“If the facts don’t fit the theory, change the facts.” The above mentioned words though said by Albert Einstein would not be the plausible plan of action that can be adopted while dealing the recent sovereign debt crises which has affected the European Union in the aftermath of the 2008 financial crisis. In light of the debt-stricken conditions of multiple European nations, the role of the International Monetary Fund (IMF) is set yet again to undergo change with its debt reforms mechanisms taking prominence. In the past, the IMF has been given the responsibility of reconstructing and reforming economies after crises however, the difference that arises with the present sovereign crisis is that developed countries like Greece, Italy and Ireland, the contributories to the IMF in the past have been affected. The present sovereign debt restructuring mechanism is three fold consisting of surveillance, technical assistance and financial lending.
With such a change in the circumstances and ongoing crises, the existing theories and mechanisms based on ad hoc measures to deal with the bankruptcies of economies are a misfit thereby demanding a change in the theory of the mechanism itself. After the Asian crises and the globalised world, there were reforms proposed to IMF’s sovereign debt restructuring model in 2002. The alternatives proposed were either adopting a contractual method based on collective action clauses or a statutory model based on certainty. However, due to the split in the reformative action to be finally accepted and the US opposition to the statutory model, the present ad-hoc model based on bail-outs has been in vogue which has created problems for the European Union as well, therefore necessitating a modification in the foundations of the SDRM.
The scope of the paper has been limited to evaluate the sufficiency of the ad-hoc bailout and lending system which acts as the sovereign debt restructuring mechanism [hereinafter ‘SDRM’] followed by the IMF to deal with the current EU crisis as a continuation of its age-old policy and not the causes of the financial downturn. The researchers hypothesize that in light of the urgency of dealing with the sovereign debt crisis, there is a need to ensure a structured SDRM with some legislative foundation rather than rely on the ad hoc alternative measures adopted in the present.
The paper has been sub-divided as follows: First, an overview of the present bailout alternative mechanism seeking to fulfil the demands of the sovereign debt restructuring mechanism has been undertaken in light of the European debt crisis highlighting the problems that were encountered. Secondly, the importance of a suitable sovereign debt restructuring mechanism especially in a globalised world has put forth in brief. Thirdly, a mechanism based on the SDRM proposed in 2002 reflecting on the benefits of the same has been analysed. Conclusively, the redundancy of the ad-hoc measures has been brought out with comparison with the domestic bankruptcy provisions.
2.0 ANALYSIS OF THE SOVEREIGN DEBT RESTRUCTURING MECHANISM IN EU: THE BAILOUT AND LENDING SYSTEM
The efforts in 2002 to set up a sovereign debt restructuring mechanism failed with a split in the IMF’s members to amend the articles of association. The treaty based framework for the SDRM could not be formulated due to the lack of the necessitated 3/5th votes with USA rejecting to support the move. Therefore, since the Asian and Indonesian crises, which brought out the insufficiencies of the economic policies of IMF, there has been no alternative framework in place that the IMF can control/regulate. Consequentially, in light of the sovereign debt crisis in Europe, the IMF acted as a lender of last resort rather than pursue the mode of restructuring under its ambit. 2.1 THE CONCEPT OF SOVEREIGN DEBT & THE RESTRUCTURING MECHANISM The term sovereign debt which is the crux for understanding the restructuring mechanism deals with the debts undertaken by nations (sovereign debtors) through borrowing from outside of their own territory which can be enforced by the creditors. Since there is no concept of attachment that can be enforced against sovereigns, the international community expectations and reflections on the national banking system ensure repayment.
The lending can be from other sovereigns or even through the issuance of securities, government bonds and bills. The creditworthiness of the sovereigns is dependent on the repayment of these debts and on the failure to repay; the entire banking structure is affected. Further, inability of the sovereigns to repay the debt can lead to bankruptcy of the nations when the deficits far outweigh the Gross Domestic Product of the sovereigns. On the bankruptcy of the sovereigns, the creditors as well as the domestic economy crumble leading to a need for financial lending and restructuring as is seen for individual insolvencies.
The Sovereign Debt Restructuring Mechanism is aimed at creating a negotiating environment similar to the domestic bankruptcy regimes provided at the national level. It means that the sovereign can be provided protection against creditor litigation during the restructuring process. The goal is to protect the collective interests of the nations and the creditors usually on the failure of lending and austerity measures. The sovereign debt restructuring mechanism can either be statutory in nature or through the inclusion of the collective action clauses in the lending arrangements. These mechanisms ensure tightening of the monetary economy to ensure subsistence for longer and to regain the creditworthiness. However, IMF has adopted a unique approach to deal with the sovereign debts through bailouts rather than handouts.
2.2 THE CURRENT SOVEREIGN DEBT CRISIS IN THE EUROPEAN UNION
The Eurozone currently has a number of countries which are over-leveraged where the debt far exceeds the relative size of their economies. Due to the use of the single currency, the effect of such debts is far worse irrespective of their individual economic health. Portugal, Ireland, Italy, Greece and Spain are the nations suffering from bankruptcy. The reasons for the massive debts amassed by the nations without considering the ability to pay back differ for each country. With five nations suffering from a sovereign debt crisis, the common currency is undergoing change with the responsibility being transferred on stronger economies like Germany and France to not only keep their debts at manageable levels but also ensure a relief programme.
The other European States like Germany and France who were in a more fiscally sound position could bailout the sick states but a European Financial Stability Fund was set up to ensure raising of funds by selling special bonds. The European Central Bank (ECB) through the issuance of euros and purchase of Greek bonds could assist to deal with the crisis. However, there is apprehension with respect to its role as printing euros would lead to inflation. Finally, the IMF which acts as the lender of last resort and loans to developing countries was sought after for relief.
2.3 ROLE OF THE IMF IN TACKLING THE CRISIS
The International Monetary Fund known as the lender of last resort usually provided loans and financial lending to developing countries. However, with the situation in the Eurozone deteriorating, the European countries turned to the IMF for assistance. While the IMF had no separate debt restructuring mechanism in place, the conditions placed by the IMF on the borrowing countries indirectly resulted into restructuring the economy. Therefore, the conditions laid down by the IMF not only were inappropriate for the European debt crisis considering the nature of the borrowing countries but it was an ad-hoc measure undertaken by the IMF to deal with the sovereign debt crisis. The mechanism adopted by the IMF was three-fold based on the bail-out method.
2.3.1 TECHNICAL ASSISTANCE
One of the modes that the IMF provides assistance to the debt-stricken sovereigns is through the provision of technical assistance which can help improve the capacity of their institutions and make policy making more effective. The assistance is in terms of macroeconomic policies, tax policies and revenue administration among other areas. This entails sending experts and placing them in the country for the period necessary thereby ensuring proper implementation of the conditions that have been laid when financial assistance is provided.
2.3.2 FINANCIAL LENDING
The most important part of the IMF in the European crisis was the provisions of financial support to the debt-stricken nations to overcome their imbalances. The funds have been provided by the member states of the IMF. Due to the absence of any foundation to deal with such bankruptcy, the IMF resources were provided through Stand-By Arrangements using the mechanisms of Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL). Such an arrangement had led to the devotion of 64% of IMF’s total commitments to Europe itself thereby affecting the other parts of the world.
Most of the IMF programs began in 2008-09 for countries in emerging Europe for countries like Hungary and Romania. With the need for funds felt by bigger economies like Greece and Italy, collaboration between the IMF, European Community and European Central Bank was formed. While financial assistance was provided by IMF, simultaneously various conditions including compulsory application of austerity measures and reduction of expenses were imposed giving rise to circumstances which would be similar to restructuring without the use of exact words.
In pursuance to Article IV of the Articles of Association, IMF provides policy advice, economic analysis and assesses the economic and financial developments in the country. The government, representatives of the business community, labour unions and the civil society are also met with and policy decisions then reached. Annual consultations with the various European Organisations are a part of the surveillance process. Further, the IMF publications also carry analysis and projections dependent on its surveillance.
The mechanism currently applicable allows for a private sector involvement with the aim of avoiding a credit event. If there is no restructuring taken, then the risks would be much higher. Therefore, the three-pronged approach adopted by the IMF to deal with the sovereign debt crisis of Europe was an ad-hoc measure taken in the absence of a statutory foundation or contractual basis for debt restructuring. Due to the adoption of such a mechanism based on bailouts meant for illiquid nations to insolvent nations instead of a proper restructuring mechanism, multiple predicaments have arisen. It is necessary to comprehend the predicaments before determining the insufficiency of the current model.
2.4 THE PREDICAMENTS INVOLVED WITH THE INTERVENTION OF IMF
An analysis of the nature of the abovementioned intervention of the IMF in Europe, there is no doubt that there is a need for reformation of the crisis resolution framework. In the present framework, private sector involvement is relied on for restructuring as the IMF has no mandate or legal framework to rely on for the same. The reliance on the private sector to undertake restructuring proceedings not only raises the cost but also delays the entire process. Further, the risks of continuously lending without any significant debt reduction can lead to several problems. One of the primary reasons for the failure of the bailout system is that political considerations that go into the decision to determine the amount to be lent as well as when the same should be lent. The IMF was primarily a political body set up to rectify the economic disruptions in the economy. One of the ways to get rid of such uncertainty due to the existence of political factors is the introduction of a framework based, statutory SDRM which can be resorted to when the need arose.
The conditions of the IMF mandate implementation of austerity measures and reduction of public spending as a mode to restructure the economy. However, the implementation of the programme can lead to number of domestic, social and political developments with the resistance of the public sector due to the loss of privileges. Further, the restructuring process is based on the implementation by private parties thereby raising questions on the sufficiency and sustainability of the measures. In the present model, if debt reduction is not undertaken by the official lenders then the lack of market access as well as official creditors holding the debt may affect the sovereignty of the country. The situation also has the potential of abusing euro-area political crisis. An analysis of the problems faced while approaching the IMF for assistance and its consequences needs to be undertaken. One of the purposes for lending by the IMF is to shorten the duration and lessen the degree of disequilibrium in the international balance of payment of members.
On financial assistance by the IMF, there are a few basic conditions to be met. First, the resources can only be used for helping the country resolve the balance of payment problems. This condition restricts the nation’s ability to carry out restructuring due to the lack of funds. Secondly, the country must be in a position to repay the sum as required under the articles as well as implement an appropriate economic adjustment programme. Therefore, it can be seen that the bail-out method used by the IMF to deal with the insolvency of nations and then impose conditions that could facilitate a restructuring have a number of disadvantages and predicaments involved in the entire process. The bailout method is resorted to by the IMF only because of the lack of an alternative mechanism at its disposal to deal with a problem of this nature. With such problems it becomes necessary to look at the importance of a SDRM and the minimum requirements it must fulfil for its success.
3.0 INSIGHT OF THE IMPORTANCE OF A SDRM: THE PUBLIC LAW ALTERNATIVE
The Mexican, Asian and Russian crises in mid 1990s with the European crisis in 2009-12 have prompted that a more feasible approach for prevention and financial reform be adopted. In the globalised market, the effect of the failure of a sovereign is felt by many countries. With the instances of sovereign indebtedness increasing, it is necessary that the uncertainty and ad-hoc measures based on a one size fit all strategy adopted by IMF undergo change.
3.1 SDRM: A NEED BASED PUBLIC LAW APPROACH
The objective of the SDRM is to facilitate an orderly, predictable and repaid restructuring of the unsustainable sovereign debt while protecting asset values and creditors’ rights. The purpose for sovereign restructuring is similar to the bankruptcy and restructuring mechanisms at the national level provided for individuals and corporations. The end result of a successful restructuring mechanism would be to reduce the costs of the restructuring for sovereign debtors and their creditors thereby contributing to efficiency of the market and reducing the risks of too many aberrations. In the present circumstances, a restructuring is either based on collective action clauses or voluntary arrangements agreed upon by the country and creditors. However, the SDRM would be a condition imposed on the debtor country which will be implemented when financial assistance was acquired from IMF under its supervision.
With the uncertainty in the processes at present, there is a need for the existence of a predictable legal mechanism that will remedy the lacuna and operate in a segment parallel to the domestic bankruptcy laws. The need for SDRM is felt to deal with problems arising out of the ad-hoc measures taken by the IMF to deal with the debt crisis. An alternative and foundational SDRM would be invoked only when there is no feasible set of macroeconomic policies that would assist the debtor or postpone his bankruptcy. The drawback of the ad-hoc measure or even the collective action clauses is the dependence on the private parties and their arrangements. Such private law approaches would not be the most successful mechanisms to adopt due to their contractual background.
The private law approach can not bind non contracting parties to solve the collective action problem. On the other hand a public law approach would bind all creditors including other states lending the finances by creating a group exercising their rights through super majority votes benefitting the smaller creditors. The IMF mechanism of providing bail-outs has led to a delay in the initiation of the restructuring process rather than accelerate the speed. Such a delay only exacerbates the economic dislocation further affecting the creditor claims. Therefore, there is a need to set up a structure which would be favourable to both the sovereign debtor and the creditors.
3.2 SDRM: DETERMINING A BETTER MODEL TO REPLACE THE CONTEMPORARY Even if both the creditor and the debtor agree to restructure the debt, the issue of time consumption and complications make the process similar to the domestic restructuring processes. Considering the benefits of having a public law approach for SDRM and the predicaments faced with the private law approach in vogue in the contemporary times, it is now necessary to strengthen the legal framework/foundation that will provide for restructuring the sovereign debt. The alternatives are one contractual basis or a treaty framework based on an amendment to the IMF’s articles of association. Irrespective of which alternative is proposed, priority must be placed on the resolution of collective action problems that do not shift the leverage from the creditors to the sovereigns. Prior to determining the feasibility and benefit of SDRM, there are two key challenges to the successful design and implementation of SDRM.
First, the model must create enough incentives for the debtors with unsustainable burdens to restructure their debts and address the problems in a manner that preserves asset values for restoration and sustainability. Secondly, the design of the mechanism must be such that the relative roles to the debtor and the creditors must be conducive to reach an agreement on restructuring beneficial to all. The benefits of a SDRM are many-fold: debtors can prevent exhaustion of official reserves and economic location through a timely restructuring. The debtors would also be able to benefit from a greater capacity to resolve collective action problems. The creditors would gain as the restructuring would happen prior to the dissipation of the debtor’s reserves.
The predictability in the model would provide assurances to the creditors. Such a change in the model is necessary due to the change in the nature of creditors and the debtors. Due to such changes the complexities in creditor claims have increased as there is no homogeneity. A sovereign restructuring may now need co-ordination across any bond issues, syndicated loans and trade financing. The risks of creditors free-riding and prevalence of complex financial instruments with default clauses will aggravate the predicaments mandating that a proper model be adopted. With the needs of public-law approach and the benefits of a stabilized SDRM, the IMF must pursue a legal framework for the SDRM. The statutory framework would create a legal basis for the SDRM.
3.3 BENEFITS OF A STATUTORY FRAMEWORK FOR SDRM
Having weighed the risks and benefits for a SDRM, it is necessary that the statutory approach for the SDRM be adopted. There are multiple benefits associated with the adoption of the statutory framework. The statutory framework implemented through universal treaty obligations would ensure that there is no circumvention of the framework. The IMF must mandate restructuring of the sovereign debt even though it might be coercive. The treaty would ensure that there is uniformity in the interpretation of the treaty. Similar to the domestic mechanism, a single international judicial entity can be established for the jurisdiction over the disputes.
The implementation of SDRM would also be easier as the amendment to the IMF articles of association would help achieve universality in the absence of unanimity and could be made binding on all members. The problem that arises is that the IMF’s existing institutional infrastructure would not accommodate playing such a role as it cannot be considered impartial. Therefore, one of the most important factors to be considered in the bargain is to ensure that the model for SDRM is implementable and efficient to deal with the current and future problems.
4.0 SDRM MODEL: THE EMULATED AND EVOLVED ALTERNATIVE
The SDRM was initially proposed by the IMF in view of some of the problems that existed in the context of sovereign debt, i.e., the collective action problem, sovereigns’ inability to bind minority creditors, fears concerning inter-creditor equity, and the problem of financing during the restructuring period. The ultimate goal of the IMF, through its SDRM program, was to create a predictable, orderly and rapid process for restructuring the debts of sovereigns.
4.1 THE INGREDIENTS OF THE IMF PROPOSAL
The IMF had borrowed several key components of the U.S. bankruptcy law for achieving this goal. To oversee the SDRM process, the IMF proposed the creation of an international bankruptcy court, over which the IMF would have control and oversight. It was emphasised that the most important element of any new restructuring framework had to be a mechanism that allowed a qualified majority of the creditors to bind the minority creditors. To deal with the minority holdout issue, the IMF proposed a stay on litigation by creditors during any restructuring period. This was because even the mere possibility of litigation could be sufficient to hamper restructuring efforts as the uncertainty created by pending litigation could prevent creditors from facilitating restructuring. The IMF proposal additionally required the balancing of the interests of the creditors outside a litigation context by the SDRM. For achieving this, the sovereign had to first be prevented from making any payments to non-priority creditors.
The IMF had control over the sovereign’s ability to drain resources, which served to reassure creditors that the debtor would conduct policies in a manner that preserved the asset values. Additionally, the SDRM granted priority to creditors giving in new money during the stay period as without this feature, there would be no incentive for a creditor to lend to a debtor in default. This in turn had the potential to encourage a market for restructuring financing and thereby facilitating the entire restructuring process. The final feature of the IMF’s proposal was the implementation of the SDRM through the establishment of universal treaty obligations as it would help in avoiding the enactment of an independent legislation by each sovereign independently to approve its adoption. Additionally, a universal treaty would ensure uniformity because it could not be subjected to the interpretation of every country’s legislature.
4.2 LEARNING FROM EXPERIENCE: THE CASE OF MEXICO AND URUGUAY
In February 2003, Mexico became the first major issuer to incorporate the collective action clauses (CACs), which are considered to be the most essential component of curbing disruptive holdout litigation, into the sovereign bonds governed by New York law. Although other large capital markets had included CACs in sovereign bonds for quite some time, the New York markets had been hesitant to incorporate them. These clauses enable a sovereign to amend certain reserved matters on an outstanding bond by plain super majority vote. Since a super majority of bondholders can enforce new repayment terms on obstinate holdout creditors, the CACs are an effective restraint on the ‘tyranny of the minority’ problem. Further, the use of heightened approval thresholds was available to address the new risk of the majority abusing its bargaining power at the expense of minority bondholders, which the CACs brought with them.
Pursuant to the issuance of this bond, three-fourths of the bondholders became capable of ratifying an amendment to certain reserved matters, such as repayment terms. Such was the influence of Mexico’s drastic contractual reforms that the CACs became the standard market practice in New York. Further, in March 2003, Uruguay became the second country to issue sovereign bonds incorporating the CACs. Like the Mexican model, Uruguay provided for both a 75% approval threshold on reserved matters as well as an issuer disenfranchisement provision. Additionally, Uruguay re-profiled all its outstanding sovereign debt and included majority action clauses in the terms of the new bonds. This meant that a future debt restructuring could be performed in an orderly manner by just tendering the votes of the bondholders without having to resort to an exchange offer. An extra benefit from this was the pre-emption of the problem of holdouts since an agreeing majority could bind all the dissenting creditors.
4.3 EVOLVING AN IDEAL SDRM
For a system to reach an ideal position, it is imperative for it to overcome the lacuna prevalent in it. The SDRM does not satisfactorily address two critical issues, i.e., the absence of a coherent priority scheme; and the need for an independent decision maker to oversee the sovereign bankruptcy framework. The resolution of these twin issues can lead to the conceptualisation of a better SDRM, one that would be conducive to the needs of many a nation. Firstly, with respect to priority, the sovereign bankruptcy framework should include a straight first-in-time priority scheme, together with voting procedures that call for absolute priority treatment, i.e., the assurance that higher priority creditors would be paid in full, and that any cut would be aimed first at the lower priority creditors. Thereby priority would be based on the time that the credit was extended for, with the debt of any given year taking priority over the debt issued in a subsequent year. Based on this priority, the sovereign debtor would be able to divide its creditors into classes at the outset of a two tier voting process for restructuring the sovereign’s debt.
For the purposes of the first vote, the debtor would make a proposal as to how much of its overall debt would be discharged, i.e., what would be the scale of the overall cut to the creditors and submit the proposal to a vote of all creditors. If this is approved by a majority of all the creditors, the debtor would submit a restructuring plan delineating the proposed treatment of each class of creditors for a second, class-by-class vote. If the requisite majority of each class votes in the affirmative, the plan would be implemented according to its terms. In the event that the plan is rejected by one or more of the classes, the court would reduce the creditors’ claims in the amount of the agreed upon cut, starting with the lowest priority creditors and working up the priority hierarchy. This two-step approach has several critical merits.
Most importantly, it clarifies the creditors’ priorities outside of bankruptcy and sharply reduces the risk of debt dilution. Since it would be to the creditors’ knowledge that any subsequent bankruptcy would be governed by the first-in-time priority scheme, the priorities would apply within and without sovereign bankruptcy. For sovereigns that actually invoked this procedure, the two-step voting structure would provide a mechanism for pushing the parties towards a resolution even in the event of a breakdown of the bargaining. Secondly, the issue of who would oversee the sovereign bankruptcy framework is a contentious one.
Unlike earlier proposals, which would vest authority in a panel of experts set up by a new or existing international organization, it is submitted that sovereign debtors should be permitted to file their cases in the bankruptcy or insolvency court of any jurisdiction where the sovereign has issued bonds, for example, New York, London, Frankfurt, or Tokyo. Rather than the experts selected by a bureaucratic process, the judges would be better equipped to take the decisions and this availability of choice to the sovereigns would promote jurisdictional competition and, as a result, further enhance the decision-making process. Thus, it can be seen that a statutory framework like the SDRM has the potential to holistically tackle the problems of sovereign debt restructuring, albeit with the initiation of reform in its own framework as well.
The time to change was yesterday, the time to wake up is now. The objective of the Sovereign Debt Restructuring Mechanism (SDRM) of the International Monetary Fund is to provide a framework that strengthens incentives for a sovereign and its creditors to reach a rapid and collaborative agreement on a restructuring of unsustainable debt so as to preserve the economic value of the assets and facilitate a return to the medium term viability, thereby reducing the cost of the restructuring process. In order for the SDRM to achieve these objectives, it must be a part of a general effort to strengthen the framework for crisis prevention and resolution, including the policies on lending into arrears and on exceptional access to IMF resources. However, the system has not found much acceptance at the international stage. Therefore, there is a need to restructure and reorganise it to tap into its potential as a statutory insolvency regime to resolve sovereign debt crises.
Firstly, a well-designed collective insolvency proceeding would give sovereigns the option of binding all creditors by majority vote, and thereby eliminate the creditor coordination and holdout problems. In addition, a statute that gives the sovereign at least a brief respite from paying its debts and from creditors’ enforcement actions would provide the sovereigns with the time to negotiate with all the creditors simultaneously. This in turn would prevent individual creditors or groups of creditors from disrupting the restructuring either by suing the sovereign in a national court or by attempting to exact unreasonable concessions during the restructuring.
By giving sovereigns the option of forcing all creditors to participate in, vote for, and be bound by the restructuring, a statutory system can better provide incentives for lenders to supply additional funds to distressed sovereigns. A final benefit of a mandatory statutory approach is that it can eliminate the first-mover disadvantage that the first sovereign to enact a statutory regime may have. Essentially, without a mandate to enact insolvency legislation, any sovereign that unilaterally chooses to enact a debt restructuring legislation would be forced to incur costs, to design the new statutory system and educate potential investors about it, and therefore might be viewed in the capital markets as less creditworthy. Hence, the existence of a common statutory framework that is to be followed by all would provide the required impetus to make it a level playing field for everyone.
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