The economic harm being caused by the novel coronavirus may soon result in multiple sovereign debtors moving into default territory. But the existing playbook for dealing with multi-sovereign emerging market debt crises is blank.
A key official sector response to this situation was the Debt Service Suspension Initiative (DSSI), originally proposed by the President of the World Bank and the Managing Director of the IMF in March 2020 and adopted by the G20 on April 15. The objective of the Initiative was to give 73 low-income countries a debt holiday for the rest of 2020 and hope – via exhortation – that the private sector would voluntarily follow suit in providing equivalent relief. At the time of writing, 45 countries have applied for relief under the DSSI and no private sector relief has been provided.
Over the past decades there has been progress in the design of instruments to deal with sovereign debt crises. However, the current design of the international financial architecture is not well equipped to deal with a situation in which a large number of countries default at the same time as a result of an exogenous shock. If all creditors could be coordinated, they would presumably agree that they would benefit from a standstill that allows the affected sovereigns to use their scarce resources to fight the pandemic and get their economies back on track. At the center of such coordination mechanism would be a stay on creditor litigation, so that the crisis countries can undertake an orderly debt work-out. This is akin to the debtor-in-possession regime under US corporate bankruptcy.
However, no fast and efficient mechanism exists to provide a multi-country stay. The recent G20 Common Framework is a step in the right direction, with its aim of comparable of treatment of Paris Club and non-Paris Club creditors, somewhat allaying concerns that large creditors that do not belong to the Paris Club would seek better restructuring terms. However, there are at least two problems with the Common Framework.
First, the Framework appears to be limited to DSSI-eligible countries, and we suspect that several non DSSI-eligible countries are already in, or on the brink of, debt trouble.
Second, while explicitly mentioning private sector participation, the Framework does not detail concrete measures that could induce the private sector to participate in debt relief. Specifically, countries that request a suspension of official debt service are required to ask for similar treatment from the private sector, but that does not preclude some private creditors choosing not to get involved and suing debtor countries in default. The Common Framework does not include any legal mechanism that would prevent such suits.
In the absence of such a legal mechanism, countries that want to divert resources from debt service to pandemic related expenditures risk having to fight a plethora of creditor lawsuits while approaching their creditors for a bespoke debt restructuring. As this require time and resources, it would be desirable if countries could be temporarily protected against lawsuits. This is the notion of "legal air cover" that we describe in Bolton, Gulati, and Panizza (2020).
We focus on three options which can be put in place quickly, without the need for lengthy legislative wrangling or contract-by-contract and country-by-country negotiations. The air cover they provide may facilitate negotiations with creditors and buy time for conducting debt sustainability analyses, without the fear of a rush to the courthouse. In this sense, the solutions that we propose can be useful to deal with both liquidity and solvency crises in a world that still lacks a statutory mechanism for dealing with sovereign defaults.
The first option is a UN Security Council Immunity Shield similar to that used to restructure the Iraqi debt accumulated by Saddam Hussein. The second option is an executive order by the US President and a similar legislative action by the UK parliament (most international debt is issued under either New York law or English law). The third option would instead require using the doctrine of Necessity under Article 25 of the International Law Commission’s Articles on Responsibility of States for Internationally Wrongful Acts.
There are challenges related to using these three options. A key issue has to do with the fact that these options envision a degree of ex-post state intervention in the debt contracts. Under normal circumstances, retroactive modifications of contract terms are disfavored in every modern legal system because they diminish the value of contractual commitments. Ex-post interference with contract terms can however be optimal in exceptional circumstances where the parties themselves – had they been able to negotiate a contract provision ex-ante -- would have wanted modifications to the contract. Under these circumstances, ex-post intervention in contracts by the state can be welfare enhancing.
Bolton, Gulati and Panizza (2020) provide empirical evidence suggesting that it is unlikely that the actions that we propose – if implemented with care -- will have significant negative repercussion on the functioning of the global debt market. On the contrary, by helping overcome a severe debt-overhang problem these measures allow all sides—debtor and creditors—to benefit from avoiding a messy and protracted debt crisis.
In this setting, the G20 can play a key role by certifying that such an ex-post intervention is indeed necessary and welfare-enhancing for both creditors and debtors.
Bolton Patrick, Mitu Gulati and Ugo Panizza (2020), “Legal air cover”, CEPR Discussion paper