Joseph E. Stiglitz

April 2013

DEBT RESTRUCTURING:GAPS IN LEGAL AND INSTITUTIONAL STRUCTURES

I. Objectives of restructurings

II. Designing a good bankruptcy system

III. Implications: When will restructuring help?

IV. Reflections on the basic theory—why it can’t be left to markets

V. The need for an SDRM

OUTLINE

Bankruptcy has a central role in modern capitalist economies. One cannot imagine a modern economy without limited liability and the

possibility of debt restructuring

Both efficiency and equity dictate providing a fresh start As a result of excess indebtedness (as in Europe), there is a massive waste of

resources Resources before the crisis are the same as after

Debt is just an obligation

The problem is that there are “excess claims”

In the fight over whose claims will be satisfied resources are destroyed This is a distributive battle

Outcome may be (is likely to be) Pareto Inferior

I. OBJECTIVES OF RESTRUCTURINGS

A system of orderly discharge would more likely lead to more efficient use of resources today

But if no one repaid debts, debt market would dry up

Bankruptcy regime attempts to balance Ex post efficiency

Ex ante efficiency (credit assessment, excessive risk taking)

Efficiency in the restructuring process Excessive penalties in restructuring can induce costly delay

II. DESIGNING A GOOD BANKRUPTCY SYSTEM

Creditors are to blame as much as debtors—loans are voluntary agreements Creditors are typically more financially sophisticated—know how to assess risk Creditors often engage in predatory lending In case of lending to sovereigns, problems are even worse Often make loans, knowing that there will be IMF bail-out Even worse, often make loans to private borrowers, knowing (or at least hoping) that

the private debts will be socialized, and then there will be IMF bail-out In case of loans to poor countries, high interest loans may even displace

concessionary loans If projects were good, FDI should be used—lender at risk

Take advantage of political economy problems “Audits” to see what really happened

Many of debts are “otiose debts”

CREDITORS ARE TO BLAME

But fairness is also important, especially in a world with predatory lenders Who take advantage of those who are financially less sophisticated

Fraud laws may not suffice Creditor equity issue: creditors have (at least partially) been

compensated for risk in form of higher interest payments

There is not a single bankruptcy code to be packaged and sold around the world. Large differences across countries

Large debates within countries America’s bankruptcy reform was a step in wrong direction, creating partially

indentured servitude, and contributing to financial crisis

A bankruptcy law that facilitates the flow of capital in ways which: Maximize sustainable growth

Minimize hardship following crisis

Include concerns of all, including those within the developing country, formal domestic creditors, and foreign creditors

A quicker more certain resolution would Reduce risk premia

Reduce costly delay (problems of asset stripping, deterioration of value in limbo state)

Reduce magnitude of macroeconomic disturbances

Exchange rate stabilization

Objective is NOT to maximize the flow of capital Or even to minimize short-term interest rates – when costs of borrowing have

to be borne by others

Excess capital flows have contributed to crisis, with high costs

Objective is NOT to maximize income of intermediaries

Legal framework—difficult to enforce And even more so in an era of privatization

Not clear who full list of claimants should be Implicit versus formal claimants (pensioners) Chapter 9 of US bankruptcy code gives weight to these other claimants

Political economy/agency problems Costs of painful restructuring borne by different political actors than those who

create problem (Greece) Citizens are made to bear costs of others’ mistakes Ireland—bankers and political leaders made mistakes

Raises issues both of effectiveness of incentives and of fairness Issues of debtor moral hazard may not be so important Issues of creditor incentives may be more important

SPECIAL PROBLEMS OF SOVEREIGN DEBT RESTRUCTURINGS

Most importantly, we must distinguish between systemic/sovereign bankruptcy and “isolated” firm bankruptcy.

A default by a single firm does not have macro-economic consequences

A default by large number of firms and a sovereign restructuring typically have significant macro-consequences, especially when accompanied by exchange rate changes

Sorting out the consequences may be difficult

Which is why there needs to be a special Super Chapter 11, or other broad procedures to deal with these circumstances Debt contracts may have to be rewritten

If a country has a primary surplus, it can be potentially better off if it has a deep restructuring of debt

Especially if there is Keynesian unemployment Money that went to foreign creditors can now be used to stimulate demand

Especially if the government had borrowed excessively from abroad “Optimal” investment going forward may call for no borrowing, and especially no

borrowing from abroad Which can impose a high price through multiple channels

Recent research has shown that there is typically excessive borrowing, and especially in foreign denominated currencies

III. IMPLICATIONS: WHEN WILL RESTRUCTURING HELP?

But even if the country wished to return to markets, it normally can

Markets are forward-looking

In competitive markets, there is no way they can collectively impose punishment IMF sometimes viewed as “creditor cartel”

Tried to impose punishment (“Can’t accept yes as an answer”)

Once debts have been restructured and country grows, it can gain access more easily Prior to restructuring, the flow of money is out of the country, not in

There are significant short run costs

Contracts have to be rewritten

Distributive conflicts can be magnified

Credit flows can be interrupted

Bankruptcies can become widespread

Governments with primary deficits, who lose access to finance, have to contract quickly (or risk inflationary printing of money)

DEBT RESTRUCTURING WITH EXCHANGE RATE ADJUSTMENTS: LESSONS FOR EUROPE

But there can be long-run gains

Both from the debt restructuring and the realignment of exchange rates “Internal devaluations” are slow and costly; issues of bankruptcy still significant

Delay is very costly

Benefits at micro and macro level

Imperative that Central Bank, government maintain flow of credit Can be done

Given likelihood of high SR costs (which may cost them their job), understandable that political leaders try to postpone day of reckoning: incentives for excess delay

Which is why an SDRM should not impose excessive penalties on restructuring—the market is likely to do it on its own—but rather to provide temporary assistance

Problems are made worse by investment treaties—lesson of Argentina is that countries should be wary about signing them Little evidence of benefit, strong evidence of high costs

Economic theory focuses on “equilibrium,” has much less to say about adjustments, out of equilibrium behavior.

Bankruptcy largely about “incomplete contracts” Risk sharing (equity) contracts would (in absence of information asymmetries and

contracting costs) be better; would avoid bankruptcy

Government necessarily “completes” contracts—specifies what happens when creditor can’t pay what is owed; prioritizes different claims

That makes bankruptcy law political—different laws have different equity and efficiency consequences Some are more pro-creditor, some are more pro-lender

Pro-creditor laws attenuate incentives for due diligence Some put partial blame for America’s mortgage crisis on Bankruptcy Reform Act

Excessive risk taking encouraged by law giving derivatives priority in bankruptcy

IV. REFLECTIONS ON THE BASIC THEORY

Bankruptcy affects not only lenders, but also other "stakeholders (large externalities)

Signaling problems Ex ante, contract provisions are used to signal Again, signaling equilibrium is typically inefficient With incentive to offer excessively stringent contract provisions Bargaining models with imperfect information often engenders delay as a costly signal When there are macro-economic disturbances, there are externalities associated with delay

which parties will not take into account

Problems exacerbated in political context (sovereign lending), where government making commitment does not bear costs

Asymmetric information also leads to contract rigidities—difficulty in moving out of inefficient equilibria

MARKET SOLUTIONS BY THEMSELVES WON’T WORK (BE EFFICIENT)

There are large conflicts of interest among different claimants

There are often large disputes about valuations (both of claims and proposed settlements) and priorities

Such disputes are a manifestation of imperfect markets/imperfectinformation (whole issue of “liquidity/solvency” reflects differences in beliefs)

In such situation, there is no presumption that market solutions will be efficient (let alone fair)

There are also important coordination problems across contracts

And public good problems— Each claimant wants to enjoy benefit of country’s ability to repay from debt

reduction

But each wants to be repaid in full

Necessity of courts to ensure no inefficient delay

Necessity of courts to ensure fair asset preservation

Necessity of courts to coordinate across classes, jurisdictions

Necessity of courts to ensure reasonably fair treatment of all parties

WHY COURTS ARE NEEDED

Even when restructuring does not go through courts, bankruptcy law affects the outcome of the bargaining process, which is typically designed to avoid the uncertainty & delay of relying on courts

Collection action clauses don’t suffice If they did, within countries for “simpler” ordinary bankruptcy, they would have

sufficed

No country relies upon them

Complicated issues of dealing with multiple classes of claimants

Recent US court decisions have made matters worse Interpretations of “pari passu” clause makes debt restructurings essentially

impossible

Have introduced new level of uncertainty into sovereign lending

Attempt to use of bilateral investment agreements to enforce claims may also make matters worse

FAILURE OF MARKET BASED SOLUTIONS

CDS’s are “advertised” as helping complete the market—but have failed—but have made matters worse “Triggering” event interpreted by secret committee of ISDA that has

representatives of banks that have self-interest in outcomes Lack of transparency of contracts have increased financial fragility and

impeded restructuring ECB’s insistence that the Greek restructuring be voluntary—paying more attention to

interests of banks than of countries, CDS’s were supposed to reduce risk, thereby making restructuring easier; have had exactly the opposite effect

Over-the-counter CDS’s undermined decentralization of the market economy and effectiveness of capital market discipline Most importantly, have resulted in those having a seat at the table in debt

negotiations having no interest in good resolution—may even have an interest in “bad” outcomes

“COMPLETING THE MARKET”

Trying to do better job at risk-sharing than the market—through GDP bonds

For sovereigns, akin to a debt-equity restructuring (chapter 11)

Align incentives—creditor now has an interest in borrower doing well

But markets have resisted

Bankers encouraged countries to take on more debt

Irony is that money is flowing wrong way—from poor countries to rich

Risk has also been flowing wrong way—poor countries are asked to bear burden of risk

Evidence that international capital markets do not work in the way they should Not really improving efficiency of capital allocation

CHANGING PERCEPTION ON DEBT (LEVEL AND FORM)

Countries should be wary about excessive foreign indebtedness, other than for investment projects

Especially in foreign denomination Less “real” risk in domestic debt, can reflect changes in domestic circumstances

(Korinek) Large growth in domestic borrowing

European countries have voluntarily chained themselves to a currency they (individually) can’t control

Like having a gold standard

Contributed to Great Depression; now contributing to the European Great Recession

IMPLICATION

There is no orderly process for restructuring sovereign debt

In aftermath of Argentina crisis, recognition of need

But US vetoed discussion

As a new wave of restructurings appears in offing, discussion needs to be reopened

V. THE NEED FOR AN SDRM

Design of contracts

Decision to default

Outcome of bargaining

Capital flows (quantities and allocations)

Resolution of problems which follow from default

MUST BEGIN WITH RECOGNIZING LIMITATIONS OF MARKETS

Recognizing conflicts of interests, perceptions What kind of system might we try to work towards?

IMF too linked to creditors

Collective action clauses not a solution

Dangers of majority voting within a class Majority can deprive minority of legitimate claims May have an incentive to do so because of their ownership position on other

claims Because of “endogeneity” of voting (ownership shares) problem is

exacerbated Even/especially with rational expectations (of a bad outcome)

Dangers of majority voting across classes Risks exacerbated because of likely differences in interests

A WORLD BANKRUPTCY ORGANIZATION

Sovereign initiates resolution

Stay in litigation; provision for lending into arrears

Temporary exchange controls

Sovereign proposes a restructuring

A POSSIBLE FRAMEWORK

Those who believe that proposed restructuring treats them “unfairly”may submit counterproposals. Such objections and counterproposals should provide a methodology for assessing the magnitude of the effective debt write-down and an evaluation of the seniority of different creditor claims. All those affected by proposed settlement would have standing.

The bankruptcy court (arbitration panel) would rule on the alternative resolution proposals, giving deference to the proposal of the sovereign and its legitimate concerns to maintain the economic strength of the economy in the short run and the long, and recognizing the claims not only of foreign and domestic bondholders but also claimants, including pensioners and workers

A POSSIBLE FRAMEWORK (CONT.)

A recognition of the importance of the imposition of capital controls/exit taxes in the event of crises that are likely to lead to sovereign bankruptcy; and provisions for lending into arrears.

An agreement on “mutual recognition” of the bankruptcy laws of each other and procedures to resolve jurisdictional conflicts. If a bankruptcy procedure is going forward under the laws of one jurisdiction, e.g. to attach assets.

Sovereign would propose a resolution/alternative resolutions.

An international bankruptcy evaluation/mediation service, which would help evaluate the consequences of different proposed resolutions on different parties, on different categories of creditors, the government and the economy, working with sovereign (and creditors) to arrive at one which is viewed to be “reasonably fair”.

AN INTERMEDIATE SOLUTION

Restructuring is costly

But not restructuring may be even more costly

Economic theory and experience has shown the advantages of a timely restructuring and that delay can be costly

How the restructuring is done has implications for efficiency and equity Remember: the financial markets have a vested interest, and their

perspectives have to be treated with caution

LIFE AFTER DEBT

It would be desirable to have a more efficient restructuring framework, an SDRM, a World Bankruptcy Organization

But countries facing excessive debt can’t and shouldn’t wait: they need to consider carefully all options

Further reading:

Overcoming Developing Country Debt Crises, B. Herman, J.A. Ocampo, and S. Spiegel, eds., Oxford: Oxford University Press,

Including chapter by J. E. Stiglitz, “Sovereign Debt: Notes on Theoretical Frameworks and Policy Analyses”

Stiglitz, J.E., forthcoming, "Crises: Principles and Policies: With an Application to the Eurozone Crisis," in the proceedings of the International Economics Association's 2012 Buenos Aires roundtable.