Do We Need a New Bankruptcy Regime?

Recently the debate on the reform of the international financial architecture has centered on the development of an appropriate mechanism or regime to ensure orderly sovereign debt restructurings. Recent cases involving sovereign bonded debt restructuring (those of Ecuador, Pakistan, Russia, and Ukraine) have been successfully completed with the use of unilateral debt exchange offers (complemented by a system of carrots and sticks, such as exit consents, to ensure successful deals). But many observers have expressed dissatisfaction with this "market-based" status quo approach. The IMF has proposed the creation of an international debt restructuring mechanism that would have many of the features of an international bankruptcy regime.¹ The papers by Jeremy Bulow, Jeffrey Sachs, and Michelle White are all interesting contributions to this debate.² All address the question of whether we need an institutional change in the international financial system that would lead to a new way of providing for orderly sovereign debt restructurings or workouts when they become necessary.

The policy question to be addressed, then, is the following: when sovereign debt restructuring or debt reduction becomes unavoidable, what is the appropriate regime that provides for an orderly restructuring while safeguarding the balance of rights of both the creditors and the debtor? Is it better to continue with the market-based status quo regime and the use of exchange offers? Should we instead move to the wholesale introduction of collective action clauses (CACs) in bond contracts (also described as the "contractual approach")?³ Or should we consider creating an international bankruptcy mechanism (a "statutory approach") like that proposed by the IMF? Two caveats are in order here. First, the very concept of insolvency is problematic in the sovereign context, because a restructuring may result either from the sovereign's inability to pay or from its unwillingness to pay. And second, the assessment of the sustainability of a country's debt is always probabilistic, because a sharp adjustment to the primary fiscal balance could in principle make an unsustainable debt path sustainable. These caveats notwithstanding, there is a general consensus that, in cases of sovereign "insolvency," further official finance is not warranted and the sovereign should suspend debt payments and restructure or reduce its debts, while at the same time undertaking serious and credible domestic fiscal adjustment and structural economic reform.⁴

Each of these three approaches just described—the status quo approach, the contractual approach, and the statutory approach—has its pros and cons. One way to think about their relative merits begins by asking what are the market failures that may prevent an orderly and efficient restructuring of sovereign debt when such a restructuring would be beneficial to both debtors and creditors. Several types of externalities might prevent such a restructuring, but three are crucial and have to do with collective action problems among creditors.⁵

The first is the "rush to the exits." As a sovereign debt crisis unfolds, many creditors may try to liquidate their claims at the same time, causing a disorderly crisis that has real and avoidable costs. An example is that of liquidity or rollover runs, in which investors become unwilling to roll over maturing short-term government debt (such as the Mexican tesobonos ) or short-term cross-border interbank lines of credit (such as in the East Asian crisis). As I will argue below, a debt suspension or standstill (including capital controls, freezes on bank deposits, or both) may avoid such destructive behavior.

The second externality is the "rush to the courthouse" or "grab race." Although a unilateral debt standstill may overcome the inefficiencies of a rush to the exits, creditors may instead initiate litigation to recover their claims. This externality can become a serious problem if creditors can attach the debtor's assets. As discussed below, however, there are important differences between corporate and sovereign debt on this matter, in that the ability of creditors to seize or attach sovereign assets is very limited.

The third externality is the "free rider" problem (also called the "holdout" or "rogue creditor" problem). In situations where initiatives to restructure debt require unanimity among the creditors, minority holdout...