Tackling Sovereign Debt Systematically - If not

now then when?

by Anna Gibson, Research Associate, Re-Define

Development actors have long argued for an overarching international mechanism that
would resolve sovereign debt crises in a fair, transparent, and consistent manner. Such a
mechanism would assist poor countries that often suffocate under unsustainable levels of
(sometimes odious) debt, lacking the political power and legal rights to negotiate with their
creditors in an impartial and efficient forum. It would make handling sovereign debt problems less
messy, more predictable, and the burden sharing simpler and fairer. It would also provide
incentives to curtail irresponsible lending policies on behalf of creditors.

However, since these problems were seen to be 'out there' and we in the rich OECD world
were mostly the creditors there was little political will to support this call. That was a missed
opportunity. The developed world is now realising just how vital a sovereign debt workout
procedure really is. The escalating sovereign debt levels of Iceland, Greece, Italy, Ireland and
Spain, not to mention Dubai, that have transpired in the wake of the global financial crisis, have
brought the severity of the issue out of the hypothetical realm and into that of Western reality.

With these countries entering the territory of debt unsustainability with which many developing
countries are uncomfortably familiar, it has both catalysed and provided ample opportunity to
develop a mechanism to deal with the implications of this looming sovereign default. And given
the economic interdependence of the EU in particular, and the globe as whole, this is not an issue
that can be avoided for much longer without catastrophic consequences.

The current situation in Greece, whose membership in the Euro zone brings with it additional
complications and repercussions highlights how unsustainable sovereign debt has come to haunt
the west. With Greece’s public debt currently amounting to 113% of GDP and a deficit four times
the EU’s 3% limit, a default of this kind would have disastrous consequences within and beyond
Greece itself, provoking financial institutions to scrutinise other European economies facing
similarly dangerous levels of unsustainable debt, such as Italy, Ireland, Spain and Portugal. This
would subsequently escalate the costs of borrowing and insuring sovereign debt within the region
as a whole, given its economic interdependence, precipitating a vicious cycle of debt overhang
and downgraded sovereign ratings from which it is difficult to escape, in addition to damaging the
EU’s financial standing as a whole and thus threatening overall European economic prosperity.

Furthermore, the severity of the Greek situation is exacerbated by the large proportion of its
sovereign debt owned by foreigners – recent figures suggest as much as 72% – which leaves the
economy particularly vulnerable to a sudden withdrawal of funds should these debt-holders lose
confidence in the government’s ability to restore fiscal stability. And this would seem frighteningly
plausible given the austere stance the ECB is taking with regards to a potential Greek bail
out. Moreover, given the constraints on sovereign monetary policy that follow Euro zone
membership, should it be forced to default, Greece may have little option but to leave the
currency union in an attempt to improve international competitiveness through currency
devaluation. Again, this would have widespread ramifications, potentially precipitating a
disintegration of the Euro zone if others were to follow its downward spiral. As has been proven
with the vast contagion of financial markets following the collapse of the US sub-prime mortgage
market, the scope of the current sovereign debt crisis cannot be isolated easily once it has been
triggered, and so a mechanism which could prevent this situation unfolding by orderly and
efficiently arbitrating debt restructuring or insolvency negotiations would evidently be a mutually
preferable outcome.

Outside of the EU, Iceland’s recent controversy over whether to pay 3.9 billion in Icesave’s lost
bank deposits to Britain and the Netherlands is also a prime example of the deficiency of the
status quo for sovereign debt resolution. With a quarter of the electorate petitioning against the
payments on account of their unfair burden of recovering foreign savings, its road to recovery is
vastly jeopardised by the prospect of default: both the receiving of indispensable loans from the
IMF and Iceland’s accession to the EU rest on the country’s ability to stabilise its dire public
finances; a default of this kind would suggest otherwise. Yet the ambiguity of Iceland’s legal
obligations for repayment under European banking law makes an expeditious resolution of the
issue difficult. As has been suggested, whether the British or Dutch governments would take on a
proportionately equivalent amount of debt per capita to compensate foreign savers is highly
doubtful, whilst they are also not without some culpability for the Icelandic crisis. Evidently, all
countries involved would benefit from a sovereign debt resolution mechanism that impartially and
transparently works to resolve these issues in order to foment financial recovery in the debtor
country, a heightened return for creditors, and the stability of the wider financial system, to which
Iceland is inextricably connected.

So, given the ubiquitous need for such a sovereign debt resolution mechanism, what would this
look like? In 2001, Anne Krueger of the IMF proposed a Sovereign Debt Restructuring Mechanism
(SDRM) where a super-majority of creditors would vote to negotiate new terms under a
restructuring agreement. The IMF would be the chosen arbitrator of this process, determining debt
sustainability levels, judging debtors’ economic policies, and thus determining the necessary
reduction of debt claims. Yet, facing criticism of creditor bias, with the IMF essentially being a
judge in its own cause, alternative frameworks have been proposed. This includes the
internationalisation of Chapter 9 of the US bankruptcy code, originally intended to provide
financially distressed municipalities with protection from creditors. Like municipalities, sovereign
nations are unable to be liquidated, and thus their approach to debt resolution must come with
realistic outcomes in mind for both debtors and creditors, whilst the model also includes the
treatment of both bilateral and multilateral debt – a considerable deficiency of the IMF’s proposed
SDRM. Furthermore, the Chapter 9 model provides debtor protection by resolving the conflict
between the legal rights of creditors and the recognised human right that one should not be forced
to fulfil contracts that endanger life or violate humane dignity.

Consequently, like with US municipalities, resources needed to finance essential public services
such as health and education must be taken into consideration when resolving debt disputes,
releasing sovereign states from the prospect of a “debtors’ prison.”

Accordingly, this begs the question: what would the current predicaments of Iceland or Greece
current look like through the lens of a Chapter 9-like of sovereign debt workout mechanism?
Firstly, it would involve the arbitration of any debt restructuring agreements by an independent
and neutral panel in line with the rule of law, allowing for a fair and unambiguous decision to be
reached which brings legal predictability to all parties involved. Moreover, it would result in more
equal rights and a fairer burden sharing between debtor and creditor, protecting the debtor’s right
to provide for the welfare of its citizens. As Martin Wolf recently commented, asking a people to
transfer as much as 50% of GDP plus interest to its creditors, as is the case with Iceland, exceeds
the limit of the acceptable pursuit of a country’s debt, while treating Iceland as insolvent exempts
resources from being seized bybona fide creditors.

Not to be mistaken, such a procedure would not absolve a country of its debt obligations, as filing
for insolvency through a chapter 9-like mechanism without being in sufficiently dire need would
serve only to tarnish a country’s reputation in international capital markets; but by treating the
sovereign debtor as insolvent, creditors would most likely receive a greater return through a fairer
and more feasible workout process, whilst at the same time avoiding the prescription of counter-
productive austerity measures that would only exacerbate the country’s debt overhang. This was
the case after Mexico’s default in 1914, when creditors received only 10% of the face value of debt
after years of debt management, and it is still the case today, where countries like Greece are
‘gambling for redemption’ by increasing their unpayable debt due to a fear of default, rather than
addressing the problem as a case of insolvency. A sovereign debt workout procedure in the vein of
the Chapter 9 model would secure pareto efficient outcomes for Greece, its creditors, and the
wider Euro zone, which stands to bear the aftermath of Greek default. On the other hand, the lack
of such a mechanism brings with it the prospect of sovereign financial and economic collapse, an
ability to adequately provide for its citizens, and a domino-effect fallout on the wider financial
community. It is not an eventuality worth gambling for.

To be sure, the steady yet perilous crisis of unsustainable sovereign debt is not a new
development. Yet up until now the call for an orderly sovereign debt workout procedure has been
relegated to the fringe of financial debate, where it has fallen upon deaf ears to those whose
sympathy lay with the creditors. What the current financial crisis has revealed is that all countries
are susceptible to the dangers of debt unsustainability, and the potential repercussions on the
stability of the global financial system is a tangible threat to be dealt with. With the debt levels of
OECD countries soon expected to be three times as high as that of emerging economies, bringing
a magnitude of default equally calamitous, there is no better time to make an equitable and
international sovereign debt workout mechanism a reality. Furthermore, it is clear that there is no
shortage of innovative proposals for such a mechanism, with the essential components – largely
fairness, transparency, predictability and efficiency – a strong basis from which one could be
brought to fruition. The extensive need and political opportunity have aligned, and the risks of not
taking action are too serious to be ignored.

References:

§ “A fair and transparent debt workout procedure”, EURODAD, 17 December 2009

§ Raffer, Kunibert., “The Present State of the Discussion on Restructuring Sovereign
Debts: Which Specific Sovereign Insolvency Procedure?”. 2002/
§ “Sovereign Debt Crises: Orderly Workouts”, Centre for Economic Policy Research,
§ Pettifor, Ann, “Dealing Justly with Debt”, Ethics and International Affairs, 2003, 17/2,
§ Pettifor, Ann, “A Fair Deal for Iceland”, The Guardian, 8 January, 2010
§ “New Architecture for Sovereign Debt”, Jubilee Australia Agenda Paper, April 2009
§ “Do no put Iceland in a debtors’ prison”, Financial Times, 6 January, 2010
§ “ECB warning to debt-ridden governments”, Financial Times, 14 January, 2010
§ Alloway, Tracy, “Greek debt disaster”, Financial Times, 18 January, 2010
§ Wolf, Martin, “How the Icelandic saga should end”, Financial Times, 15 January, 2010