Targeted legislative adjustments could help contain damage from debt crises

This is a cardinal principle of private enterprise: a business that is bogged down in debt deserves a second chance – an opportunity.”start over“After a financial misfortune. For more than a century, this principle has enabled businesses to take the financial risks they need to succeed. Today, the right to a second chance is enshrined in the corporate bankruptcy laws of most major economies.

Yet governments are denied the same leniency—with predictable grave consequences for the poorest citizens of the poorest countries. At the end of 2021, low- and middle-income governments were required to valued at $9.3 trillion— Record — to foreign creditors, mainly private lenders and bondholders are scattered across countries. For them, there is no bankruptcy court to ensure a quick and orderly restructuring should a debt crisis approach. Instead, they must navigate through a more procedurally controlled maze. bizarre conventions than by statute.

Governments are keenly interested in enacting legislation to correct this imbalance. Consider this a long overdue move to protect your taxpayers from being exploited by a third party—something that national legislatures are constantly doing.

It’s time to correct the imbalance. As global growth slows and interest rates rise, the risk of a wave of debt crises rises, yet the mechanisms available to deal with them are wholly inadequate. The time is too short to allow large-scale legislative decisions, such as Sovereign debt restructuring mechanism— Who often fail because of their own ambition. But just several legislative amendments can make a huge difference, especially when combined with other reforms which were proposed by the World Bank and the International Monetary Fund.

Today, some 40 low-income countries and about half a dozen middle-income countries are either in debt distress or at high risk of one. For both types of economy, there is only one way to restructure unsustainable debt – paris club for middle-income countries and G-20 General Framework for Dealing with Debts for low income economies. Both mechanisms come with a major hurdle: in exchange for debt relief from foreign public creditors, borrowing countries must seek equivalent concessions from foreign private creditors with whom they have no bargaining power.

No wonder progress has been icy. Only three countries – Chad, Ethiopia and Zambia – have asked for help under the Common Framework. More than a year after they applied, there was little movement. This is consistent with the experience of the G-20 Debt Service Suspension Initiative (DSSI), which encouraged (but did not require) borrowing countries to seek comparable concessions from both private and public creditors. There was only one “private” lender involved in DSSI, but that was just a national development bank that called itself a private lender.

Today, in a significant number of developing countries, debt restructuring cannot take place without the full participation of foreign private creditors. Governments in low- and middle-income countries should $2 trillion to private creditors about five times the amount they owe government creditors. Moreover, most private debt is owned by bondholders, who often buy the right to receive secondary markets.

A small minority of bondholders are vulture investors– Those who focus on governments’ bad debt by buying their bonds at a deep discount in order to sue for full payment. These investors have little incentive to participate in debt relief initiatives: to maximize their returns, they hold out until other creditors make concessions—in the expectation that concessions from others will free up cash that will allow dissenters to receive the highest possible repayment. This is a form of freeriding that harms all other creditors.

Giving distressed governments even some of the remedies normally given to distressed businesses would solve most of the problem. Adoption in just a few jurisdictions—New York and London, for example—would be significant, given that almost all external contracts for developing country sovereign debt are governed by the laws of these financial centers. The Common Framework, a debt restructuring program endorsed by the G-20 for the world’s 73 poorest countries, might be a good place to try one or more of these methods.

First, point out that all creditors have a legal obligation to cooperate in good faith in sovereign debt restructuring. The principle of good faith is already built into the legal systems of many countries and is a key private sector principle, also. It should be codified to state that creditors are required to cooperate in a Common Concept restructuring once the public debt is found to be unsustainable and the creditor has been asked to participate on terms comparable to other creditors.

Second, limit the amount that a creditor can recover in litigation outside the Common Framework process. The aim should be to link the maximum allowable amount to amounts recovered by other creditors under the Common Concept. But the restriction should be applied only in narrow circumstances – after the framework has been established formula for equal burden sharing among creditors and after the vast majority of creditors agreed to debt relief.

Third, limit the ability of creditors to seize the assets of a debt-strapped government that has acted in good faith. Some governments have already moved in this direction. France, for example, has law in 2016 this limits the ability of French courts to authorize the seizure of foreign state assets to pay off the debts of a country receiving foreign development assistance. This approach can protect sovereign assets even if the judgment was issued for a higher amount than received by other Common Framework creditors.

Fourth, embed where possible collective action mechanisms into existing debt contracts.. Sovereign bond contracts issued over the past 20 years increasingly include collective action clauses that make it easier to reach a restructuring agreement: a supermajority decision by bondholders allows the agreement to prevail even over dissenting bondholders. But syndicated loans are not, and they account for a significant portion of sovereign debt issued by developing countries. Legislation enacting such provisions in all future sovereign debt contracts will help solve this problem.

For too long, governments capable of fixing an inherently flawed global debt restructuring system chose not to—at the cost of mounting costs to their own taxpayers. During a debt crisis, governments inevitably give way to private lenders on getting their money back: private lenders get the money first, and it comes back roughly. 20 percentage points more of their own funds than the government.

Governments are keenly interested in enacting legislation to correct this imbalance. Consider this a long overdue move to protect your taxpayers from being exploited by a third party—something that national legislatures are constantly doing.