Sovereign Debt Restructurings: The Evaluation of Three Approaches

A New Wave of Sovereign Debt Defaults

Sovereign debt, or public debt, is an important way for governments to raise capital for growth and development and it is crucial for governments to ensure debt burden remains sustainable. In its 2022 Annual Report, the International Monetary Fund (IMF) warned that "governments are now struggling with rising import prices and debt bills in a highly uncertain environment of elevated inflation and a slowdown in economic growth." A new wave of sovereign debt defaults and restructurings is underway, which is caused by economic and political disturbances. First, rising global interest rates increase the costs of securing new debt and refinancing existing debts. Second, increased risk aversion of global investors has made refinancing costly. Third, emerging markets governments face larger expenditures during a pandemic. Finally, the war in Ukraine surged global commodity prices.

The Complexity of Sovereign Debt Restructurings

Future sovereign debt restructurings face uncertainty stemming from prolonged processes, insufficient debt repayment, and unequal treatment of creditors. Factors that complicate the resolution of this debt crisis include political risks and government instability, inefficient negotiation processes due to holdouts and creditor litigation, lack of liquidation provided by bankruptcy law, and sovereign immunity doctrine protection.

Creditor Organization and Holdouts

In a sovereign debt restructuring, the organization and fair treatment of creditors is challenging. Debt restructuring requires collective action by a diffuse group of creditors holding debt instruments with different interests and maturities, including domestic and international investors as well as retail and institutional investors. How are creditor representatives selected? How large should the supermajority of creditors be to approve collective action clauses (CACs) that allow them to agree to a debt restructuring that is legally binding on all creditors? How can equal treatment be provided to diverse creditors? Creditors may refuse the supermajority’s agreement and hold out the restructuring process. Holdout creditors may file lawsuits to enforce their contractual claims against sovereign debtors. All of these issues contribute to the complexity of sovereign debt restructurings and these questions must be answered in response to the sovereign debt crisis.

Sovereign Immunity

Sovereigns are protected under the theory of sovereign immunity, which means the government cannot be sued without its consent. Compared with absolute sovereign immunity, restrictive sovereign immunity prohibits sovereign immunity with regard to commercial activities of foreign states or with regard to property taken by a foreign sovereign in violation of international law. Even under restrictive sovereign immunity, judicial enforcement is often ineffective and sovereign property still enjoys special treatment as the property could either be classified as having immunity for military purposes or be considered distinct from the sovereign entity itself.

Proposed Solutions and Reforms

Statutory Approach

Academics have been advocating for statutory solutions for decades. In November 2001 (initial version) and April 2002 (revised version), Anne O. Krueger, First Deputy Managing Director of IMF, proposed a centralized Sovereign Debt Restructuring Mechanism (SDRM) in order to establish an international legal framework that offers a debtor country legal protection and is equitable across all of the sovereign’s creditors. In Krueger’s revised version, a supermajority of creditors would be statutorily empowered to approve an initial stay of payments, which would automatically defer litigation. However, statutory implementation of a universal clause would have unforeseeable consequences. Bondholders may be reluctant to lend to emerging-market sovereigns perceiving that SDRM made it easy for sovereign debtors to default.

Contractual Approach

CACs permit a qualified majority of the sovereign’s creditors to approve a restructuring agreement and to make this decision binding on a minority. Only the qualified majority may initiate litigation and recoveries must be shared pro rata among all bondholders. However, such an approach raises new challenges. First, it is difficult to persuade debtors and creditors to include a collective action clause in all forms of debt instruments in a uniform manner. Second, uniform adoption of these clauses would not guarantee uniform interpretation and application unless they were subject to the same jurisdiction and governed by the same law. Third, newly adopted CACs would not affect existing debt. Therefore, this organized restructuring procedure could not be established until existing debt matures or is refinanced with new bonds that include CACs.

Innovation Vehicle – State-Contingent Debt Instruments (SCDIs)

SCDIs link a sovereign’s debt payments to its capacity to pay, where the latter is linked to real-world variables or events. In other words, SCDIs allow variations in future payments based on economic conditions. For instance, instruments can be linked to a country’s Gross Domestic Product (GDP-Linked Securities), to commodity prices, or to natural disasters such as hurricanes or earthquakes. The most prevalent form of SCDIs are bonds indexed or linked to the GDP of the issuer. For example, a series of GDP-Linked Securities was issued in Latin America under the Brady Bonds program (1980s). Additional sovereign debt restructurings in which GDP-Linked Securities played a significant role took place in Argentina (2010), Greece (2012), and Ukraine (2015). The annual coupon payment is adjusted depending on real GDP growth rate for the prior year.

SCDIs benefit both investors and borrowing countries. First, the vehicle facilitates international risk-sharing and aligns the interests of sovereign debtors and their creditors. It would offer investors equity-like exposure to a country by taking a position on that country’s future growth. Second, it would optimize the relationship between sovereign debt and domestic fiscal policy. By linking a country’s economic performance to the government’s payment obligations, SCDIs stabilize government spending and limit the need for pro-cyclical policies (an increase in public spending and a reduction in taxes during an economic boom while reducing spending and increasing taxes during a recession). Third, it reduces the likelihood of defaults and debt crises during economic downturns. However, one potential problem with GDP-Linked Securities involves moral hazards related to opportunistic defaults. By increasing debt obligations when GDP is higher, governments may be tempted to manipulate GDP data or reduce incentives for growth and development.

Zixuan Luo is an LL.M. candidate at NYU and serves as a Graduate Editor of the NYU Journal of Law & Business. Zixuan is licensed to practice law in China and, prior to attending NYU, she practiced for almost four years at two prestigious financial institutions in Hong Kong. Her practice is focused on Banking & Finance, OTC Derivatives and Structured Products.