Time for a new sovereign debt restructuring regime?

By Joe Vladeck
Greeks protest austerity cuts by Piazza del Popolo | Flickr

Nations have been defaulting on debt for about as long as nations have been borrowing money. The Greeks went first. In the 4th century B.C., three quarters of Greek city-states defaulted on loans issued by a temple on the island of Delos.

Today, Greece is still struggling. Although it is not the most recent nation to default on its sovereign debt (that dubious honor belongs to Cyprus), Greece's on-going sovereign debt travails nearly led to the collapse of the Euro in 2012 and continue to fester. Granted, the question of whether Greece actually "defaulted" in December 2012 involves complicated semantics, but Greece's track record of debt repayment record is spotty. According to two renown economists, "Greece has been in a state of default about 50% of the time" since the country's independence in the 1830s. 

Modern-day Greeks have recoiled at the policies of domestic austerity that the country's creditors, notably Germany, have insisted upon as part of Greece's debt restructuring. But in historical context, austerity might not seem so bad: When Venezuela defaulted on German, British, and Italian debt at the start of the 20th century, Germany et al sent warships, set up a blockade, sank Venezuelan ships, and shelled Venezuelan military installations. Venezuela got the message, and the parties eventually agreed to U.S.-led mediation of the dispute.

Fortunately, creditor nations no longer resort to "gunboat diplomacy" when debtor nations fail to make payments. But it is difficult to say that sovereign debt restructuring has become significantly more systematic in the intervening eleven decades. A report by the Brookings Institution recently noted that while "[s]overeign debt crises occur regularly and violently," there is still "no legally and politically recognized procedure for restricting the debt of bankrupt sovereigns."

Critics of this ad hoc approach point to two factors as evidence that a more formal system is needed for dealing with bankrupt nations. The long-held view that sovereign bankruptcies only exclusively (or even primarily) affect developing nations has been refuted, as demonstrated by the financial tremors that rippled through Europe following Greece's crisis. Moreover, recent court decisions in a long-running dispute between Argentina and a U.S. hedge fund upheld the “hold-out” strategy that the hedge fund had pursued. (The hedge fund, Elliott Management, refused to participate in Argentina’s debt restructuring following the country’s 2002 default and insists on being paid in full if Argentina pays off any of its other debts.) Policymakers fear the impact of the “hold-out” strategy on future debt restructurings.

Along those lines, both Brookings and the International Monetary Fund have recently set forth proposals to formalize the sovereign default process. The Brookings proposal, at its essence, is simple: once a country's ratio of debt to gross domestic product exceeds a certain limit, that country cannot receive any official-sector assistance (from the World Bank or IMF, for example) without first undergoing a debt restructuring. The IMF goes the other direction and takes a more complicated (or, perhaps, more sophisticated) approach, largely predicated on marshaling broad support for early intervention, before sovereign defaults turn into widespread crises. 

Still, many remain unconvinced that the IMF and Brookings proposals represent progress. For example, many buyers of sovereign bonds have not been persuaded that the current approach to sovereign debt restructuring is broken. "[T]his whole thing looks to me a bit too much like a solution in search of a problem," writes Reuters columnist Felix Salmon, who goes on to suggest that policy-makers are over-reacting to the Greek calamity and holdout litigation. Salmon invoked a venerable legal adage as he urged caution. "Hard cases,” he explained, “make bad law."