An international framework for restructuring sovereign debt

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1 Federal Department of Finance FDF State Secretariat for International Financial Matters SIF An international framework for restructuring sovereign debt Federal Council report of 13 September 2013 in response to the Gutzwiller postulate An insolvency procedure for sovereigns

2 Contents Mandate Overview Sovereign debt and the international financial architecture Trends in government debt Creating debt sustainability Fiscal consolidation and debt reduction Prevention of debt crises Crisis resolution Principles for restructuring sovereign debt Evolution of the current instruments Creation of the Paris Club by official creditors (1956) Restructuring of international bank loans in the London Club The Brady Deal (1989) and the securitisation of sovereign debt Collective action clauses and SDRM as potential solutions for dealing with crises in emerging economies Self-regulation; IIF Principles (2006) Debt crisis in the eurozone and the introduction of eurozone CACs Argentina's problem with holdouts Evaluating the current framework Reform proposals Statutory approaches Permanent courts Ad hoc courts of arbitration Recourse to existing courts Consultation and information sharing platforms (with no jurisdiction) Contractual approaches Collective action clauses Other contractual elements Standardisation of contractual elements Switzerland's position Conclusions Figures Abbreviations Further reading Annex I: Case studies Case 1: Argentina Case 2: St. Kitts and Nevis Case 3: Greece Annex II: Collective action clauses Eurozone CACs G10 CACs Annex III: Activities undertaken by Switzerland in relation to the postulate /40

3 Mandate The Gutzwiller postulate "An insolvency procedure for sovereigns" was submitted on 30 September 2011 with the support of 27 signatories. In its reply of 30 November 2011, the Federal Council expressed its intention to present a report on this matter. The Council of States referred the postulate on 20 December Wording of the postulate The Federal Council is mandated to present a proposal for a fair and independent international insolvency procedure for sovereigns, which also involves private investors and contributes to avoiding future debt crises while ensuring the stability of the monetary and financial system. In its report, the Federal Council should also demonstrate how it intends to advocate for the international support and implementation of its proposal. Reasoning The global financial and economic crisis has caused many countries' debt situation to worsen, in some cases quite substantially. Some of the world's poorest developing countries whose debt had been largely cancelled prior to the crisis have also been affected. To date, however, there are no internationally recognised rules for dealing with highly indebted sovereigns facing insolvency. The need for such rules is exemplified at present by the situation in Greece. New refinancing is still being sought in an attempt to prevent Greece from defaulting. Nonetheless, the likelihood is growing that Greece will no longer be able to service its overwhelming debt load, and with it the voices calling for Greece to declare bankruptcy. An unspecified insolvency procedure would undoubtedly have very serious consequences. As a result, the financial markets are jittery, with direct repercussions on Switzerland in addition to effects from the strength of the Swiss franc. This situation also creates difficulties for some critically indebted countries in the southern hemisphere: these are left to face the crisis on their own, at the mercy of their creditors' interests and decision-making. On top of that, vulture funds are dragging them before courts to force repayment of some questionable debts. Switzerland already proposed a possible alternative in the early 1990s with the idea of an insolvency law for sovereigns. This would require: - an insolvency procedure for states that encompasses all creditors and all debts, - an impartial decision-making model (e.g. an independent court of arbitration), and - an impartial judgement; the IMF and the World Bank cannot act as both creditor and appraiser at the same time without risking a conflict of interests. An orderly debt restructuring procedure would offer debtor countries as well as their creditors the benefits of a predictable and reliable framework. The procedure would be such that it respects each country's national sovereignty and does not create false incentives for debtors to take on even more debt. Also, an impartial approach would, for the first time, offer the possibility of having the legitimacy of creditors' claims checked in the verification of claims framework. This could create an incentive in favour of more responsible lending. Given its strong position in bodies such as the Financial Stability Board, Switzerland would 3/40

4 be well placed to also promote international implementation of such rules. Statement by the Federal Council on 30 November 2011 The Federal Council is concerned by the sharp deterioration of the debt situation in most advanced countries and in some of the world's poorest countries. In this respect, the importance of a prudent economic policy and the creation of suitable mechanisms for consolidating fiscal balances cannot be overemphasised, and, in particular, measures to help prevent over indebtedness. However, for those countries that have already amassed too much debt on the international capital market, the creation of an international insolvency procedure could also be of interest. In the current situation, a discussion on the creation of such an insolvency procedure should be clearly separated from measures to resolve the present debt problems of some individual states, particularly in the euro area. An insolvency procedure could contribute to resolving such problems in the future. However, immediate solutions must be based on the current framework, which do not by any means rule out a sustainable solution to the debt problem. Nonetheless, a predictable framework and process to overcome the problem of coordinating claims of different domestic and international creditors would contribute to finding a solution. With regard to measures for dealing with over indebtedness, a distinction should also be made between cancelling poor countries' debts and debt restructuring in countries that obtain most of their financing on the international capital market. The debt of poorer countries is primarily owed to bilateral and multilateral official creditors and, to a large extent, was addressed by the international HIPC and MDRI initiatives. With countries that obtain most of their financing on the international capital market, the coordination of a highly diverse creditor base is considerably more complex. The restructuring of internationally held sovereign debt should generally be regarded as part of a package of measures to create a sustainable economic environment. As a rule, such packages also include financing within the context of an IMF programme to support the implementation of reforms in economic policy. However, too much financial support increases the danger of creditors again underestimating the risk of default in the future, as they come to rely on international support, and disregarding their duty of due diligence in extending finance. An international insolvency procedure could therefore lead creditors to a more sustainable lending model. Meanwhile, there would have to be guarantees that debtor countries obtain no incentives to wilfully declare bankruptcy. The IMF will and must play a key role in such complex issues of the international financial architecture and its dual function as both creditor and assessor will remain unavoidable. For this reason, particular attention must be given to the principles of transparency in funding and a strict supervision of the IMF by its member states. Switzerland was a strong advocate within the IMF for the creation of an insolvency procedure for states, the Sovereign Debt Restructuring Mechanism (SDRM) from 2000 to Although the work specifically related to the SDRM has been suspended, Switzerland has continued to promote the benefits of further work on such an insolvency procedure within the IMF and other relevant international financial bodies. The Federal Council is therefore prepared to present the Federal Chambers a proposal for an orderly restructuring of sovereign debt and to promote it internationally. Federal Council motion of 30 November 2011 The Federal Council proposes that the postulate should be accepted. 4/40

5 1 Overview The Gutzwiller postulate "An insolvency procedure for states" of 30 September 2011 mandates the Federal Council to "present a proposal for a fair and independent international insolvency procedure for states, which also involves private investors and contributes to avoiding future debt crises while ensuring the stability of the monetary and financial system. In its report, the Federal Council should also demonstrate how it intends to advocate for the international support and implementation of its proposal." The Federal Council adopted the postulate on 30 November It argues in this report, that the absence of a reliable framework for sovereign debt restructuring constitutes a gap in the international financial architecture. Switzerland should therefore continue to support the creation of a more robust framework for restructuring sovereign debt within the relevant international bodies such as the International Monetary Fund (IMF), the Financial Stability Board (FSB), the Paris Club and the G20. The objective of such a framework should not be debt reduction per se or debt relief motivated by development policy but the formulation of reforms that contribute to improving the functioning of markets. The Federal Council proposes that Switzerland support measures to enable a more systematic inclusion of different creditors in debt restructurings. The report shows that this mainly concerns possible international agreements on amendments to sovereign bond contracts. As shown in Chapter 2, the current rise in debt worldwide is a worrying trend. The euro area debt crisis raises, above all, the question of how such situations can be better prevented in the future. At the same time, the development of the crisis makes clear the desirability of a more effective crisis resolution including a more robust framework for dealing with sovereign insolvency. The report spells out principles for such a framework, which should be part of the reforms for a more stable global financial system with well-functioning markets. Chapter 3 describes the evolution of the existing instruments for restructuring sovereign debt. While the current framework is flexible and can adapt to special circumstances, the outcomes it has produced to date are, overall, not satisfactory. Debt restructurings have often been too little and too late, increasing the financial burden on the official sector. The need to coordinate a heterogeneous creditor base across different jurisdictions makes any possible solutions difficult to implement. Also, those creditors who refuse the restructuring deal, so-called holdouts, pose a threat to finding a generally acceptable solution. Chapter 4 presents the main current proposals for reforming the framework for sovereign debt restructuring and evaluates their feasibility. Basically, these proposals can be divided into statutory approaches, which foresee some form of institutionalised jurisdiction, and approaches based on sovereign debt contracts. It is shown that while there already exists a wide range of proposals, there is very little international support at present for discussing holistic reform approaches. Against this background, the report shows how the work can nonetheless proceed in pragmatic steps based on the contractual approach. Chapter 5 draws conclusions for Switzerland's further engagement in favour of a more robust international framework for restructuring sovereign debt. This report also serves to fulfil the Eymann postulate The Eymann postulate "Creation of arbitration proceedings for reconciliation of interests between debtor countries and creditors" of 20 March 2000 called upon the Federal Council to "work with likeminded countries to create independent and transparent arbitration proceedings for the reconciliation of interests between debtor countries and creditors, particularly for the establishment of an international insolvency law." On 4 October 2000, the National Council 5/40

6 referred the motion in the form of a postulate at the request of the Federal Council. The Federal Council believes that the Eymann postulate is also fulfilled by the present report and will therefore propose its dismissal. 6/40

7 2 Sovereign debt and the international financial architecture The current rise in government debt levels worldwide is a worrying trend: high public debts crowd out private enterprise, limit states' room for manoeuvre, burden future generations and can, when there are doubts concerning the ability to service debts, pose a threat to financial stability and thus also economic growth. The global financial crisis, which originated in the US subprime mortgage crisis in 2007, and the subsequent sovereign debt crisis in the euro area caused public debt to rise sharply in most industrialised countries. Several countries Iceland, Ireland, Portugal, and Cyprus needed massive international support programs with drastic fiscal adjustments to continue to be able to service their debts. In the case of Greece, the restructuring of sovereign debt held by private investors was part of a reform package supported by the eurozone countries, the European Central Bank (ECB) and the IMF. The costs of this package are enormous. Above all, the euro area debt crisis raises the question of how such situations can be better prevented in the future. At the same time, the development of the crisis makes clear that more effective crisis resolution would be desirable including a more robust framework for dealing with sovereign insolvency. The according work must take place in the context of the reforms for a more stable global financial system with well-functioning markets. 2.1 Trends in government debt Figure 2.1 summarises debt developments worldwide over nearly the past 100 years, showing a broad historical perspective of debt-to-gdp ratios in large advanced, emerging and low income countries. Figure 2.2 also shows the debt-to-gdp ratios of some of the world's leading economies in the years 1960, 1980, 2000 and Figure 2.1: Global debt developments since (adjusted for purchasing power) Debt-to-GDP ratio G-20 advanced G-20 emerging Low income 1 Source: IMF, Fiscal Affairs Department; 2012 data based on provisional estimates 7/40

8 Figure 2.2: Debt-to-GDP rates of selected countries in 1960, 1980, 2000 and Country USA Canada Germany UK France * Italy Ireland Spain Portugal * Greece Cyprus Iceland * Japan * Australia Brazil China India Mexico Switzerland * In all of the large advanced countries, debt ratios trended up since the 1990s and rose sharply after the 2007 financial crisis. This was driven by debt in Japan, the US and the euro area. Despite efforts to consolidate their public finances, these countries are likely to see their debt rise even further. The IMF expects debt ratios to peak in 2014, although it remains unclear how quickly the burden can be reduced. Advanced countries generally place their debt on the market. Until recently, their sovereign bonds were commonly seen as safe investments. Their main creditors are domestic and international banks, central banks, state funds and institutional investors. Emerging economies have generally managed to maintain stable public debts over the past ten years, thanks to robust growth as well as low interest rates worldwide. The vast future demands in these countries to build up infrastructure and social security networks are likely to increase the pressure on public spending. Higher interest rates and, as in most advanced countries, the challenges of ageing populations could bring emerging economies' public finances under pressure. Emerging economies finance themselves predominantly by accessing international financial 2 Source: IMF, Fiscal Affairs Department; * indicates provisional data 8/40

9 and capital markets, making them vulnerable to fluctuations on these markets. They are also the biggest customers of the World Bank and the regional development banks. On average, the debt ratio of low income countries has more than halved since the 1990s, mainly due to the generous debt relief by bilateral and multilateral creditors. The Heavily Indebted Poor Countries (HIPC) Initiative launched in 1996 produced debt relief of some USD 76 billion. This was primarily borne by the official creditors of the Paris Club (36%), the World Bank (20%), other official bilateral creditors (13%), the IMF (9%) and other multilateral creditors. At 6%, the proportion of debt relief from commercial private creditors was comparatively low. The HIPC Initiative was enhanced by the Multilateral Debt Relief Initiative (MDRI), launched in 2005 by the G8. It brought the cancellation of the entire multilateral debt of heavily indebted poor countries with the IMF, the World Bank and the African Development Bank (AfDB). This was intended as a contribution to meeting the United Nations' Millennium Development Goals (MDGs) and to helping these countries to achieve debt sustainability. Together, HIPC and MDRI have reduced the debt levels of highly indebted poor countries by an average of 90%. Debt service was cut by an average of 2% of economic output. At the same time, there was an increase in spending on poverty reduction. The approach taken by HIPC and MDRI was holistic and focused on strengthening national institutions to support poverty reduction and growth strategies. Most of the countries significantly improved their economic policy toolkit and particularly their fiscal and debt management capacities. Debt levels are, nonetheless, rising again rapidly in some of the more dynamic countries (e.g. Ghana, Senegal, Tanzania and Uganda). Against this background, it remains uncertain whether an excessive increase in public debt can be sustainably prevented. Since debt relief was granted, the composition of the creditor base has changed markedly: whereas up to 98% of creditors in the 1980s and 1990s were multilateral and traditional bilateral creditors, recent years have seen a return of private capital flows into poorer countries. This is due, on the one hand, to the more credible and sustainable economic policies pursued by these countries. On the other hand, it is also a result of low interest rates worldwide, making the relatively higher yields on investments in developing countries increasingly attractive. More and more HIPC countries can now access international financial and capital markets and thus issue sovereign bonds. Some 10% of developing countries' debt is now held by private creditors. The growing significance of private capital markets in developing countries raises new challenges and makes them more vulnerable to global market developments. For several years now, "new creditors" such as China, Brazil and India have come to play an important role in financing. These invest in low income countries, where they cover a significant portion of their demand for raw materials. There is often a degree of uncertainty regarding the terms on which according loans are granted and how they fit into the development architecture. The lower debt levels in low income countries achieved through HIPC and MDRI, the changing role of emerging market economies and the growing debts of advanced countries are the main reasons behind the lack of international support for further debt cancellation for low income countries. In addition, a global framework for restructuring sovereign debt would, in principle, apply to all countries. 9/40

10 2.2 Creating debt sustainability The above makes clear that achieving and maintaining debt sustainability is a great global challenge. Without sustainable debts, it will hardly be possible to stabilise the global financial system. Ensuring debt sustainability is, essentially, the responsibility of the debtor country, which contains its debts through a prudent conduct of fiscal policy. Private and official creditors make an important contribution to preventing debt crises by conducting appropriate risk assessments and by ensuring that a risk-adjusted interest rate enforces discipline on the debtor countries lending patterns. This requires corresponding market-based incentives for creditors to assess risks adequately, which are closely linked to the rules and practices of the national and international official sector. A stronger general framework to ensure sustainability of debts therefore requires good coordination and general consistency between the individual countries' reform efforts and the international financial architecture. In this respect, the efforts to strengthen the IMF's surveillance activities which include members' debt sustainability analyses play a pivotal role. The IMF's surveillance of members economic policies is, however, beyond the scope of this report Fiscal consolidation and debt reduction In the current environment of modest global growth, stabilising or reducing debts poses particular challenges for economic policies. Carefully designed retrenchments have a positive impact on medium and long-term growth prospects and can substantially influence expectations in the short term. Therefore, fiscal consolidation must not necessarily be inconsistent with efforts to promote growth. However, this does require acceptance and adoption of credible measures that are well targeted and well timed. In principle, the international community is aware of the positive long-term impact of conservative fiscal policies, as repeatedly stated, for example, in G20 initiatives as well as the IMF s analyses and policy recommendations. Many countries are, nonetheless, hesitant to adopt and implement concrete measures. This means that the road to debt sustainability could well remain a long one. Switzerland is, in international bodies such as the IMF and the G20, a strong advocate of setting and implementing credible consolidation targets. Despite some exceptions, it must be recognised that the main reason behind persistent fiscal deficits is the lack of structural reforms and an inadequate assessment of risks. For example, the materialisation of risks from contingent liabilities related to large financial institutions led to enormous burdens on public finances in many countries Prevention of debt crises Debt sustainability reflects a country's willingness to use official funds sensibly and economically and to take a prudent approach to long-term debt management. Governments must, above all, keep their own houses in order, meaning that the implementation of sustainable fiscal policies should be accompanied by structural and financial sector reforms. Sustainable debt management comprises a complex interaction between monetary, fiscal and financial sector policies. This poses a particular challenge to states with weak institutions. Switzerland therefore supports international initiatives and projects that support developing and emerging economies in attaining sound public finances and which enhance their competitiveness and integration into the global economy. This includes measures such 10/40

11 as the reinforcement of debt management capacities, mobilisation of the country's own tax revenues, responsible use of official funds and the promotion of a stable and strong financial sector. Fiscal rules can play an important role in ensuring medium-term sustainability of public debts. Switzerland's experience with the debt brake shows that clear budgetary targets are by no means incompatible with growth; in fact, they can actually go towards creating confidence on the markets. However, the credibility of fiscal rules depends on the relevant countries having a sound track record. Countries' debt management could be generally improved with a more systematic risk assessment and the inclusion of this in fiscal planning. This also includes improving transparency in public accounting and the corresponding international tools. This is particularly evident from two examples from the euro area debt crisis: The correction of Greece's budget deficit in the wake of the crisis was due to the fact that the authorities did not have reliable figures on the actual debt situation. In Portugal's case, the lack of transparency on liabilities incurred as part of Public Private Partnerships resulted in the actual level of government debt being significantly underestimated. There is, therefore, a pressing need to strengthen and harmonise the rules for public accounting, to ensure their systematic implementation and to support states with weak public institutions. The IMF, in particular, is reviewing its toolkit for overseeing its members budgetary situations. At the same time, several international bodies (IMF, OECD, World Bank, UNCTAD, and G20) are currently working on establishing internationally recognised practices for debt management and debt financing. Of particular importance are the IMF's debt sustainability analyses, which help to identify non-sustainable debt developments as early as possible. Private creditors also make an important contribution to preventing debt crises. As shown in the case of the euro area debt crisis, imprudent risk assessments can exacerbate the impact of a debt default on the international financial system. Misjudgements can seriously impact the functioning of money and capital markets over many years. In turn, bank bailouts, i.e. the use of substantial official funds to recapitalise financial institutions, also cause public debt to increase sharply. The vicious circle between public debt and undercapitalised banks can then have a destabilising effect on the real economy. Reforms in the international financial system seek to break this vicious circle, among other things, by making private creditors take responsibility for assessing credit risks. This includes a review of the risk assessment models and accounting rules. Rating agencies should detect potential risks more accurately and communicate these faster so as to create added value among market participants. Also, systemically relevant financial institutions should adopt additional precautionary measures in the form of stricter capital and liquidity requirements. Finally, the rules for the resolution of banks should be made more predictable. At the same time, the IMF and the FSB are pushing forward reforms for stronger prudential supervision of the financial system and of economic policies, with the G20 playing a significant role Crisis resolution Even if preventative measures can be stepped up considerably, it will most likely not be possible to prevent future financial and debt crises entirely. A well-designed and effective toolkit for crisis resolution will therefore continue to be necessary. Where crises are of global nature, the international official sector is of particular significance. Above all, this includes the multilateral institutions of the IMF, the World Bank and regional development banks as well as other countries or country groups and their central banks. 11/40

12 The goal of international intervention in crisis resolution is to stabilise the situation and prevent it from spreading to other countries or regions. The extent of intervention is largely determined by the perceived risk of such a crisis spreading regionally or internationally. Generally, the objective is to restore public finances to a long-term sustainable level through fundamental institutional and economic reforms. Fresh funds should be made available temporarily to bridge the time until necessary adjustments have been made. In the past, international official sector support has, in most cases, helped to overcome crisis situations and prevent them from spilling over into other countries and regions (e.g. Mexico, Brazil, Turkey, Uruguay, Iceland, and Ireland). There are, however, also risks and distortions associated with official sector involvement. If the debtor country and its creditors can expect the official sector to provide emergency financing, this will affect the way default risk is assessed. In this respect, the official sector's financial engagement can, in principle, create moral hazard among both, creditors as well as debtors. If a sustainable debt situation cannot be restored through bridge financing, the debt will have to be restructured. This implies that private creditors are also involved in financing the resolution of the crisis. Such private sector involvement is compatible with IMF policy, which permits lending into arrears, provided that the debtor country is negotiating in good faith with its private creditors a restructuring of its debts. In reality, however, both the debtor country and its creditors have a natural tendency to avoid debt restructuring whenever possible. Debtor countries fear that restructuring will damage their long-term reputation as being willing and able borrowers and thereby sharply increase their financing costs due to the higher perceived credit risk. Large creditor banks fear the loss of market and investor confidence because of their risk positions, which could also trigger the need to recapitalise. For one thing, this results in unsustainable situations dragging on for years a situation from which neither the country nor its creditors stand to benefit. It also ties up official funds excessively, thereby transferring the burden from the private to the official sector. Finally, avoided restructurings increasingly distort markets assessment of the risks associated with government bonds. 2.3 Principles for restructuring sovereign debt High public debts crowd out private enterprise, limit states' room for manoeuvre, burden future generations and can, when there are doubts concerning the ability to service the debts, pose a threat to financial stability and thus also economic growth. The current reforms of the international financial architecture must ensure that countries bring their debts to sustainable levels as quickly as possible, that they establish the instruments and institutions to prevent debts from building up again, and that the markets for sovereign bonds function more smoothly. The last point, in particular, means that default risks are appropriately assessed and priced. As long as excessive engagements of official funds are used to avoid sovereign insolvencies, markets will not assess risks accurately. Improving the functioning of markets is thus a core motivation for creating a more predictable framework for restructuring sovereign debt. Based on the above discussion, the Federal Council derives the following principles for a more robust framework for restructuring sovereign debt: Crisis resolution should seek a fair burden sharing among all creditors. The inclusion of private creditors in crisis resolution should, in particular, be better anchored in the international financial architecture. 12/40

13 The restructuring of sovereign debt must find acceptance as a credible measure of last resort: The existence of a reliable framework would act as a deterrent, reducing creditor and debtor moral hazard and thereby improving the assessment of sovereign bond risks. An orderly framework for restructuring sovereign debt would ensure greater predictability and make it easier to achieve a long-term sustainable debt situation across borders. The objective of restructuring should not be debt reduction per se. Instead, it should form part of the reform measures to put the economy on a path that is sustainable in the long-term. 13/40

14 3 Evolution of the current instruments The instruments currently available for restructuring sovereign debt have evolved in different waves. While sovereign insolvencies have occurred for centuries, the roots of the current approaches to deal with them lie in the period between the 1950s and the 1970s, when a number of emerging economies and developing countries became excessively indebted to traditional creditor countries and to bank syndicates. When it came to renegotiating these debts, the various international creditors needed to be treated as equally as possible. This resulted in the creation of two informal groups: the Paris Club, for the debtor country's negotiations with its official creditors, and the London Club for coordinating the negotiations with commercial banks. The Latin American debt crisis of the 1980s was resolved by splitting up and re-securitising bank debts. This started the spread of internationally issued and traded sovereign bonds, which, in turn, fundamentally altered the creditor structure of emerging economies. With regard to debt restructurings, the changed structure of lending exacerbated the problem of coordinating an increasingly heterogeneous creditor base and the risk of "holdout" creditors. The lack of an orderly framework to deal with sovereign insolvency again came to the fore with the crises in emerging economies in the mid-1990s, where private creditors played a dominant role in negotiations. With a view to bridging this gap, the IMF discussed the possibility of a Sovereign Debt Restructuring Mechanism (SDRM) in the period between 2001 and Such a mechanism failed to attract majority support among the international community, however, and was opposed by the large international banks. Nonetheless, these discussions did make a contribution to defining the key aspects of sovereign debt restructurings. The SDRM also helped to advance the broader introduction of collective action clauses (CACs) in bond contracts. Through the creation of the European Stability Mechanism (ESM), CACs have now become a regional standard. 3.1 Creation of the Paris Club by official creditors (1956) The Paris Club 3 is an informal group of industrialised nations 4 which coordinates the rescheduling of bilateral official debts of low income and emerging market countries. The sole object of discussion within the Paris Club is public debt and government-backed assets of creditor countries, which are also guaranteed by the debtor country. Depending on its debt situation and state of economic development, a debtor country may qualify for different debt rescheduling conditions. The Paris Club grew out of talks held in 1956 to renegotiate Argentina's debt. Originally, Paris Club agreements covered only the extension of maturities and did not include debt reduction. This changed in the 1980s when a number of very poor countries were unable to continue servicing their debts. With the establishment of the HIPC Initiative in 1996 (cf. Section 2.1), the Paris Club began to play a key role in debt relief for some of the world's poorest countries. To date, the Paris Club has concluded more than 428 debt restructuring contracts with 90 debtor countries, covering a total of USD 573 billion of debt. Decisions within the Paris Club are taken according to its own rules and principles, the main ones of which are: 3 Cf. also 4 The permanent members of the Paris Club are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Russia, Spain, Sweden, Switzerland, United Kingdom and United States. 14/40

15 Case-by-case debt treatment: The Paris Club makes decisions on a case-by-case basis in order to tailor its action to each debtor country's individual circumstances and needs. This aims to address the extraordinary nature of each debt restructuring. Consensus: All decisions are taken by unanimous vote among the members. This ensures a degree of solidarity between official creditors. Conditionality: The Paris Club negotiates debt restructurings only with debtor countries that are committed to implementing reforms under an IMF programme. Solidarity: All members of the Paris Club agree to act in a manner that ensures that the burden of debt restructuring is more or less equally distributed among all members. Comparability of treatment: The debtor country guarantees that no other creditor obtains a more favourable deal. If private creditors or non-members receive better restructuring terms, members of the Paris Club are also entitled to higher payments. This does not concern the preferred status of multilateral creditors. In the past, the Paris Club has played a key role in debt restructurings. Recent developments have caused it to lose some significance, however. For instance, debt relief in the poorest countries is now largely complete under the HIPC Initiative. As briefly mentioned in Chapter 2, the nature of debt has also changed considerably, particularly among the world's poorer countries. New creditors have appeared, such as China, India and Brazil, which were not previously members of the Paris Club and thus have participated only marginally in debt cancellation. Also, more and more lower income countries are now seeking finance on the international capital market. This raises the question as to how the Paris Club could share its vast experience in orderly debt rescheduling negotiations in the future. 3.2 Restructuring of international bank loans in the London Club The London Club emerged alongside the Paris Club as an informal grouping to renegotiate official debt owed to international commercial banks. It originated in the 1970s, when commercial banks (again) increasingly assumed the role of state creditors, particularly in Latin America. At the time, commercial banks also joined forces in syndicates so as to be able to offer larger loans to official debtors. As a rule, these syndicated loans were denominated in foreign currency and carried a variable interest rate. In the early 1980s, rising interest rates worldwide and depreciating currencies in many emerging market and developing countries contributed to a debt crisis. Mexico (1982) and a number of other countries, mainly in Latin America, were no longer able to service their debts to international banks. As most loans had been granted by bank syndicates, they contained a "cross default clause", whereby the failure to service one creditor can trigger the default for all other creditors. This means that the costs of a non-payment to one bank in the syndicate would have to be borne proportionately by all the other banks. As a result, the banks forming a syndicate were forced to enter into joint negotiations with the relevant governments. With some loans involving up to 500 banks, it was clear that reliable creditor coordination was needed. The banks with the greatest interest in the loans joined together to form ad hoc groups called Bank Advisory Committees. These generally met in London, hence the name. The negotiating structure within the London Club proved effective for the challenges faced at the time: the number of majority banks was limited, and their interests contributed to a positive negotiating outcome. Many banks were in favour of extending additional loans to debtor countries so as to avert a payment default. This gave them extra time to increase their 15/40

16 reserves against default. Also, many commercial banks were anxious to maintain a good relationship with the debtor country. There was therefore limited interest in insisting on immediate repayment of the entire debt and in pursuing legal action. In principle, the ad hoc system of the London Club still exists. However, the increased diffusion of government bonds has greatly altered the creditor composition and thus also the role of international banks (cf. Section 3.3). Long-term relationships between a debtor country and its creditors a situation that once contributed to finding a solution have become rarer. With the International Institute for Finance (IIF), a centralised lobby of large international banks has been established (cf. also Section 3.5). 3.3 The Brady Deal (1989) and the securitisation of sovereign debt The 1989 Brady Deal brought a resolution to the Latin American debt crisis. The deal converted bank loans at a discount into "Brady bonds", which were backed by US Treasuries and loans from the IMF and the World Bank. The banks could then trade in loans that were no longer serviced. The creation of Brady bonds quickly led to the spread of standardised government bonds that were easy to trade in markets. One of the lessons from the Latin American debt crisis was the realisation of the huge risks inherent to extending large bank loans to official creditors, particularly emerging economies with poorly developed markets. With the exchange of traditional bank loans (at a discount) for standardised and tradable Brady bonds, risks could be better spread and priced. The growth of securitised bonds opened up new investment opportunities for smaller and more anonymous investors. The diversification of the creditor base changed the incentives of creditors, who were not necessarily as interested as the banks in securing follow-up business in the relevant countries. With regard to a framework for restructuring sovereign debt, the Brady Deal paved the way for a more diverse international creditor base. This, in turn, made short-term valuation more important, making the reliability of the markets risk assessments all the more crucial. Furthermore, the variety of jurisdictions now issuing bonds has made debt restructuring even more complex and costly and achieving an even-handed treatment of all creditors more difficult. On the other hand, the securitisation and international tradability of debt have given emerging markets and developing countries much easier access to global capital and thus greater financing opportunities. 3.4 Collective action clauses and SDRM as potential solutions for dealing with crises in emerging economies The crises that hit emerging market economies (Mexico, Korea, Brazil, Russia, Argentina, Uruguay) in the mid-1990s increasingly highlighted the problems associated with a diverse and international group of creditors. Access to the ever more dynamic international financial markets had given these countries a means of covering their significant capital needs. They seized the opportunity to raise funds in different countries and currencies, spreading their external debt over a highly diverse international creditor base. The main places of issue for emerging market bonds were traditionally London and New York, followed by others such as Frankfurt, Zurich and Tokyo. As a rule, the place of issue determines the terms of the bond, the applicable law and the place of jurisdiction. Thus, apart from the increased heterogeneity of creditors, there was also greater diversity in terms of legal procedure. Clearly, any debt restructuring that became 16/40

17 necessary could be expected to involve long and costly negotiations and procedures. In seeking ways to prevent costly debt workouts, renegotiation of the payment terms for bond contracts became relevant: while bonds issued under English Law generally allowed for a renegotiation of payment terms, New York-issued securities explicitly excluded this possibility. 5 The market had overlooked this fundamental contractual difference for decades, with no difference in price between similar issuances in New York and London. One reform measure pursued by the Group of Ten (G10) 6 since 1995 was the introduction of collective action clauses (CACs) in government bonds issued under the laws of foreign countries (cf. also Section 4.2 and Annex II). This aimed to allow for the restructuring of bond contracts and eliminate the problem of holdouts, i.e. creditors who reject a restructuring deal and subsequently take legal action to assert their contractual rights. Based on the work of the G10 7, a large portion of the bonds issued by emerging market economies abroad have contained CACs since From 2001 to 2003, the IMF held talks with the international community, the private sector and a broader public on the establishment of an institutionalised insolvency procedure for states, the Sovereign Debt Restructuring Mechanism (SDRM). The SDRM sought to address not only the problem of holdout creditors but also that of collective action, given a diverse international creditor base. The introduction of CACs was meant to be a complementary element of the mechanism. The SDRM's main objective was to provide strong incentives for debtor countries and their creditors to reach a consensus quickly and in an orderly and predicable fashion and thereby bring about a long-term sustainable situation. The very existence of the SDRM, i.e. the possibility of debt being restructured, was supposed to work as a deterrent for creditors and debtors alike, so the SDRM would ideally never need to be activated. Only the debtor country would have been able to activate the SDRM, by demonstrating its inability to reach a sustainable debt situation. The basic pillars of the SDRM were debt restructuring by way of a qualified majority decision, the possibility of a temporary debt moratorium, creditor protection, and mechanisms to raise fresh funds. Supervision of the process was to be transferred to a Sovereign Debt Dispute Resolution Forum (SDDRF), an independent international body of arbitrators. The SDRM could have been established through an amendment of the IMF Articles of Agreement, requiring an 85% majority within the IMF. This would have created new international legislation as the SDRM's restructuring decisions would have been internationally binding, requiring the revision of national laws. Most of the support for the SDRM came from Europe, Canada and Japan. The emerging market economies, at which the mechanism was targeted, remained highly sceptical. For its part, the US used the discussions on the SDRM to advance the introduction of CACs: immediately after the G10's model CACs were published, the US succeeded in suspending IMF talks on the SDRM. Many countries thought the loss of sovereignty associated with the internationally binding force of restructurings under the SDRM to be too great. The private 5 In fact, under the US Trust Indenture Act of 1939, bondholders could not be forced to waive their rights from a bond contract. 6 The G10 was founded in 1962 by the world's leading industrialised countries. The founding members (US, Canada, UK, France, Germany, Italy, Belgium, Netherlands, Sweden and Japan) extended extraordinary loans to the IMF under General Arrangements to Borrow (GAB). Switzerland became the 11th member of the G10 in Group of Ten (2003). Report of the G-10 Working Group on Contractual Clauses. Washington, D.C. 17/40

18 sector also exhibited a largely negative attitude towards an institutionalised procedure. The main achievement of the SDRM was the systematic consideration given to complex restructurings with a large creditor base in different jurisdictions. Although it continues to have only little backing, as is likely the case with most other proposals having international legal effect (cf. Section 4.1), the SDRM does provide a holistic and timely approach to resolving the main problems of restructuring sovereign debt that is held by a diverse and international creditor base. 3.5 Self-regulation; IIF Principles (2006) The period following the rejection of the SDRM in the spring of 2003 was marked by a robust global economy and relative calm on international financial markets. Many countries took this opportunity to reduce their public debts. The International Institute of Finance (IIF), the association of the largest international banks, utilised this favourable environment to promote an approach of self-regulation. The IIF had been a firm opponent of the SDRM and, originally, the IIF had also had serious reservations about CACs. This changed with the work of the G10 in Then in 2006, together with representatives of the main emerging markets, the IIF adopted general, nonbinding principles for public debt. These principles advocate introducing CACs and include non-binding principles for crisis resolution and debt restructuring. A key element of the principles is the terms and conditions for the cooperation of the debtor country with its creditors. The focus here is on transparency, timely information, regular dialogue and cooperation, good-faith actions, and fair treatment of creditors. The IIF has since then led creditors in a series of restructuring negotiations, e.g., with Greece. Based on this experience, the principles were revised in 2012 and basically extended to all debtor countries. The IIF principles 8 are non-binding and constitute a useful basis for discussion. Given the IIF's many references to Greece in the revised principles, it is quite clear that these are still a work in progress and not yet a refined framework. On certain points, such as the independent drafting of debt sustainability analyses, they are not compatible with IMF policy. Also, the principles establish relatively more obligations for the debtor countries than for creditors, a fact that could jeopardise their general legitimacy. The IIF principles contain useful recommendations for restructuring government debt. For cooperative, rapid and adequate debt restructuring, however, they do not constitute a robust framework of action. The main points of relevance for future discussions are likely to be: - Interest: The private sector appears to have an interest in establishing a stable framework. - Flexibility: A certain degree of flexibility is important, as demonstrated by a range of aspects in the case of Greece. - Representativeness: It is not clear whether the IIF, which represents the interests of large international banks, can appropriately represent all creditors. - Responsibility: More clarity is needed regarding the division of duties and responsibilities between creditors and debtors. - Soundness: Very little has been said to date about the delays in restructuring on account of some European banks being too thinly capitalised. 8 Cf. Principles for Stable Capital Flows and Fair Debt Restructuring. 18/40

19 3.6 Debt crisis in the eurozone and the introduction of eurozone CACs The prospect of sovereign insolvency in Greece and other eurozone countries gave rise to the creation of the European Financial Stability Facility (EFSF). This European rescue fund was soon thereafter transferred to the European Stability Mechanism (ESM), a permanent crisis resolution mechanism for eurozone countries. The ESM came into force on 27 September 2012, offering support for eurozone countries with severe financing difficulties, under certain economic-policy conditions, through loans from the community of euro states. The treaty establishing the ESM provides for the creation of a permanent facility with a credit volume of EUR 500 billion. Another element of the treaty is the introduction of CACs for all government bonds newly issued by eurozone countries from 1 January Known as eurozone CACs, these are a further development of the G10's model CACs published in 2003 (cf. Annex II). In particular, they include an aggregation clause whereby restructuring decisions can be made to apply to different issuances. The case of Greece (cf. Annex I) was instrumental in resuming the international discussions on state insolvency in the following aspects: - Consensus existed at an early stage on the need for debt restructuring. Delaying such action turned out to be extremely costly for most stakeholders. A particular problem is the extraordinarily high engagement of official funds, which replaced private engagement. - Debt contracts subject to domestic law provide room for manoeuvre in the case of debt restructuring. This is likely to create considerable uncertainty in future cases. - Flexibility was important as, due to its high level of debt issued under national law, Greece was not a typical case of debt restructuring. - CACs were of key significance, though mainly because of their absence in Greek bonds. However, even where they did exist, they could not always resolve the holdout problem. - For the first time, credit default swaps (CDS) played a significant role, as there was much uncertainty surrounding their effect and the behaviour of the creditors covered in the restructuring negotiations. A core problem was the fact that activating CDS was subject to a decision by one of the committees within the International Swaps and Derivatives Association (ISDA). - It is unclear whether creditors' interests are adequately represented by the IIF. 3.7 Argentina's problem with holdouts Holdouts are creditors who decide not to accept the debt restructuring deal and then subsequently seek legal action to assert their contractual rights. One of the main types of holdouts are what are known as "vulture funds", which purchase bonds at highly discounted prices during the crisis with a view to claiming redemption of their full face value in case of an insolvency. Until recently, the problem of holdouts one of the main driving forces behind the SDRM was generally perceived to be exaggerated. 10 In the spring of 2013, however, the Court of Appeals in New York ruled in favour of holdout creditors asserting their rights from Argentine bonds issued prior to the 2001 state bankruptcy. This ruling was based on an interpretation of the pari passu clause, which is a standard element of most bond contracts, intended to 9 For the terms of reference of eurozone CACs, see: 10 In the context of multilateral debt relief (HIPC/MDRI), however, there have been several cases in which private investors claimed redemption and thus pushed up the cost of debt relief that was financed by official funds. 19/40

20 guarantee that all creditors of the same class are treated equally. Over time, the pari passu clause came to be interpreted to refer to making proportionate payments to the holders of new bonds as well as holdouts. The New York court went one step further, forbidding Argentina to pay the holders of the exchanged bonds before settling the holdouts' claims, thereby forcing payment of the holdouts. This ruling could set a precedent for future holdout cases, making it far more interesting to hold out, and limiting the advantages of the flexible ad hoc approach used today. This would eliminate much of the incentive to accept debt restructuring deals. The case of Argentina also shows the lack of coordination between the different courts and jurisdictions. Independently of each other, courts in different jurisdictions and also the World Bank s International Centre for Settlement of Investment Disputes (ICSID) handle cases brought by holders of Argentine bonds (cf. also Section and Annex II). This international dispersion of court cases is particularly problematic in the context of equitable treatment of creditors. This, in turn, could well spur calls for a more reliable framework for sovereign debt restructuring. 3.8 Evaluating the current framework The current framework for restructuring sovereign debt remains informal and based on voluntary ad hoc solutions. In regard to the restructuring of debt, recent resolutions of crises have not produced wholly satisfactory outcomes. Moreover, a range of new problems has surfaced. The question is, therefore, to what extent this framework could be enhanced. As the case of Greece shows, the current ad hoc approach can accommodate special circumstances quite well. This has, however, not produced particularly satisfactory solutions. Restructurings tend to come late and place an excessive financial burden on the national and international official sector. Regarding organisation and solution finding, the restructuring talks in the case of Greece were satisfactory. The fact that most of the debt was subject to domestic law facilitated considerably the solution. Similar types of solutions are, however, likely to be anticipated by creditors in the future and will therefore probably be excluded. Eurozone CACs address the holdout problem and create the basis for coordination across different groups of creditors. It has not been proven, however, that CACs and aggregation clauses are sufficient for reaching a decision among creditors of different jurisdictions. Debt relief of the poorest countries by official creditors was resolved quite satisfactorily with the current approach under the Paris Club. The international community will, however, have to ensure a renewed build-up of excessive debts is prevented. The protection by a New York Court of Appeals of claims by holdouts of Argentine bond is likely to make creditors less willing to voluntarily accept debt restructuring deals. Given the protracted proceedings over many years, the question arises as to whether a final restructuring decision binding on all parties would not be advantageous. There is no possibility of a debt moratorium to protect creditors from other creditors being paid out in full before a debt restructuring deal is concluded. Fresh funds for crisis resolution generally come from official sources, which should therefore be excluded from the restructuring. However, there are no reliable mechanisms or incentives for a comparable mobilisation of private funds. This further complicates private sector involvement in crisis resolution. 20/40

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