Sovereign Debt Restructuring: Messy or Messier?

Abstract

Ever since the Mexican, Asian, and Russian crises of the mid-1990’s, efforts have been underway to find means for more effective prevention and resolution of currency-financial crises. Much has been done with respect to crisis prevention: exchange-rate flexibility is much greater than it was; there is increased transparency and improved oversight of the financial system; and greater attention is paid to unsustainable policy stances. Work continues to strengthen economies’ immunity to crises. However, no matter how much is done, there will inevitably be a crisis or crises. Much has already been learned with respect to crisis resolution, and the international financial community is better equipped to cope with crises than was the case earlier. But, as with prevention, more can be done. One item on the agenda, which should contribute both to prevention and to resolution, is dealing with unsustainable debt burdens of sovereign nations. Two of the hallmarks of most of the 1990’s crises were, first, the importance of private capital flows, and their reversals, in triggering the crises and in intensifying their severity; and second, the involvement of the financial systems in them. The countries afflicted by these crises were ones that had succeeded in raising per capita incomes and rates of economic growth. That success hinged in significant part on their having put in place economic policies that are conducive to economic growth, including a predictable legal framework, respect for property rights, openness to the international economy, and much more. The fact that the policy framework was generally appropriate implied, among other things, that there were relatively high real returns to investment in these economies. That is of course the main reason why private investors were interested in them. At the same time, capital inflows permitted more rapid development than would otherwise be possible. These associations of high real returns, growth, and appropriate policy stances continue. For these reasons, there is typically a strong stake for emerging markets to maintain international creditworthiness, and policymakers go to great lengths to maintain their international reputations and market standings. An efficient private international capital market benefits both developing countries, which are thereby able to invest more than domestic savings at high real rates of return, and investors in high-income countries, who can realize higher real returns and greater portfolio diversification than they could achieve without these investment opportunities. Because countries are sovereign, their high stakes in maintaining creditworthiness are crucial for attracting international capital flows. This is because foreign creditors do not have the rights they do in domestic courts and hence must have other protections against default on the part of borrowers. This is especially true for sovereign borrowers; international lenders to private entities in emerging markets normally have the same protection as is afforded to domestic lenders. For sovereign borrowing, however, the chief protection foreign creditors have is the losses that would accrue to the sovereign debtor (both directly, through the future reduction in access to international credit markets, and through the effects on private economic activity of a sovereign default) in the event of † Discussants: Guillermo Calvo, InterAmerican Development Bank and University of Maryland; Morris Goldstein, Institute for International Economics; Michael Mussa, Institute for International Economics; Ann Harrison, University of California–Berkeley.