Thursday, November 25, 2010

"....advantages to the dispersion of your creditors"

How to default: a primer

by Norman Strong

Norman Strong is the pen name of someone who spends his life surrounded by financiers and central bankers.

Debt default ought to be considered one of the most important policy weapons in the arsenal of any developing country sufficiently creditworthy to have international bonds outstanding. It has much to recommend it over IMF austerity programmes: it's available immediately, and the burden is borne mostly by foreigners.

The Latin American defaults of 1982-86 have given default a bad name, but it's wholly undeserved. Countries that defaulted first came through with the least disruption to their economies, with no consequences for future access to international bond markets. Default has been part of the development strategy of every G8 country except Japan, including the U.S.: long after Gorbachev settled with token payments on Tsarist-era debts which had been repudiated in 1917, the government of Mississippi still hasn't paid a penny on its bonds of 1870.

This introduction to default is aimed at presidents, finance ministers, and their advisors in developing countries with more than $1 billion in international bonds outstanding. Sadly, this guide offers little to the poorest countries, who can't sell bonds, and rely largely on official lenders like governments and the World Bank. For them, we recommend the work of Drop the Debt.


An early theory of sovereign default is the Palmerston doctrine, introduced in a British diplomatic circular of 1848. Sir John Simon of the Foreign Office nicely summarized it in a speech: "[I]f investors chose to buy foreign bonds with a yield of 10 per cent rather than British government bonds with a lower yield, they should not expect as a matter of right that the British government would intercede on their behalf in the event of a default"

Traders understand this. Emerging market debtors pay interest rates well above those paid by G7 countries because of the greater risk that they may not pay back in full. Bond investors know this, or Ecuador's bonds would yield the same as the U.S. Treasury's.

One effect of the Palmerston doctrine - observable today - was a policy of "constructive ambiguity" in sovereign debt crises. Unlike traditional lender of last resort theory, under which the government's role is to provide boundless support in a crisis, the approach internationally has been to maintain a studied lack of certainty - to avoid a situation in which the global hegemon is assumed to stand behind the debts of peripheral states, allowing investors to pick up a risk premium for a risk that doesn't exist.


The next big theoretical advance came from Walter Wriston, chairman of Citibank in the 1970s, who said: "Countries don't go bust." Given that this remark was made shortly before Citibank was rendered insolvent by the default of more than twenty countries, it might be thought asinine, quite deserving the retort of an IMF official; "Yes, but their bankers do." However, Wriston's short remark also encapsulates great theoretical depth (and, besides, Citibank never went bust, since it was eventually rescued by the U.S. government).

The first implication of Wriston's aphorism is that of all entities, a nation-state, with its power to tax, is of the highest creditworthiness. And second, Wriston's remark was only factually inaccurate because of his use of the colloquialism "go bust." Skip an interest payment and you've "gone bust." But going "bankrupt" is a legally precise concept: to enter proceedings aimed at resolving debt issues with the minimum of inconvenience and loss to all. Typically, interest payments are suspended, assets are transferred to creditors, and creditors recognize that they're not going to get all they're owed.


But there's no bankruptcy procedure for countries. As Christopher Huhne put it, in sovereign lending, one is exposed to the borrower's willingness to pay, rather than their ability to pay. The trigger for default isn't the arrival of an interest bill when there is no money in the bank, but the realization that to pay it would require a politically unsustainable level of domestic austerity.

With no bankruptcy law, sovereign insolvency is intensely complicated. A typical First World bankruptcy code has provisions to deal with "problem creditors" who refuse to recognize that full payment is impossible and continue to demand their pound of flesh. If they persist, a settlement can be forced on them. Not in sovereign workouts. There are even professional problems - professional speculators like "vulture funds," or the Dart family, who were at one point Brazil's largest single creditor, having bought bonds at cents in the dollar hoping to make back lots more.

As Jeffrey Sachs noted, Macy's entered into Chapter 11 bankruptcy the same week in 1994 that Russia declared itself unable to pay its debts. Macy's was out of bankruptcy with its debts restructured and trading again within four weeks, while Russia was still unable to finance its trade gap two years later.

The lack of a sovereign bankruptcy procedure was less problematic when the debts were held by a small group of banks, as they were during the 1982-86 crisis. There were relatively few creditors who would have to do business together in the future. Problem creditors could be dealt with by peer pressure. When a country's external creditors are numerous, dispersed, functionally anonymous bondholders, many of them professional problems, things are completely different. Without some authority to force the process, workouts could get very messy. This partly explains why every major crisis since the 1980s has been met with a major rescue effort (emphasis on major - smaller countries get treated more roughly).


With this theoretical knowledge, we can now ask: how does a debtor help itself to a payment holiday without being forced into autarchy?

You could just not pay - a "disorderly default." This is not the best way to go about things; it will make life unnecessarily difficult. Defaults coming out of nowhere startle creditors, and they will shut off lending. In order to make the process as painless as possible, it is necessary to do an "orderly default." Here's how.

Hire the right names. The sovereign debt underwriting businesses of global banks are typically staffed by former employees of the IMF or G7 finance ministries. Their advice may be useful, but their contacts will be far more so; having them on your side will help to assure that you are taken seriously by the IMF mission when it arrives. They're more likely to know how much you can get away with when drafting a budget or persuading the IMF to stretch conditionality.

What is really vital, however, is not so much the advice you get, as who you get it from. Your advisors must include the most important market makers in your country's bonds: JP Morgan and Goldman Sachs in Latin America, Morgan Stanley in Southeast Asia, and so on. The secret of creditor negotiations is to ensure that the market makers have an economic interest in working for you.

There are advantages to the dispersion of your creditors; they can't easily form a cartel against you, and since they hold your bonds only as a small portion of a diversified portfolio, they don't have the massive exposure the banks did in the 1980s, so they aren't as motivated to collect. But the disadvantage of dispersed bond finance is that there is no legal provision for negotiating a reduction in interest or principal. Professional troublemakers can always hold you to ransom. You need a threat to hold over their heads.

This is where the market makers come in. They have large positions in your debt. They are the providers of liquidity to the market, and the thing capital markets fear most is illiquidity. Having the market makers on side pressures other parties to fall in line. If you persuade them and a few big investors to trade their old bonds for a new, debtor friendly round, the new bonds will become the benchmark debt of your country, and problem creditors would be left with an illiquid "stub" issue, which they'd have a hard time selling. Since many problem creditors trade on borrowed money, this would put them in a very dangerous situation.

However, of course, you should not be telling your advisors of your plans at this stage; the information would certainly leak. Instead, tell them that their services will be needed for "a comprehensive review of the financing of your country. They are unlikely to provide any useful analysis, but it will keep them busy.

Prepare the IMF. The IMF needs to be told of your plans before you announce them to the general market, and preferably at least two weeks before the date of the coupon or principal payment on which you intend to default. You need to make the following points:

  • The current IMF program is politically unsustainable.
  • Your reserves are being depleted quickly.
  • There is a danger of a run on the domestic banking system.
  • Unless the situation changes, you will have to declare a moratorium on foreign payments.
  • You require access to a large loan.

The request for a loan will be rejected, but it makes your intention to default less obvious and ensures that the IMF will deploy a team to your country to review the books. When they arrive, greet them along with your advisors; they will usually be reassured to see that you have an experienced team on your side. And the IMF team will be able to spend the first evening drinking with their old colleagues turned bankers, which will put them in a more favorable mood.

As IMFers sift through the analysis produced by your advisors, they will discover that you cannot run the budget you plan to unless you either borrow more money from them or the market - or default. They will suggest you revise the budget. You insist on the political impossibility of this request.

The crunch

Next, prepare the default. You don't want to take your creditors by surprise; give them three days notice. Call the IMF team - in town only a week, and not feeling fully in control - and your advisors to a 6 AM meeting. Tell them that at noon, you plan to announce a payment moratorium starting in three days. Wave aside their objections, tell them that the decision is made, and ask them to assemble a creditors' committee.

Turn next to domestic consequences. Capital flight is bound to be a problem, so announce a three day bank holiday and capital controls. This will not stop the very wealthy, but will hinder the merely affluent, which usually do the real damage. The bank holiday will also make it harder to speculate against your currency. By the time the banks open again, they will probably be facing deposit runs and loan losses. Stand ready to nationalize them, and reassure the populace that the government stands behind every deposit. (It would be a good idea to not have done as Argentina did, and pledged your entire reserves to the defense of an exchange rate peg. And while we're looking backwards, if there are any army units whose loyalty you doubt, now would have been a good time to have sent them on maneuvers somewhere a month ago.) As markets open in New York, watch your bonds drop like a stone, and then announce the default as scheduled at noon. Allowing a few hours of trading is a courtesy to the market makers, as it allows them to square away their books.

After the default is announced, huddle with the IMF team and help them to draft their press release. It ought to state that the IMF team is in the country, and that the government is working with them. This is as close as you will ever get to an "IMF-sanctioned default," and is basically taken as such by the markets. If the IMF plays rough, play the nice guy and intimate you will sign a rigorous program. Now is not the time to play hard ball, and the program agreed matters less than you might think, given that these things are made to be renegotiated

In the evening, discuss names for the creditors' committee. Call your bankers and ask them to send negotiating representatives to your capital. Don't invite any creditors who are not banks, no matter how large they are; as mentioned above, the providers of liquidity are the only investors you need on your side, as the rest of the market will follow them.


Your starting point should be an exchange of all your outstanding bonds for new bonds worth 50% of face value. This is an aggressive stance, but your creditors will respect that. You hold the cards. The IMF will extend credit for the reconstruction of your economy only after you have come to an agreement with the majority of your creditors. Pay the army and reduce interest rates as much as you can; you can now return to the budget you wanted to pass with a greatly reduced external payments line. Don't hurry to remove controls on capital outflows.

After a decent interval, say eighteen months, time will be ripe for you to "return to the market". You will pay a bit more on your debt, but not prohibitively much, and quite possibly this premium will be outweighed by the improved outlook for your economy. (Thailand, which has never defaulted, pays more for its money than many Latin American sovereigns which have defaulted repeatedly.) The market has surprisingly little memory, and any residual uneasiness will be easily assuaged by an additional quarter-point of yield. You may now declare the crisis over.

If countries were more like companies, nobody would ever suggest that a risky and volatile proposition which looked like the typical emerging market economy should be funded out of debt; it would be funded out of venture capital or equity. Stockholders do well in good times, but share in the pain of bad; debt is a much more unforgiving arrangement, since principal and interest are fixed and regularly due. Since countries can't float stock (not yet, at least), they can do the next best thing, which is issue debt on which one plans to default if things get tough. Markets rarely figure this out in advance, and they have short memories.

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