Joseph E. Stiglitz

November 17, 2014

DEBT RESTRUCTURING:GAPS IN LEGAL AND INSTITUTIONAL STRUCTURES

I. The Current situationII. Objectives of restructuringsIII. Designing a good bankruptcy

systemIV. Implications: When will

restructuring help? V. Reflections on the basic theory—

why it can’t be left to marketsVI.The need for a FSDR

OUTLINE

Background: Judge Griesa’s ruling and UN resolution Following earlier calls for SDRM by IMF, UN Commission Earlier efforts blocked by US

Some concerns that current efforts will be similarly stymied Questions about “underlying political economy”

Borrowing countries reluctant to show enthusiasm for reform, lest it provide unfavorable signal

THE IMPETUS FOR A FSDR

Policy questions Are there quick fi xes posed by these developments? Are

the problems really systemic, needing a systemic solution? Could private contractual approaches provide an adequate

and easy solution? What improvements in the standard contracts are desirable? What can/should be done about large body of existing contracts

written under old language? Could old bondholders be encouraged/forced to exchange bonds

with new language? To what extent can principles that are reflected in good

bankruptcy laws be incorporated into contracts? What reforms in domestic law in issuing countries would

be desirable? What might a FSDR look like?

KEY QUESTIONS

Answers to these questions need to be informed by analyticsWhat are the underlying economics of debt

restructurings Equity and effi ciency considerations Why are debt restructurings desirable? What are the underlying market failures? Why are market

solutions unlikely to be effi cient and fair? In what ways are sovereign debt restructurings

diff erent from private debt restructurings

ECONOMICS UNDERLYING THE LAW

There are quick fi xes Just extend sovereign immunity But will they really work? Do they address underlying problems?

Private contractual framework as an alternative Just change language of contracts, clarifying pari passu, and using

collective action clauses But what about existing debt? And will these approaches really suffi ce? If they could, why does every country have a bankruptcy law for private debts

Sovereign debt restructuring are more complex than private debt restructuring

It is impossible to achieve a FSDR We actually have some incomplete frameworks These need to be extended There are significant costs to not doing so

Ineffi ciencies and inequities Flow of funds Timing of restructurings Cost of restructurings

ARGUMENTS AGAINST NEED FOR FSDR

Bankruptcy has a central role in modern capitalist economies. One cannot imagine a modern economy without limited

liability and the possibility of debt restructuring

II. OBJECTIVES OF RESTRUCTURINGS

Both effi ciency and equity dictate providing a fresh start As a result of excess indebtedness (as in Europe), there is a

massive waste of resources Resources before the crisis are the same as after Debt is just an obligation The problem is that there are “excess claims” In the fight over whose claims will be satisfied resources are destroyed

This is a distributive battle

Private outcome may be (is likely to be) Pareto In ferior Market equilibrium (flow of funds before crisis; restructuring after

crisis) characterized by market failures Coordination failures, bargaining failures, signaling failures Even more so in presence of macro-economic externalities—essentially

always present with sovereign debt restructuring Part of the explanation for why every government has a private

debt restructuring mechanism (bankruptcy law)

A system of orderly discharge would more likely lead to more effi cient use of resources today

But if no one repaid debts, debt market would dry up

Bankruptcy regime attempts to balance Ex post effi ciency Ex ante effi ciency (credit assessment, excessive risk taking) Effi ciency in the restructuring process

Excessive penalties in restructuring can induce costly delay

III. DESIGNING A GOOD BANKRUPTCY SYSTEM

Creditors are to blame as much as debtors—loans are voluntary agreements Creditors are typically more financially sophisticated—should know

how to assess risk Creditors often engage in predatory lending In case of lending to sovereigns, problems are even worse

Often make loans, knowing that there will be IMF bail-out Even worse, often make loans to private borrowers, knowing (or at least

hoping) that the private debts will be socialized, and then there will be IMF bail-out

In case of loans to poor countries, high interest loans may even displace concessionary loans If projects were good, FDI should be used—lender at risk Problem evident in Africa today

Take advantage of political economy problems Those benefiting from loans are different from those bearing cost of repayment

“Audits” to see what really happened

Many of debts are “otiose debts”

CREDITORS ARE TO BLAME

But fairness is also important, especially in a world with predatory lenders Who take advantage of those who are financially less

sophisticated Fraud laws may not suffi ce Creditor equity issue: creditors have (at least partially)

been compensated for risk in form of higher interest payments

There is not a single bankruptcy code to be packaged and sold around the world. Large differences across countries Large debates within countries

America’s bankruptcy reform was a step in wrong direction, creating partially indentured servitude, and contributing to financial crisis

A framework that facilitates the fl ow of capital in ways which: Maximize sustainable growth Minimize hardship following crisis Include concerns of all, including those within the

developing country, formal domestic creditors, and foreign creditors

A quicker more certain resolution would Reduce risk premia Reduce costly delay (problems of asset stripping,

deterioration of value in limbo state) Reduce magnitude of macroeconomic disturbances Exchange rate stabilization

OBJECTIVES OF FSDR

Objective is NOT to maximize the flow of capital Or even to minimize short-term interest rates – when costs

of borrowing have to be borne by others Excess capital flows have contributed to crisis, with high

costs

Objective is NOT to maximize income of intermediaries

Legal framework—diffi cult to enforce And even more so in an era of privatization Judge Griesa’s ruling putting burden of enforcement on financial system

imposes burden which will provide adverse to role of US financial system Contempt rulings raise further questions about sovereign immunity

Fundamental rewritings of understandings of international law

Not clear who full l ist of claimants should be Implicit versus formal claimants (pensioners)

Chapter 9 of US bankruptcy code gives weight to these other claimants

Political economy/agency problems Costs of painful restructuring borne by diff erent political actors than those

who create problem (Greece) Citizens are made to bear costs of others’ mistakes

Ireland—bankers and political leaders made mistakes Raises issues both of eff ectiveness of incentives and of fairness

Issues of debtor moral hazard may not be so important Issues of creditor incentives may be more important

SPECIAL PROBLEMS OF SOVEREIGN DEBT RESTRUCTURINGS

Most importantly, we must distinguish between systemic/sovereign bankruptcy and “isolated” fi rm bankruptcy.

A default by a single firm does not have macro-economic consequences

A default by large number of firms and a sovereign restructuring typically have significant macro-consequences, especially when accompanied by exchange rate changes In the case of systemic private sector bankruptcies sorting out

the consequences may be diffi cult Which is why there needs to be a special Super Chapter 11, or other broad

procedures to deal with these circumstances Debt contracts may have to be rewritten

If a country has a primary surplus, it can be potentially better off if it has a deep restructuring of debt, even if there is a suspension of credit fl ows Especially if there is Keynesian unemployment

Money that went to foreign creditors can now be used to stimulate demand

Especially if the government had borrowed excessively from abroad “Optimal” investment going forward may call for no borrowing, and

especially no borrowing from abroad Which can impose a high price through multiple channels Recent research has shown that there is typically excessive borrowing, and especially in

foreign denominated currencies

Governments with primary deficits and current account deficits, who lose access to finance, have to contract quickly (or risk inflationary printing of money)

Bargaining power obviously differs in two different situations Outcomes in private bargaining more dictated by bargaining power than

either effi ciency or equity

III. IMPLICATIONS: WHEN WILL RESTRUCTURING HELP?

But if the country wished to return to markets, it normally can

Markets are forward-looking

In competitive markets, there is no way they can collectively impose punishment IMF sometimes viewed as “creditor cartel” Tried to impose punishment (“Can’t accept yes as an answer”)

Once debts have been restructured and country grows, it can gain access more easily Prior to restructuring, the flow of money is out of the country,

not in

EXCESSIVE FEAR OF LACK OF ACCESS TO MARKETS

Exchange rate adjustments mark many crises There are significant short run costs

Contracts have to be rewritten

Distributive conflicts can be magnified

Bankruptcies can become widespread

DEBT RESTRUCTURING WITH EXCHANGE RATE ADJUSTMENTS

But there can be long-run gains

Both from the debt restructuring and the realignment of exchange rates “Internal devaluations” are slow and costly; issues of

bankruptcy still significant Delay is very costly

Even creditors can lose from delay But private bargaining games often characterized by excessive delay

Benefits at micro and macro level Before restructuring, growth slow, unemployment high, large waste of

resources

Imperative that Central Bank, government maintain flow of credit Can be done

SIGNIFICANT BENEFITS FROM DEBT RESTRUCTURING

Given likelihood of high SR costs (which may cost them their job), understandable that political leaders try to postpone day of reckoning: incentives for excess delay

Which is why an FSDR should not impose excessive penalties on restructuring—the market is likely to do it on its own—but rather to provide temporary assistance

Problems are made worse by investment treaties—lesson of Argentina is that countries should be wary about signing them Little evidence of benefit, strong evidence of high costs Recent “trade” agreements trying to extend investment

agreements

IN ABSENCE OF A FSDR THERE IS A TENDENCY FOR EXCESSIVE DELAY

Economic theory focuses on “equilibrium,” has much less to say about adjustments, out of equilibrium behavior.

Bankruptcy largely about “incomplete contracts” Risk sharing (equity) contracts would (in absence of information

asymmetries and contracting costs) be better; would avoid bankruptcy

Government necessarily “completes” contracts—specifies what happens when creditor can’t pay what is owed; prioritizes different claims

That makes bankruptcy law political—different laws have different equity and effi ciency consequences Some are more pro-creditor, some are more pro-lender Pro-creditor laws attenuate incentives for due diligence

Some put partial blame for America’s mortgage crisis on Bankruptcy Reform Act Excessive risk taking encouraged by law giving derivatives priority in bankruptcy

V. REFLECTIONS ON THE BASIC THEORY

Bankruptcy aff ects not only lenders, but also other "stakeholders (large externalities)

Signaling problems Ex ante, contract provisions are used to signal Again, signaling equilibrium is typically ineffi cient With incentive to off er excessively stringent contract provisions Bargaining models with imperfect information often engenders delay as

a costly signal When there are macro-economic disturbances, there are externalities

associated with delay which parties will not take into account

Problems exacerbated in political context (sovereign lending), where government making commitment does not bear costs

Asymmetric information also leads to contract rigidities—diffi culty in moving out of ineffi cient equilibria

MARKET SOLUTIONS BY THEMSELVES WON’T WORK (BE

EFFICIENT)

There are large confl icts of interest among diff erent claimants

There are often large disputes about valuations (both of claims and proposed settlements) and priorities

Such disputes are a manifestation of imperfect markets/imperfect information (whole issue of “liquidity/solvency” reflects diff erences in beliefs)

In such situation, there is no presumption that market solutions will be effi cient (let alone fair)

MARKET SOLUTIONS BY THEMSELVES WON’T WORK (BE

EFFICIENT)

There are also important coordination problems across contracts Exacerbated when different debt contracts are written

under the laws of different jurisdictions

And public good problems— Each claimant wants to enjoy benefit of country’s ability to

repay from debt reduction But each wants to be repaid in full

MARKET SOLUTIONS BY THEMSELVES WON’T WORK (BE

EFFICIENT)

I f they did, wi thin countr ies for “s impler ” ordinary bankruptcy, they would have suffi ced No country relies upon them

Compl icated issues of deal ing with mult ip le c lasses of c la imants Dangers of major i ty vot ing with in a c lass

If every classes agreement is required, easy for “vulture” to block agreement if there are many classes

Majority may have ability and incentive to deprive minority of legitimate claims even with pari passu clause because of their ownership position on other claims (including CDS’s)

Problem is exacerbated because of “endogeneity” of voting (ownership shares) Even/especially with rational expectations (of a bad outcome)

Dangers of major i ty vot ing across c lasses Risks exacerbated because of likely diff erences in interests Again, majority may have ability and incentive to deprive minority of legitimate

claims even with pari passu clause because of their ownership position on other claims (including CDS’s)

Separat ion of ownership and economic interests because of CDS’s has made issues even more problemat ic

And how does one treat “ impl ic i t” credi tors (soc ia l contract)—de facto, under col lect ive act ion c lause, they would have no vot ing r ights? Would provide incentive for governments to give full creditor rights to social security

claimants But make government agencies fi duciary for those claimants

But then these might “drown out” traditional creditors

COLLECTIVE ACTION CLAUSES DON’T SUFFICE

CDS’s are “advertised” as helping complete the market—but have failed—but have made matters worse “Triggering” event interpreted by secret committee of ISDA that

has representatives of banks that have self-interest in outcomes Lack of transparency of contracts have increased financial

fragility and impeded restructuring ECB’s insistence that the Greek restructuring be voluntary—paying

more attention to interests of banks than of countries, CDS’s were supposed to reduce risk, thereby making restructuring easier; have had exactly the opposite effect

Over-the-counter CDS’s undermined decentralization of the market economy and effectiveness of capital market discipline

Most importantly, have resulted in those having a seat at the table in debt negotiations having no interest in good resolution—may even have an interest in “bad” outcomes

“COMPLETING THE MARKET”

Recent US court decisions have made matters worse Interpretations of “pari passu” clause makes debt

restructurings essentially impossible Have introduced new level of uncertainty into sovereign

lending

Attempt to use of bilateral investment agreements to enforce claims may also make matters worse

Not really in business in providing credit to countries Really engaged in “legal arbitrage” Buying bonds in default (or about to go into default) at deep

premium Demanding payment in full

Even though high interest rate reflected risk of not being paid

Using bargaining power to extract rents—economic extortion, especially for countries needing to reenter capital markets

Because of CDS’s, real economic interests in settlement not clear Questioning “good faith bargaining”

Viability enhanced by successful campaign to eliminate Champerty defense Change in property rights advantaging vultures

Further “unjust enrichment” through litigation changing meaning of pari passu clause

THE SPECIAL PROBLEM OF VULTURES

Trying to do better job at risk-sharing than the market—through GDP bonds

For sovereigns, akin to a debt-equity restructuring (chapter 11)

Align incentives—creditor now has an interest in borrower doing well

But markets have resisted

IMPROVING UPON THE MARKET

Necessity of courts to ensure no ineffi cient delay

Necessity of courts to ensure fair asset preservation

Necessity of courts to coordinate across classes, jurisdictions

Necessity of courts to ensure reasonably fair treatment of all parties

Even when restructuring does not go through courts, bankruptcy law aff ects the outcome of the bargaining process, which is typically designed to avoid the uncertainty & delay of relying on courts

WHY COURTS ARE NEEDED

Reinstating some variant of champerty defense Reinforcing long established principle of “unjust enrichment”

resulting from changes in legal framework Clarifying pari passu on existing contracts Clarifying that creditors have been compensated for risk through

interest rates above T-bil l rate Demanding transparency on CDS’s holdings of those at the

bargaining table (and their affi liates) Extending provisions of Chapter 9 to sovereign debt restructurings Encouraging use of GDP-linked bonds as part of restructuring

(similar to debt-equity conversions under chapter 11)These reforms could be made even without a FSDRCoordination among issuing countries would be desirableCould competition among issuing countries suffi ce to bring about these changes? Should countries (l ike China) aspiring to become global fi nancial

centers be encouraged to adopt these legal frameworks?

REFORMS ARE NEEDED IN NATIONAL LAWS

Bankers encouraged countries to take on more debt

Irony is that money is flowing wrong way—from poor countries to rich

Risk has also been flowing wrong way—poor countries are asked to bear burden of risk

Evidence that international capital markets do not work in the way they should Not really improving effi ciency of capital allocation Financial markets take advantage of lack of sophistication of

borrowers, political economy problems And even work to undermine transparency

CHANGING PERCEPTION ON DEBT (LEVEL AND FORM)

Countries should be wary about excessive foreign indebtedness, other than for investment projects

Especially in foreign denomination Less “real” risk in domestic debt, can reflect changes in

domestic circumstances (Korinek) Large growth in domestic borrowing

IMPLICATION

There is no orderly process for restructuring sovereign debt

In Argentina crisis, recognition of need

But US vetoed discussion

As a new wave of restructurings appears in offi ng and in light of recent US court decision, discussion needs to be reopened

V. THE NEED FOR A FSDR

Design of contracts

Decision to default

Outcome of bargaining

Capital flows (quantities and allocations)

Resolution of problems which follow from default

MUST BEGIN WITH RECOGNIZING LIMITATIONS OF MARKETS

Recognizing conflicts of interests, perceptions What kind of system might we try to work towards?

Arguments for an international legal framework even more compelling than need for Court framework for bankruptcy domestically

Potential confl icts over contracts written under diff erent jurisdictions need to be addressed

Existing institutional arrangements inadequate

IMF too linked to creditors Informal arrangements slow and not up to task

UN Commission called for a World Bankruptcy Organization

A WORLD BANKRUPTCY ORGANIZATION

Sovereign initiates resolution

Stay in litigation; provision for lending into arrears

Temporary exchange controls

Sovereign proposes a restructuring

A POSSIBLE FRAMEWORK

Those who believe that proposed restructuring treats them “unfairly” may submit counterproposals. Such objections and counterproposals should provide a methodology for assessing the magnitude of the eff ective debt write-down and an evaluation of the seniority of diff erent creditor claims. All those aff ected by proposed settlement would have standing.

The bankruptcy court (arbitration panel) would rule on the alternative resolution proposals, giving deference to the proposal of the sovereign and its legitimate concerns to maintain the economic strength of the economy in the short run and the long, and recognizing the claims not only of foreign and domestic bondholders but also claimants, including pensioners and workers

A POSSIBLE FRAMEWORK (CONT.)

But is there something the could work short of a WBO? If we can’t get the international consensus on a binding legal and institutional framework? Recognition of the importance of the imposition of capital

controls/exit taxes in the event of crises that are l ikely to lead to sovereign bankruptcy; and provisions for lending into arrears.

An agreement on “mutual recognition” of the bankruptcy laws of each other and procedures to resolve jurisdictional confl icts.

Sovereign would propose a resolution/alternative resolutions.

An international bankruptcy evaluation/mediation service, which would help evaluate the consequences of diff erent proposed resolutions on diff erent parties, on diff erent categories of creditors, the government and the economy, working with sovereign (and creditors) to arrive at one which is viewed to be “reasonably fair ”.

AN INTERMEDIATE SOLUTION

Restructuring is costly

But not restructuring may be even more costly

Economic theory and experience has shown the advantages of a timely restructuring and that delay can be costly

How the restructuring is done has implications for effi ciency and equity Remember: the financial markets have a vested interest,

and their perspectives have to be treated with caution

LIFE AFTER DEBT

There is ample room for improving private contractsBut the private contract approach will not suffi ceThere is a need to reform of the legal framework

within issuing countries Restoring some variant of the Champerty defense

But neither of these reforms go far enough It would be desirable to have a more effi cient

restructuring framework, a FSDR Or, going further, a World Bankruptcy Organization

CONCLUDING COMMENTS