Resolving the Debt Crisis of Low-Income Countries

The idea of bankruptcy FOR insolvent sovereign borrowers has been around a long time, at least since Adam Smith's favorable mention of it in the Wealth of Nations.¹ Kenneth Rogoff and Jeromin Zettelmeyer have recently reviewed the history of the idea, as has Ann Pettifor.² The current international framework for workouts of distressed sovereign borrowers is woefully inadequate, lacking both the efficiency and the equity protections that characterize well-designed bankruptcy systems. This paper focuses on one part of the problem, namely, the plight of the world's most highly indebted poor countries, and illustrates the serious problems that have arisen because of the weakness of international institutional arrangements. I conclude with several recommendations for reform.

Motivations for Bankruptcy Laws

Bankruptcy laws have two somewhat distinct motivations. The first is to overcome the collective action problems that arise when multiple creditors confront an insolvent debtor.³ In the absence of a bankruptcy law, a creditor "grab race" can undermine the value of the assets of an insolvent debtor. The bankruptcy law forestalls the grab race through devices such as an automatic stay on debt collection that is triggered by the filing of a bankruptcy petition. In bankruptcy reorganizations under Chapter 11 of the U.S. bankruptcy code, further protections against a grab race are implemented, such as debtor-in-possession financing and provisions for confirmation of a restructuring plan in the absence of unanimity among creditors; the latter weaken the power of an individual creditor to hold out for special treatment.

The second motivation of bankruptcy law is to offer a "fresh start" to an insolvent debtor. Whereas the motivation to avoid a grab race applies in principle to all kinds of insolvent debtors—businesses, individuals, and municipalities—the motivation for a fresh start applies only to individuals (Chapters 7, 12, and 13) and municipalities (Chapter 9) rather than to businesses.⁴ The key instrumentality of the fresh start is the discharge of debt, which frees the debtor from future collection efforts while leaving the debtor with some exempt assets and with a future income stream. An insolvent debtor may seek the discharge of debt even when there is only one creditor, and thus no possibility of a creditor grab race.

The motivation for forestalling a creditor grab race is efficiency. The motivations for offering a fresh start, however, include both efficiency and equity. The creditors' claims are superseded by the higher interest of protecting the autonomy of the individual vis-à-vis the creditors,⁵ or analogously, of ensuring that a debt-strapped municipality maintains the sovereignty needed to provide public services to its residents. For example, under Chapter 9, a municipality's assets cannot be liquidated to pay creditors, because that would undermine sovereignty. Moreover, "neither creditors nor the court may control the affairs of a municipality indirectly through the mechanism of proposing a plan of adjustment of the municipality's debts that would in effect determine the municipality's future tax and spending decisions."⁶ Indeed, the powers of the court and of creditors are deeply circumscribed. "The debtor's day-to-day activities are not subject to court approval and . . . the debtor may borrow money without court authority. . . . The court also cannot interfere with the operations of the debtor or with the debtor's use of its property and revenues."⁷ Most important, neither under individual bankruptcy (Chapter 7 or Chapter 13) nor under municipal bankruptcy (Chapter 9) do creditors obtain the maximum discounted value of income and property potentially collectable from the debtor. Individuals and municipalities are allowed to keep important property out of the creditors' reach, such as a homestead up to a certain value, as well as keep most or all future income.⁸

The idea of the fresh start can be framed variously in terms of ethics (preserving the autonomy of the individual or the sovereign), equity (preserving an acceptable standard of living for an insolvent debtor), or ex ante efficiency (bankruptcy mechanisms as a way to spread risks between a debtor and world financial markets when other risk-spreading mechanisms such as...