Sovereign-debt crises occur regularly and often violently. The recent debt crisis in Greece almost led to the collapse of the euro. Yet, there is no legally and politically recognised procedure for restructuring the debt of bankrupt sovereigns.
Procedures of this type have been periodically debated – most recently, about a decade ago – when IMF management proposed a global sovereign debt restructuring mechanism (Krueger, 2002). Yet, they have so far been rejected.
Countries have been reluctant to give up power to supranational rules or institutions. Creditors and debtors have felt that there were sufficient instruments for addressing debt crises at hoc. Importantly, there were also fears that making debt easier to restructure would raise the costs and reduce the amounts of sovereign borrowing in many countries. This was perceived to be against the interests of both the providers of both creditors and major borrowers.
In a recent report, we argue that both the nature and our understanding of sovereign-debt problems have changed in ways that create a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago (CIEPR 2013).1 Our analysis builds on the recent wave of research on the topic.2
- Pre-crisis policy mistakes, and in particular– the tendency of domestic policymakers to overborrow, or pay too little attention to private debt accumulation that might turn public – are now recognised to be a much more severe problem for borrowing countries than the costs or limited availability of private financing. Far from being a problem, proposals that would limit the ability to borrow for countries with poor policies are a good thing.
- Recent court rulings complicate efforts to resolve future debt crises on an ad hoc basis – particularly a US ruling that gives ‘holdout creditors’ the right to interfere with payments to the creditors that accept such an offer.
- Sovereign-debt crises are no longer just a problem in emerging markets, but a core concern in advanced countries as well – particularly in the Eurozone.
If the euro is to survive, this will require both better ways to resolve debt crises and stronger, market-based incentives that prevent debt problems from occurring in the first place. To address these problems, policy proposals are presented at two levels– for the Eurozone, and globally.
Eurozone policy proposals
The Eurozone differs from other integrated regions in both that its members have fewer instruments to deal with debt crises – they cannot devalue or inflate – and because a crisis in one member can have catastrophic consequences for others (by threatening the common currency). This requires both a mechanism for the orderly resolution of debt crises, and stronger incentives to prevent them. The current financial architecture in the Eurozone is inadequate in this respect, because its main pillar – the European Stability Mechanism (ESM) – is not set up to deal with unsustainable debt. If it is used even when there are significant concerns about the ability of borrowers to repay their debts, it will become source of transfers, rather than just crisis lending.
These problems could be addressed via an amendment of the ESM treaty that encourages and legitimises – both legally and politically – debt restructuring in unsustainable debt cases.
- First, assets and revenues of countries undertaking a debt restructuring would be deemed immune from legal action by holdouts, if a restructuring is approved by the ESM.
- Second, the treaty would require a debt restructuring as a condition for ESM lending when national debts exceed a pre-set level.
This should be higher than the Maastricht limit of 60% of GDP, but not so high as to render the constraint meaningless. In the Eurozone, this may mean a level of about 1½ times the Maastricht limit. The presence of such a debt threshold would help differentiate borrowing costs in normal times based on the strength of economic policies. At the same time, it would protect ESM resources and Eurozone taxpayers, and prevent extreme adjustments of public finances at the expense of citizens who usually have little control over policy mistakes leading to excessive sovereign debt.
Importantly, Eurozone countries must be given a chance to deal with legacy debt before this regime is introduced. For countries significantly above the future upper debt threshold, this will require a judgment of whether debt can be reduced below the limit within a reasonable time frame. Where the answer is no, the Eurozone needs to make a choice between an upfront restructuring – backed by the ESM – and extra support, for example, in the form of providing a joint and several guarantees on new debt issuance, as long as countries adhere to an agreed fiscal consolidation path (see Bofinger et al, 2011).
At the global level, the relatively small size of the IMF, its de facto priority, and its track record in getting repaid, makes it less likely that crisis lending will turn into transfers. However, experience shows that incentives are stacked against the timely recognition and restructuring of unsustainable debts. Recent court rulings encouraging holdouts, discouraging creditor participation in debt-exchange offers, and bringing into question the IMF’s priority status, will make this problem worse. To address this without allowing sovereigns to frivolously repudiate their debts, two alternative mechanisms are proposed.
- A coordinated introduction of a strong form of ‘collective action clauses’ in sovereign bond contract, namely, provisions that allow for the restructuring of bonded debt with the agreement of a supermajority of creditors across all bonds.
- The creation of a Sovereign Debt Adjustment Facility by the International Monetary Fund, which would combine IMF lending with debt restructuring.
A set of clearly defined ex ante criteria, analogous to those used in the Heavily indebted poor countries (HIPC) initiative, would need to be developed to steer high-debt countries towards this facility. An amendment of the IMF articles would ensure that the assets of countries using this facility would be shielded from holdouts if a supermajority of creditors agrees to a restructuring.
The main difference between the two proposals is that the second would do more to correct biases that delay necessary debt restructuring. Furthermore, while both would deal with the holdout problem in the long run, the IMF-based proposal would have immediate effects, while better collective action clauses would become effective only gradually, as existing debt is replaced by newly issued debt.
The world is currently less equipped to handle problems of unsustainable debt than at any time since the 1930s. At the same time, the extent of these problems has grown. Reform proposals that could address them have become more mature and more targeted, and arguments that led to the rejection of analogous proposals ten years ago no longer apply. It is time for policy makers to tackle the central problems head on.
Bofinger, Peter, Lars P. Feld, Wolfgang Franz, Christoph M. Schmidt, and Beatrice Weder di Mauro (2011), “A European Redemption Pact”, VoxEU.org, 9 November.
Buchheit, Lee C., G. Mitu Gulati and Ignacio Tirado (2013), “The Problem of Holdout Creditors in Eurozone Sovereign Debt Restructurings,” January, available on SSRN.
CIEPR (2013), “Revisiting Sovereign Bankruptcy”, Brookings Institution, 3 October.
Gelpern (2013), “Sovereign Damage Control”, PIIE Policy Brief 13-12, May (Washington: Peterson Institute for International Economics).
Krueger, Anne (2002), “A New Approach to Sovereign Debt Restructuring” Washington: International Monetary Fund, 16 April
Panniza, Ugo (2013), "Sovereign Default and the Rules of Engineering", VoxEU.org, 2 March.
Weder di Mauro, Beatrice and Jeromin Zettelmeyer (2010), “European Debt Restructuring Mechanism as a Tool for Crisis Prevention”, VoxEU.org, 10 November.
Zettelmeyer, Jeromin, Christoph Trebesch and Mitu Gulati (2013), “The Greek Debt Restructuring: An Autopsy,” Economic Policy, Volume 28, Issue 75, pages 513–563, July (also available as PIIE Working Paper 13-8, Washington, Peterson Institute for International Economics).
1 “Revisiting Sovereign Bankruptcy”, published by the Brookings Institution, is the third annual report of the Committee for International Economic Policy and Reform (CIEPR), comprised of Markus Brunnermeier, Lee C. Buchheit, Barry Eichengreen, Mohamed El-Erian , Anna Gelpern, José De Gregorio, Mitu Gulati, Takatoshi Ito Philip Lane, Ugo Panizza, Eswar Prasad, Hélène Rey, Dani Rodrik, Hyun Song Shin, Beatrice Weder di Mauro, Andrés Velasco, and Yongding Yu. Jeromin Zettelmeyer is an honorary advisor to the committee. All views expressed are personal.
2 See Weder di Mauro and Zettelmeyer, 2010; Gelpern, 2013; Panizza, 2013, Buchheit et al., 2013, and Zettelmeyer et al, 2013.