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Creating a Framework for Sovereign Debt Restructuring that Works
1 Martin Guzman^2 and Joseph E. Stiglitz^3 Abstract Recent controversies surrounding sovereign debt restructurings show the weaknesses of the current market-‐based system in achieving efficient and fair solutions to sovereign debt crises. This article reviews the existing problems and proposes solutions. It argues that improvements in the language of contracts, although beneficial, cannot provide a comprehensive, efficient, and equitable solution to the problems faced in restructurings—but there are improvements within the contractual approach that should be implemented. Ultimately, the contractual approach must be complemented by a multinational legal framework that facilitates restructurings based on principles of efficiency and equity. Given the current geopolitical constraints, in the short-‐run we advocate the implementation of a “soft law” approach, built on the recognition of the limitations of the private contractual approach and on a set of principles – most importantly, the restoration of sovereign immunity – over which there may be consensus. We suggest that in a context of political economy tensions it should be impossible for a government to sign away the sovereign immunity either for itself or successor governments. The framework could be implemented through the United Nations, or it could prompt the creation of a new institution. Keywords: Sovereign Debt Crises, Sovereign Debt Restructuring, Debt Contracts, International Lending (^1) We are indebted to Sebastian Ceria, Richard Conn, Juan José Cruces, Anna Gelpern, Matthias Goldman, Barry Herman, Daniel Heymann, Brett House, Charles Mooney, Kunibert Raffer, Wouter Schmit Jongbloed, Sebastian Soler, participants of the Conference on “Frameworks for Sovereign Debt Restructuring” at Columbia University, the ECON 2014 Forum at University of Buenos Aires, the RIDGE Forum on Financial Crises at Central Bank of Uruguay, the First Session of the Ad Hoc Committee of the United Nations General Assembly on a Multilateral Legal Framework for Sovereign Debt Restructuring, and seminar participants at Javeriana University (Bogota), the Central Bank of Argentina, the UNCTAD Conference on “Legal Framework for Debt Restructuring Processes: Options and Elements” at Columbia University, the INET Annual Conference at OECD, the Research Consortium for Systemic Risk Meeting at MIT, and the International Institute of Social Studies in The Hague, the Academia Nacional de Ciencias Económicas (Argentina), the CIGI-‐IPD Conference on Sovereign Debt Restructuring at Columbia University, the Central Bank of Colombia, and three anonymous reviewers for useful comments, discussions, and suggestions. We are grateful to the Ford and Macarthur Foundations for support to the Roosevelt-‐IPD Inequality Project, and the Institute for New Economic Thinking for financial support, and to Debarati Ghosh and Ines Lee for research assistance. A previous version of this chapter was circulated with the title “Fixing Sovereign Debt Restructuring”. (^2) Columbia University GSB, Department of Economics and Finance. (^3) Columbia University, University Professor.
JEL Codes: F34, G33, H63, K12, K
1. Introduction Debt matters. In recessions, high uncertainty discourages private spending, weakening demand. Resolving the problem of insufficient demand requires expansionary macroeconomic policies. But “excessive” public debt may constrain the capacity for running expansionary policies.^4 Evidence shows that high public debt also exacerbates the effects of private sector deleveraging after crises, leading to deeper and more prolonged economic depressions (Jorda, Schularick, and Taylor, 2013 ). Even if programs of temporary assistance, e.g. from the IMF, make full repayment of what is owed possible in those situations, doing so could only make matters worse. If the assistance is accompanied by austerity measures, it would aggravate the economic situation of the debtor. 5 6 (^4) It is not high debt per se that is bad for economic growth or full employment, as careless studies that had been influential in the policy debate have suggested (Reinhart and Rogoff, 2010; see, in particular, the important critique of Herndon, Ash, and Pollin, 2014 ). Indeed, standard general equilibrium theory argues that there is a full employment equilibrium regardless of the level of debt (Stiglitz, 2014). Instead, it is the difficulty of running expansionary macro policies when primary surpluses are allocated to debt payments in times of recessions (which are indeed often associated with high debt) what makes debt a constraint for economic recovery. Note too that even then, it is not only the economic constraints which matter, but those arising out of political economy—a political economy which itself is affected by the largely ideological research referred to in the previous paragraph. In particular, for countries like the United States which can borrow even now at a negative real interest rate—and borrowed at very low real interest rates even when its debt to GDP ratio was in excess of 130%—borrowing for public investments that yield significantly higher returns than the cost of capital can improve the nation’s balance sheet. (^5) The only situation in which the temporary assistance (“bail-‐out”) might make sense is if there is a liquidity crisis, e.g. markets are irrationally pessimistic about the country’s prospects, with the evidence that they are wrong expected to be revealed in the not-‐too-‐distant future. But it is ironic that those in the financial market which normally profess such faith in markets suddenly abandon that faith when markets turn skeptical on them; and that at that point, they seem willing to rely on the judgment of a government bureaucrat or an international civil servant over that of the market. There are other irrationalities implicit in these arguments: it is sometimes suggested that if the intervention stabilizes, say, the exchange rate, that will restore confidence and prevent contagion. But if it is known that the reason that the exchange rate has been stabilized is that there has been IMF intervention, why should the stabilization of the exchange rate change beliefs, and especially so if the intervention is announced to be short term? And if there are reasons to believe that the IMF would not intervene in other countries (e.g. because they are less systematically important or less politically connected), then why should the intervention in one country change beliefs about the equilibrium exchange rate in the others? It is even possible that it could have adverse effects (Stiglitz, 1998). (^6) Even if the funds were offered without such conditions, to the extent that the funds are not used for addressing the fundamental problems that make debts unsustainable, the country would be worse off over the long run unless there was commitment to provide these funds indefinitely—which is in effect equivalent to a debt write-‐off.
the backdrop of political power. Restructurings come too little, too late.^7 And when they come, they may take too long.^8 The lack of a rule of law leads to ex-‐ante and ex-‐ post inefficiencies, and inequities both among creditors and between the debtor and its creditors. Furthermore, unlike domestic bankruptcies, sovereign bankruptcy negotiations take place in an ambiguous legal context. Several different jurisdictions, all with different perspectives, influence the process. Different legal orders often reach different conclusions for the same problem. It may not be clear which will prevail (and possibly none of them would prevail), and how the implicit bargaining among different countries’ judiciaries will be resolved. At the time we write this article, events are making the reform of the frameworks for SDR a major issue. Countries in desperate need of addressing profound debt sustainability issues, like Greece at the moment, are confronting the risks of a chaotic restructuring and this discourages them from undertaking the restructurings that are now recognized as desirable, or even inevitable. Besides, the gaps in the legal and financial international architecture favor behavior that severely distorts the workings of sovereign lending markets. The emergence of vulture funds—investors that buy defaulted debt on the cheap and litigate against the issuer, demanding full payment and disrupting the whole restructuring process— as recently seen in the case of Argentine restructuring, is a symptom of a flawed market-‐ based approach for debt crises’ resolution. Recent decisions 9 have also highlighted the previously noted interplay among multiple jurisdictions, none of which seems willing to cede the right to adjudicate restructuring to the others (Guzman and Stiglitz, 2015b). There is consensus on the necessity of moving to a different framework, but there are different views on the table about how to move forward. (^7) Since bonds replaced loans, nearly 40 per cent of restructurings ended in re-‐default or another restructuring within five years (Gelpern, 2015). (^8) And when they do not take too long, they may not achieve the objectives of restructuring that we define in section 2. This is the case of the Greek debt restructuring in 2012. The deal was mostly a socialization of banks’ debts that was not conducive to the recovery of the economy. Three years later, the country is still suffering an even worse depression: GDP has fallen by 25 percent since the beginning of the recession, and the unemployment rate is above 25 percent in January 2015 (as reported by Hellenic Statistical Authority -‐ Labor Force Survey, 2015). (^9) Where an American court seemingly has taken an action affecting payments on Argentinean bonds issued in other jurisdictions, such as the UK, and a British Court has ruled that they cannot do so (England and Wales High Court (Chancery Division) Decisions, Case No: HC-‐ 2014 -‐000704).
The International Monetary Fund (IMF) and the financial community represented by the International Capital Market Association (ICMA) recognize that the current system does not work well (ICMA, 2014; IMF, 2014). They are proposing modifications in the language of contracts, such as a better design of collective action clauses and clarification of pari passu —a standard contractual clause that is supposed to ensure fair treatment of different creditors. These proposals are improvements over the old terms, but they are still insufficient to solve the variety of problems faced in SDRs. And it is almost surely the case that new problems will arise—some anticipated, some not—within the new contractual arrangements. On the other hand, a large group of countries is supporting the creation of a multinational legal framework, as reflected in Resolution 69/304 of the General Assembly of the United Nations of September 2014, that was overwhelmingly passed (by 124 votes to 11, with 41 abstentions).^10 The framework should complement contracts, putting in place mechanisms that would establish how to solve disputes fairly. Building it on a consensual basis will be essential for its success. This in turn requires fulfilling a set of principles over which the different parties involved would agree on, an issue that we analyze in this article. While, as we have noted, the importance of the absence of an adequate mechanism for sovereign debt restructuring has long been noted (see also Stiglitz, 2006), five changes have helped to bring the issue to the fore and motivate the global movement for reform of existing arrangements: (a) Once again, many countries seem likely to face a problem of debt burdens beyond their ability to pay; (b) court rulings in the US and UK have highlighted the incoherence of the current system and made debt restructurings, at least in some jurisdictions, more difficult if not impossible; (c) the movement of debt from banks to capital markets has greatly increased the difficulties of debt renegotiations, with so many creditors with often conflicting interests at the table; (d) the development of credit default swops (CDSs) —financial instruments for shifting risk—has meant that the economic interests of those at the bargaining table may actually be advanced if there is no resolution; and (e) the growth of the vulture funds, whose business model entails holding out on settlement and using litigation to get for themselves payments that are greater than the original purchase price and of (^10) This is not the first attempt to implement a framework of this nature. The IMF had called for the implementation of a Sovereign Debt Restructuring Mechanism (Krueger, 2001; although the IMF Executive Board would have determined sustainability and judged on the adequacy of the debtor’s economic policies), and the report of the International Commission of Experts of the International Monetary and Financial System appointed by the President of the General Assembly of the United Nations had pointed out the necessity of exploring enhanced approaches for the restructuring of sovereign debt (Stiglitz et al. , 2010).
The probability of entering into situations of debt distress depends on a variety of economic conditions^14 but also on the actions of the debtor.^15 And once the distress arises, the debtor’s capacity of production and repayment going forward will depend on how the debt situation is resolved. If the debtor defaults, she normally loses access to credit markets until a restructuring agreement is reached.^16 The mechanisms in place for debt restructuring determine how all these tensions are resolved. A good system should incentivize lenders and debtors to behave in a ways that are conducive to efficiency ex-‐ante (i.e. the “right” decisions at the moment of lending) and ex-‐post (i.e. at the moment of resolving a debt crisis). It should also ensure a fair treatment of all the parties involved. 2.1. Efficiency issues A system that makes restructurings too costly induces political leaders to postpone the reckoning. When there are no mechanisms in place that would ensure orderly restructurings, the perceived costs of default to the party in power become too large. Therefore, “gambling for resurrection”, delaying the recognition of debt unsustainability, may be the optimal strategy for the debtor. Delays are inefficient. They make recessions more persistent and decrease what is available for creditors if a default occurs.^17 In the presence of cross-‐border contagion, furthermore, the delay is costly not only to the given country, but to those with which it has economic relations (Orszag and Stiglitz, 2002). The objective of the restructuring process itself must not be to maximize the flows of capital or to minimize short-‐term interest rates. Instead, the framework should ensure overall economic efficiency, a critical feature of which is ex-‐post efficiency in a broader sense: it should provide the conditions for a rapid and sustained economic recovery. A (^14) Importantly, it also depends on the discrepancy between the expectations on the future capacity of repayment and the realizations that determine the actual capacity of repayment. See Guzman (2014). (^15) The nature of the distress also depends on actions of the creditors, i.e. their willingness to roll over. (^16) There is some controversy over whether after the resolution of the debt there is a stigma that makes it more difficult for the borrower to borrow. There is theory (and some evidence) that markets are forward looking, infer that the cost of bankruptcy is sufficiently high that few if any countries go into default if they can avoid it—and that therefore there is no inference of a flawed “character trait” that can be made from a default; as a result of the cleaning of balance sheets, at least following a deep restructuring, there will be more access to credit markets. Russia’s 1998 default falls into this model. See Stiglitz (2010). (^17) That is, there are both macro-‐inefficiencies and micro-‐inefficiencies. In the chaos surrounding disorderly debt distress situations, assets typically do not get used in the most efficient way, and complementary investments to those assets are not undertaken.
system of orderly discharge of debts would permit the debtor to make a more efficient use of its resources, which may be in the best interest both of the debtor and the creditors. Normally, contractual and judicial arrangements should support this kind of ex post efficiency that is necessary for achieving Pareto efficiency.^18 A curious feature of the current restructuring process is that countries that are in the process of restructuring typically face massive underutilization of their resources. This is because such countries cannot get access to external resources; financial markets often become very dysfunctional in the midst of a crisis, with adverse implications for both aggregate demand and supply. Creditors, focusing narrowly and short-‐sightedly on repayment force a cutback in government expenditures (austerity), and the combination of financial constraints and decreases in private and public demand bring on a major recession or depression. They wrongly reason that if the country is spending less on itself, it has more to spend on others—to repay its debts. But they forget the large multipliers that prevail at such times: the cutbacks in expenditure decrease GDP and tax revenues. The underutilization of the country’s resources makes it more difficult for it to fulfill its debt obligations—the austerity policies are normally counterproductive even from the creditors’ perspective. Another critical feature is ex-‐ante efficiency. A system that does not put any burden on the lenders ex-‐post does not provide the right incentives for due diligence ex-‐ante. Selection of “good” borrowers requires in general specific actions from the lenders, such as screening (before lending) and monitoring (after lending). The existence of a mechanism for sovereign debt restructuring would act as a signal that money will be lost unless due diligence is applied. Note that good due diligence will result in better screening and lending practices, so that interest rates may actually be lowered as a result of better bankruptcy laws (that is, more punitive bankruptcy procedures may so adversely affect lender moral hazard that financial markets become more dysfunctional). This is especially the case when, as now, large fractions of lending are mediated through capital markets, not banks. Arguably, that was one of the consequences of the passage of the creditor-‐friendly US bankruptcy law reforms in 2005 (through the Bankruptcy Abuse Prevention and (^18) It is important to realize that the normal presumption that markets on their own are efficient fails in this context for a large number of reasons: there are imperfections and asymmetries and incomplete risk markets (and in such situations, there is a strong presumption that markets are not efficient). Moreover, the context in which we are most concerned—where there is significant underutilization of resources—is one again in which there is a presumption of market inefficiency. Finally, the bargaining that surrounds debt resolution is itself evidence of the absence of perfect competition, another essential assumption if markets are to be efficient. See, e.g. Greenwald and Stiglitz (1986).
3. The Current Problems The current non-‐system doesn’t achieve the described objectives of restructuring. Instead, it creates a host of inequities as well as inefficiencies. It over-‐penalizes debtors in distress, causing delays in the recognition of the problems. It leads to the “too little, too late” syndrome. In some cases, there is too much lending—and too much suffering later on; in other cases, there may be too little lending. Moreover, the legal frameworks permit a situation in which a few specialized agents (the vulture funds) can block the finalization of a restructuring, imposing large costs on the debtor and on other creditors. This section describes a variety of factors that are leading to these problems. The vulture funds Restructurings involve a public good problem: each claimant wants to enjoy the benefit of the country’s increased ability to repay from debt reduction, but each wants to be repaid in full. The existing frameworks fail to solve the public good problem. Instead, they provide the conditions for the emergence of vulture funds. The vulture funds are a class of holdouts that are not really in the business of providing credit to countries. Instead, they are engaged in “legal arbitrage”. Their business consists in buying debt in default (or about to be in default) in secondary markets at a fraction of their face value. Then, they litigate in courts, demanding full payment on the principal plus interest (typically at an interest rate that already includes compensation for default risk). A victory in courts brings exorbitant returns on the initial investment. Their modus operandi relies on a legal framework that has weakened sovereign immunity, and on a flawed design of contracts. They resort to activities (many of which are socially unproductive) to increase their bargaining power and to influence the decisions of the actors involved—including lobbying and threats about economic and political consequences of a failure to reach a settlement satisfactory to the creditors (some liken it to extortion) to affect the debtor’s behavior. Economic "extortion" is especially effective in influencing countries needing to re-‐enter capital markets, and political extortion is especially effective to influence governments whose officials have been engaged in illegal activities or who are motivated by a concern over their "standing" in the international community.
Their presence creates huge inefficiencies and inequities in sovereign lending markets. It can even lead to the total impossibility of debt restructuring. Recent events—in particular, the Argentine debt restructuring, which pitted the country against NML Capital (a subsidiary of the hedge fund Elliott Management)—show that these inefficiencies are a major issue. In that case, the presiding U.S. federal judge, Thomas Griesa, ruled in favor of the vulture funds and ordered an injunction that obliged Argentina to make payments to vultures and the holders of bonds denominated in foreign currency issued by Argentina in the 2005 and 2010 debt exchanges on a ratable basis , i.e. an interpretation of pari passu that requires Argentina to pay to the vulture funds their full judgment whenever it makes any payment under the exchange bonds, even if it is just a coupon payment—or otherwise any holder of exchange bonds would be barred from receiving payments. The injunction was based on a peculiar interpretation of pari passu ,^19 a contractual clause that is supposed to ensure equal treatment among equally ranked creditors.^20 The design of contracts also facilitates the emergence of vulture funds. Many existing debt contracts do not have collective action clauses (CACs)—clauses that allow a majority of bondholders to agree to changes in bond terms (for example to reduce the value of the principal) that are legally binding to all the bondholders, including those who vote against the restructuring. Some contracts do include them but the majority is defined at the level of each individual bond.^21 Under a unanimity rule, vulture funds can emerge easily. With CACs at the level of each security, vultures’ behavior is more constrained but it is still possible. They can still buy the minimum fraction that would block the restructuring of a unique series of bonds, and by doing so they would be able to block the whole restructuring. A formula for aggregation of CACs (over different classes of bonds), as the one proposed by ICMA (see section 4), would alleviate these problems. But it raises other questions: how are different bonds to be added together for purposes of voting (how (^19) The judge's decision was peculiar in other ways: it forced the trust bank into which funds were deposited to enforce his decision, i.e. the trustee was forbidden from distributing funds that it had received on behalf of the restructured bonds. Thus, to enforce one contract, it had to break other contractual arrangements. There seemed to be little rationale for the Courts decision about which contracts to respect and which to abrogate. Thus, the decision was not (as it has sometimes been put) about the sanctity of contracts (see the chapter by Sergio Chodos (2016) in this volume). (^20) The upshot is that vulture funds are poised to get returns on their “investments” more than five times greater than the holders of the exchange bonds. (^21) In the 1990s, bonds issued in the London market under the English law contained CACs, while bonds issued in the New York market under the law of the state of New York did not (Eichengreen and Mody, 2003). Mexico was the first country to put these clauses in its contracts under the jurisdiction of the state of New York in 2003.
was to be paid in full or otherwise to sue. Then, according to the Second Circuit, Elliot’s intent did not meet the champerty requirement because litigation was contingent. Such an interpretation is absurd, as it was not reasonable to expect to be paid in full over a promise that had already been broken. The exorbitant returns obtained based on an interpretation that was unreasonable to expect could have constituted a case of “unjust enrichment” (Guzman and Stiglitz, 2014c). In 2004 , the New York state legislature effectively eliminated the defense of champerty concerning any debt purchase above 500,000 US dollars. That decision constituted a change to the understanding over which hundreds of billions of dollars of debt had been issued, redefining property rights. This change in legislation ensured the good health of the vultures’ business. Distortive Credit Default Swaps (CDSs) The problems are aggravated by the non-‐transparent use of CDSs. A CDS separates ownership from economic consequences: the seeming owner of a bond could even be better off in the event of a default, as the payments over the CDS would be activated in such event. The opacity of this market makes unclear the real economic interests of those who have a seat at the restructuring bargaining table. They provide another reason for delayed restructurings, with its associated inequities and inefficiencies. The unbalanced background for negotiations The legal frameworks and the bailout policies of the IMF determine the background of the negotiations (cf. Brooks, Guzman, Lombardi, and Stiglitz, 2015). The current arrangements favor short-‐term creditors against long-‐term creditors, including in the latter group the “informal creditors” (the citizens towards which the sovereign has obligations, such as workers and pensioners). IMF bailout policies only aim at ensuring repayment in the short-‐run. In practice, they have not been designed with the purpose of favoring sustained economic recoveries. In occasions they even undermined them (both as a result of counterproductive conditionality and because of insufficiently deep restructuring), increasing the probability of a subsequent restructuring being needed down the road. In the case of Europe, the European Stability Mechanism (ESM) leads to the same perverse effects. By construction, it’s not a mechanism for debt restructuring but a mechanism for “bailouts” (Brooks and Lombardi, 2015), that gives creditor countries
enormous power in the negotiations with a debtor country. In the case of Greece, it was the main instrument by which the Eurozone countries enforced their demands for policy decisions that were not in the best interest of the country (at least as judged by the vast majority of people in the country, as reflected repeatedly in the polls, and by a large fraction of economists). Political economy issues SDR mechanisms must take political economy issues into account. The costs of restructuring are usually borne by different political actors than those who created the problem. Political economy tensions increase in times of distress, when the incumbent government has larger incentives to achieve deals with short-‐term benefits but long-‐term costs that will be paid by the next government. One of the strategies for better short-‐term financing conditions is giving up on sovereign immunity. Every bad loan is equally the result of bad lending and bad borrowing: these are voluntary agreements. But a system the puts the onus on the debtor (i.e. making it more likely that more of the debt will be repaid) encourages bad lending—it encourages banks to encourage the government today to borrow too much, exacerbating the already present distortion. (There is a further argument for putting more of the onus on the lenders: they are supposed to be the experts in risk analysis; that is supposed to be their comparative advantage; government officials typically have no expertise, and rely on the judgments of those in the financial market concerning reasonable debt levels.) Political costs are also often borne disproportionately by those willing to take actions
- that is, to actually do the restructuring. Thus a system that makes restructurings too costly exacerbates these natural political economy tensions, as it incentivizes debtors to delay the recognition of problems. Creditors’ behavior may also worsen these distortions, for instance, by providing short-‐term lending at high interest rates to countries that are obviously in need of a restructuring, taking into account the distorted incentives of the distressed debtors to make use of those funds, the “gambling on resurrection” behavior that we described earlier. Such short term lending is, of course, risky: when the situation is bad enough, eventually there will be a restructuring. But the short-‐term creditors can typically charge a sufficiently high interest rate to compensate them for this risk.
(ICMA, 2014). In other words, ICMA states that pari passu does not mean what judge Griesa interpreted it to mean. These new terms are improvements over the previous ones, but leave some important issues unaddressed. We analyze these issues in the next section.
5. Limitations of the private contractual approach: why a market-‐based approach will not suffice Sovereign debt restructurings are more complex than private debt restructurings. They involve dealing with contracts issued under different terms, under different legislation from different jurisdictions, and different currencies, over which there may not be obvious ways for comparing values when the contracts need to be rewritten. At those times, distributive conflicts get magnified.^29 The private contractual approach does not solve these issues according to efficiency or equity considerations, but on the basis of relative bargaining strength (related, for instance, to the ability to withstand large litigation costs and delays). Outcomes are generally inefficient and inequitable. That is why no government relies on the private contractual approach within its boundaries for private debts. The advocates of the private contractual approach have never explained why, if it were as good as they claim, it has been universally rejected. And as the complexities of sovereign debt restructuring are greater, the need for a statutory approach is larger. The problem with existing contracts The IMF estimates that roughly 30 percent of the $900 billion in outstanding bonds issued under the old terms will mature in more than 10 years. Approximately 20% of those stocks do not include any kind of CACs, and virtually all of the 80% that does include them have CACs that operate only at the level of each security (IMF, 2014). What would prevent the current problems from arising if those debts had to be restructured (events which, unfortunately, are especially likely to occur in the context of an anaemic global economy)? Debt issued under the old terms could in principle be exchanged for securities that incorporate the new terms. But what would rule out holdout behavior if such a (^29) That is, if the country had issued only one set of bonds, there would be a clear meaning to equity: repayments should be proportional to the face value of the bonds. This is not so if, as it is the case in practice, there are many different kinds of bonds.
proposal were carried out? The vultures would have an incentive not to exchange existing bonds for these new bonds. There is no solution to this quandary within the improved contractual approach. Inter-‐creditor fairness There are complicated bargaining problems among classes of creditors. A supermajority voting does not solve them all. A simple supermajority rule could lead to a situation where junior creditors vote to have themselves treated equally with more senior creditors – and where they impose their position through a supermajority. 30 This would make the senior status conditional on the outcome of the bargaining process. Indeed, if senior creditors were sufficiently small relative to the junior creditors, there is a presumption that their seniority would not be fully taken into account, and under the proposed arrangements, there is nothing they could do about it. Senior creditors would anticipate this possibility, and would react by demanding different contract terms ex-‐ ante (for instance, an early senior credit might limit the amount of junior creditor bonds that could be issued so as not to dilute voting interests, but that would have a deleterious effect on growth; alternatively, he could demand a higher interest rate^31 ). When countries issue debt under different jurisdictions, establishing priority of claims could be a daunting task, with multiple contradictions. Contracts could become inconsistent in crises times. For example, the terms of a bond issued under the jurisdiction A could state that the holder of that bond has priority over all the other claims. But at the same time another bond issued under the jurisdiction B could state the same. If it were not possible to satisfy both claims at the same time, how would priority be determined? Who would ultimately judge over it? It might be impossible to ensure the consistency of rulings from judges of different jurisdictions.^32 (^30) In the world of sovereign bonds, bondholders are on an equal foot. However, some creditors (the IMF for instance) are de facto treated as senior creditors. But nothing prevents the possibility that in the future there could be unsubordinated debt not only de facto to official creditors but also de jure to other bondholders. Indeed, the legal literature suggests that this is feasible (cf. Chatterjee and Eyigungor ( 2015 ) for a concrete proposal). A comprehensive solution must also address this concerns (Mooney, 2015). (^31) Moreover, the set of contracts in the market will respond endogenously to the rules of the game. For instance, the senior debt contract could have a provision that in the event of a default, the face value of what is owed is multiplied such that, under the aggregation clause, those bondholders have sufficient votes to block any proposal by junior creditors. (^32) See Guzman and Stiglitz (2015b) for a description of the interplay between legal jurisdictions in the case of Argentina’s restructuring after the 2001 crisis.
Besides, bargaining models with imperfect information often result in excessive delay—delay itself is a costly signal—again leading to an inefficient global equilibrium. Political economy issues As described in the previous section, sovereign lending markets are featured by important political economy tensions both on the debtor and the creditors side. A purely market-‐based approach for debt crises resolution would only exacerbate these tensions, leading to inefficient solutions. On the debtors side, a free market solution will not internalize the negative externalities of an incumbent government willing to take actions that result in short-‐ run benefits, like giving up on sovereign immunity to receive better financing conditions, on succeeding governments that would pay the costs of these actions. The frameworks for sovereign debt restructuring should recognize these perverse incentives, and should consequently make it impossible to sign away sovereign immunity. On the creditors side, a decentralized negotiation would face the opposition of investors that use sovereign bonds as collateral, and that in a world of less than perfect corporate governance will oppose to see the value of the bonds written-‐down in the short term, even if not writing debt-‐off leads to more sustainability problems, and larger haircuts in a longer term.
6. Possible further improvements to the contractual approach There are other modifications to the standard contract that could improve the workings of the market-‐based approach. They entail regulations on contracts, changes in domestic legislation, and the inclusion of clauses that make debt payments contingent on the economic situation of the debtor. Regulation of Sovereign Credit Default Swaps (SCDSs) CDSs have been advertised as helping to complete markets.^34 But they have failed to do so, and instead have made matters worse. The use of SCDSs distorts incentives. (^34) Arrow and Debreu have established that only if there were a complete set of risk markets would competitive markets be efficient. Some in the financial market thus argued that introducing new securities (such as CDSs) helps complete the market, and thus improves societal welfare. But that
SCDS distort incentives when they are used for insurance purposes (as noted above). But third parties can also demand SCDS for speculation purposes. This would not necessarily be a problem if there were no connections between the actions of the buyers and the interests of the sovereign. But the lack of transparency of these markets makes the connections possible (and profitable).^35 To avoid conflicts of interest that could undermine the success of restructurings, and considering that the opacity of CDSs markets makes regulation too difficult, all CDSs positions of parties involved in the restructuring negotiations should be fully disclosed.^36 Reinstating variants of the champerty defense If investors that purchase debt in default were willing to settle under “reasonable” conditions, they would just provide a liquidity service in the markets for defaulted debt, and could thus contribute to avoiding an even larger depression in bonds prices in such circumstances. But that is not what vulture funds do. Reinstating variants of the champerty defense that prohibit the purchase of defaulted debt with the intent of litigating against the issuer, together with a clarification of the pari passu clause, would undermine the vultures’ business, correcting the numerous inefficiencies associated with their behavior that we have identified.^37 conclusion ignores the basic insights of the theory of the second best, which demonstrates that in the presence of multiple market failures, reducing the scope of one could actually (and under plausible conditions, often would) lead to a decrease in societal welfare. Thus, Newbery and Stiglitz (1982) showed that eliminating barriers to trade, in the presence of imperfections in risk markets, could lead all individuals in all countries to be worse off. In this context, Guzman and Stiglitz (2014a, 2015a, 2015d) have shown that introducing these new instruments for betting may actually increase economic volatility and lower output permanently. (^35) The recent case of Argentine debt restructuring illustrates how perverse incentives can turn. In the aftermath of Judge Griesa’s injunction that blocked the payments of the country to its bondholders, the International Swaps and Derivatives Association (ISDA) classified the credit event as a default. Interestingly, one of the members of ISDA committee was Elliot Management, the same vulture fund that was litigating against the country. (The debt contract only specified that Argentina turn over the requisite funds to the "agent" – which Argentina did. Argentina was thus not in breach of the contracts which it had signed in the process of restructuring. Indeed, Argentina had even warned investors in its contract of the possibility of these difficulties. That is why the so-‐called default has been labeled a Griesafault , to distinguish it from a normal default, where a party actually breaches a key contract provision. See Guzman and Stiglitz (2014b)). (^36) Some have suggested going further: banning the purchase of SCDSs by third parties (Brook, Lombardi, Guzman, and Stiglitz, 2015). (^37) One could even imagine some variant of such a clause being inserted into the contract: that no secondary purchasers of the bond could make a claim in court for an amount greater than the price at which he had purchased the bond. While such a provision arguably might lower the price of the bond
