Creditor Rights in Sovereign Debt Markets – Term Paper

Globally, governments are increasingly defaulting on their debt obligations with the most recent example being Argentina, Greece, Russia and a host of East Asian economies. The situation has elicited mixed reactions in international markets and bilateral institutions such as the International Monetary Fund and the World Bank, which have proposed aggregate collective action clauses that protect the investor’s interests (Broner et al. 2013). According to Noy (2008 p.64-78), without creditors, international financial markets cannot exist; therefore, investors must have meaningful ways to recoup back their investments in case of sovereign default. However, information access is considered key towards making informed investment decisions; thus, close cooperation between sovereign borrowers and creditors is critical. During a default, a country’s financial reputation is questionable, and oversight agencies such as the International Monetary Fund, World Bank, and Iconic agencies such as Moody rating often raise the red flag when dealing with defaulting nations (Diaz-Cassou and Erce 2011, p.14-18). Such defaulting economies suffer economic consequences, including restrictions on accessing financial markets, trade embargo, and tightening of the fiscal deficit in their home countries. These restrictions are implemented because the sovereign creditors, just like ordinary investors, have their rights in the sovereign debt markets. It is in light of this fact that the paper will focus on creditor rights in the sovereign debt markets, the potential costs of sovereign default for a country and the magnitude of the costs likely to be incurred should a country default its sovereign debt obligations. 

How Economies default their Sovereign Debts

Since the advent of the global financial markets, sovereign debts have been considered the safest investment type due to their risk-free nature coupled with their potential for high returns. However, in 2002, the market was shocked when Argentina announced it was unable to service its bond debt. A decade later, Greece restructured its sovereign debts. These two situations elicited mixed market reactions, raising the question, if the two governments completely defaulted, how could investors recover their invested assets? This is because government-issued bonds are considered risk-free and never accompanied by any form of collateral other than the government’s guarantee to service its debt (Manns 2015, p.118-152).

During the world’s financial meltdown, major economies were pushed into a deep recession because the countries experienced low growth and huge budget deficits, leading to a sharp rise in debt-GDP ratio. Previously, in such scenarios, countries absorbed their debts by utilizing different approaches. By late 2009, the average spreads were still minimal, and the allocation of sovereign hands in the domestic residents was below 50 percent in emerging economies such as Greece, Ireland, Italy, Portugal and Spain (GIIPS) (Ahmed 2016, p.43–59; Rogers 2012, p.117-148). The situation deteriorated and economies such as Ireland, Spain, Greece and Argentina reported massive debt deficits than previously anticipated. These events not only slowed down the repayment of the debts, but also affected how different credit instruments were absorbed in the market.

The same year, Greece defaulted on its IMF loan repayments, but surprisingly, the same government decided to settle a yen-denominated bond held by private entities fully. The situation was shocking since the IMF is the most authoritative lender and financier of last resort. According to Greece’s move, IMF and other multilateral agencies are considered the de facto senior creditors; therefore, raising the question why first settle the yen-dominated debt. However, IMF’s senior status as the principal economic lender is not enshrined anywhere legally (Waibel 2014, p.22-41).

Creditors Rights in Sovereign Markets

Aguilar and Zejan (1985, p.385-395) debated on the relative importance of distressed economies meeting their debt obligations. Key emerging economies such as Argentina, Greece and Bulgaria have underscored the importance of understanding the bargaining positions of their debt-riddled economies. According to Dowell-Jones (2014, p.51-85), the most fundamental question that remains unresolved is ‘What can creditors do to reclaim back their assets if a sovereign nation does not fully ascribe to its debt obligations? Metz and Tudela (2011) continue to argue that sovereignty implies that no single agency globally can seize the assets of a foreign country. This discussion attempts to address the underlying issue using two approaches:

Reputation Approach 

Direct Punishment 

Reputation Approach 

This principle works on a very direct premise because countries value the access to the international money market that facilitates smooth consumption in the face of volatile output or fluctuating investment opportunities (Longstaff et al., 2007). Countries are always trusted to issue timely loan repayments, hence do not wish to reprieve their status as good debtors. Considering reputational symmetry, there is no need for the creditors seeking arbitration or political sanctions; rather, investors should understand economies’ sovereign borrowing limits on external debts since the flow of repayments largely depend on a country’s fundamental computation of consumption spending (Arellano and Bai 2013). Therefore, should creditors extend so much to a country, an elastic limit may be reached whereby the country is unable to retain its debt repayment program. Investors must acknowledge that reputational approach comes with the undeniable feature of analyzing the country’s macroeconomic situation instead of the murky institutional capacity to participate (Pepino 2015, p.73-95). 

Punishment Approach 

It is assumed that foreign creditors have no legal mandate whatsoever to repayment in debtor country courts (Stephanou 2013, p.127-158). However, these are other people’s assets because creditors accord investment rights in sovereign debt contracts, and any controversial government to an individual or government-to-government trade dispute can always be resolved by the international court of justice, affiliated to the IMF and the World Bank (Porte and Heins 2016, p.1-13). Creditors’ legal rights, if violated in certain cases, may interfere with a country’s business privileges such as imposing embargoes on the free movement of cargo within certain jurisdictions, a scenario that may interfere substantially with a country’s economy.

Despite creditors’ rights, there is also the issue of seniority in the sovereign debt markets, and unlike the corporate debts, there are no legal rules of priority and seniority when it comes to the international debt market (Santiso 2009). Due to the lack of a harmonized standard in relation to a sovereign bankruptcy procedure, no single government can decide which creditor cluster to service their debts and the extent of the payment levels (Dam 2015). Seniority in debt repayments is considered an optional decision, thus not legally enforceable in a court of law. Conclusively, it can be argued that only credit-specific factors propel debt repayment patterns, and a nation’s economic fundamental cannot be used as a metric illustrating seniority in sovereign debt repayments. For instance, in 2005, Greece defaulted payment to the most senior creditor, the IMF, while serving its junior creditors such as the fund managers and other institutional investors. 

Factors Driving Sovereign Debt Default

One of the key factors prevalent with sovereign default is the accumulation of vast reserves of foreign denominated debts from the market, making the economy unable to make timely payments due to factors such as tight budgets and lack of political goodwill. In such scenarios, sovereign investors find it difficult acquiring support from supranational courts or creditors’ rights enforcement agencies. According to Wright (2010, p.295–315) and Schroeder 2015 p.73-104), when countries default on some of their treasury obligations, it means that the state is no longer willing to handle its debt liabilities or pay up the interest. Signs of sovereign debt defaults begin to emerge when an economy is associated with massive overspending or too much borrowing for approximately 8 to 10 years. However, there are always consequences for the creditors and, in most cases, international negotiations commence, which often end up in partial debt cancellation. Under such an arrangement, partial repayments are remitted while the investor surrenders a huge chunk of the debt. A perfect example is the Argentine’s economic crisis (1999-2002), whereby creditors unanimously agreed to relinquish 75 percent of the outstanding debt. In certain instances, the creditors may wait for a regime change to recoup their dues.

Creditors’ rights are clearly spelled out in international law, and they not only entail the rights of creditors against the debtor, but also amongst other creditors. In cases where there is a default over several cases, the rules in favor of the creditors’ rights establish the particular creditor that holds the strongest right towards any particular relief, whether attaching state assets or seeking any other form of compensations if possible. Waibel (2013, p.209–251) reiterates that to mitigate against default risks, contemporary economies have responded through issuing bonds in “hard” currencies via international financial institutions as transaction intermediaries, and as a result, courts have been established in New York, London and Tokyo to deal with cases of aggrieved creditors (Baldacci and Gupta 2011, p.251-263). To curb or control sovereignty credit defaults, the International Capital Market Association (ICMA), an entity legally mandated to oversee the international financial market, has enacted a multilateral legal framework that regulates the sovereign debts restructuring process for the sake of enhancing predictability, stability, and efficiency in the international financial system (Erdem and Varli 2014, p.42-57). 

Consequences for the Economy

If a country defaults its treasury obligations, it simply disposes of its monetary obligations towards creditors. The immediate effect under such a scenario is that the country benefits from an immediate reduction in its debt portfolio and the accompanying interests associated with such debts (Hu, An and Yang 2008). However, the country’s reputation is dented among multilateral creditors and other credit rating agencies (Doug 2014, p.1–4). This means that the country cannot easily participate in the international financial market because investors perceive the economy as high risk. In a different scenario, foreign lenders may jeopardize the country’s monetary sovereignty. Sovereign defaults also include constrained access to credit not only in international markets, but also domestically since the government of the day has lost its credibility amongst investors. Besides, the domestic financial institutions also hold significant amounts of domestic debts, and if a government defaults, the situation may degenerate into bank runs and lead into a financial crisis since most investors find it difficult to cope up with broke governments. These effects have consequences to an economy’s Gross Domestic Product (GDP) because the country is faced with a higher borrowing cost due to its poor credit score (Kolb 2011, p.1–13). The situation may exacerbate if the creditors are domestic borrowers because the government must always visit financial markets to offset their operational expenses such as paying workers and suppliers. Such a situation may lead to a knock effect on the entire economy and completely paralyze operations (Christodoulakis 2006).

Argentina’s Case Study

Argentina can be used as a perfect case on how a section of an economy may escalate the debt crisis. The country defaulted its sovereign debts in 2002 and the economy’s fiscal deficit and debt position deteriorated significantly. As a result, the interest rate spread increased dramatically from below 10 percent to almost 50 percentage points by the end of 2001 (Bruno 2009). The Argentine government responded by increasing reliance on local financial institutions, whereby the government debt as a percentage of the banking system’s total assets rose from 15 percent in 2000 to 21 percent by the end of 2001 (Wei 2003, p.709-705). In this light, the banking sector’s credit risks increased significantly. Besides, the voluntary debt exchanges that increased the maturity of the bonds also increased maturity mismatches on the institutions’ financial statements. Due to the weakening of the banking system, there were widespread panic withdrawals throughout 2001, whereby deposits fell by 20 percent by the year-end (Féliz 2010, p.52-72; Zutshi 2008). 

By early 2002, the Treasury confirmed that it was defaulting $18.8 billion of their external debt and concurrently announced it was ditching the currency exchange board regime. These series of events prompted the Peso, Argentines official currency, to fall from 1 peso per US dollar to 3.9 by the end of March 2002. As a result, the country was heavily indebted when the debt is converted into their local currency. The situation impaired the local financial institution systems that provide liquidity and credit to the economy, and the banks’ credit to the private sector as a proportion of annual GDP reduced by 50 percent from 20.8 percent in 2001 to 10.8 percent by the end of 2003. The scenario led to lessened economic activity, hence increasing the country’s fiscal burden compared to GDP. The banks’ non-performing loans also increased dramatically when the recession deepened. According to Horn and Fritsche (2012, p.118-126), Argentina had a sovereign debt more than $123.7 billion, which was not sustainable even with conservative estimates. Additionally, it is noteworthy that no financial valuation of the country’s export and import growth could deliver the requisite net long-run foreign exchange earnings adequate for servicing the debt, even if the country’s interest levels were to move back to pre-crisis level. The country’s trade deficit expanded and its currency got overvalued, trade liberalization stalled and the exports only comprised of an insignificant share of the country’s economic bedrock (Schaumberg 2014, p.135-154).