Given Europe’s debt problems, questions on how to restructure sovereign debts and whether the world needs a rule-based sovereign debt restructuring mechanism have once again come to the fore. The Latin America and Caribbean region has an unenviable history of debt restructurings. There have been over 25 restructurings in the last 35 years and nine since 2002.¹ The most important lesson Latin America and the Caribbean can teach Europe during these hard times is that: the old continent needs a debt restructuring mechanism.² This would allow for a faster resolution of Europe’s debt problems; maintain greater discipline in Europe’s fiscal affairs relative to a bail-out; result in a deeper reduction in debt relative to a voluntary restructuring; lead to a more equitable sharing of the pain among private creditors; and, in the long run, it would minimize the erosion of investor confidence.

The lack of a restructuring mechanism created a bipolar approach to Latin America’s dealings with investors. Uruguay and Jamaica are examples of countries that implemented market friendly restructurings; with no reductions in principal and longer maturities. Uruguay returned very quickly to international markets and Jamaica to its domestic market at lower interest rates.³

Other countries, including Argentina, adopted a more aggressive route. Argentina has been unable to access international markets after a deeper principal haircut was imposed on investors. The Argentine story is long but the policy vacuum at the end of 2001 and early 2002, and a set of decisions made in that context, certainly contributed to making the crisis the worst in the country’s history. The case also highlights the important role of the IMF. And while it is hard to construct counterfactuals, had there been an alternative for local policy makers and a better mechanism to maintain engagement around August 2001, when the IMF signed its last agreement with the country, most likely a better outcome would have resulted for both the country and bond holders.⁴ 

The current “system” for executing deals with significant haircuts exacerbates tensions between countries and creditors. It fuels a cat-and-mouse game between lawyers acting for the countries and those acting for loosely formed creditor committees and individual creditors.⁵ 

The borrower tries to convince creditors to accept a set of options of lower value or threaten they will get nothing. Creditors try to force the best deal for themselves threatening to “hold out”. Holdouts try to attach the borrower’s assets, disrupting trade or other transactions to force higher payments.⁶ 

In addition, some “vultures” lurk around, buying up the claims of those investors, who would rather exit than fight to save a few bucks. These vulture investors then intentionally try to block any deal, blackmailing the borrower into paying in full, or facing the consequences of the whole thing falling apart. 

Faced with limited choices, countries have tough decisions to make. A market friendly route might bring in a lot of creditors. But the question is whether such deals do enough in terms of bringing down the present value of the debt to really solve the problem.⁷

Uruguay has been highly innovative in issuing new bonds with clauses that facilitate restructurings under the current system, with Collective Action Clauses in contracts but also facilitating aggregation across bond issues. These will help to prevent holdouts and vultures in the future. They give the cat bigger claws, but it is hard for a country to predict and plan for every possible contingency. Ultimately, the system still remains a cat and mouse game and these clauses are an adjustment to the game, not a new panacea.⁸

If a country decides that the friendly route will not cut it, then a deeper haircut is inevitable. Creditors may then complain that the borrower is not acting in “good faith” or is “rogue,” shunning its debt for a long period of time.

In sum, the lack of a restructuring mechanism forces a bipolar view. Be friendly and risk not solving the problem or be tough and risk being branded a pariah.⁹

Europe seems to be moving along a path to avoid the problems faced by Latin America, edging towards an agreement that would include access to liquidity but at the cost of subjugating some sovereignty to a type of debt-restructuring mechanism.¹⁰ 

But the devil is in the details, and this is not an easy machine to design. In order to work , the debt-restructuting mechanism must have three overriding objectives: to prevent a massive drop in investment or a run from government bonds or banks; to ensure through fiscal adjustment that a country’s budget is sustainable; and to seek that an equitable part of the pain is shared by private sector creditors.

Many tensions will appear in the overall design and some discretion will be required in the execution, so institutional design will be as important as setting the rules.¹¹ 

If Europe comes up with something that works, policymakers may yet decide that the world should have a debt restructuring mechanism. The current system is really no system at all and Latin America has suffered as a result.
 

Disclaimer: the views expressed are strictly personal and do not necessarily represent the views of the Inter American Development Bank or any other institution.

References:

Abuelafia, Emmanuel and Andrew Powell (forthcoming) “Jamaica’s Successful Debt Exchange: Why the World (still) Needs an SDRM”, mimeo, IDB.

Alleyne, Trevor (2011) “The Challenges of High Debt, Addressing the problems of the debt overhang in Jamaica and Antigua” IMF, presentation prepared for the conference, “Options for the Caribbean After the Global Financial Crisis” January 27–28, 2011, Barbados.

Arozamena, Leandro and Andrew Powell (2003) “Liquidity Protection versus Moral Hazard: the role of the IMF”, Journal of International Money and Finance, Volume 22, Issue 7, December 2003, Pages 1041-1063.

Beattie, Alan (2010) “State of Bankruptcy” Financial Times, August 1st, 2010.

Bolton, Patrick and David Skeel (2004) “Inside the Black Box: how should a sovereign debt restructuring mechanism be structured?” Emory Law Journal, 53, 763-822, 2004.

Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2003) “Sudden stops, the real exchange rate and fiscal sustainability: Argentina’s lessons”. NBER working paper, number 9828, July 2003.

Cline, William (2003) “Restoring Economic Growth in Argentina” World Bank Policy research Working Paper, 3158, October 2003.

Cruces, Juan and Christoph Trebesch (2010) “Pricing Haircuts: Do Markets Punish Low Recovery Values in Sovereign Debt Restructurings?”  mimeo, Universidad Torcuato Di Tella, Buenos Aires, November 2010.  

Davis, Bob (2010) “Latin America: Lessons for Europe” Wall St Journal, December 6th, 2010.

Galvis, Sergio and Angel Saad (2004) “Collective Action Clauses: recent Progress and the Way Ahead”, mimeo, 2004, Sullivan and Cromwell LLP.

Hausmann, Ricardo and Andres Velasco (2002) “Hard Money’s Soft Underbelly: understanding the Argentine crisis” paper prepared for the Brookings Trade Forum (2002).

IMF (2002) “Three essays on how financial markets affect real activity”, Chapter 2 of the IMF’s World Economic Outlook.

Inter-American Development Bank (2006) Living With Debt, Inter-American Development Bank and Harvard University Press.

Krueger, Anne (2002) “Sovereign Debt Restructuring Mechanism: One Year Later” Speech presented at the Banco de Mexico's Conference on "Macroeconomic Stability, Financial Markets and Economic Development" Mexico City, November 12, 2002

Krueger, Anne and Sean Hagan (2005)” Sovereign Debt Restructuring: Sovereign Workouts, An IMF Perspective”, Chicago Journal of International Law, Summer 2005. 

Krugman, Paul (2011) “Can Europe be Saved?” New York Times Magazine, January 12th 2001, New York Times Magazine.

Mercopress (2011) “Argentina still haunted by the holdouts from the 2001 default” Mercopress, February 4th 2011.

Mussa, Michael (2002) “Argentina and the Fund: From Triumph to Tragedy” July 2002. Policy Analyses in International Economics 67, the Peterson Institute.

Panizza, Ugo, Federico Sturzenegger and Jeromin Zettelmeyer (2009) "The Economics and Law of Sovereign Debt and Sovereign Default," Journal of Economic Literature 47(3), pages 651-98,  

Powell, Andrew (2002) “Argentina’s Avoidable Crisis: Bad Luck, Bad Economics, Bad Politics, Bad Advice” in Susan Collins and Dani Rodrick eds., Brookings Trade Forum (2002), pages 1-58. Brookings, Washington DC.

Reinhart, Carmen and Kenneth Rogoff (2009), “This time is different: eight centuries of financial folly”, Princeton University Press, September 2009.

Steneri, Carlos (2003) “Voluntary Debt Profiling: the case of Uruguay”, mimeo, Uruguay Ministry of Finance paper prepared for the UNCTAD Conference on Debt Management, Geneva, 11-14 November 2003

Sturzenegger, Federico and Jeromin Zettelmeyer (2007), “Debt Defaults and Lessons from a Decade of Crises” MIT Press, January 2007.

¹ On debt restructurings in LAC see the essay in IMF (2002), more detailed accounts of several cases are found in Sturzenegger and Zettelmeyer (2007) and see Reinhart and Rogoff (2009) for a more general treatment.
² On the Sovereign Debt Restructuring Mechanism (SDRM) proposed 2001 see Krueger (2002) and Krueger and Hagan (2005).
³ On Uruguay see Steneri (2003) and on Jamaica see Alleyne (2011) and Abuelafia and Powell (forthcoming).
⁴ On the Argentine crisis there is a wide literature. Cline (2003) provides a useful review. My own view is expressed in Powell (2002) which evaluates four theories of the crisis. Calvo et al (2003) and Hausmann and Velasco (2003) provide particular and contrasting views. Mussa (2005) provides yet another and an account of the relations between Argentina and the IMF including a characterization of the flawed August 2001 package. Arozamena and Powell (2005) present a game theoretic account of the interaction between a county and the IMF; the authors argue that the international financial architecture remains incomplete. 
⁵ Cruces and Trebesch (2010) find that restructurings with higher haircuts also lead to a) higher post-restructuring spreads and b) longer post-restructuring exclusions from credit markets.
⁶ On the cat-and-mouse game that accompanies restructurings there are many examples; Beattie (2010) details that an investor obtained a novel ruling in the 1990s to attach government payments made through Euroclear, the clearing house in Brussels, the avenue was then closed off through a clarification in Belgian law; Mercopress (2011) discusses the continuing actions of hold-outs from the Argentine restructuring.
⁷ There are of course cases of relatively successful debt restructurings with significant haircuts outside of LAC; one often-cited case is that of Iraq where it is interesting to reflect that this was conducted in the context of significant US political involvement in the country - see Beattie (2010) for comment.
⁸ See Galvis and Saad (2004) for an interesting discussion of advances in collective action clauses including the Uruguay case.
⁹ To a large extent the bipolar view is confirmed in the data on haircuts from 202 sovereign debt restructuring calculated in Cruces and Trebesch (2010). In particular, the authors claim that one half of the haircuts are either lower than 23% (the friendly restructurings) or higher than 53% (aggressive restructurings) and that the 5th and 95% percentiles are 0.11 and 0.71 respectively.  This suggests a distribution that has very fat tails and that is very far from normal.  
¹⁰ For alternative journalistic accounts regarding the lessons for LAC for Europe see Davis (2011) and Krugman (2011).
¹¹ See Bolton and Skeel (2004) on the institutional design for sovereign debt restructuring mechanisms.