Jacques de Larosière, former head of the IMF and the European Bank for Reconstruction and Development and now adviser to the chairman of BNP Paribas, welcomes more realistic moves towards debt restructuring.

After a few years of intensive debate of a rather theoretical nature, decision makers seem to have returned to reality in terms of restructuring debt in emerging markets. Common sense is back, with participants realising that:

debt issues involve debtors and creditors;

these issues have to be dealt with on a case-by-case basis;

in a world of free capital movements and private contracts, prescriptive mechanisms emanating from administrative or judicial bodies cannot be forced on market participants;

prevention is of the essence – but, when push comes to shove and when a debt situation is no longer viable, the debtor and the creditors have no option but to negotiate a restructuring that makes sense;

there are no free lunches and no miracle solutions. Issuers have to honour their contracts and perform in terms of macroeconomic policy and transparency if they wish to keep their creditworthiness and avoid being closed off from the markets. If, in extreme cases, a debt restructuring appears indispensable, real negotiations between all parties are needed;

by the same token, creditors know that they will not be bailed out. They must carefully assess the risks they are taking and, if things turn out negatively, take their losses. The steering committee of the Institute of International Finance (IIF), which I co-chair with Bill Rhodes, has made crystal clear our view that investors should not expect to be bailed out. Big packages of public money cannot provide a general and viable solution. They may have contributed, in one or two cases, to moral hazard (although this is debatable). But they have eventually led the public sector to realise that a clear policy of pre-announced limits on IMF lending was important.

Return to reality

This return to reality is manifest in the decisions taken by the G7 and the International Monetary and Financial Committee in Washington last April. These decisions have put aside the Sovereign Debt Restructuring Mechanism (SDRM) initiative and focus on collective action clauses (CACs) and the negotiation of a code of conduct.

CACs

CACs are designed to help debt restructuring in a contractual framework. Basically, they allow a super-majority (75% in the recent cases of Mexico, South Africa and South Korea) to decide on possible amendments to the initial contractual key terms. This has the advantage of addressing the issue of potential “free riders”, limiting precipitous legal actions, and instituting procedures for the formal establishment of creditor groups to facilitate negotiations and to allow restructuring to proceed.

These clauses contribute to a smooth and orderly restructuring when this appears necessary.

The recent move towards CACs is encouraging. Bonds issued with CACs (which are common practice under English law) in the past three months by Mexico, Brazil, Uruguay and South Africa are a breakthrough and are being done voluntarily.

Last year, many representatives of governments and international finance institutions asked: “Are the private sector and the issuers serious about introducing CACs?” The answer given by the markets is an unequivocal: yes. The work done by the IIF, in close association with the other private sector groups of bond holders, has played an important role in this evolution.

CACs have not influenced the emerging market bond yields negatively. They should be generalised. Consistent with recent research (Mark Gugiatti and Anthony Richards, “Do collective action clauses influence bond yields?”, March 2003, Reserve Bank of Australia), no noticeable impact on spreads has been observed concerning bonds issued by emerging market sovereigns including CACs.

A generalisation of the use of CACs will, by itself, tend to eliminate any remaining doubts on this subject. When standard CACs become ingrained in market practice, they will no longer be seen as a discriminating factor. I hope that, now that Mexico has successfully shown the way in Latin America and South Africa has joined the movement, CACs will also become a feature of Asian and central European bonds. This should be encouraged by the recent EU decision to include CACs in its foreign currency issues.

CACs alone will not solve all the debt restructuring problems, nor do they operate in the crucial phase of crisis prevention. At the beginning, CACs will only cover a limited portion of the existing outstanding debt (except for Uruguay, where the exchange covers 93% of all bonds). But what is important in a world where bonds are the major instruments of international debt is to show that the private sector – including the buy-side – and the issuers are able to organise themselves and, through CACs, to build an agreed framework for eventual negotiations. I have no doubt that this market-oriented approach will significantly help the upcoming debt restructuring discussions.

The case of Argentina is, evidently, in all our minds. It will be important for the Argentine authorities to engage in a process of discussions with the different groups of creditors involved as early as possible. As the IIF has proposed, these groups should form a representative committee to facilitate the negotiation process. The achievement of an agreement between Argentina and the IMF will be essential in this regard.

Code of conduct

The interest shown by the G7 and the private sector for the negotiation of a code of conduct is a clear manifestation of all parties’ desire to move from judicial mechanisms to an understanding on the best ways they should behave in a co-operative framework. In this respect, I am encouraged by the work that has already been done by the official sector as well as by the IIF.

The code should provide a voluntary framework for all interested parties: debtors, creditors, governments and the IMF. All parties have a common interest in a smooth functioning of the international financial system.

This framework should focus on the preventive side of debt problems. The idea is to strengthen crisis prevention and to engage in early consultations between all parties long before debt issues become unmanageable. In many cases, a co-operative attitude by debtors, creditors and IFIs could restore market confidence and prevent broad-based restructurings.

Should restructuring become unavoidable, prompt negotiations directly between debtors and a representative group of creditors will best ensure a speedy and acceptable solution. Such negotiations should be conducted in good faith, on the basis of transparent data and aim to achieve an equitable outcome for all parties. The outcome should also convince the markets that the solution is viable and sound.

The implementation of strong adjustment policies in line with an agreement with the IMF will be of decisive importance, preferably before a restructuring becomes necessary but, if not, certainly as a basis for a restructuring. So will be the notion that the IMF interventions will be consistent with the access policy decisions. It is clear also that the market will need to know the IMF’s views on the medium-term debt viability of the country in question. These views should be shared with, and examined by, the private sector.

The negotiation of such a code should not be an insurmountable task. The IIF has already worked on a draft that seems reasonable and could be a basis for future discussions.

The private sector, for its part, wishes to contribute actively to the process in a pragmatic way so that an agreement could be reached, if there is broad support from all parties, for the next annual meetings of the IMF and the World Bank.

For this to happen, a few simple notions should be kept in mind:

The negotiating body should include, in a balanced fashion, representatives of all the interested parties.

The code should be formulated in simple terms. It should set forth principles with guidelines included only to help provide a framework for action. Unnecessary detail should be avoided, allowing for flexible use of the code according to case-by-case circumstances.

No legally binding language should be used.

In no way should the code be a vehicle for reintroducing some objectionable or impracticable aspects of the SDRM.

A monitoring group could be a useful element. As the code is voluntary, it would be useful to set up such a group, consisting of public and private sector representatives as well as issuers. The group would assess compliance with the code, which would be particularly useful in the prevention phase.

Conclusion

The debate on sovereign debt issues is moving from legalistic approaches to reality. It is encouraging to note that spreads are reducing on countries that, like Brazil, are pursuing constructive economic policies and it is notable that CACs are becoming more standard practice in New York. The private sector is eager to continue to contribute to these favourable developments, to promote the use of CACs and to participate in the negotiation and implementation of a code.

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