002. The IMFC reviewed progress at its September 2002 meeting.

Conclusion

Reforming the sovereign debt-restructuring framework is a formidable task that will take many years to develop and implement. These reforms are just one part of the IMF's larger effort to improve crisis management, and are intended to complement crisis prevention and crisis management efforts undertaken in response to the market turmoil in the late 1990s. Those reforms include: revamping of existing lending tools; examining the analytical framework it uses to assess debt sustainability; and clarifying the Fund's policy on the access members have to IMF lending. The result will be better allocation of global capital and a stronger, more stable, and more efficient international financial system.

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