At its meeting in Washington this week, the IMF will discuss its proposal for dealing with countries that go bankrupt. The proposal has been revised several times in response to criticisms from creditors and emerging market governments, yet it has still failed to receive the support that the IMF desired. That reaction is understandable since the IMF's bankruptcy mechanism is riddled with problems.
What the IMF proposes in effect is a bankruptcy law designed for sovereign debtors that would provide protection for countries in financial distress comparable to the provisions of corporate bankruptcy law. Comparable but not identical. A domestic bankruptcy court can seize physical assets for the benefit of creditors and fire a company's board of directors, whereas an international bankruptcy judge is unlikely to enter a debtor country and seize physical assets, much less fire the country's government. When a company files for bankruptcy, and no reorganization plan is adopted, the judge may order liquidation of the company, unthinkable in the case of a sovereign bankruptcy.
According to the IMF's proposal, the sovereign country would have the right to activate the bankruptcy mechanism unilaterally when it showed that its debt was unsustainable. The mechanism upon activation would enable that country to propose a restructuring agreement that would bind all of its creditors through the vote of a qualified majority. Upon activation, the debtor country would be required to provide information to its creditors regarding its indebtedness, including debt that would not be restructured. A representative creditors' committee would be given a role to address both debtor-creditor and inter-creditor matters. Claims of creditors would be registered and verified.
The IMF argues that the mechanism is needed to improve the current process for restructuring the debt of a sovereign nation. However, it is not at all self-evident that the specific features of the current process that the IMF wants to improve pose problems. Contrary to the IMF's view, it is not difficult to assemble committees of creditors who hold bearer bonds of various maturities; rogue creditors pose no threat to the successful conclusion of a restructuring; and official intervention is not needed to facilitate restructuring. Today, all bonds are registered, so the identities of holders are known, and it is simple to organize committees of homogeneous claimants. A rogue has the incentive to start litigation to obtain a full claim only after a majority of creditors have accepted some form of debt renegotiation. Finally, market solutions already exist to renegotiate outstanding debt of troubled sovereign debtors.
The draft of the plan is also full of unsettled issues. One such issue is the activation of the mechanism. The IMF regards it as a critical issue for further discussion whether it is necessary to provide an independent confirmation of the member's representation of unsustainability as a condition for activation and, if so, who should perform this function.
Another unsettled issue is whether creditors should have the opportunity to terminate the mechanism after completion of the verification process if they believe the activation was unjustified. An additional unsettled issue is whether the claims of official creditors, like the IMF itself, should be restructured outside the mechanism or within it as a separate class.
Before it tackles unsettled issues, the IMF should concern itself with a basic question. Did the proposal for a mechanism to restructure sovereign debt originate in response to pressure from the debtors and their creditors for the IMF to intervene on their behalf? All indications are to the contrary. To the creditors, the mechanism seems to be a means to weaken their rights and encourage defaults.
To the debtors it seems to portend higher interest rates and a threat to the future of the market for sovereign debt. In a recent National Bureau of Economic Research Working Paper Andrei Shleifer asks if the debt market will survive under the IMF's bankruptcy arrangement for sovereigns. Unlike domestic bankruptcy laws, which are required to operate "in the best interest of the creditors," the IMF mechanism fails this test.
In the history of the IMF, previous amendments to its Articles of Agreement dealt with major changes to the structure of the Fund and the rights and obligations of its members. The proposed new amendment would affect the contractual rights of private parties. Is this really a course the IMF wants to pursue?