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Bankruptcy, Efficiency and Social Justice

Joseph E. StiglitzGraham Lectures, Princeton University

April 24, 2003

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Argentina Experience: Need for an Alternative to Bail-outs

Bankruptcy, or “sovereign debt restructuring mechanism”

Had been recognized in earlier Latin American crisis

But problems since then had become worse East Asia crisis also highlighted need for

better bankruptcy procedures (“super-chapter 11”) but these focused on private sector lending

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Traditional (19th Century) Approach to Sovereign Bankruptcy: Military Force And Regime Change 19th Century Views on enforcement of bankruptcy

markedly different from 21st century principles Debtor prisons Repeated use of military force

Questions: To what extent is the use of economic force, especially when

exercised by international institutions dominated by major powers, the new “instrument of choice” of the latter half of the twentieth century and the beginning of the twenty-first century?

To what extent can these new instruments be abused, and seem “uncivilized,” just as the older military interventions now seem uncivilized?

Example: Indonesia, Korea

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Drago Doctrine

Promulgated in response to bombardment of Venezuela by Germany, England, and Italy, with express consent of the United States (1902)

Rejected the use of physical force to enforce sovereign debt payments

Recognized the importance of the “essential rights as a sovereign entity”

Recognized that creditors in making loans should be well aware of these limitations

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Parallel Between Private Debt and Sovereign Debt

Every advanced country has a bankruptcy law which: Limits the liability of debtors Provides for a fresh-start Balances debtor’s and creditor’s interests Ensures equity and efficiency Reflects social justice Cannot be left to technocrats, particularly to the ones with

vested interest

Critical difference between private and sovereign debt: Absence of court enforcement mechanism No clearly defined ‘assets’ to be distributed in the process

of bankruptcy Many claimants besides formal foreign (and domestic)

creditors Mostly implicit

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Intellectual Framework….. Modern theory of bankruptcy Modern theory of corporate reorganization (take-overs,

voting rules) Modern theory of capital markets—with credit

constraints, especially with enforcement problems Modern theory of bargaining, especially with imperfect

information Recent policy discussions on alternative views of

bankruptcy reform Ethical as well as economic perspectives

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Intellectual Framework …..

Recent history of problems in bankruptcy in East Asia, Russia, Ecuador, Argentina…

Important caveat: In attempting to solve the most immediate problem, new problems may be created

Views about “appropriate” bankruptcy regime also affected our understanding of the nature of the origins of the problem

In private bankruptcy, little sympathy for creditors who extend credit cards to 14 year olds

Creditor was in a better position to “avoid problem” than debtor

Creditor was trying to take advantage of an uninformed borrower

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Moral Issues in Sovereign Bankruptcy Odious debts:

Loans to Mobutu Loans to Megistu

More difficult cases: 1998 loan to Russia Loans for failed projects

“Bankruptcies” which are at least partially attributable to advice and pressure from lender to follow policies which led to economic collapse

Still more difficult cases: Excess debt burden arises from poor advice or poorly designed

contracts, in which poor countries, instead of rich, are made to bear burden of risk associated with changes in foreign exchange rates or interest rates

Particularly problematic when: source of disturbance is in lending countries When they pursued policies, ignoring their impacts on debtors

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Economic Perspectives Every loan has a borrower and a lender When loan goes bad, it may be as much the responsibility of the lender as the

borrower Lenders lending too much, not taking into account adequately the risks Lender has to have incentives for due diligence Borrowers need some incentive to repay

Bankruptcy processes need to provide: Good incentives before bankruptcy Good incentives after bankruptcy Appropriate incentives for timing of bankruptcy Huge costs associated with delay: Quick resolution Balanced consideration of all interests: Not just formal interests

In U.S. bankruptcy law, chapters 9 and 11 provide for all of these, including explicit recognition in the case of “bankruptcy” of public bodies of the critical importance of maintaining their public functions.

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Objectives A bankruptcy law that facilitates the flow of capital in ways which:

Maximizes sustainable growth Minimizes hardship following crisis Addresses 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 macro-economic disturbances

Exchange rate stabilization A variety of efficiency issues:

Ex ante/Ex post Timing of bankruptcy: Strong penalties with bankruptcy will lead to delay Incentives for screening Quick resolution: Huge costs associated with prolonging resolution

Balanced consideration of all interests: Not just formal interests Creditor equity issue: creditors have (at least partially) been compensated

for risk in form of higher interest payments

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A Few Basic Insights… Objective is not to maximize flow of capital - Excess

capital flows have contributed to crises, with high costs Objective is not to maximize income of intermediaries

A few basic insights: There are large conflicts of interests 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/imperfect information (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)

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Major Policy Issues Today

Statutory approach or just collective action clauses

Problems in implementing collective action clauses Risks in collective action clauses Problems in implementing statutory approach

“Ease of debt forgiveness”—creditor vs. debtor “rights”

Rights of other claimants, and how those rights are to be defended

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Limitations of Market Solutions Bargaining models with imperfect information often engender delay as a

costly signal When there are macro-economic disturbances, there are externalities

associated with delay, which parties will not take into account Ex ante, contract provisions are used to signal

Again, signaling equilibrium is typically inefficient With incentive to offer excessively stringent contract provisions

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

There are also important coordination problems across contracts

And public good problems: Free rider problems on management Free rider problems on resolution Free rider problems on takeovers

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Limitations….

U.S. Treasury position that “all that is required is change in bond contracts to include collective action clauses” is clearly wrong

If that was all that was required, why has every advanced industrial country chosen a statutory approach?

Bargaining theory and evidence: shows that the outcomes of private bargaining processes (with transactions costs and imperfect information) can be highly inefficient

Cram down provisions may not provide sufficient protection for minority shareholders

No way of aggregating across classes of creditors, especially when there are multiple debts

No way of balancing formal creditors and other claimants

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Dangers of Majority Voting….

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 “endogenity” 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 Dangers can be mitigated by a bankruptcy judge, so long as he

is viewed as impartial and fair Problem of finding such a judge exacerbated by the importance

in sovereign bankruptcy of other claimants (pensioners), often not represented formally in negotiations (except through finance minister)

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IMF Approach to Sovereign Debt…

While Collective Action Clauses do not suffice, IMF approach to sovereign debt restructuring is also problematic

IMF, as one of key creditors, cannot be allowed to play a central role, either in the design of the statutory regime or its implementation (other than as one among many claimants)

Legal basis of IMF’s claim to be preferred creditor may even be questioned

Creditors’ interest is in making bankruptcy costly, to discourage bankruptcy

“Can’t take yes for an answer”

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Key Concern: Impact of Default and Changing Bankruptcy Regime on Developing Countries

Major lessons to emerge from large number of countries for whom debt payments represent a major drag on their development and/or who find it impossible to meet their debt commitments, without abrogating basic functions of government and other commitments made to citizens

Debt is highly risky, Especially foreign debt Market failures in global debt market force developing countries to bear

exchange rate and interest rate risks Countries are exposed to vicissitudes of capital markets:

When interest rates may suddenly soar, for no reason to do with what is going on in the country

Or because of rational or irrational anticipations of what might occur, e.g. associated with a political campaign

Benefits from loans are dwarfed by the costs when things go sour. This is evident from experiences in Latin America and East Asia

What matters for growth is real investment And the short term myopic interests of finance often are at odds with the long

term interests of real investors The instability which is associated with finance worsens the investment

climate

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Excessive Fears About Bankruptcy For most countries with high indebtedness, greatest fear is loss of access to

international capital markets But:

The net flow of funds is from these poor countries to the advanced industrial countries

And they are unlikely to gain access to positive flows from an extended period of time

After default, they often regain access more quickly Markets are forward looking—they become better prospects With less debt overhang And more robust growth “Reputation” models are unpersuasive in competitive capital markets

Political Concerns:Indebtedness means that there will be a high price to pay for political autonomy, for not subjecting oneself to the “tyranny of the whims of financial markets.”

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Excessive Fears About Being Cut Off From IMF Assistance

Money is only short term loan Money often goes simply to repay IMF, doesn’t provide finance to real sector Question: does IMF “seal of approval” lead to more capital inflows?

Answer: In most cases, information asymmetries are not as large as in past. So result depends more on impact of policies that accompany programs. If they are contractionary or otherwise misguided, capital is less likely to flow in

In Argentina, during 2002, growing recognition that it would be a mistake to focus attention on obtaining funds from the IMF. If it can obtain those funds, with reasonable economic policies, so much the better. But if the cost of obtaining those funds is excessively contractionary fiscal policies, policies for restructuring the financial system which do not comport with Argentinean’ sense of social justice or what is in the best interests of a quick restoration of growth, then the costs may well exceed the benefits.

Argentina focused on the restoration of growth of its economy. what matters—its physical and human resources—were still here Changed exchange rate led to import substitution and increased exports Investment became more attractive Lessons from Mexico and East Asia: importance of trade credit and exports

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A More Balanced Regime Would Enhance Economic Growth…

Two central fears: Moral hazard—too lenient regime will lead to much higher rate of

bankruptcy But even if economic costs have been exaggerated, political and

economic costs/risks are sufficiently great that countries do not quickly default on their debts—risk is that they delay too long

Worry that a more balanced regime, with greater debtor protections, will lead to higher interest rates and less borrowing But that may be a good thing Benefits to borrowing have been dwarfed by the costs More generally, lending is pro-cyclical Contributing to high levels of volatility in Latin America Governments are often persuaded into borrowing Makes current government’s task easier, even if successors face more

difficult problem High interest rates will induce them to think more carefully

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Is there an Alternative to IMF Statutory Approach?

A World Bankruptcy Court? But creating new and effective global

institutions seems increasingly problematic!

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Some Ingredients of a Bankruptcy (Sovereign Debt Restructuring Mechanism) Framework

The sovereign will initiate the debt resolution, and it will be encouraged to do so at an early stage, by ensuring that the resolution process pays due attention to its concerns.[1]

At the initiation of the debt resolution, there will be a stay on litigation New lending, especially for short term trade purposes, will be treated as

senior to existing debt The country will need to consider the imposition of temporary exchange

controls and/or exit taxes to stabilize capital flows The sovereign will, within a short period of time, after discussions with

different creditors, propose a restructuring (which may include rescheduling, and debt write downs). It should detail those aspects of an economic plan that might affect the value of any contingent assets, and the basis of its claim that raising taxes or cutting expenditures would either not enhance its ability to repay or would impose undue costs.. .

[1] As we noted, large penalties, including the implosion of excessively contractionary monetary and fiscal policies, serves as a deterrent to entering into the resolution process.

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Some Ingredients of a Bankruptcy (Sovereign Debt Restructuring Mechanism) Framework… Those who believe that the proposed restructuring treats them

adversely 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. Holders of bonds that pay above market interest rates would be viewed as having already been (at least partially) compensated for the risk of bankruptcy through their higher interest rates, and it would be inappropriate in a bankruptcy resolution to provide them with a payment without a substantial effective debt write down (not using the higher interest rate as the benchmark) Claims that the country could reasonably meet its debt obligations by raising taxes or cutting expenditures without undue adverse effects would be substantiated by economic models and political analysis.

The bankruptcy court 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 of other claimants, including pensioners and workers.

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Some Ingredients of a Short-run Move in the Right Direction

Agreement on the framework will not likely be achieved in short-run.

Need Other Steps: 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 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, it should not be possible for a claimant to appeal to a more friendly court in another jurisdiction, e.g. to attach assets.

An international bankruptcy evaluation/mediation service, which would help evaluate the consequences of different proposed resolutions on different parties, both different categories of creditors, the government, and the economy.

In the absence of an agreement on what the law should be, independent information about the impacts from a disinterested third party could be of enormous value in constructing what may be viewed by all parties as a fair solution. It should be clear that such evaluations would not be without controversy, and it would be important that alternative perspectives be provided. For instance, information that a class of creditors received 25% interest (presumably in part because of the fear of bankruptcy) for five years before default occurred—and therefore more than recovered his principal—might or might not be considered relevant in deciding on whether a more substantial write down in his debt was fair (in comparison, say, to a creditor who lent money a few years earlier, before the change in country’s economic circumstances, and had received only 6% interest.)

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Concluding Remarks

Drago doctrine, in 1902, was a defining point in sovereign debt

The Argentine crisis in 2002 marks another defining point

We need a better way of dealing with crisis We need to do a better job of avoiding

crises We need to recognize that there are

systemic problems with global financial system and the way it has been managed