Debt crises act as a Damocles' sword

Debt crises act as a Damocles' sword

The issue of foreign debt has made a major comeback due to the crisis in Europe, in which many countries had to seek big bailouts to keep them from defaulting on their loan payments. Before this, debt crises have been associated with African and Latin American countries. In 1997-99, three East Asian countries also joined the indebted countries' club.

This year, European countries, notably Germany, insisted that private creditors share the burden of resolving the Greek crisis. They had to take a ‘haircut’ of about half, meaning that they would be repaid only half the amount they were owed.

It is increasingly clear that bailouts – where new loans are given to indebted countries to enable them to keep paying their old loans in full – are not enough and may be counterproductive, when the countries are facing a problem of insolvency and not just a temporary lack of liquidity. The restructuring of some of Greece's debt that was owed to private creditors is an example of what needs to be done.

However, the ad hoc restructuring undertaken in the Greek case is not enough. A more systematic framework needs to be made available to countries on the verge of debt default, with principles agreed to internationally. In the absence of this, unilateral debt restructuring will probably be messy, as when a country is forced by desperate circumstances to declare a default and propose its own debt restructuring, which may or may not succeed in getting its creditors to agree to the terms.

Vulture fund

And even if a majority of creditors agree to take the "haircut" proposed, a minority may hold out against the restructuring and this may disrupt the whole exercise. The current court case taken by a "vulture fund" that is holding out against Argentina's debt restructuring is a clear example.

Though the debt crisis now has Europe as its epicentre, many developing countries may soon also be facing the same predicament. Due to the effects of the global economic slowdown, with export prices and earnings beginning to take a significant hit, many developing countries are becoming vulnerable to a debt crisis. An increasing number have dwindling foreign reserves that can only pay for less than three months of the value of their imports.

There are many weaknesses in the present situation of voluntary systems such as including an element of burden sharing in collective action clauses in loan agreements, or in unilateral workouts that countries seek.

These voluntary methods can be either inadequate or unpredictable in design and effect as they do not have the benefit of an internationally agreed system. There should thus be new efforts to find an international solution such as a statutory debt workout mechanism.

For the past three decades the United Nations Conference on Trade and Development (Unctad) has analysed the features of such an international sovereign debt workout system. The pioneering Unctad model is mainly based on the principles of the US bankruptcy law. The elements of such a system are as follows.

First, a country facing debt difficulties can declare a temporary standstill on its external debt servicing. This gives some breathing space to formulate a proper debt servicing plan. The plan should cover all debt servicing, whether the difficulty is due to solvency problems, in which the debt has to be reduced, or liquidity problems, in which case the debt has to be rolled over.

Second, there is an automatic stay on litigation by creditors during the standstill. This is to avoid problems to both debtor country and its creditors. The stay on litigation is to prevent a situation where many creditors are scrambling for an exit or lining up to sue the country.

Third, an independent panel of legal and economic experts would be established to address the issues arising from the standstill, including assessing the countries' debt situation. The independence of the panel is important, in that creditors should not be on the panel as they have a direct interest in the case.

Fourth, the country undertaking a temporary standstill would have to also undertake selective capital controls to prevent capital flight that can result from the standstill on debt payments. Fifth, new loans should be provided to the debtor country, in a situation known as lending into arrears, in order that the country can continue to implement policies for economic and social development.

Sixth, the new loans contracted after the standstill should be given seniority status. This is to facilitate the emergence of new creditors and new loans. Seventh is the debt restructuring exercise. The terms should be the result of negotiations between the debtor country and creditors. The United Nations is well placed to take the lead in this whole exercise of establishing a statutory debt workout mechanism.