The Hindu Business Line : SDRM: Debt restructuring or liquidation?

Experience makes clear that under the currently prevalent liberalised financial regimes, financial crises are inevitable. As a result, even the Bretton Woods institutions are in search of ways not just to prevent financial crises but to deal with them. One scheme being advocated by the IMF is the Strategic Debt Restructuring Mechanism. C. P. Chandrasekhar and Jayati Ghosh examine the proposed mechanism, discuss the factors that motivate those advocating it and assess the likely con sequences of its implementation.

FINANCIAL crises are now the norm in those developing countries that were discovered as "emerging markets" by international financial capital. In fact, the number of instances of crises of significant dimensions has been growing.

Among the major crises that have accompanied the rise of finance have been the crisis in the Southern Cone in the late 1970s; the Third World debt crisis of the early 1980s; the savings and loan debacle in the US in the late 1980s; India's balance of payments crisis in 1991; the so-call ERM crisis in 1992; the Mexican crisis of 1994-95 and its follow-on crisis in Latin America; the East Asian crisis of 1997; the Russian meltdown of 1998; the collapse of the real in Brazil and its impact on the rest of Latin America in 1998-99, the Turkish crisis in 2000 and the Argentinian crisis which still has not gone away. Over time the distance in time between crises in different emerging markets has shrunk.

It is not just that the number of crises has increased, but they have affected relatively "strong" developing countries that were not characterised by large fiscal deficits or strongly interventionist regimes, which are the factors to which the Bretton Woods institutions (BWIs) have conventionally seen as triggering financial crises. Not surprisingly, when financial crises affected the East Asian economies, including South Korea and Malaysia, in the late 1990s, the World Bank and the IMF were taken by surprise. Large public deficits or repressed financial systems could hardly be held responsible for these crises.

Refusing to seek alternative explanation, these institutions stuck to the ideological frame which supports their adjustment policies and made the generation of public sector surpluses a condition for financial support to economies which were already facing severe deflation. It was only when the folly involved in such a policy stance became the subject of widespread criticism that the IMF chose to revise its recommendations, paving the way for a hesitant recovery from the depths of the crisis.

Since the East Asian crisis, a number of other countries that were adopting strongly positive macroeconomic positions from the point of view of the Bretton Woods institutions have experienced crises, with the most damaging instance being Argentina, which till recently was a favourite of both the BWIs and the financial markets.

The message was clear. Once countries went down the path of opening up their financial sector, increasing the role of markets in determining exchange rates, financial returns and the scope of financial instruments, and providing space for less regulated private financial players and financial capital from abroad, the threat of crises was real and the timing of crises unpredictable. Thus, efforts to forge an international financial architecture which provides pride of place to private financial capital required not just measures to try and prevent financial crises but also measures aimed at dealing with crises in a manner that prevents major losses to financial players and an implosion of financial system. That is, even in the face of crises, default on commitments must be prevented at all costs.

The danger of default

The problem for institutions like the IMF, which want to tinker with the international financial architecture, rather than reform it wholesale, is that the structure of financial markets increase the likelihood of default. Ever since the debt crisis of the early 1980s it has been clear that the growth of private lending to developing countries had generated an inherent tendency in the world's financial markets towards overexposure of individual financial institutions in particular emerging markets. This was partly because banks and other financial institutions flush with funds were eager to lend to newly discovered borrowers in emerging markets, who were creditworthy because their lack of access to the market for commercial credit in the past had kept their exposure to private debt extremely low. It was also because of the herd instinct characteristic of financial markets, which encouraged financial players to rush into newly discovered emerging markets that their competitors were entering.

The consequent overexposure of the system as a whole meant that when an external shock eroded the ability of any developing country to meet its commitments, the task of ensuring an orderly debt workout or restructuring of debt proved extremely difficult. This was because the exposure of individual agents/banks in an atomistic financial system differed substantially across debtor countries. Even if entities with a high exposure were willing to accept a negotiated restructuring package, those with smaller exposures, and therefore a smaller threat of loss, demanded that liabilities to them must be liquidated rather then deferred or restructured. Thus the presence of a large number of independent players in any one market, which was inevitable within a private-debt-dominated, market-driven system both increased the probability of a debt crisis as well as made it difficult to resolve such crises.

With the further evolution of the global financial system, this difficulty has been compounded by the fact that developing countries have diversified away from bank loans to bond issues to raise capital. Since such bond issues can be subscribed to by a range of financial entities, the number of players, still with differing degrees of exposure in developing country debt markets, has increased substantially.

Thus, in the event of a developing debtor country facing difficulties meeting its commitments, it is even more difficult to coordinate between the large number of anonymous private creditors to ensure an orderly debt workout. This is because individual creditors with smaller exposures, even more than banks in a similar situation, would prefer to hold out for the best terms and even go to court for the purpose.

National versus corporate debt

Chapter 11 and insolvency provisions in the US and the UK make their imitation in the case of national debt difficult to implement. Since in theory at least nations cannot be politically, and therefore economically, liquidated, creditors do not, in principle, have the guarantee that if any effort at restructuring unsustainable debt fails they would be at least partially compensated with sums realised from the sale of assets.

Nations finding their debt unsustainable would have to default, and then either repudiate the debt in part or full or adopt policies that do away with the need for further borrowing and help conserve foreign exchange that can be used for gradually meeting past debt commitments. The likelihood that such policies would be adopted is all the greater because developing country governments do not "own" their countries and their resources, and since governments change, particular governments may be unwilling to be held responsible for the actions of their predecessors that lead up to the accumulation of unsustainable debt.

Given this special characteristic of sovereign debt, we should expect that creditors would exercise far greater diligence when lending to countries as compared with lending to asset-rich corporations. The reason why this has not been true in practice is that there has in recent years been an implicit sovereign guarantee that developing countries would not renege on their international debt commitments.

That sovereign guarantee has been extracted from developing country governments by the intervention of the Bretton Woods institutions, especially the IMF, which has coordinated and part-financed all debt restructuring exercises and overseen the "resolution" of all financial crises in emerging markets.

In all such instances the emphasis has been on redeeming commitments and adopting policies that help procure additional funding from international finance capital. The problem is that those policies themselves ensure that developing countries experience deflation that undermines investor confidence, remain externally vulnerable because of further liberalisation of capital markets, face currency depreciation and end up in new situations when their external debt becomes unsustainable.

The point is that the "solution" to balance of payments difficulties comes principally from two sources: i) an improvement in the current account because of deflation that reduces imports substantially; and ii) a temporary restoration of investor confidence, resulting from access to IMF standby credit and from the adoption of more market-friendly policies, which leads to the renewal of capital inflows into the economy.

This means that the fundamental sources of vulnerability, which are current account uncertainties created by trade liberalisation and the growing reliance on unstable capital flows in the wake of financial liberalisation are left unaddressed. This is in keeping with the ideology of the BWIs and the interests they represent, which requires keeping the economy open and finding other means, even if temporary, of dealing with financial vulnerability and crises.

The difficulty with this means of resolving crises has been that it is crucially dependent on the confidence in the IMF's assessment of a country's debt repayment capacities, since, unlike in the case of corporate bankruptcy, the government cannot liquidate the nation to meet public and/or private debt commitments. And the IMF has won that confidence on the basis of its ability to enforce fiscal adjustments and market-oriented policies that favour finance.

Unfortunately, experience over the last two decades has shown that, though international finance favours such policies, they are no guarantee against the recurrence of financial crises. This creates a situation where the presence of the IMF in debt restructuring negotiations is not enough to fully restore investor confidence.

That being the case, unless the IMF itself comes up with substantial financial support, countries would not be in a position to meet their commitments, and the threat of default is real. Unfortunately for the IMF, it is finding it increasingly difficult to be a substantially large financier of increasingly large debt work-outs, and is facing substantial opposition from its own leaders, especially the US, in this regard.

The intent of SDRM

This is the problem that the SDRM seeks to address. When financial difficulties afflict any country, large lenders with heavy exposures who would like to protect their investment as far as possible, want to provide the country a chance to adjust and meet its commitments by deferring them, even if on harder terms. But investors and creditors with smaller exposures want to cut their losses and leave and therefore want immediate and not deferred settlement, on the best possible terms.

This conflict of interest between a growing number of independent private players who have come to dominate the global debt market could have two consequences that the IMF or international finance need not favour. First, since it makes restructuring difficult even in desperate situations of financial crises, it could force debtor nations into default as well as make it impossible for them to remain open to and integrated with the world economy. Second, it could destroy the very entities (the emerging markets) whose existence is necessary for the now omnipresent global financial system to functional effectively and profitably.

It is to stave off these consequences that the IMF advocates the SDRM, which like Chapter 11 and administration provisions in corporate law, seeks to offer some temporary "relief" for the debtor, in order to protect the larger, long-term interests of creditors in the global financial community. Since atomistic players in the debt market are unlikely to come to the necessary agreement, the IMF has come in once again as the overseer of global financial system to enforce a system which it thinks is in the interests of global finance, even if it is seen as unacceptable by individual financial players in particular contexts.

To realise this aim the IMF has been authorised by the International Monetary and Financial Committee of its Board of Governors to adopt a "twin-track" approach. To quote the IMF: "The first, a statutory approach, would create a legal framework that would allow a qualified majority of a country's creditors to approve a restructuring agreement which would be binding on all. In order to make the agreement binding on all creditors, enactment of a universal statutory framework would be necessary. The second approach would incorporate comprehensive restructuring clauses, so-called `collective action clauses', in debt instruments. Collective action clauses, found in sovereign bond contracts, limit the ability of dissident creditors to block a widely-supported restructuring."

Both of these would require changes in law relating to debt instruments issued by creditors, to the enforcement of creditor and debtor rights and to the realisation of creditor claims. The new restructuring mechanism would in fact require a universal reform of law across countries, which would be cumbersome and politically near-impossible to achieve. In response, the IMF has come up with the idea of binding countries into an international treaty on the matter. The suggested route is to establish a treaty obligation by amending the Fund's Articles of Agreement. This would require the support of three-fifths of the IMF's members, holding 85 per cent of the Fund's total voting power.

Once countries vote in the amendment, debtors confronted with unsustainable debt would be in a position to call for a temporary stay on payments, individual creditors would be bound into the decision of the majority with regard to restructuring and the IMF can play the role of ensuring that the restructuring goes through and that the interests of the creditors are respected by the debtor country. As Anne Kreuger puts it, "the debtor would have to conduct its economic policies in a way that would help put the country back on the road to growth and viability. Implementation of an IMF-supported program would be one way to provide these assurances. Creditors would have an interest not only in monetary, fiscal and exchange rate policies, but also in bank restructuring, the integrity of the domestic payments system, the operation of the domestic bankruptcy regime, and the nature of any exchange and capital controls." That is, we are likely to have more of the same policies under the new mechanism.

It should be clear that this involves a loss of sovereignty, since an international treaty would supersede national laws relating to settling debt claims. Getting developed countries to agree to this would be difficult enough. But getting financial agents in developed-country financial markets to agree to collective action clauses may be even more difficult. For developing countries, the loss of sovereignty is all the greater. In return for a temporary reprieve at times of financial difficulty, they are to be tied into working towards a negotiated restructuring agreement that would involve a range of policy and other concessions.

Clearly, the IMF wants to have powers akin to that of a supra-national world government. But its power relative to developed and developing countries is bound to be asymmetric, since it is the developed that control and run the IMF.

The nature of restructuring

A crucial issue is: What would be the nature of the debt restructuring exercise that would occur under the new mechanism into which countries are to be bound by treaty? Responding to criticism that it is not the role of the IMF to negotiate between private creditors and private or public debtors, Kreuger argued: "People have questioned whether it would be appropriate for the Fund to interfere in the relationship between debtor and creditors, and to impose the terms of a restructuring on them. The simple answer is that we would have no intention of doing so and could not do so. The Fund would be mandating the process within which a restructuring would be negotiated, but not the outcome. The restructuring terms would emerge from negotiations between the debtor and creditors. But once the necessary majority of creditors had agreed the terms, the mechanism would make it possible to bind in minority creditors, thereby resolving the collective action problem."

This mandating of the process by treaty while leaving the shape of the outcome partially open (partially, because it is expected to include an IMF-supported programme) raises one question. Would developing country governments bound into the restructuring process be pressured into putting up resources for sale as a means of liquidating sections of the debt as a part of the process? Resources can vary from public sector assets to publicly owned resources such as deposits of minerals and oil. That is, is the effort akin to moving the relation between creditor and debtor at the international level in the direction of what prevails with regard to corporations in the national context, where debt restructuring occurs in a context where there is always the guarantee that there exist some assets which can be liquidated to redeem at least a significant portion of the debt?

It must be recognised that so long as the open, market-driven and poorly regulated international financial system that the IMF urges countries to adopt is kept in place, financial vulnerability and financial crises in developing (and even developed) countries are inevitable. If in such a situation the cross-border flow of finance is to be sustained so that developing countries are not forced to withdraw from global capital markets, the guarantee provided by assets that can be liquidated is crucial, even if that option is not commonly exercised.

By providing debtors a modicum of protection through the SDRM, in the form of a temporary halt to payments while negotiating restructuring, the IMF is clearly doing two things. It is forcing these countries to take "ownership" of policies that would be in the interests of the creditors. It is binding them into arriving at a negotiated settlement, even if this may require some liquidation of assets and resources.

If the effort of putting in place the SDRM proves successful, given past experience with the persistence of financial vulnerability and the recurrence of financial crises, a gradual process of liquidation of developing country assets seems inevitable. In the name of maintaining an efficient, transparent and functioning global financial system, the IMF may be engineering an efficient process of transfer of resource ownership from the South to the North, leading to the recolonisation of the developing world.

Components of the scheme

DEVELOPING countries experiencing debt-servicing difficulties would be reticent to seek early restructuring, increasing the possibility of a major debt crisis that could lead to default, with damaging consequences for debtors and the international financial system. Thus far the IMF has managed to prevent any major default by financing large rescue packages that bail-out creditors, who had not exercised due diligence when lending to public and private agents in emerging markets.

Given the repeated instance of crisis in recent years and the large and increasingly infeasible bail-outs that the IMF has had to coordinate and part-finance, this situation is clearly unsustainable. Since the option of reverting to a regime of regulation of the financial sector in individual countries and of financial flows across borders into different countries would work against the interests of finance, it is an option that is not acceptable to the IMF and the World Bank. It is in this context that the IMF has sought to ensure the "prompt" and "orderly" resolution of problems of unsustainable debt, through a scheme titled the "Strategic Debt Restructuring Mechanism" (SDRM) being advocated by Anne Kreuger, its First Deputy Managing Director.

The scheme has three components to it. The first is a mechanism to ensure that when creditors provide credit to emerging markets they explicitly sign into a commitment to be bound by any restructuring exercise that a majority of creditors might agree to. This also means that individual creditors forego the right to disrupt restructuring negotiations by resorting to litigation in national courts. The second is to put in place mechanisms to ensure that debtors can request for a stay on debt service payments till they restructure debt, and use this facility in a manner that does not prove detrimental to creditors. Debtors must be "well behaved" during the stay and adopt policies that are "appropriate" according to the creditors as well. Finally, during and after the restructuring process there must be means to ensure that private lenders provide additional financing with the assurance that they would be repaid in advance of existing creditors.

This approach is obviously inspired by domestic laws, especially in the US, which permit corporations to undertake similar restructuring when faced with financial distress or "bankruptcy", so that they do not have to go into liquidation in the first instance. Till the mid-1970s, bankruptcy provisions were biased in favour of creditors. A bankruptcy petition could be filed either by the debtor or creditor, requesting a court of law to declare that an individual or company is insolvent and cannot meet its debt service commitments when due. The court then appoints a receiver to investigate whether a debtor is indeed insolvent, and if the receiver considers it necessary, they can call a meeting of creditors to find out whether they wish to declare the debtor bankrupt.

If they do, the company goes into liquidation, its assets are realised and the proceeds distributed as per specified norms among the creditors and shareholders.

In the US, under Chapter 11 of the Bankruptcy Reform Act of 1978, an effort was made to redress the obvious bias in favour of creditors in this scheme of things. Chapter 11 allows a firm to apply to a court of law for protection from its creditors while it undertakes a reorganisation that enables it to pay off its debts. In a similar way companies in the UK, under the Insolvency Act 1985 and 1986, can be placed under administration rather than go into liquidation with the affairs of insolvent debtors being the responsibility of a registered insolvency practitioner.

Thus Chapter 11 and insolvency provisions in the US and the UK are laws that provide for an intermediate step between financial distress and liquidation and thus seek to provide some degree of protection to debtors, so that the system is not completely loaded in favour of creditors whose short run interests may result in unnecessary liquidation of still productive assets.

Send this article to Friends by E-Mail
Comment on this article to BLFeedback@thehindu.co.in

Stories in this Section
Audit effectiveness

Rejuvenating NATO

SDRM: Debt restructuring or liquidation?

Improving India's investment climate

Caring for the elderly — Challenges and opportunities

Retirement scheme

Kelkar proposals

Small-savings schemes