Crisis Resolution: Next Steps

The debate over how to manage and resolve crises in emerging markets, under way for the better part of a decade, reached a climax at the spring meetings of the International Monetary Fund (IMF) and World Bank, which were held in Washington in the spring of 2003. Agreement was reached to push ahead with the contractual approach to smoothing the process of sovereign debt restructuring by promoting the further introduction of collective action clauses (CACs) into bond contracts while continuing to study and develop the statutory approach, in particular the IMF's Sovereign Debt Restructuring Mechanism (SDRM).¹ These decisions were shaped by Mexico's successful launch the preceding March of a $1 billion global bond, subject to New York law but featuring CACs, at spreads that were, if anything, slightly tighter than those on its previously issued New York law bonds.² Mexico then followed in April with two additional issues also including collective action clauses, and Brazil, South Africa, and the Republic of Korea all issued bonds in New York with similar provisions. These events put paid to the view that investors would not accept bonds that included collective action clauses and that the governments of emerging markets would be unwilling to issue them for fear of higher borrowing costs. They galvanized the debate by demonstrating the feasibility of contractual innovation.

It is tempting for officials and analysts to congratulate themselves on a job well done and turn to other topics. But the process of improving how one goes about sovereign debt restructuring, much less the larger task of making the world a safer financial place, is still incomplete. It remains to be seen how many other emerging markets will follow the examples of Mexico, Brazil, South Africa, and the Republic of Korea. And while collective action clauses provide mechanisms for coordinating the creditors holding an individual bond issue, they do not coordinate the creditors holding different issues. Recall that Argentina had more than eighty separate sovereign bonds in the market at the time of its December 2001 default. Thus it cannot be taken for granted that the addition of these provisions to individual loan contracts will significantly facilitate creditor coordination and smooth debtor-creditor negotiations.

Above all, there remains the question of how much can be expected of these improvements in procedures for sovereign debt restructuring. Contractual clauses specifying how restructuring is initiated, how the creditors are represented, when legal action can be initiated, and under what circumstances a change in the financial terms of a bond agreed to by a qualified majority of creditors will be binding on dissidents constitute only limited changes to the status quo. Even those limited changes would have applied only to a subset of recent crises. Then there is the critique that the official community directs too much attention to building better morgues. It should devote more effort, in this view, to preventing crises and promoting capital transfer from rich to poor economies than to cleaning up after crises when they occur.

In this paper we reassess the efficacy of this strategy for addressing problems of crisis resolution. We focus on two questions, bringing to bear both theory and evidence. First, are speculative credits likely to follow investment-grade countries in adding CACs to their loan instruments? While our analysis of sources of resistance to contractual innovation creates reasons for hoping that Mexico's path-breaking issue may have broken an important logjam, both theory and evidence highlight the moral hazard associated with restructuring-friendly provisions for countries with relatively poor credit. They suggest that CACs may raise the cost of borrowing for countries with poor credit ratings, especially in periods when sentiment toward emerging markets is relatively unfavorable, leaving them slow to embrace these provisions.

In addition we ask how difficult it may be for countries whose existing bond issues feature unanimous action clauses (UACs) to effect the transition to CACs. The concern is that the holders of bonds that require unanimous consent to changes in financial terms may be able to hold out for favorable restructuring terms at the expense of investors...