GEI Projects

11. A Bankruptcy Code for Sovereign Borrowers

AIMS AND OBJECTIVES

The project analyses recent proposals for an international bankruptcy mechanism for resolving problems of sovereign indebtedness and financial crises. In the light of the recent Mexican crisis, a number of suggestions have been made to reform the international financial system, ranging from radical proposals to establish an international bankruptcy court in analogy with Chapter 11 bankruptcy procedures in the USA, to more moderate ideas to facilitate quick and efficient debt workouts. We aim to conduct a theoretical analysis in the first instance of the potential problems and benefits associated with such proposals. Following on from theoretical work, we then plan to make specific proposals for an international treaty to enact an appropriate procedure.

STUDY DESIGN AND POLICY IMPLICATIONS

We will begin by developing two models which will allow us to address some of the central issues. The first looks at whether an automatic standstill for debt payments is needed to handle potential debt defaults. The second examines the moral hazard issues associated with debt write-downs.

A standstill to avoid a grab raceUsing the analogy to corporate debt, we evaluate sovereign debt under different institutional arrangements. What we find is that, without ‘watertight’ sovereign immunity, creditors face a serious prisoner’s dilemma in the absence of a bankruptcy code. Although it may be collectively inefficient, individual creditors may see it in their self-interest to grab what they can of the available collateral in a ‘race of the vultures’. Reducing the returns to litiginous creditors by a payment ‘standstill’ procedure could check this downside risk, however; and we provide quantitative estimates of the benefit to other creditors. These potential gains from a standstill provide a substantial counterweight to losses from moral hazard, emphasized by, for example, the Institute for International Finance. Taking the standstill as a prelude to an orderly workout, we also investigate how credible conditionality and debt restructuring might affect asset values. In conclusion, we suggest that the analogy between corporate and sovereign debt may be closer than the G–10 was ready to acknowledge in their recent report on The Resolution of Sovereign Liquidity Crises. For if sovereign immunity is waived and creditors learn how to apply the sanctions available, creditor grab races may occur in sovereign debt markets too. And the sovereign’s right to manage can be effectively abrogated by payment standstills subject to strict conditionality.

Asymmetric information and moral hazard.The second study will examine bankruptcy procedures in an environment of uncertainty about country characteristics. In particular it will consider the incentive problems associated with a bankruptcy procedure which permits a debt write-down in certain cases. We shall examine two potential inefficiencies of a bankruptcy system. First, there are ex-ante inefficiencies associated with a distortion of investment and adjustment effort incentives. Second, there are ex-post inefficiencies due to opportunistic behaviour by countries for whom a debt write-down is not appropriate; in the absence of public information about country characteristics, it would be difficult to design a procedure which ruled this out.

Conference on Financial Crises and their Management. These and other issues, such as the role of herding behaviour and of lax banking regulation in percipitating crises, will be considered at an international conference to be held in Cambridge and the Bank of England in July 1997.