6-11-2014 (Emerging Markets) – It is 13 years since the IMF called for an international agreement on how to wind up defaulted sovereign debt. Still there is no mechanism, and regrettably the vulture funds pursuing Argentina still seem to hold sway in the US. It’s time for change.
More than a decade ago, the IMF called for a sovereign debt restructuring mechanism.
But today, there is still no such mechanism. And with recent court rulings showing how unfairly countries may be treated without an international rule of law on debt restructuring, it is becoming ever more urgent that world leaders make its creation a priority.
We need a fair and efficient sovereign debt restructuring mechanism for the same reasons that efficient capital markets depend on a balanced bankruptcy law. Too creditor-friendly, and there will be reluctance to borrow, and an inefficiently low level of credit, while lenders will have insufficient incentives to vet borrowers’ creditworthiness. A law that is too borrower-friendly might have the opposite effect, also resulting in a shortage of credit.
Every advanced country has a bankruptcy law, because they realise that the resolution of debt problems cannot be left to unfettered markets. There is typically tough bargaining, but fair outcomes rely on a legal framework that prevents the powerful from exploiting the weak. Firms that get over-indebted need a fresh start; a bankruptcy law ensures that the necessary restructuring of debts is done in a fair and efficient way. A sovereign debt restructuring mechanism would ensure the same fairness for countries.
The IMF recognised that there was not such a framework for sovereign debts, and that such a framework was badly needed. They saw that the lack of such a framework could have severe consequences not only after a crisis occurs, but also before. Scholars have drawn the same conclusions: it was a key finding of the Commission of Experts on Reforms of the International Monetary and Financial System, which I chaired — the commission appointed by the President of the General Assembly of the United Nations in the aftermath of the global financial crisis.
Regrettably, the US effectively vetoed the earlier IMF initiative. And now, US courts have ruled in favour of vulture funds, bringing the issue to a head. The funds bought Argentine defaulted bonds on the cheap and are now demanding full payment with interest — at a high rate that was meant to compensate lenders for the risk of default and restructuring — which ironically, the ruling says, in effect, never should occur. The ruling overturned longstanding principles of sovereign immunity (recognised once again by a very recent ruling in a separate case in Australia) and provided a novel — and unreasonable — interpretation of the pari passu clause in sovereign bond contracts, which is intended to ensure that identical creditors receive the same treatment. The American judge who decided the Argentine case actually ensured unfair treatment. The vultures would get paid far more than other creditors who had accepted the necessity and desirability of restructuring. The ruling makes future restructurings for existing bonds essentially impossible.
As the Argentine case proceeded, the IMF first offered to support the country’s cause in US courts, but then recanted — it’s easy to guess where the pressure came from — again showing how politics can hijack fairness and logic when there is a legal vacuum.
Fortunately, the UN has now stepped into the breach, voting overwhelmingly (124 to 11) to begin developing a framework for sovereign debt resolutions. In doing so, they follow the advice of a group that includes me, another Nobel Prize winner and an array of international economics experts.
But the vultures are clearly the ones influencing the United States, which opposed the UN vote. This influence of special interests is damaging American credibility. The US Treasury suggests that “free bargaining” should determine outcomes, which is really just the law of the jungle in disguise: the powerful can have their way. They also argue that a change in language of bond contracts — clarifying the pari passu clause, and inserting collective action clauses — would resolve the matter. This callously ignores the consequences for the many, many countries that have issued hundreds of billions of dollars of debt with terms that make restructuring virtually impossible (if the American courts’ views prevail). Countries have bankruptcy laws because they know that changes to contract terms like these are not enough. There needs to be a rule of law.
Indeed, sovereign debt restructuring is in even stronger need of a specialised mechanism, because it is far more complicated than domestic restructuring. Political entities have obligations that go well beyond those of a private company. Even US bankruptcy law recognises that when public authorities restructure their debt, there are claimants besides the “formal ones” — there is a social contract that may ensure the continued provision of pension, education, food, or health benefits.
Recent changes in capital markets reinforce these concerns. Credit default swaps (CDS’s) separate ownership from economic consequences: the seeming owner of the bond could be even better off in the event of a default. The opacity of the CDS market means that there is no way we can be sure whether the vultures really have any “skin in the game” and if so, how much.
If globalisation is going to work for all citizens, then we have to have an international rule of law — at least more so than we have today. Well-functioning sovereign debt markets are important — not just for developing countries but, as the euro crisis has taught us, for developed countries.
So the world needs a sovereign debt restructuring mechanism. In 2001 the IMF called for it. It’s high time that we came together to do it.
Joseph Stiglitz is Professor of Economics at Columbia University and recipient of the 2001 Nobel Memorial Prize in Economics