Ebook Using Standstills To Manage Sovereign Debt Crises
The succession of financial crises in emerging markets since the mid 90’s raised awareness about the specific risks posed by financial globalization for a number of countries. This realization prompted an intense debate on the reform of the international financial architecture, and various far-reaching proposals have been discussed over the last decade in both academic and official circles. More often than not, this debate has revolved around the extent to which emerging markets crises have been primarily a result of failures in international financial markets or of mistaken policies.
Those stressing the importance of market failures have advocated for the creation of a meaningful official financial safety net articulated around the IMF acting as a pseudo-lender of last resort (Fisher, 1999). In turn, those stressing the importance of policy failures have prioritized the need to avoid distorting the incentives of both sovereign borrowers and private lenders, placing moral hazard at the centre of the discussion. Eventually, the debate has tended to result in the adoption of difficult compromises between the two camps, of which the Prague Framework for crisis resolution is a good example. According to this framework, adopted by the international community in 2001, liquidity crises ought to be resolved by combining limited and predictable official assistance, catalysis of private capital flows, and private sector involvement.
In the realm of solvency crises, two differing approaches can also be identified. On the one hand, according to the statutory approach, an international institution is needed to intervene in situations in which a standstill and/or a debt restructuring is needed to restore a country’s solvency. Such an institution could take the form of an international solvency regime (Sachs, 1995 or Rogoff, 2003) or of the Sovereign Debt Restructuring Regime (SDRM) proposed by Krueger in 2002 and shelved in 2003. On the other hand, the contractual or market-based approach, which was ultimately adopted by the international community, argues in favour of including collective action clauses (CACs) in bond contracts (see Krueger, 2002 or Eichengreen et al., 2003). Such CACs allow for a pre-specified majority of bond holders to approve the terms of a debt restructuring, preventing such processes from being held hostage to the action of rogue creditors, and potentially mitigating the collective action problems inherent to debt restructurings. The inclusion of CACs in sovereign bonds is generally considered as a successful experience, given that this practice has become widely accepted by the market relatively fast. Their potential in a crisis resolution setting, however, remains to be seen. Indeed, there is still a relatively large proportion of outstanding bonded debt that does not include CACs, and other contractual innovations, such as aggregation clauses, may be needed to prevent minority groups from disrupting restructuring processes.
This paper provides a fresh look at the statutory approach to crisis resolution from a theoretical perspective. The framework outlined here, however, differs from previous proposals such as the SDRM in the sense that it is designed to cope with liquidity problems. . It is argued that there could be scope for creating an international entity, i.e. an International Investment Court (IIC) which would monitor countries, would be empowered to declare standstills under certain circumstances and, if necessary, would decide on how debt should be restructured. The paper shows that designing debt contracts which, in case of a liquidity crisis, allow for arbitration and for the application of a standstill/restructuring, reduces the coordination problem faced by creditors, and enhances aggregate well being. It is also analyzed whether such a measure, as argued in the literature, may generate debtors’ moral hazard. Although moral hazard can not be ruled out, conditions under which the presence the IIC represents an incentive to apply corrective policies are found.
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