Drawing the Wrong Lessons From Argentina’s Debt Mess

The Financial Times  has joined the chorus of those calling for a new statutory sovereign debt restructuring mechanism (SDRM), citing Argentina’s legal battle with holdout creditors as evidence of a broken system for restructuring sovereign debt. The SDRM, as most commonly understood, envisages a formal restructuring process, analogous to national bankruptcy law, to deal with the debt of distressed countries.   It was an impractical and unnecessary idea when first raised by the IMF in 2001, and it remains so today.

The case for the SDRM rests on the judgment that the current approach for restructuring international debt is chaotic and inefficient, and in particular that holdouts have too much power to prevent good deals from being done.  With SDRM, creditors would negotiate a deal with the country subject to certain principles (e.g., standstill during negotiation, appropriate creditor prioritization, debt sustainability). If the agreement passed official muster, it would be enacted.  The legal protections provided by the SDRM’s treaty-like status would override national law and thus limit the incentives for holdouts.

The earlier IMF-led effort to establish the SDRM failed primarily because of the unwillingness of the United States and some other major countries to relinquish sovereignty over its courts to a multilateral organization.  It’s hard to believe that convincing the U.S. Congress to pass SDRM would be any easier today.  One could look to Europe, where a common set of rules for restructuring is envisaged, to test-drive the approach.  But as long as non-EU law debt is outstanding, the problem remains.  Further, most European debt is domestic, its terms subject to the laws of the debtor country, which reduces significantly the holdout problem.  Greece in 2012 was able to bind in all Greek-law bondholders and some international law bonds, leaving only a small amount of holdout debt (which is being paid).

Beyond the politics, the current system of debt restructuring–primarily through officially supported debt exchanges–has worked reasonably well.  It has allowed a flexible case-by-case approach, with debt relief that has varied based on country situation and the strength of the adjustment effort.  Most creditors will prefer the certainty of the exchange to a time consuming and costly litigation; holdouts have been further limited by legal innovations in contracts and moral suasion from the international community.  The majority of restructurings do not end in litigation.  If you think these deals have provided too little debt relief, it’s primarily a critique of the principles the IMF and other policymakers have used to define the goals of these deals, rather than a failure of creditor coordination or market failure that would justify a more formal, rules-based approach.

Why Argentina Matters

Argentina’s battle with holdout creditors from its earlier debt restructuring took a dramatic turn last year when a New York court ruling expanded the remedies available to creditors under the heretofore minor pari passu clause.  The court, frustrated by what it saw as Argentine contempt for its earlier rulings, in essence said that should any creditor receive 100% of what’s due (interest on bonds issued during the restructurings, in this case), then the holdouts must receive 100% of what’s owed them.  More significantly, it sharply expanded the range of related parties that could be drawn into the litigation, including the banks and payments systems that act as intermediaries in the transfer of payment.  The ruling is now being appealed.

The problem for most policymakers is not what it means for Argentina, which has been much more aggressive than other countries in defying efforts at a settlement, but its implications for other countries that are acting cooperatively with creditors.  If a financial institution fears that a sovereign might someday have such a ruling against them, and that as a result it may have its assets attached, it will not be willing to be an intermediary.  That logic could cause substantial stress on the sovereign funding market and increase the incentive to holdout.  This concern has led SDRM skeptics, such as Anna Gelpern, to reassess their opposition to SDRM.  If this is the end of sovereign debt restructuring as we know it, then the SDRM is worth the effort.

There are several reasons for avoiding a rush to this conclusion. The ruling could be reversed, or the scope of the remedy narrowed.  Further, contract innovations have the potential to restore an appropriate debtor-creditor balance by redefining and narrowing the pari passu law. Policymakers could reinforce this move through endorsement of the new contracts, as well as more aggressive actions to encourage old debt to be converted to the new terms (one example, also from Gelpern, would require narrowly worded pari passu clauses as a condition of accessing payment systems, though she admits it seems a remote possibility for now).  In sum, the SDRM is an unlikely fix to a system that isn’t now, and may not in the future, be broken.

This piece is cross-posted from Macro and Markets with permission.