FROM CORONAVIRUS CRISIS TO SOVEREIGN DEBT CRISIS / THE FINANCIAL TIMES

From coronavirus crisis to sovereign debt crisis


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In this guest post, Lee Buchheit, professor at the University of Edinburgh’s Law School and a former senior partner at Cleary Gottlieb, and Sean Hagan, a visiting professor at Georgetown University’s Law Center, and the former general counsel at the IMF, urge bondholders to consider debt forbearance for emerging market countries with precarious finances and high levels of poverty. Forceful action is needed to protect stricken countries from litigious creditors.


In the 21st century, no country borrows money with the expectation that it will ever repay the full sum. They simply assume that when their liabilities come due they will borrow from someone else to pay the maturing debts. This assumption has permitted countries, large and small, to carry debt loads that in a quainter era would have been thought wildly unsustainable. But this notion is an illusion. Covid-19 may expose how fragile it is.

The combination of economic downturns, capital flights, commodity price collapses, political instability resulting from the social consequences of the epidemic and a pervasive “risk off” sentiment in the markets may in the coming months make it difficult or impossible for some countries to refinance their debts — what the economists call a sudden stop.

Drawing down reserves could in some cases postpone a default, but those reserves may be needed for more pressing humanitarian purposes. Once defaults begin, bondholders will be entitled to commence legal enforcement measures, making a sovereign debt crisis irreversible even if the global economy recovers.

The vast majority of creditors can be expected to show restraint in light of the coronavirus crisis. The danger lies in the small minority of creditors who pride themselves on being more aggressive and litigious than their more docile peers.

For stricken countries unable to keep servicing their debts - because the bond market has been shut off or because all available resources must be directed to ameliorate the crisis - this means avoiding a situation where their debts are rendered permanently unmanageable as a result of accelerations and legal enforcement by small groups of creditors.

Initiating a standstill mechanism

While some defaults could be avoided by emergency financing from the IMF or World Bank, their resources would be swamped in a global recession. Rather, what is needed is a standstill mechanism that would freeze the situation until the longer-term effects of this crisis can be assessed.

A key issue is how such a standstill could be legally implemented. Potential tools may involve either self-help mechanisms implemented by the countries themselves, or some form of official intervention. The objective of such measures will be to erect roadblocks for litigious creditors bent on exploiting this crisis.

Self-help remedies will probably require a creative use of the “collective action clauses” (CACs) that now appear in most sovereign bonds in the developing world. Sovereign issuers could, for example, attempt to use those clauses to raise the percentage of holders that must vote in favour of an acceleration of the debt from the customary 25 per cent to 50 per cent – or even higher.

The majority or supermajority of bondholders will thus remain in control of the situation, while protecting themselves and sovereign debtors from precipitous action by a maverick minority.

A particularly innovative use of CACs would permit the supermajority of bondholders to impose an obligation to share rateably with all holders the proceeds of any recovery following a rogue litigation; a feature common to syndicated bank loans.

This is not a panacea, however. Although potentially useful, CACs have significant limitations.

Not all sovereign bonds have them. The scope and terms of the clauses vary widely country-by-country and even bond-by-bond. Some sovereign debt, like syndicated bank loans, lack CACs altogether. Some form of official sector intervention may therefore be needed to preserve the status quo until the world can begin to recover from this crisis.

Although there have been discussions in the past about an international treaty that would create some kind of sovereign bankruptcy court, there is neither the time nor the political consensus to resuscitate those debates. If the official sector at either the national or international level is disposed to intervene, it will need to do so quickly.

Halting legal exposures

For example, the sovereign immunity laws in the US and the UK - the jurisdictions whose laws are chosen to govern most emerging market sovereign bonds - could be amended to permit judges to halt lawsuits against countries where the IMF certifies that normal debt service is impossible in light of the current crisis. Think of it as the international equivalent of a temporary moratorium on mortgage foreclosures.

Alternatively, the litigious instinct might be suppressed by making the prospect of an eventual recovery more remote. In 2003, for example, the UN Security Council passed a resolution that created worldwide legal immunity for the oil assets of post-Saddam Iraq, shielding those assets from “all forms of judicial process.”

One objective was to deflate any expectation on the part of Saddam-era creditors that they would be able to seize Iraqi assets abroad while that country’s economic recovery program was underway. In the US, the president has considerable scope to intervene in matters, like sovereign debt, that bear upon the foreign relations of the United States.

If a suspension of some sovereign debt payments becomes unavoidable in the coming months, the goal should be to ensure that this does not precipitate a destructive debt crisis for the afflicted countries.

Corporate borrowers may seek such a standstill protection from a bankruptcy court; sovereign debtors must look elsewhere.

Securing an effective standstill will also be critical to achieving inter-creditor equity. The IMF and World Bank earlier this week requested all official bilateral creditors to exercise forbearance with respect to amounts due to them. It will be difficult for official sector creditors to justify this forbearance to their taxpayers if the money is simply paid over to more importunate commercial lenders.