How to speed up sovereign debt restructuring

Sean Hagan is former general counsel of the IMF, a professor from practice at Georgetown Law and an adviser to Rothschild & Co. Brad Setser is a senior fellow at the Council on Foreign Relations.

The sovereign debt restructuring process continues to be too slow. Zambia’s forthcoming restructuring agreement comes almost four years after default. Sri Lanka has been in default for two years, and out of the market for much longer. These delays are costly for the sovereign: they undermine foreign investment and domestic confidence, and further extend the timetable for rebuilding payment history and regaining market access.

Even more troubling, a delay in the restructuring of official claims can also delay support from the IMF, jeopardizing the entire economic adjustment process. The IMF did not lend to Sri Lanka for a year after its default because of difficulty in securing agreement among official creditors. As a result, Sri Lanka turned to other sources of emergency credit, undermining the IMF’s centrality in the restructuring process.

What is the source of the delay? Optimistically, the problem can be described as “growing pains”: China became a large creditor only in the past ten years and needs to be given time to internalize the type of stock relief that Paris Club creditors have been providing for decades.

In our view, however, the problem is broader: China’s emergence and the evolving preferences of private bondholders have made all creditor groups more focused on inter-creditor equity. Paris Club creditors are reluctant to move without China, China is reluctant to move without private creditors and private creditors are unwilling to move without knowing the broad terms of the official restructurings. Of course, geopolitical tensions have only exacerbated the mistrust.

In a recent paper, we argue that the existing “sequential” approach to restructuring — where official creditors move before private creditors — is exacerbating these inter-creditor problems and needs to be reformed. In theory, the principle of “comparability of treatment” — where the debtor commits to its official creditors that it will not give its private creditors preferable treatment — is designed to reassure the first movers. But measurement of comparability has become contested. Indeed, the lack of clarity on this issue contributed to the delays in completing Zambia’s restructuring: its agreement with private bondholders had to be re-opened twice because of objections from the official creditors committee.

To address these problems, we propose a shift from sequential restructuring to one where negotiations among the various creditor groups proceed in parallel and, in principle, lead to simultaneous decision-making by all creditor groups. The objective would be to ensure that, before accepting an offer, each creditor group would know what is being offered to the other group.

Simultaneous decision-making does not mean that different creditor groups would receive the same deal. Experience demonstrates that official creditors and private bondholders have different preferences. Bondholders value upfront payments, while official creditors — including China’s policy banks — tend to want to preserve the face value of their claim while having more flexibility to defer near-term payments.

But instead of trying to define, ex-ante, a single “comparability” formula as to how these preferences should be accommodated in every case, a “fair” trade-off between the priorities of different creditor groups would effectively be negotiated on a case-by-case basis. Moreover, a simultaneous settlement would get rid of the need for the type of “clawback” enforcement that is being used as a backstop to the sequential approach. If one group is of the view that the deal being offered to the other was unfair, it would simply withhold acceptance of the deal it was being offered. Fairness would, in effect, be self-enforcing.

For this approach to work, there would need to be more sharing of information than has been the case. More specifically, private creditors would need to receive, at an early stage in the process, information regarding the IMF’s Debt Sustainability Analysis and the macroeconomic parameters that support it. All creditors would need to know the full stock of claims on the debtor and the terms that are being offered to all groups of creditors. Fortunately, over the past two years, the IMF has adopted policies that are designed to ensure that both types of information are made available. It is now a question of implementation. Among other things, Chinese policy banks will need to be more transparent about the stock of their claims and the terms of their restructuring.

One potential objection to simultaneous decision-making is that it would give private creditors excessive leverage, especially if it meant that a deal with official creditors would become contingent upon a deal with private creditors. After all, the sequential restructuring process we have today arose because commercial banks began dragging their feet during the latter part of the 1980s debt crisis: to avoid giving the banks a veto over the process, the IMF adopted a policy whereby, as long as there was a Paris Club commitment to provide debt relief, it would proceed with the approval of a program, with a view to the completion of the commercial bank restructuring at a later stage.

Today, though, most private creditors have limited incentives to slow things down. A protracted process will often result in a fall in the secondary market value of creditors’ claims, particularly when the delay contributes to greater economic dislocation in the country in question.

Creditors have to balance the potential for achieving marginal improvements in restructuring terms over time against the opportunity cost of holding claims that pay no interest — and the risk of receiving a worse offer over time. Moreover, market creditors are aware of the risk that restructuring terms that fail to allow a true return to sustainability won’t create bonds that trade well after the restructuring: The fall in the market value of the bonds that emerged from Argentina’s 2020 restructuring upon completion of the restructuring is illustrative.

Still, one cannot rule out the risk that one or more groups of creditors could hold up the process. Our paper therefore recommends that simultaneous decision making not be required in all cases. For example, official creditors would be free to move without private creditors in cases where private creditors are unwilling to negotiate within the parameters of the IMF debt targets. However, we expect that official creditors would opt to use the simultaneous decision-making process in most cases, since given the diversity of creditors, clarity on equity has become central. There also may be cases where private creditors are willing to conclude a deal before official creditors are ready, as they may prefer the resumption of certain payments to the possibility of getting a better deal after the official creditors conclude their own restructuring.

The sovereign debt restructuring process is built entirely on accepted norms and practices: unlike corporate or bank reorganization, there is no public law that guides the process. One of the advantages of this “soft law” architecture is that it can be adjusted relatively easily to respond to developments in the international financial system. Our view is that, because of the growing complexity of the composition of official creditors, an adjustment is now overdue. We owe it to both low-income and emerging market countries to ensure that we have a restructuring framework in place that is fit for purpose.