Sovereign Debt at Square One

Nonetheless, Argentina s latest debt trauma shows that the global system for sovereign debt workouts remains badly in need of repair. Deepening domestic debt markets and perhaps change along the lines proposed by the IMF is sorely needed.

How to Default on Sovereign Debt

Sovereign debt restructurings with private creditors

A New Approach to Eurozone Sovereign Debt

The Root of All Sovereign Debt Crises

See IMF Reviewing the process for sovereign debt restructuring within the existing legal framework, Policy Development and Review, International Capital Markets, and Legal Departments, 1 August 2003.

Some sovereign debtors and private creditors have been attempting to develop voluntary Principles of stable capital flows and fair debt restructuring in emerging markets , but progress has been slow.

Until the euro crisis, it was generally believed that problems servicing sovereign debt occurred only in emerging markets and the least developed countries. The US Supreme Court s decision on Argentina adds a new wrinkle, and may well further increase the risk attached to holding sovereign debt and this to the cost of issuing it.

Some might assume that bond markets are shielded from the effects of climate change, ecosystem degradation, and water scarcity. With more than 40 trillion of sovereign debt in global markets at any given time, that is a very high risk game.

One of the key challenges is the negative feedback loop between the weaknesses of many banks and the doubts about the peripheral countries sovereign debt. The sovereign debt and banking crises have become even more closely interlinked as banks bought greater amounts of their home countries sovereign debt.

In the case of sovereign debt, however, there is no binding international law that permits bankruptcy. Though some routine practices have emerged as international capital markets have grown, they remain ad hoc.

Table 3 Recent sovereign debt restructurings with private creditors main features

If Europe could show in the worst possible scenario of sovereign default how such a process might operate, uncertainty would be reduced and markets would be reassured. And, in the longer term, we would have a viable international model of how to tackle severe sovereign debt problems.

26 The risk of litigation has increased with the emergence of vulture funds that would buy distressed sovereign debt on the secondary markets and then sue for full repayment once restructuring negotiations commenced.

15. Reiterates the importance of the orderly resolution of sovereign debt crises, notes the increasing voluntary use of collective action clauses in international sovereign bonds, and takes note of the efforts led by sovereign debtors and private creditors to develop a voluntary code of conduct for the resolution of sovereign debt crises

Noted the request of Iraq for the cancellation or reduction of their sovereign debt.

The US sovereign debt market shows no similar evidence of having reached a limit yet. But bond markets do not issue many early warning signals witness the sudden run up of yields in Italy and Spain a year ago.

The solution to breaking the nexus between sovereign debt crises and banking crises is straightforward limit banks to lending where evaluation of borrowers willingness and ability to repay isn t a great leap in the dark. This means no cross border sovereign debt (or esoteric instruments, such as collateralized debt obligations).

But, as industrial countries, beset by fiscal, sovereign debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand.

Sovereign obligations, such as bonds, are commonplace in the capital markets, and demonstrate strong investor demand and confidence.

When financial markets discovered that supposedly riskless government bonds might be forced into default, they raised risk premiums dramatically. This rendered potentially insolvent commercial banks, whose balance sheets were loaded with such bonds, giving rise to Europe s twin sovereign debt and banking crisis.

When a sovereign decides that its foreign debt is unsustainable, the government and its creditors have had to negotiate among themselves about what to do. For sovereign bonds held by other sovereigns, the Paris Club of creditor countries has developed procedures for handling the debt.

Recognizing the current debate on sovereign debt restructuring, especially the efforts led by sovereign debtors and private creditors to develop a voluntary code of conduct, and stressing that modalities for sovereign debt restructuring should be voluntary, market friendly and flexible, with due consideration of the specific circumstances of individual countries, and should result from the participation of all relevant stakeholders,

(f) continue deliberations on the creation of a framework to deal effectively with all sovereign debt of developing countries.

All of this has underpinned a much welcome calm in financial markets. Sovereign interest rate spreads have been well behaved, the euro has strengthened, and equity markets have risen robustly.

More broadly, the ECB s marginal lending facility is an indirect means of monetizing sovereign debt. It is an even less direct way to address the private, related debt overhang.

Finally, GDP indexed bonds and other tools for dealing sensibly with unsustainable debt could be applied exclusively to member states debt not covered by the program and in line with international best practices for sovereign debt management.

Their economies are still tumbling, and the debt continues to grow. The credit ratings agency Standard Poor s has just downgraded the sovereign debt ratings of nine eurozone countries, including France.

The credit ratings agency Standard amp Poor s has just downgraded the sovereign debt ratings of nine eurozone countries, including France.

Meanwhile, governments were running large deficits a legacy of the economic downturn which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign debt crises as bank bailouts turned private debt into public debt.

One view dubbed the domino theory claims that if Greece exited, markets would immediately start wondering who is next. Other countries' fate would be called into question, as occurred during the Asian currency crises of 1997 98 or the European sovereign debt crisis of 2010 2012.

But the stimulus measures transformed a banking crisis into a fiscal and sovereign debt crisis. From 2010 onwards, governments started to raise taxes and cut spending in response to growing fears of sovereign default.

The international community has, so far, failed to develop effective and equitable arrangements for restructuring sovereign debt, despite the clearly dysfunctional and problematic consequences of past international public debt crises. This prevents timely debt workouts when needed, effectively impeding recovery.

Thus, the recent problems faced by Greece are only the tip of a sovereign debt iceberg in many advanced economies (and a smaller number of emerging markets). Bond market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher.

In fact, one would be hard pressed to find broad agreement with Hollande s assessment anywhere in Europe. Before the recent Italian election, financial markets showed signs of optimism, encouraged by the European Central Bank s policy of guaranteeing eurozone members sovereign debt, expanding its balance sheet, and lowering interest rates.

True, the country s periodic debt crises are often the result of self destructive macroeconomic policies. But, this time, the default has been triggered by a significant shift in the international sovereign debt regime.

But, although the current European political process will not create strong fiscal discipline, financial markets are likely to force eurozone governments to reduce their sovereign debts and limit their fiscal deficits. During the single currency s first decade, private investors belief in the equality of all eurozone sovereign bonds kept interest rates low in the peripheral countries, even as their governments ran up large deficits and accumulated massive debt.

But the creation of the euro caused a sharp fall in interest rates in the peripheral countries, leading to debt financed housing bubbles and encouraging their governments to borrow to finance increased government spending. Amazingly, global financial markets ignored the credit risks of this sovereign debt, requiring only very small differences between interest rates on German bonds and those of Greece and other peripheral countries.

Regardless of how the current impasse is resolved, the ruling raises many questions for issuers and holders of sovereign debt. If creditors now believe that holding out makes it more likely that they will receive full value at a later date, restructuring sovereign debt and restoring a debtor economy s normal functioning will be more difficult.

Moreover, some debtor countries which have gone through debt restructurings soon resumed their access to capital markets.

This distinction between foreign and domestic debt is particularly important in the context of the euro crisis, because eurozone countries cannot devalue to increase exports if this is required to service foreign debt. And the evidence confirms that the euro crisis is not really about sovereign debt, but about foreign debt.

We welcome the commitment of the Paris Club to reduce substantially Iraq's sovereign debt and urge the other creditors to take similar decisions.

Likewise, Europe is on life support, thanks to European Central Bank President Mario Draghi s astute maneuvering and promises of unlimited intervention in sovereign debt markets. But unemployment is at its highest in decades and growth has essentially stalled, even in Germany, while the troubled southern economies are mired in deep recession.

Lower interest rates on loans are available in capital markets to borrowers who have ample debt service coverage , which is defined as total revenues available for debt service as a percentage of the required debt service.