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CARDIFF SCHOOL OF MANAGEMENT: ASSIGNMENT FEEDBACK PROFORMA

STUDENT NAME: James Macleod-Nairn PROGRAMME: MSc Finance

STUDENT NUMBER: ST05002068 YEAR: 2013/14 GROUP: NA

Module Number: MBA7006 Term: 2 Module Title: Finance of International Business

Tutors Responsible For Marking This Assignment: Charles LarkinModule Leader: Charles LarkinAssignment Due Date: 14/1/14 Hand In Date: 14/1/14

ASSIGNMENT TITLE: SDRM

SECTION A: SELF ASSESSMENT (TO BE COMPLETED BY THE STUDENT)In relation to each of the set assessment criteria, please identify the areas in which you feel you have strengths and those in which you need to improve. Provide evidence to support your self-assessment with reference to the content of your assignment.STRENGTHS AREAS FOR IMPROVEMENT

I certify that this assignment is a result of my own work and that all sources have been acknowledged:

Signed:____________________________________ Date___________________SECTION B: TUTOR FEEDBACK

(based on assignment criteria, key skills and where appropriate, reference to professional standards)

STRENGTHS AREAS FOR IMPROVEMENT AND TARGETS FOR FUTURE ASSIGNMENTS

MARK/GRADE AWARDED DATE: SIGNED

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It is anticipated that marked coursework with feed back will be available to candidates two weeks(14 days) after submission. Notice of availability will be posted on blackboard.

Using the insights of International Monetary Law, the law of contract and international exchange rate regimes, presented a case for and against the development and implementation of a Sovereign Debt Restructuring Mechanism. If in favour of such a scheme outline the basic institutional aspects.

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Contents

Page 3:----------------------------------------------------------------Introduction.

Pages 5-14:-------------------------------------------------------------Main Body.

Pages 14-16: ----------------------------------------------------------Conclusion.

Pages 16-17:---------------------------------------------------------Bibliography.

Page 17-19:------------------------------------------------------------References.

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Introduction:

In the past few years, there have been many countries that have had financial crises and many of them have led to a debt crisis, some of them have had to default on its debts because they have become unsustainable (Reinhart & Rogoff, 2011). Because of this there has been a recent resurgence in the necessity to look at sovereign debt restructuring mechanisms (SDRM). In particular, the IMF’s Anne Krueger who suggested this by taking inspiration from the U.S. corporate bankruptcy law under Chapter 11 of the 1978 Bankruptcy act. In particular, because of the Eurozone debt crisis it has highlighted that the current ad hoc, contractual approach has many weaknesses. The current need for a mechanism was mentioned by Anne Krueger in a recent article; she indicated that “having a clear mechanism could have prevented all sorts of problems in the Eurozone” (Wigglesworth, 2013).

In this context, this essay aims to address the current issues regarding sovereign debt restructuring mechanisms (SDRM); considering the benefits and negatives of implementing a SDRM and to look at some of the issues facing a possible framework for a future SDRM. In addition, addressing some of the current problems a country faces when it goes into default and tries to restructure its debts; using recent examples and highlighting some of the legal and institutional aspects. In particular exploring the current ongoing situation regarding Argentina and its debt restructuring and what may be the consequences of any outcomes of this for future SDRMs.

Throughout history there have been always countries or municipalities in a state of default or debt restructuring, as shown in the graph below which shows global sovereign default cycles from 1800-2008. This is not a new phenomenon and invariably there will always be countries that will have a problem with its finances and need a mechanism to restructure or have its debts written off.

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(Source: Reinhart, C. Rogoff, K. 2011, pg. 7)

Historically, there have been many methods by which a country and its creditors have dealt with this issue of default, some more acceptable than others. A good historical example, was the situation regarding Philip II of Spain, when there were three royal bankruptcies from 1557-1596, this led to various actions taken by its creditors, such as the use of an embargo to force the crown to pay its debts (Conklin, 1998). This has been discussed in an academic journal article by James Conklin, which has helped to develop modern theories regarding SDRM.

Main Body:

Currently, countries that go into default have many ways to deal with the problem; firstly they can renegotiate the terms of the loans and extend them, or they can decide not to pay back their creditors at all (but this has consequences for the country such as no access to international credit markets, having its foreign assets seized or impounded).

The two general methods by which a country deals with this problem is; firstly by a Bail-in, which “is an agreement by creditors to roll over their short-term claims or to engage in a formal debt restructuring with a troubled country” (Reinert et al, 2010, pg. 95). Secondly, a Bailout is when “a country borrows hard currency reserves from the IMF, enabling it to pay off its maturing debt.” (Reinert et al, 2010, pg. 95). As Reinert et al indicates; that the use of both in

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dealing with a sovereign debt crisis may be a solution. However as he points out, the country must be careful when gaining additional financing; and must weigh the costs because if it attempts to restructure or extend claims, it might inadvertently make other creditors uneasy and scare them off. These tools by which a country may use to deal with a debt crisis are often complicated and may not efficiently resolve its problems; this is another reason why the issue of a cohesive strategy to deal with SDRM is important.

In regards to debt resolution, currently there is an organisation called the Paris club which dates back to 1956, which acts as an informal group to help finance debt restructuring, however it has no legal backing. “Paris Club creditors provide debt treatments to debtor countries in the form of rescheduling, which is debt relief by postponement or, in the case of concessional rescheduling, reduction in debt service obligations during a defined period (flow treatment) or as of a set date (stock treatment)” (Paris Club, 2014). This group has much experience in resolving debt crises and may be able to provide an additional forum for any resolution, but may require new laws for it to help it enforce resolutions.

Because there is no formal international legal structure in place to deal with sovereign default and a simple mechanism for countries to use as a method for restructuring its debts simply, there is a need to address this issue as economic crises of this nature tend to impact more than just the indebted nation. But what happens when a country decides not to pay back its creditors, this is an important issue because of the distinct differences between a debt belonging to an individual, corporate and sovereign.

The main problem is, that unlike when a company or an individual goes into default or bankruptcy; creditors are unwilling to continue to carry out business with the debtor (other than to pursue them for the outstanding debt), the debtor is unable to continue to gain credit to pay its debts other than liquidating its assets or be taken to court, and there are strict laws that compel the debtor to comply with an arrangement. Whereas, the matter regarding countries is far more complex; why are creditors still willing to do business and offer credit? This is because it is extremely costly to default and may have dire socio-economic consequences for the country; therefore it is in the nation’s

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best interest to pay off all or some of its debts and so creditors are happy to oblige.

However, the main problem with this is the key difference between a sovereign debt contract and a corporate debt contract; which is the ability for the contract to be legally enforced. The corporate contract can be enforced, whereas it is much more difficult to enforce a sovereign debt contract, “In a sovereign default, the remedies at the disposal of creditors—particularly private creditors—are limited by the fact that most sovereign assets are located within a sovereign’s jurisdiction and cannot be seized, even when creditors have won in court” (Buchheit, 2013, pg. 10). Therefore, the issue regarding contract enforcement is a problem as there is no international law governing this, this is important as any cases brought before a court may set a new legal precedent that may have unintended consequences for future sovereign or municipal defaults; as shown in some of the examples below.

Conversely, in recent literature regarding this issue it has been suggested that there is a trade-off a sovereign has to make between defaulting and not defaulting, as highlighted by Buchheit (2013, pg. 10); in “that attempts to reduce the costs of default could also reduce welfare because they would make sovereign debt more expensive and lower the maximum level of debt that a sovereign can accumulate… Conversely, attempts to improve enforcement could improve welfare even if they make debt crises more painful and protracted”. This indicates the balance that a sovereign has to make in choosing to default or not; therefore impacts on what kind of mechanism is in place to restructure its debts and any proposals for dealing with the costs post default could have unintended consequences.

In the context of law, as there is no existing legal framework for dealing with a SDRM, a possible start would be to look at contract law; fundamentally this is where there is a legally binding agreement between two or more parties, and there is a legal remedy for a breach of contract. Thereby looking at this from an international perspective may be a more suitable avenue, this is because as international trade has increased substantially post Second World War, the need for international commercial law has become increasingly important as different countries have different laws and legal jurisdictions; therefore one court ruling has little or no affect in another jurisdiction. This is why

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international contractual obligation of sovereign debt using similar existing legal framework as a template; such as when international corporations that are in different legal jurisdictions create contracts between each other and are legally enforceable, may provide an opportunity to resolve issues regarding SDRM.

There are organisations that look to harmonise international law, such as the Hague Conference on Private International Law which is an inter-governmental institution. Its objective is to find “internationally-agreed approaches to issues such as jurisdiction of the courts, applicable law, and the recognition and enforcement of judgments in a wide range of areas” (HCCH, 2013). In particular the recent study by the organisation named the Hague Principles on Choice of Law for International Contracts, which is aimed to “enrich the quality of the international discourse by providing a guiding light in the search for proper solutions to the problems encountered in honouring, and defining the limits of, contractual choice of law in international contracts” (Symeonides, 2013). Therefore the principals covered can be used internationally by courts and arbitration panels in dealing with matters of international contracts; however it does not cover aspects of insolvency. In this regard an organisation such as this might be able to create a set of principals regarding contracts and insolvency and could be used by courts to help resolve disputes.

This could then become the foundation for a legally binding SDRM. But the problem of implementing a new international law would be how to get sovereign to accept it. A possible option is the use of an international organisation such as the UN. As members of the UN ratify treaties and that become international law, so too a new law regarding contracts regarding sovereign debt restructuring could be put into effect so that in would become international law superseding domestic laws which should stop countries unilaterally making decisions to deal with its creditors, such as in the case of Argentina. The case of the United Nations Convention on Contracts for the International Sale of Goods (CISG), is a prime example of countries adopting a treaty that makes what was before a very inefficient legal procedure due to the issue of “choice of law” much more efficient. Choice of law is defined as “a difference between the laws of two or more jurisdictions with some connection to a case, such that the outcome depends on which jurisdiction's law will be

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used to resolve each issue in dispute” (Cornell University Law School, 2013). The CISG is then adopted into the countries law making it legally binding for all of the UN members. If a comprehensive law was created that members could implement, it could solve the problem of arbitration, court cases and set out clearly defined rules of the contractual relationship between the parties. For example, certain aspects of the law would need to be agreed such the issue of interpreting the “parri passu” clause, would need to be clearly defined before implementation.

Some recent examples of sovereigns and municipalities having a debt crisis focus on some of the difficulties and consequences in dealing with default. In the case of Detroit, which filed for Chapter 9 bankruptcy in 2013, due to its unsustainable debt of $18bn (Lichterman et al, 2013). The courts have to find out whether it can “meet federal eligibility requirements, Detroit had to prove that it is insolvent, it was authorized to file for bankruptcy and that it negotiated with creditors in good faith or that negotiations were impractical” (Lichterman et al, 2013). In this case the U.S. Judge Steven Rhodes had determined that they were eligible and in part of the restructuring effort the city “could cut pensions as part of the restructuring, ruling against an argument that Michigan's constitution protects them from being slashed” (Lichterman et al, 2013). However in an appeal made in the bankruptcy court by the municipal employees and pension funds, emphasising the fact that the judge made an error in ruling that the bankruptcy law takes precedent over Michigan’s constitution that protects pensions. This is important because the ruling made the unsecured bondholders equal to the employees as creditors and therefore be able to treat them the same. However, it was highlighted that leading up to the bankruptcy filing they did not act in good faith by not being transparent about the plans to file for bankruptcy, but the debtor argues that it was unfeasible to negotiate with all its creditors. It was also stressed that it was inevitable for the city to go bankrupt irrespective of liquidating assets or an infusion of credit to solve its finances. This case highlights the issue that new precedent will be set legally which could lead to further bankruptcy filings in order for cities in the US to avoid fulfilling pension contracts.

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Another recent example of a debt crisis was in 2009 when the Dubai government owned investment firm Dubai World could no longer pay its debts which led to a financial crisis in the Emirates. In an unusual solution it was bailed out by its neighbour Abu Dhabi. Its solution to its debt management was highlighted in a recent article; “the government bailed out bondholders, who were paid back fully and on time; as a result, the emirate has preserved its access to the capital markets… More than two-thirds of $34 billion in troubled bank loans to Dubai Inc. has now been restructured on tough terms: on average, maturities were stretched out by five years and interest rates cut to 2%” (Economist, 2013). This example shows that in debt restructuring it is important to act quickly so that it can continue to access capital markets, without this the situation could have deteriorated rapidly causing a prolonged crisis.

In 1994 Mexico went through its own crisis, where poor macro-economic decisions and a currency devaluation led Mexico into a debt crisis where they were bailed out by the US government. In an article written by Joseph Whitt Jr for the Federal Reserve Bank of Atlanta (1996) he indicated that it would have been much more prudent if the US had not bailed out Mexico. Seidman (Cited by Whitt, 1996, Pg16) “argued against US involvement, suggesting that the problem be resolved through negotiations between Mexico and its creditors. In this scenario, both Mexico and its creditors would suffer, but in the future both borrowers and lenders would be more careful”. This highlights a very important point dealing with countries needing financial assistance, which is the issue of moral hazard of a bailout because of a “lender of last resort”. If the sovereign or municipality knows that they will be given financial assistance every time they have financial difficulty it could encourage the continuation of reckless fiscal and monetary policy (this is the same case as with large banks).

Another very important example of a debt crisis was in 2012 when Greece could not meet its debt repayments and “in February 2012, Greece launched the largest sovereign debt restructuring in history covering EUR 205 billion in debt” (IMF, 2013, pg. 6). It went through two loans from the EU and IMF, private sector debt restructuring with lower rates of interest and write-off of a large percentage of outstanding debt. In return for this assistance Greece was

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had to make radical structural reforms, such cutting spending, tax hikes, labour and pension reforms.

In addition, the issue of the South America debt crisis in 1980, which created social unrest, political instability and lost growth until the value of the debts was reduced and converted into “Brady Bonds”. This plan identified by the U.S. Treasury Secretary Nicholas F. Brady in 1989 which was based on the US mechanism for dealing with debt restructuring for corporates. It had three points; “(1) bank creditors would grant debt relief in exchange for greater assurance of collectability in the form of principal and interest collateral; (2) debt relief needed to be linked to some assurance of economic reform and (3) the resulting debt should be more highly tradable, to allow creditors to diversify risk more widely throughout the financial and investment community.” (EMTA, 2014).

Another example of a recent bailout was in the case of Cyprus in 2013. Because of the financial interconnectivity of itself and Greece, Cyprus was being funded through Greek loans and also bought Greek debt, as Cypriot debt spiralled out of control because of the recession it suffered a financial crisis. As a consequence of the bailout of Greece “the bonds suffered a 50% haircut, in turn threatening the collapse of the Cypriot banking sector” (WealthCycles, 2013). There was no option for Cypress except to agree to “an €10 billion international bailout by the Eurogroup, European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF)” (WealthCycles, 2013). This example was unique because of the fact that it to introduce radical solutions at the behest of its creditors in order to qualify for the bailout, it had to close one of its largest banks and also had to impose a one-off bank levy on deposits over a certain threshold. This money would be used to capitalise the banks in return for equity, this mechanism may be used by other countries such as in the US and the UK. This was discussed in a joint article written for the BOE and FDIC named “Resolving Globally Active, Systemically Important, Financial Institutions” (FDIC, 2012), in which depositors money would be taken in order to fund the bank and in return equity.

In the case of Argentina in 2001, when it defaulted on its $106bn in external debt (Hornbeck, 2013 pg. 8) due to a prolonged financial crisis. This crisis was due to many factors; bad economic policies, massive over borrowing, a global

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recession and investors looking for high yielding debt. In addition to this, there is some debate as to whether the IMF compounded this problem by questionable advice and lending, which led “Argentina toward a position of unsustainable debt that ended in financial crisis, unprecedented default, and a controversial restructuring scheme.” (Hornbeck, 2013, pg. 4). After a while Argentina unilaterally made a decision to force bondholders to accept their terms in the two bond exchanges of 2005 and 2010. In these instances 91.3% of the bondholders accepted the new terms, but the remainder were not happy with this and have taken Argentina to court in the US. In Argentina’s defence they ague these two restructurings had occurred after negotiations in good faith, whereas the holdout creditors argue that the decision was made unilaterally and not mutually agreed and they had no choice but to accept the offer. This is why this contentious issue is been dealt with in the New York court under the US legal system rather than an international court under international law, because of legal enforceability. This case is ongoing as we speak and Hornbeck (2013, pg. 11) mentions the fact that “Holdout bondholders remain unpaid while Argentina is current on its obligations to the bondholders who exchanged their debt, an outcome that is currently being challenged in court as illegal under the equal treatment (pari passu) provision of the bond contracts.”

The “pari passu clause in a contract provides, in broad terms, that one debt will be treated in the same way as another” (Clifford Chance, 2012, pg. 2). This clause is very clear in a corporate sense in that all creditors will be paid equally and at the same time. The issue is that this clause is unclear for sovereigns, because the assets of a country cannot be liquidated and the proceeds used to pay of its creditors. The case in the New York courts of NML Capital Ltd v The Republic of Argentina is hinged upon the fact that Argentina is ranking its creditors. Its opponent, NML Capital is a vulture fund which buys up sovereign debt which is at a massive discount and imminent of default then sues them for a greater amount than the value of the debt at which they purchased it. Previously in the UK and the US it was illegal to purchase debt from a sovereign with the intent of litigation, this law has been changed and with the creation of Brady Bonds, it allowed banks and hedge funds to purchase these debts which were previously held by syndicated banks. This situation in ongoing and this year will see if there is an outcome as the “U.S. Supreme Court will agree to

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review a dispute between Argentina and a creditor that is owed substantial sums on defaulted bonds” (Samp, 2014), since the appeals court in New York held upheld an order dictating that Argentina could not treat NML Capital any differently from any of the other creditors.

The case of Argentina is very important because highlights important issues that need to be addressed and it could set a new precedent for sovereign debt restructuring in the future, as Hornbeck (2013, pg. 2) highlights “these include lessons on the effectiveness and cost of Argentina’s default strategy, the ability to force sovereigns to meet debt their obligations, and options for avoiding future defaults like Argentina’s”. He also mentions that if Argentina had actually entered into good faith negotiations with its creditors, this could have offered an efficient restructuring and resolution of the debt, which would have in turn hastened its access to international credit markets and led to a quick resolution.

In the context of international exchange rate regimes, it is about the resolution of contracts. Contracts are made between different countries have particular currency stipulations. In many cases a country could repay debts if it was in the domestic currency and not a foreign currency due to it having limited foreign currency available. In the case of the debt issuance it has two options; firstly to issue Government debt which is issued in domestic currency and secondly to issue Sovereign debt which is issued in foreign currency. The need for adequate funding for the government is important and may not be able to gain the necessary amounts though issuing debt in its own currency therefore it is forced to issue debt in an international currency, which could in turn exposure itself to foreign exchange risk by having a disproportionate amount of debt. As Melecky (2007, pg. 2) suggests that “the inability of developing countries governments to issue desired amounts of debt denominated in domestic currencies can be attributed to the unwillingness of foreign investors to hold sovereign debt denominated in currencies of small developing countries”. Therefore dealing with debt restructuring and the currency in which it has to repay is important, and it may not have any choice in the amount of foreign debt it has as a percentage of total debt. Particularly when dealing with financial assistance as special creditors (e.g. IMF, ECB, US Treasury) fall under international monetary law and this law partly dictates how these countries

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behave and it also dictates the behaviour of currency and currency repayments.

Conclusion:

In conclusion, some of the better and more efficient ways of dealing with SDRM may be to create a similar existing structure much like for human rights violations are dealt with in the Hague by the international criminal court. There would have to be an internationally agreed set of laws and principals regarding arbitration and dispute resolution and a clear set of rules in the formation of a contract between the debtor and creditor with no ambiguity. As discussed in a report covering this issue by AFRODAD (2002); it suggests that a “permanent Court of Arbitration based in The Hague, the United Nations Commission on Trade could either have its mandate extended to include Debt issues or a new Commission specifically for Debt could be established”. Also, in coordination with the UN, IMF and the Paris club a legal structure could be put into place that could become legally enforceable by creating a treaty that members would agree to, if there are holdouts this could impact their ability to gain access to international credit markets. There is also as highlighted in a recent study by AFRODAD (2002), that there may also be an alternative to a SDRM, which is called the “the Fair and Transparent Arbitration Process (FTAP)”, which is primarily focused on any future debt agreement to have a clause stipulating mechanisms for arbitration in the case of a dispute, again the problem is political will to create such a mechanism.

However, some believe that the current framework is enough, but with a few enhancements rather than a new framework. This was highlighted in a recent letter to Vladamir Putin, Tim Adams, President and CEO of the IIF (Institute of International Finance) highlighted that the current framework used to deal with SDRM is sufficient, but there are areas of which that need improving; “We believe strongly that the current contractual, market-based approach to sovereign debt restructuring—which emphasizes voluntary negotiated agreements… continues to be a practical and fair framework. But we also recognize that further enhancements are possible and desirable, including through more robust aggregation clauses and creditor engagements provisions” (Adams, 2013).

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In addition, it is also important to mention that there is an ethical dilemma with any SDRM, and that is the motivation of private creditors. As there sole purpose is to gain a return on their investment, there is a trade off in their tolerance in whether a country has a clear restructuring mechanism put in place and the time scale of when they will be paid back and the welfare cost is not taken into consideration. As in the case of Argentina the “private creditors are extending credit at a market rate in the expectation of earning a commercial profit, not making a concession to help the country through a crisis” (Reinert et al, 2010, pg. 96). Therefore in the interest of a country and its welfare there would seem to be balancing act between the types of creditors a country has to deal with and their motivations. In contrast the special creditors, such as the IMF are there to help countries without necessarily only being interested in returns. But their articles of agreement only give them the ability to go so far in helping; as highlighted in a recent IMF report that their “Articles of Agreement require that, when we lend to a country, we do so to help that country resolve its balance of payments problems within a timeframe that allows it to return to medium-term viability and repay the Fund” (IMF, 2013). This indicates a distinct problem with the current funding framework that a sovereign has to deal with if it gets into financial difficulty and balancing act it faces between private and special creditors. This issue must be addressed in any future legal framework, as there is a massive social cost to any debt crisis and a protracted affair in any debt resolution. There also must be an effort to deal with so called “vulture funds” and their impact on sovereign’s effort to restructure its debts, may be by implementing new laws which prohibit such activities. Overall the welfare cost on the population of the sovereign should be of the upmost priority and any new laws must take this into account, if not as previous crises has shown any ineffective measures put in place go far beyond just the economic consequences for a country.

If a new framework is put into place the mechanism must be able to have the enforceability of sovereign debt contracts like corporate debt contracts and no ambiguity in particular clauses; however this essay does not offer a complete solution to this issue but aims to highlight areas that need addressing for any future effective SDRM. But it also may be important to try and understand

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why countries get into a position where they have to have a SDRM in the first place and try to put into place a set of measures that avoids the need for this. The governments and international organisations can work together to try and tackle this issue, such as creating a transparent mechanism for countries to borrow money they need within their means and not get into a situation where they borrow more than they can afford to pay off, this is why it may be prudent for the existing structure of the IMF to change in order to take a more proactive approach to supporting countries before a debt crisis even occurs.

Finally, taking heed from the experiences from previous crises, it would be prudent for a sovereign to have a period of debt relief during a debt crisis so that it can have an opportunity to recover. In addition it is important to mention that there should be a fair burden sharing between the country, official creditors and private creditors. The end result being that it would it time to implement structural and fiscal reforms that help to stabilise the economy and mitigate any problems that may arise from this problem for example; stopping any contagion such as that within the EU or welfare issues.

Total Word Count: 4881

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