The restructuring ‘revolution’: sovereign debt deals are no longer such a familiar game
Harnessing financial market innovation may help smooth the politics of sovereign debt
Debt restructurings are complicated affairs. They are the products of a combination of ingredients, such as financial ingenuity, legal experience and different macroeconomic and institutional contexts. Despite their regular recurrence, each debt restructuring presents a unique set of challenges. Some recent developments in a range of different countries bring that to the fore.
As Greece attempts to recover from a depression-like crisis, it is not the private side of its large recent debt restructuring (the so-called PSI) that presents an obstacle. Official negotiations with the EU, European Central Bank and IMF (the ‘troika’) are proving incoherent and ineffective in helping to solve what remains a debt sustainability problem.
The debt deal in the case of Cyprus was challenged not by creditors who own foreign bonds, but most forcefully by bailed-in bank depositors whose savings were taxed as part of a clumsy last-minute arrangement put together by the ‘troika’.
Turning to Latin America, Argentina’s protracted defensive battle with hold-out creditors (those who refuse to participate in debt restructuring) in US courts has prevented the country from issuing debt in foreign markets for the past twelve years. Yet private investors have not only been buying Argentine domestically-issued debt, but also Argentine stocks, even in the midst of news that the (still unresolved) litigation in New York may turn sour for Argentina in the near future.
The (moralist) rhetoric that private markets shun sovereign defaulters has been exaggerated in this case as the empirical record has revealed. The menace for Argentina has not been financial (lack of willing creditors), but legal (hold-out litigation that prevents the issuance of foreign-law bonds).
So what underlies these isolated idiosyncrasies of recent debt restructurings? The answer, paradoxically, is what some have called a ‘revolution’ in the restructuring of sovereign debt.
First, debt crises are clearly no longer a developing country-specific problem. In Europe they have triggered concerns about contagion, given deeply intertwined banks and sovereigns (even in the Greek case where the crisis originated in the public sector) in a context of severely restricted monetary policy autonomy.
Second, hold-out creditors have emerged as a significant problem. Indeed, the ‘revolution’ in sovereign debt post-Argentina has to do with the fact that a group of wealthy hold-out creditors (i.e. those who refused to participate in both the large restructuring in 2005 and the smaller one in 2010) have found a way to convince a disapproving federal judge in New York of a particular interpretation of a common contractual clause – known as pari passu. The clause broadly suggests equal repayment to creditors, and Judge Griesa’s order barred Argentina from making payments on its restructured debt unless it pays hold-outs in full, plus past-due interest.
This outcome could be severely disruptive. The implication is not so much that hold-out creditors with the time and money to sue defaulters in foreign courts will become more numerous. For most creditors, litigation is an inefficient strategy. The problem is that participation in general may become less attractive, as debt restructurings would not only mean reductions in creditor repayments but also the risk of having those repayments disrupted by hold-outs.
Moreover, as legal scholars have observed, with the US court’s decision (later backed by the US Federal Appeals Court), potential hold-outs now can count on ‘third party enforcement’ directed not at the sovereign itself but at those private parties on which the sovereign depends.
That is because Argentina was prohibited from rerouting payments on new bonds and the court threatened to sanction third parties (trustees, clearing houses and payments systems) that might help Argentina pay this debt (except to the hold-out litigant). Hence the costs of getting involved in debt restructurings are now higher, even for those actors linked to the ‘infrastructure’ of debt deals, usually external to the content of debtor-creditor negotiations.
This is not all. The great prevalence of domestic debt adds new challenges to the sovereign debt restructuring landscape. On the one hand, opportunities for debtors emerge, as in the case of Greece whose bonds were mostly issued under domestic law.
In that case, savvy legal advisors to the Greek government suggested a crafty manoeuvre: get the Greek Parliament to retrofit a collective action mechanism on the local law debt stock that added collective action clauses to all of them, thereby preempting hold-out action. On the other hand, the risk of sovereign defaults on domestic debt will be highly disruptive to local financial institutions – from local banks to pension funds. The political costs should not be underestimated.
If there is a silver lining in this ‘revolution’, it is an unexpected and neglected one. Ironically, although the first decade of the 2000s has made explicit the grave problems caused by market ‘irrational exuberance’ with all its ramifications, when it comes to sovereign debt, private bondholders – with the great exception of the few but largely disruptive hold-out creditors – have facilitated contractual innovation that dampens, but unfortunately does not eliminate, the hold-out problem.
Indeed, collective action clauses that give a majority of creditors the ability to agree on contractual changes have not significantly increased the cost of credit – an outcome largely feared in the 1990s. Similarly, financial innovations such as GDP-indexed bonds (countercyclical tools which link debt repayments to economic performance) have been well received by market participants who have collected handsome profits from investing in them.
Contingent convertible bonds, or ‘cocos’, are being suggested by a few scholars as an innovation that could be added to bond covenants to make them into a mechanism that could potentially reduce unsustainable debt accumulation. Since there has been demand for these types of securities in the case of banks, sovereign supply could also prove welcome.
New debates on the design of a statutory mechanism for more uniform debt restructuring procedures are important in light of current developments, but their dismissal of a host of financial market incentives and innovations that add counter-cyclicality to an otherwise vicious cycle of indebtedness and disruption is unjustified.
The idea is not to let the market resolve debt dilemmas on its own. But, to some extent at least, using the inherent short-termism and competitive drive of markets as tools for debt management could prove fruitful in the face of new challenges.Print page
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