*EPF104 10/07/2002
Text: Bush Aide Urges New Contracts for Emerging Market Debt
(Would also encourage economic growth, Hubbard says) (2890)

Modifying debt contracts, implementing a dispute resolution forum, and clarifying official financing likely would bring more order to the sovereign debt restructuring process for heavily indebted emerging-market countries, says the chairman of President Bush's Council of Economic Advisers.

Speaking October 7 to a symposium sponsored by the American Enterprise Institute in Washington, Glenn Hubbard said this new approach to restructuring would encourage private sector growth and private capital flows. It also would fit with Bush's "new compact for development" that links increases in foreign aid to developing countries' taking more responsibility for their economic policies, he said.

Hubbard said contracts should be modified to discourage bondholders from "holding out" during restructuring negotiations in hopes of receiving better payment terms.

He said borrowers would be more willing to consider restructuring if preliminary, nonbonding discussions were held before formal negotiations. He added that the restructuring process could be streamlined if a "trustee" representing bondholders was present when negotiations begin.

The process could be helped further by a sovereign debt dispute resolution forum that would coordinate a debt restructuring plan among debtors and all classes of creditors, he said. The International Monetary Fund (IMF) has proposed such a forum, he added. However, the forum should be voluntary, not a product of IMF statutory change, Hubbard said.

Hubbard also suggested that the Group of 7 (G-7) finance ministers and central bank governors work with the IMF to provide incentives for countries to cut back on accessing additional credit and restore their ability to repay their debts. "These incentives would reinforce the important idea that official financing should be complementary to restoring private sector growth," he said. The Group of 7 consists of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.

Hubbard said debt restructuring should be discussed within the context of private sector creditworthiness.

Creditworthiness would be enhanced by the adoption of best-practice accounting standards and creditor rights and by contract enforcement. This would ease the restructuring process "without having the International Monetary Fund (IMF) assume a central adjudicatory role," he said.

AEI is an independent research institute.

Following is the text of Hubbard's prepared remarks:

(begin text)

Enhancing Sovereign Debt Restructuring

Remarks of R. Glenn Hubbard
Chairman, Council of Economic Advisers
Conference on the IMF's [Internaitonal Monetary Fund's]
Sovereign Debt Proposal
American Enterprise Institute
Washington, D. C.

October 7, 2002

The Setting

Patterns of emerging-market finance have changed significantly since the early 1980s, as greater integration of capital markets and a trend toward a greater use of direct lending through bonds has led to relatively decreased use of indirect finance through syndicated bank loans. These changes have produced benefits to investors through opportunities for risk diversification and to emerging-market sovereign borrowers by increasing the investor base.

The broadened investor base in bond financing, however, raises problems of coordination and collective action in the event of a sovereign borrower's default and restructuring. Now, three parties are involved in determining the "debt markdown" required to produce solvency -- the debtor, creditors, and the global taxpayer through international financial institutions (IFIs).

The complex relationships among the borrowers, creditors, and the global taxpayer have made restructuring obligations a costly and time-consuming exercise, especially with the possibility of "holdouts." Both the sovereign and its creditors have an incentive to avoid a restructuring in the hope of financial assistance from the global taxpayer. Sovereigns may not undertake the politically painful steps involved in beginning a restructuring when there is always the hope that official assistance will be forthcoming. Creditors may not accept a reduction in the value of their claims, also in the hope that official assistance will be forthcoming. Costs of postponed and disorderly restructurings are real and substantial. Delays in restructuring can drain a country's resources and increase the ultimate costs of restoring financial sustainability. Creditors bear a burden as well, because the losses associated with the restructuring are reflected in values of bonds.

Proposals for Enhancing Sovereign Debt Restructuring

These observations about costs of sovereign debt restructuring are, of course, not new. Many studies have been conducted and proposals advanced, including the 1996 Rey Report of the G-10 [Group of 10 countries agreeing to the General Arrangements to Borrow: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, the United States], and suggestions by the Bank of England and Bank of Canada and by academics including Professor Jeffrey Sachs of Columbia University and Professors Adam Lerrick and Allan Meltzer of Carnegie Mellon University, among others. Several proposals have been put forward to address the problem of sovereign debt restructuring. International Monetary Fund First Deputy Managing Director Anne Krueger advanced the IMF's sovereign debt restructuring mechanism (SDRM) for amending IMF Articles to impose standstills and stays on legal actions by creditors. The U.S. Treasury Undersecretary for International Affairs John Taylor put forward the U. S. Treasury's position, which centered more on the reform of financial contracts. These valuable contributions to the debate raise the hope of action and progress.

The IMF and Treasury proposals view the coordination problem between sovereigns and their creditors in a different light and therefore offer a different solution. The SDRM proposal sees legal challenges from holdout creditors as the main obstacle to a sovereign restructuring. From this perspective, protection for the sovereign from holdout creditors is required to encourage the restructuring process, and under the SDRM proposal, this protection would be provided by an amendment to the IMF Articles that would allow for a sanctioned stay while a restructuring proposal is put together.

The U.S. Treasury proposal promotes a voluntary or market-based solution that calls for the increased use of collective action and representation clauses to formalize ex ante the interaction between the sovereign and its creditors in the event of a restructuring. To increase usage of this approach, the proposal envisions financial carrots and sticks wielded by the official sector to encourage the adoption of such clauses in new contracts that might also replace existing contracts.

As called for in the September 27 Statement of G7 [Group of 7 industrialized nations: Canada, France, Germany, Italy, Japan, the United Kingdom, the United States] Finance Ministers and Central Bank Governors and Communiqué of the Ministers arid Governors of the Group of Ten, one can complement these proposals with a means to clarify the possibility of official financial assistance through the IFIs. Unless and until policies for official intervention are clarified, sovereigns and their creditors will face a costly and complex process for negotiation. An important part of an overall solution is a mechanism to make sure that the cost of providing IFI resources is as transparent as possible.

Contractual Modifications

The contractual approach -- involving clauses in debt contracts that encourage creditors and borrowing countries to undertake negotiations aimed at an expeditious, but orderly, restructuring of unsustainable sovereign debt -- is an essential first step to addressing sovereign debt restructuring. A set of model clauses can encourage creditors and borrowing countries to undertake negotiations aimed at an expeditious but orderly restructuring. Contractual modifications could include: (1) collective action and sharing clauses to deal with possible holdout creditors; (2) collective representation clauses to structure discussions among creditors; and, (3) exit consents to encourage participation in exchanging old debt instruments for new ones.

The key lever for holdout creditors in a restructuring is the conventional requirement that all creditors agree to any amendments to the payment terms of a bond. (Under U.S. law, such a requirement exists for corporate borrowers under the Trust Indenture Act of 1939, but not for sovereign borrowers.) By contrast, the incorporation of collective action clauses would allow a supermajority of bondholders (say, 75 percent of holdings of an issue) to agree to amendments to the payment terms of the bond, and the decision would bind other bondholders. The inclusion of sharing clauses would also force a creditor receiving a disproportionate payment under a multi-creditor instrument to share the payment on a pro rata basis. The inclusion of collective action clauses and sharing clauses would mitigate the holdout problem and speed the restructuring process.

Renegotiations and restructuring would be more streamlined if a trustee could represent bondholders at the beginning of the restructuring process. Current issues allow the trustee only to summon bondholders for meetings, but the incorporation of collective representation clauses would permit the trustee to represent the bondholders in initial restructuring discussions. While sovereign borrowers may be wary of calling bondholders together (for fear that such a meeting might facilitate an acceleration of claims), those borrowers might be more willing to contemplate a restructuring if preliminary and nonbinding discussions could be held. This clause would also spell out the process by which a sovereign would initiate a restructuring and how the debtors and creditors would come together in the event of a restructuring. Such clauses might create a creditors committee that would coordinate relations with the sovereign, similar in spirit to the bondholders committees that have operated in the United Kingdom and the United States.

Restructuring is also more likely to occur if bondholders are discouraged from "holding out" in hopes of receiving better terms. Exit consents are one mechanism that can help discourage holdouts. When exchanging old bonds for new bonds as part of a restructuring, existing bondholders (if a majority) can modify the non-payment terms of the old bonds to make retaining the old bonds unattractive, thereby discouraging holdouts. The use of exit consents worked well in Ecuador in 2000, where exiting bondholders agreed to remove cross-default and negative pledge clauses. (Such a strategy is difficult to implement if there are many small issues, however, as in the case of Argentina.) Moreover, an exchange could be encouraged by a one-time financial enhancement from the official sector.

Of course, it is important that these clauses be included in all contracts -- bonds and bank loans and perhaps trade credit -- and these clauses must allow for aggregate collective action and representation across all the instruments. Achieving this inclusion is a tall order, especially given that contractual clauses in each instrument may not be able to address disputes among holders of different bond issues or different classes of creditors (e.g., banks, bondholders, and IFIs). To address this coordination problem, a sovereign debt dispute resolution forum, similar to that proposed by Anne Krueger, could bring together debtors and all classes of creditors.

Sovereign Debt Dispute Resolution Forum

The forum would be established so creditors could work together with debtors to restructure debts and resolve disputes. Under U.S. domestic law, for example, a bankruptcy court supervises a creditor committee that develops a workout plan for a firm that has filed for bankruptcy. In the sovereign debt context, a standing committee could perform an analogous function. A country in distress could turn to a Sovereign Debt Dispute Resolution Forum that would then bring together the different classes of creditors to work out a restructuring plan that would involve all of the relevant claimants.

Anne Krueger has proposed such a dispute resolution forum to deal with the coordination problem among the creditors. In Krueger's proposal, a statutory change would be made in the IMF Articles to allow the IMF Executive Board to create arid appoint members of the forum and give the forum the power to approve and enforce the work of the creditor committee, much like a domestic bankruptcy court does. This change would require a vote by 85 percent of the members of the IMF. Given that the members will be appointed by the IMF, there might be concerns about the forum's independence. In addition, because this change requires amendments to the Articles, it is likely to be a slow and difficult process.

These observations raise another route for consideration: It may be more expeditious to create a voluntary body first in order to understand how well it can function. It would be worthwhile to encourage the formation of such a voluntary Forum and observe the effectiveness of its operation. If it proves to be ineffective, then the case for statutory change is even stronger. If the Forum were effective, then the difficulties of reopening the IMF Articles are avoided.

The Forum's role could be acknowledged by inserting a clause in each debt instrument that would name this Forum as the venue for negotiation and resolution of sovereign debt claims. The Forum could operate akin to a domestic bankruptcy court in that a borrower could approach the Forum and request the initiation of proceedings for a restructuring. The Forum would then notify creditors of the request by the borrower and then operate as an administrator of creditor claims. The Forum would convene a committee to monitor the voting process ensuring the orderly and timely restructuring of debt. The exact details of the structure of the Forum can be left up to the market participants.

Access Incentives in the Restructuring Process

Serious discussion of sovereign debt restructuring must also be mindful of the call by the G7 Finance Ministers and Central Bank Governors to work more with the IMF on access limits. From an economic perspective, one consideration that is relevant for both the contractual and statutory approaches to sovereign debt restructuring is the possibility that creditors and debtors lack incentives to come to the table in a timely fashion to begin a restructuring process. An all-or-nothing resolution is not necessary: One could provide incentives that would help avoid IFI lending into unsustainable situations. Access incentives need not place a rigid quantitative limit on the use of IMF resources, but would instead provide incentives for countries to curb access and enter negotiations to restore sustainability. These incentives would reinforce the important idea that official financing should be complementary to restoring private-sector growth.

The Bank of England and Bank of Canada sovereign debt restructuring proposals also highlight this important issue. Their proposals call for strict limits on IFI assistance that would foreclose on the "wait for a bailout" option and encourage the troubled sovereign and its creditors to come to terms. This is a valuable proposal that focuses on a key problem. (The proposal notes the IMF has long had the ability to lend beyond normal limits -- 300 percent of quota -- by invoking the exceptional circumstances clause or through provisions by Supplemental Reserve Facility). Yet, the approach would limit policy flexibility. Any change to the existing financial structure should act as an incentive to encourage appropriate official financing rather than impose strict limits unconditionally. Again, what is needed is a mechanism to make sure that the cost of providing IFI resources is as transparent as possible.

Creditworthiness and Economic Growth

These key changes -- contractual modifications, a dispute resolution forum, and clarified official financing -- are likely to bring greater order to the sovereign restructuring process. It is important to remember, though, the reason for reforming the restructuring process: It is the encouragement of private-sector growth and private capital flows that will lift the prospects of economies around the world.

With this concern in mind, any discussion of improving prospects for restructuring of sovereign debt must take place in the broader context of improving creditworthiness in emerging-market economies in order to nurture and sustain rational capital flows that promote economic growth. Ultimately, the borrowing capacity of an economy depends on its ability -- especially that of the private sector -- to generate returns for investors. The real cost of funds to emerging-market borrowers reflects both the general real interest rates in the international capital market and compensation for the risk of default and for substandard investor protection regimes.

Recent research by economists suggests that gains from encouraging investor protection and good corporate governance practices can be substantial. Most analysis of financial liberalization approaches the issue from an asset-pricing perspective that focuses on changes in the risk-free rate or the price of systematic risk (or both) as a consequence of improved international diversification. Removing barriers to capital flows does not, however, guarantee that capital flows to its most efficient use unless international investors can be credibly convinced that investments will be repaid; the expected return to investors depends on the level of investor protection. It is interesting in this light that recent research finds that the pre-existence of an Anglo-Saxon legal system (with generally strong investor protection) magnifies the response of investment to financial liberalization events.

The creditworthiness of the private sector in emerging-market economies can be enhanced significantly by making progress toward meeting best-practice standards on accounting practices, creditor rights, and contract enforcement. Judgments on a country's progress would be based on the existing Reports on the Observance of Standards and Codes. If countries have made sufficient progress then IFI guarantees could be put in place to encourage needed contractual modifications to debt instruments. This framework would allow the IMF to encourage steps that enhance creditworthiness and the ease of restructuring without having the IMF assume a central adjudicatory role during a financial crisis.

Consistency with the Administration's Agenda for Global Growth

This framework fits hand in glove with President Bush's "new compact for development" that increases accountability for rich and poor nations alike by linking greater contributions by developed nations to greater responsibility by developing nations and emerging market economies. More broadly, the Bush Administration believes that policies that facilitate and encourage economic growth in emerging-markets should receive the greatest possible attention from international financial institutions. Proposals to reduce costs of sovereign debt restructuring should not be inconsistent with an emphasis on economic growth.

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(Distributed by the Office of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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