A step for­ward for sov­er­eign debt

“In Greece, the ab­sence of an in­ter­na­tional le­gal frame­work was an im­por­tant rea­son why its cred­i­tors – the troika of the Euro­pean Com­mis­sion, the Euro­pean Cen­tral Bank, and the In­ter­na­tional Mon­e­tary Fund – could im­pose poli­cies that in­flicted enor­mous h

Financial Mirror (Cyprus) - - FRONT PAGE -

Ev­ery ad­vanced coun­try has a bank­ruptcy law, but there is no equiv­a­lent frame­work for sov­er­eign bor­row­ers. That le­gal vac­uum mat­ters, be­cause, as we now see in Greece and Puerto Rico, it can suck the life out of economies.

In Septem­ber, the United Na­tions took a big step to­ward fill­ing the void, ap­prov­ing a set of prin­ci­ples for sovereign­debt re­struc­tur­ing. The nine pre­cepts – namely, a sov­er­eign’s right to ini­ti­ate a debt re­struc­tur­ing, sov­er­eign im­mu­nity, eq­ui­table treat­ment of cred­i­tors, (su­per) ma­jor­ity re­struc­tur­ing, trans­parency, im­par­tial­ity, le­git­i­macy, sus­tain­abil­ity, and good faith in ne­go­ti­a­tions – form the rudi­ments of an ef­fec­tive in­ter­na­tional rule of law.

The over­whelm­ing sup­port for th­ese prin­ci­ples, with 136 UN mem­bers vot­ing in favour and only six against (led by the United States), shows the ex­tent of global con­sen­sus on the need to re­solve debt crises in a timely man­ner. But the next step – an in­ter­na­tional treaty es­tab­lish­ing a global bank­ruptcy regime to which all coun­tries are bound – may prove more dif­fi­cult.

Re­cent events un­der­score the enor­mous risks posed by the lack of a frame­work for sov­er­eign debt re­struc­tur­ing. Puerto Rico’s debt cri­sis can­not be re­solved. No­tably, US courts in­val­i­dated the do­mes­tic bank­ruptcy law, rul­ing that be­cause the is­land is, in ef­fect, a US colony, its gov­ern­ment had no au­thor­ity to en­act its own leg­is­la­tion.

In the case of Ar­gentina, an­other US court al­lowed a small mi­nor­ity of so-called vul­ture funds to jeop­ar­dise a re­struc­tur­ing process to which 92.4% of the coun­try’s cred­i­tors had agreed. Sim­i­larly, in Greece, the ab­sence of an in­ter­na­tional le­gal frame­work was an im­por­tant rea­son why its cred­i­tors – the troika of the Euro­pean Com­mis­sion, the Euro­pean Cen­tral Bank, and the In­ter­na­tional Mon­e­tary Fund – could im­pose poli­cies that in­flicted enor­mous harm.

But some pow­er­ful ac­tors would stop well short of es­tab­lish­ing an in­ter­na­tional le­gal frame­work. The In­ter­na­tional Cap­i­tal Mar­ket As­so­ci­a­tion (ICMA), sup­ported by the IMF and the US Trea­sury, sug­gests chang­ing the lan­guage of debt con­tracts. The cor­ner­stone of such pro­pos­als is the im­ple­men­ta­tion of bet­ter col­lec­tive ac­tion clauses (CACs), which would make re­struc­tur­ing pro­pos­als ap­proved by a su­per­ma­jor­ity of cred­i­tors bind­ing on all oth­ers.

But while bet­ter CACs cer­tainly would com­pli­cate life for vul­ture funds, they are not a com­pre­hen­sive so­lu­tion. In fact, the fo­cus on fine-tun­ing debt con­tracts leaves many crit­i­cal is­sues un­re­solved, and in some ways bakes in the cur­rent sys­tem’s de­fi­cien­cies – or even makes mat­ters worse.

For ex­am­ple, one se­ri­ous ques­tion that re­mains un­ad­dressed by the ICMA pro­posal is how to set­tle con­flicts that arise when bonds are is­sued in dif­fer­ent ju­ris­dic­tions with dif­fer­ent le­gal frame­works. Con­tract law might work well when there is only one class of bond­hold­ers; but when it comes to bonds is­sued in dif­fer­ent ju­ris­dic­tions and cur­ren­cies, the ICMA pro­posal fails to solve the dif­fi­cult “ag­gre­ga­tion” prob­lem (how does one weight the votes of dif­fer­ent claimants?).

More­over, the ICMA’s pro­posal pro­motes col­lu­sive be­hav­iour among the ma­jor fi­nan­cial cen­ters: The only cred­i­tors whose votes would count for the ac­ti­va­tion of CACs would be those who owned bonds is­sued un­der a re­stricted set of ju­ris­dic­tions. And it does noth­ing to ad­dress the se­vere in­equity be­tween for­mal cred­i­tors and im­plicit ones (namely, the pen­sion­ers and work­ers to whom sov­er­eign debtors also have obli­ga­tions) who would have no say in a re­struc­tur­ing pro­posal.

All six coun­tries that voted against the UN res­o­lu­tion (the US, Canada, Ger­many, Is­rael, Ja­pan, and the United King­dom) have do­mes­tic bank­ruptcy leg­is­la­tion, be­cause they recog­nise that CACs are not enough. Yet all refuse to ac­cept that the ra­tio­nale for a do­mes­tic rule of law – in­clud­ing pro­vi­sions to pro­tect weak bor­row­ers from pow­er­ful and abu­sive cred­i­tors – ap­plies at the in­ter­na­tional level as well. Per­haps that is be­cause all are lead­ing cred­i­tor coun­tries, with no de­sire to em­brace re­stric­tions on their pow­ers.

Re­spect for the nine prin­ci­ples ap­proved by the UN is pre­cisely what’s been miss­ing in re­cent decades. The 2012 Greek debt re­struc­tur­ing, for ex­am­ple, did not re­store sus­tain­abil­ity, as the des­per­ate need for a new re­struc­tur­ing only three years later demon­strated. And it has be­come al­most the norm to vi­o­late the prin­ci­ples of sov­er­eign im­mu­nity and eq­ui­table treat­ment of cred­i­tors, ev­i­denced so clearly in the New York court’s de­ci­sion on Ar­gen­tine debt. The mar­ket for credit de­fault swaps has led to non­trans­par­ent pro­cesses of debt re­struc­tur­ing that cre­ate no in­cen­tive for par­ties to bar­gain in good faith.

The irony is that coun­tries like the US ob­ject to an in­ter­na­tional le­gal frame­work be­cause it in­ter­feres with their na­tional sovereignty. Yet the most im­por­tant prin­ci­ple to which the in­ter­na­tional com­mu­nity has given its as­sent is re­spect for sov­er­eign im­mu­nity: There are lim­its be­yond which mar­kets – and govern­ments – can­not go.

In­cum­bent govern­ments may be tempted to ex­change sov­er­eign im­mu­nity for bet­ter fi­nanc­ing con­di­tions in the short run, at the ex­pense of larger costs that will be paid by their suc­ces­sors. No gov­ern­ment should have the right to give up sov­er­eign im­mu­nity, just as no per­son can sell him­self into slav­ery.

Debt re­struc­tur­ing is not a zero-sum game. The frame­works that gov­ern it de­ter­mine not just how the pie is di­vided among for­mal cred­i­tors and be­tween for­mal and in­for­mal claimants, but also the size of the pie. Do­mes­tic bank­ruptcy frame­works evolved be­cause pun­ish­ing in­sol­vent debtors with prison was coun­ter­pro­duc­tive – a pris­oner can­not re­pay his debts. Like­wise, kick­ing debtor coun­tries when they’re down only makes their prob­lems worse: Coun­tries in eco­nomic free-fall can’t re­pay their debts, ei­ther.

A sys­tem that ac­tu­ally re­solves sov­er­eign-debt crises must be based on prin­ci­ples that max­imise the size of the pie and en­sure that it is dis­trib­uted fairly. We now have the in­ter­na­tional com­mu­nity’s com­mit­ment to the prin­ci­ples; we just have to build the sys­tem.

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