Restructuring sovereign debt is an inherently disagreeable process. A sovereign, locked out of international credit markets due to its irresponsible handling of public finances, requires perfectly sensible lenders to do something no sensible person would agree to. Which is to reduce or stretch out their claim against the country; it’s an inherently difficult task.

Locked out of international markets and unable to roll over its foreign currency debt, Sri Lanka now has to figure how it will repay around $25 billion in principle and interest for its foreign currency debt over the next five years. Restructuring the debt is one option.

During an interview, Lee Buchheit, a lawyer with over 40 years of experience working alongside more than two dozen sovereigns to restructure debt, discussed how the process works, its idiosyncrasies and challenges. Below we are reproducing a part of that interview structured as an FAQ.

THE NOMENCLATURE OF SOVEREIGN DEBT RESTRUCTURING

Several terms are used, often interchangeably, when sovereign debt restructuring is discussed. One term is ‘restructuring’. Other terms include reprofile, haircut, clipping coupons and clipping the principal payments. Do all these mean the same thing or are there nuances?

Each carries its own meaning. The sovereign debt restructuring business, like all activities, has its jargon. Restructuring is just the generic term. Restructuring connotes some change to the financial terms of a debt instrument. Typically that will inflict a net present value loss on the holder of that instrument.

There is a charming aspect to this business, which is, that it’s not all that complicated. Open up a toolbox of a sovereign debt restructurer and there are only three tools. There are three things you can do.

First, you can reduce the principal of the debt – the capital portion of the debt – and that is referred to in the jargon as a haircut.

If you owe $100, but in the debt restructuring you agree to reduce that to $80. That’s a $20 haircut.

The second thing is to adjust the interest rate. On bonds, the interest rate is referred to as a coupon. So you can reduce the interest rate or the coupon on the bond.

The third is to extend the instrument’s maturity. If the instrument matures tomorrow and you don’t have the money to pay it, debt restructuring can take the form of a maturity extension by three years, in the hope that in three years you will have the money to pay it. Or you can mix and match all three of those things.

There is a good deal of euphemism in this business, and reprofiling is one of them. The genus is restructuring. One species is reprofiling. Reprofiling connotes a transaction in which maturities are extended but there is no principal haircut and typically not even an adjustment to the coupon.

The term was first used in 2003 by Uruguay. Uruguay had 18 bonds in the international capital markets at that point and they did not want to restructure these in a savage way because they felt that they simply needed breathing space to recover their financial footing. So they told the creditors, let’s move the maturity date of each of those 18 bonds out by five years. But we will leave the interest rate (the coupon rates) unchanged. It worked. Uruguay never again had to restructure its debt.

The term took on greater significance, a few years ago, when the IMF changed its policy. The traditional policy of the IMF was binary; if the Fund concluded that a county had an unsustainable debt stock and the country had lost market access, the IMF would open a programme on the assumption that this country is going to restructure its debt stock. By restructuring, it means doing a principal haircut or coupon modification. If the IMF concluded the debt was sustainable they would not ask a country to do that. But a large number of countries fell in between those two bright lines and the question was what to do with those countries. You see, if the fund did not require the country to restructure its debt, then money lent by the IMF and the other official sector actors to that country might just bleed out to pay commercial creditors in full and on time. And if it turned out that the country’s debt was unsustainable, those creditors would have escaped and been replaced by the official sector creditors like the IMF, aka taxpayer-funded lenders.

So, the changed policy was to have a third category, applicable to countries which the fund staff could neither assert with confidence that the debt was sustainable nor could they say it was unsustainable, and that was to ‘reprofile’ the debt.

It means that you move the maturity date of the commercial debt outside of the window of the IMF programme into which the IMF is lending. That solved the problem of having the money simply bleed out to pay commercial creditors in full.

In effect, it’s a holding pattern; you wait to see whether the circumstances would render the debt stock sustainable or perhaps unsustainable. If the latter, the commercial creditors are still exposed to the country because they have been reprofiled, or maturities pushed out.

In a restructuring do creditors get new bonds that specify new terms?

Typically a restructuring means that creditors do get new terms and it’s called an exchange offer. Typically you do not amend your bond within its four corners, you would issue a new instrument to replace it.

HOW COUNTRIES AMASS UNSUSTAINABLE AMOUNTS OF DEBT

How do countries accumulate unsustainable amounts of debt in the first place? If you are a business wanting to borrow from a bank, they will want to see your projected cash flows and possibly want some collateral. Are these commonsense requirements somehow suspended in the global market for sovereign debt?

In this century, no sovereign borrows money with the expectation that they will repay the money, if by repay it means to divert current resources from the budget to settle the liability.

A sovereign in this century borrows with the sure and certain hope, that when a bond or loan matures, the sovereign will be able to go back to the market and borrow again to repay that maturing debt and when that new bond matures, it will do it again, in perpetuity.

It is fatuous to believe that politicians in these countries are squirrelling away money to repay their existing indebtedness on the maturity date, they are all assuming it can be refinanced, to use the jargon, or it can be paid back with the proceeds of the new borrowing when it happens.

Now that injects enormous fragility into the system and there are a variety of things that can happen that may prevent a country from refinancing its debt.

The markets may turn erratic and decide they no longer wish to take the risk of lending to emerging market sovereigns. Interest rates can go up and a country’s economy can suffer some kind of shock; a particular affliction of countries whose economy is based on primary commodity export.

What can be done if refinancing is not possible?

It means you have maturing bonds that cannot be refinanced from commercial sources, so what are your options? Your options frankly are to find an official sector lender who is prepared to give you the money, if you can. This was similar to Greece’s dilemma in 2010. However, they were part of the European Union and the EU was prepared to lend them the money to repay the maturing bonds, for a little while.

You can also run down reserves paying bonds, every country does this. You hope that the circumstances that have denied you market access will pass as long as you continue to show the market that you are paying your maturing debt. This often is a ruinous policy.

The third option is to restructure your debt. You go to your existing creditors and explain that since no one is prepared to lend money at a tolerable interest rate that will allow you to repay what is owed and you don’t have the reserves to continue to do this for more than a few months, you request the creditors for some form of debt relief. We have discussed what they are: principal haircut, coupon adjustment and maturity extensions, or probably some combination. When you reach that point, you are in debt restructuring.

Why do countries procrastinate about debt restructuring, is it a misplaced sense of vanity, is it cultural? What have you learnt?

It is partly cultural and there are countries and areas of the world that resolve that sovereign debt crisis are dishonourable. In South Korea, they put up buckets in street corners, and people would take off their wedding rings and throw them in the bucket to help the government to avoid the dishonour of debt restructuring.

Why do politicians delay? Most know that politicians who lead a country into a sovereign debt restructuring are rarely the ones who take them out of it. It is an inherently disagreeable process. It will almost assuredly involve fiscal adjustment measures that are politically unpopular.

In the old days, you had to default to show your creditors the seriousness of the situation. The modern theory is the exact opposite and recommends what’s called preemptive debt restructuring. Restructure before you default because once you default things get complicated and the lawsuits begin.

How long does the restructuring process typically take and what impact will it have on private market access?

Restructuring takes more than 11 months from beginning to end, or it can take much longer if the process gets bogged down.

The debtor country will want the restructuring done as quickly as possible. But sovereign debt restructuring is considered very unpleasant. However, local politicians respond with pathological procrastination in these situations.

Politicians would prefer that the disagreeable task of restructuring the country’s debt would fall on the next administration. If politicians are forced into the restructuring process, the memory of the financial pain of debt restructuring and the associated physical adjustment will affect them in the next election.

Will it affect the private sector? Debt restructuring will affect the private sector because markets will see a sovereign ceiling due to the credit rating. Whatever the credit rating of the sovereign, it is reflected on private-sector borrowers in the debtor country unless they have a steady and reliable stream of foreign currency earnings offshore that they could use to service their external obligations.

A sovereign can implement capital controls that could require local enterprises that have foreign currency earnings to repatriate these earnings and sell them to the central bank. This type of capital control was used in Iceland after the financial crisis, or Great Depression, in 2008.

For so long as the sovereign is trapped in debt restructuring, it is likely to make it more difficult or impossible for private enterprises to tap international markets and therefore they would also want the process to be completed as quickly as possible.

During the restructuring process, does the sovereign continue to service the debt or can it just service interest? How does it work?

Sometimes during the restructuring process, the sovereign does service the debt. These are so-called preemptive debt restructurings where the sovereign does not default, like Greece, which never defaulted; they came within 8 days of default but never did. Uruguay in 2003 never defaulted and if it can be done, then it can be desirable.

The two things that go against it are, first, the impression that the creditors won’t take the situation seriously and won’t be prepared to entertain requests for deep debt relief for a country that is continuing to service its debt. And second, is the time pressure on that scenario is wholly on the sovereign debtor not on the creditors. You stop paying and the creditors are missing coupons; the secondary market value of their bonds start declining.

That said if it can be done, other things being equal, better to do it before a default. Default tends to build up accrued and unpaid interest. Creditors in a debt restructuring will always ask for that component to be paid in cash. If it can be done, it’s probably better to do it before outright default. The longer-term memory of the debt crisis is less than indelibly stained if there hasn’t been an actual default.

What the market will remember is how a country conducts itself? Maturity and moderation will be remembered by the market long after they have forgotten the level of debt relief that a country asked for or received.

LEAD TIMES FOR DEBT WORKOUTS

If it takes at least a year for a debt workout, then a country has to plan its cash flow, if it doesn’t want to end up in the situation of not being able to service its coupons or capital payments?

Presumably, the first call to the IMF will produce a mission in a week or two to conduct a study. They will do a debt sustainability analysis and recommend a programme, and only then can the country begin to ask for a meeting with creditors and commence the commercial debt restructuring negotiations. Depending on what it is asking for in terms of debt relief and how unpopular that is with the creditors, those negotiations can go reasonably quickly or drag out for many months. Even if a deal is struck, we live in a world where commercial debts are typically represented by security bonds and there will be a process for issuing new bonds, and that takes time. A year in advance of anticipated closing is probably about right. Argentina defaulted in Dec 2001 and they did not get around to completing the restructuring of these debts until the middle of 2015.

Hypothetically if a country has $4.5 billion of maturing credit in 2022 including $1.5 billion in commercial bonds and only around $2 billion in reserves, at what point should it start speaking to creditors?

Start speaking to the IMF. Politicians usually react with procrastination in the face of these problems and they will sincerely wish it to go away. It is dangerous and harmful to run one’s reserves down to pay maturing indebtedness that cannot be refinanced from the market.

We are in an unusual circumstance in which as a result of quantitative easing institutional investors are stuffed with money that they have to deploy. Therefore, sovereigns across the globe, for the last 10 years, have been able to borrow in circumstances and at interest rates that any sober historian of this process would conclude was inconsiderate of the underlying risk. Nonetheless, they have been able to do it and there will be a close study of whether it is possible to refinance maturing debt, the coupon may be higher than one would like.

The danger is you find yourself in a debt spiral, and you refinance at an interest rate that is unsustainable and the market perceives it and the market wants higher interest rates. For a period, you can borrow and at some point, the market will shut off entirely.

Greece in the fall and spring of 2009-2010 was in that position. It had more than 200 billion euros of maturing bonds and no ability to refinance these in the market.

WHAT DEBT GETS RESTRUCTURED?

A sovereign restructuring its debt may seek principal haircuts, maturity extensions and coupon adjustments, or a combination of these. How do you negotiate this, or figure out which mix to use for which situation if the sustainability of the debt isn’t so clear in the first place?

It is always a bespoke process. It’s going to differ depending on the nature of the debt stock. How much of it is bilateral, or government to government and how much of it is commercial. If it is commercial, is it in bonds or loans? What does the maturity profile look like, and what has caused the difficulty.

Often the cause of a country’s financial distress will be chronic fiscal mismanagement. But there are certainly cases when the cause of the distress is wholly an external factor, an earthquake, hurricane or a pandemic. When a country is blameless but is nonetheless now facing a debt crisis, the reaction of the creditors will differ depending on their perception of the underlying cause.

If the creditors perceive the underlying cause to be chronic fiscal mismanagement then quite understandably they won’t want to give debt relief to the country unless the mismanagement is addressed.

This is where the IMF comes into the picture. The IMF will typically prescribe or recommend fiscal policies to put the country on a sounder footing.

Commercial creditors often, not always, will say that they want the debtor country to have the tutelage and monitoring of the IMF so out of debt relief will emerge a healthier economy.

What are so-called, official sources?

They come in two forms. One is multilateral lenders. These will be the international financial institutions, the so-called Bretton Woods institutions. The International Monetary Fund, The World Bank and the regional development banks like the Asian Development Bank and African Development Bank, and so on.

In addition, there is government to government lending. So you borrow money from China or other countries and very often those loans are extended by the creditor countries to support exports from their own country. If you want to buy a steam turbine from Germany, the German export credit agency may extend the credit that will permit that to happen.

In debt restructuring terms, by convention, multilateral money is not restructured. The theory is, those institutions are in the business of lending money into distress situations already that every right-thinking creditor is trying to get out of; those institutions lend money into it.

Bilateral debt or government to government debt is perfectly restructurable, and has been since 1956 for the OECD countries under the auspices of the so-called Paris Club, an informal group of 20-21 countries that restructure their debt to emerging market sovereign borrowers jointly; so there isn’t competition among them as to the terms on which the debt will be restructured.

Is there any possibility whatsoever to request from the official sources reprofiling, or delaying cash flows, on their outstandings in any way? And of all these varieties of debt, which ones get restructured?

The multilateral debt, IMF, World Bank and ADB, is normally not restructured. If those institutions have large exposure in the country, it is cosmetic, but what they will do is open a new programme, where disbursements are sufficient to repay. We don’t call it restructuring, but it’s a species of refinancing.

The bilateral debt or government to government debt is restructured and it can be often done without haircuts or clipping coupons. As a matter of fact, bilateral creditors have a strong preference for reprofiling, that is maturity extensions, and the only instance in which you have seen significant departures from that policy have been in that period which began in the mid-1990s and it is still going on today, in which the Highly Indebted Poor Country (HIPC) initiative was in place. This was a group of 33 of the poorest countries and for those countries, the official sector creditor wrote off a massive amount of their claims.

But if you go to the Paris Club today and ask for a principal haircut and you are what the World Bank classifies as a middle-income country, you should not expect a warm welcome.

Many counties have loans from China and India and these two countries are not part of the Paris Club. Can this potentially complicate things?

Things are changing. Last November, the G20 announced the common framework. This would be a process open to the 73 poorest countries. For the first time, it said that the G20 countries including China and India would renegotiate their debts to common framework countries, jointly with the old Paris Club. That is Paris Club plus China, India and South Africa.

This was viewed as a very significant step because, for the last 15 years, China has become the largest bilateral creditor on the planet. It is not a full member of the Paris Club but has observer status.

Therefore you had a world in which there might be a Paris club restructuring, then a bilateral or non-Paris Club restructuring and a commercial restructuring of the debt.

And the tension was if you did your Paris Club first, theoretically, you promised the Paris Club countries that you would extract an equivalent comparable net present value relief from your non-Paris Club bilaterals, and you can see the tensions that would cause.

The common framework integrates China and India and some of the other large non-Paris Club bilateral creditors into the process so that it is coordinated better than it has been in the past.

If a country is already discussing with the IMF and wishes to restructure its debt, what are the next few steps? Will it be transparent to the country as to who owns its commercial debt? How does it find out who owns the debt?

It’s often is not very transparent. The largest creditors will tend to be identifiable and they will, most likely, identify themselves. The threshold issue for a country with bilateral debt, Paris Club debt and commercial debt, is where do you start?

Do we go to Paris Club and negotiate a deal with the bilaterals? But remember that deal will come with the principle of comparable treatment; so whatever the net present value effect of that deal is on bilateral creditors, we will be under an injunction to extract that same value from the commercial creditors.

What is the sequence you will follow? The Paris Club doesn’t like to give principal haircuts to middle-income countries, it will do it only under great pressure. It needs to reduce the size of its debt stock meaning principal haircuts and it leaves the Paris Club nothing more than a maturity extension.

If a sovereign is hell-bent on not restructuring its debt although its position may appear tenuous to everybody looking at it, is it advisable that the central bank go and buy back the bonds which are now trading at a steep discount?

Typically, sovereign bonds will contain a provision that says a sovereign and the central bank can repurchase those bonds in the secondary market at whatever price it is. Sometimes there will be a limitation that such a purchase can happen only if the sovereign is not in default on the bonds. The moment you default, your ability to buy them back goes away.

But the issue will be money. Where are you going to get the money to buy the bonds other than through your reserves? You will have to run down your reserves to the point that the perception of the market is that the crisis is now unavoidable. It is possible but very often there is a practical constraint in doing that at scale.

Assume a country has bonds issued in US dollars but issued under its domestic law. The debt is held by domestic banks. Can they be kept out of the restructuring process?

This raises several issues. The first is what the Europeans call the doomed loop. What happens in a country where domestic financial institutions have bulked on their sovereign bonds in a world in which the sovereign has got to restructure those bonds in a savage way, haircuts, coupon adjustments, etc. When those bonds are heavily owned by local financial institutions, your debt restructuring will decapitate your domestic banking system.

No country can live without a domestic banking system; forcing you to take all the money you saved in debt service to recapitalise your banking system.

This is a problem that hangs over countries like Italy where the domestic banking system is heavily exposed to Italian government bonds. In a scenario where Italy had to restructure its debt, the tools that a debt restructuring could use are limited because you simply cannot decapitate your domestic banking system.

The second complication is the inter-creditor equity issue. If I am a foreign bondholder and the sovereign has issued foreign currency denominated bonds domestically; the bondholders will say that they don’t want to be asked to take on more debt relief than the sovereign is willing to impose on foreign currency bondholders within the country.

The other way a country can deal with the problem is to say debt restructuring terms will be universally applied but we recognise we may need to recapitalize some banks. Cyprus did this in 2013 and overhauled the baking system. Some banks went out of business, equity holders and others had to suffer a degree of losses.

But as a legal matter, those foreign exchange denominated but locally issued bonds governed by local law gives the government, probably, more leverage over them because they are governed by local law and if the local legislature passes a law, as the Greek parliament did in 2012, affecting local government instruments, it is likely it will be upheld in foreign courts.

There may be constitutional issues, however. Greece did it and Barbados did it, to facilitate their debt restructuring. But that is a complicated factor. My view is all those bonds get the same treatment but if that impairs the balance sheets of an individual financial institution in the debtor country that there will be some measure to recapitalize it.

RESTRUCTURINGS AND THE IMF

Is it possible to restructure debt without the IMF as one of the parties around the table?

Yes, it is possible. Belize is doing it right now and they do not have an IMF programme. There are countries and regions in which the acronym I.M.F makes people break out in hives. Part of that is history, but to bring the IMF into the process has many advantages for the debtor country.

It will get a lot of free advice and it will get some money. But there is a critical thing that the IMF brings to the process. Let’s suppose we are dealing with creditors in the form of bondholders. As a group, there may be thousands of them and they have neither the resources nor the inclination to study the country’s economy and what adjustments may be necessary for it to recover its financial footing. So when the country goes to the bondholders and asks for a 40% haircut on the principal, the bondholders have no institutionalised mechanism to vouch that it is what the country needs. As a creditor, you will always have a lurking suspicion that what the local politicians want is not necessarily what they need.

If the IMF is involved, fundamentally, every sovereign debt restructuring comes down to a burden-sharing judgement. How much of the country’s economic restructuring is to be borne by the citizens of the country in the form of fiscal adjustment, higher taxes, lower public sector workforce, stripping off subsidies etc. And how much is to be borne by the creditors in the form of debt relief. And there is almost a dollar to dollar tradeoff. Get an extra dollar of debt relief, it’s one dollar less of fiscal adjustment that a local politician will have to impose on citizens and vice versa.

So who is to make that judgement? Surely not the debtor country because politicians will favour debt relief over fiscal adjustment. Because the latter tends to have consequences in the next election. It also cannot be the creditors because they have the opposite prejudice.

 Technical capacity because they have extraordinarily talented economists who have been doing this for the last 50 years and therefore are experts in making those judgements, and political legitimacy because most countries belong to the organisation.

And by the IMF programme, implicitly the IMF is saying to the bondholders that the debt relief the sovereign seeks is both necessary to achieve sustainability and proportional to the contribution that the sovereign authorities are offering through their fiscal adjustment. That is the crucial thing that the commercial creditors will look for.

Those are the benefits of the IMF. The downsides are that they will prescribe fiscal adjustments that are politically unpopular in the debtor country and that can cause some political problems in some countries and the IMF will be the first to admit that in the past they have got this wrong. It is not a science.

How will the IMF figure out how to share the burden of restructuring?

The IMF economists will come in and sometimes say that you are carrying a gross debt stock beyond your reasonable capacity to service. Every country could repay its debt if it were prepared to take extraordinary measures. The judgement that IMF economists have to make is, what are plausible fiscal measures, measures that stop producing a revolution in the country and not damage the country’s economy permanently.

Sometimes the fund will say, it’s not the gross size of your debt stock, it is the maturity profile; you have a Himalayan spike coming up in the next two years, there is no way to pay that unless you iron it out to a sustainable debt profile. This will be a bespoke judgement on the circumstances of the country.

Do IMF programmes related to restructuring differ from the usual IMF programme? If so, how?

The IMF programmes will come in one of three types. If the IMF assesses that the debt is unsustainable, then they will ask for debt restructuring as part of the programme. If the debt is viewed as sustainable, but in effect a liquidity crisis, there may not be a request for debt restructuring but there will be other fiscal adjustment measures. And if it falls in between where the staff neither with confidence can say the debt is sustainable or unsustainable, the outcome may be a reprofiling.

Reprofiling is a species of debt restructuring. It’s the mildest one with no coupon adjustments and no principal haircuts. If the debt is deemed unsustainable, I imagine the fiscal management programme will be harsher than it would be if the assessment is worth more than a simple liquidity problem.

COLLECTIVE ACTION CLAUSES AND JURISDICTIONS

What are collective action clauses in bond agreements?

Collective action clauses are provisions in bonds that say, if a super-majority, typically 75% of the holders of that bond by value, agree to the terms of the restructuring, that decision binds any dissenting minority.

This is how corporate insolvency statutes, like Chapter 11 in the U.S. work. If you get a super-majority, often two-thirds of the creditors to agree, then it binds the entire class of creditors.

Those clauses had been used in English law bonds since the late 19thcentury but not in New York law bonds. When Argentina defaulted its debt in 2001, it had more than $80 billion of bond indebtedness and those bonds did not contain these clauses. What it meant was, there was no institutionalised or contractual method for forcing individual bondholders to go along with the deal. Stated differently there was a risk that holdout creditors, creditors who for whatever reason were unwilling to accept the deal, could decline it to pursue legal remedies, which is what exactly happened against Argentina for the next 15 years.

The response to that was to promote the use of collective action clauses in New York law and English law to emerging markets sovereign bonds and they have now become nearly ubiquitous. The latest iteration was in 2015 when a new version of a collective action clause was promulgated by the International Capital Markets Association and has now significantly caught on.

Why are international sovereign bonds issued under New York law and English law?

English law and New York law are two common jurisdictions that probably account for 90% of international sovereign bonds issued by emerging markets sovereigns.

The reason is that the investor community is familiar with the laws in those jurisdictions. Over time, the laws have evolved to strike a balance of neutrality between the interest of debtors and creditors. Both jurisdictions covet their reputation as being neutral fora in which the judiciary will not be giving an advantage, say to the home team, the creditor.

Simply, it makes the sale of bonds in their initial offering that much easier. And because they are common law jurisdictions, there is an enormous precedent for how disputes are resolved and legal advisors can tell their clients, both on the debtor and creditor side with confidence, this is how this provision of the contract would be interpreted. This, for example, is something other legal regimes might not be able to do because it’s left up to the individual judge.

CREDITORS APPROACH TO DEBT RESTRUCTURING

Do creditors form themselves into blocks or committees to face restructuring negotiations?

There is a possibility that there are fractures in the creditor universe that causes them to form multiple committees. Ecuador faced this last year where it had two committees, and one committee sued Ecuador.

There has been much sovereign debt restructuring done efficiently and fairly without the use of the committees as long as the sovereign debtor is prepared to consult with its creditor universe to get a sense of their perception of the appropriate level of debt relief that is needed.

Occasionally, counties will spurn committees and try to drive home a debt restructuring where there hasn’t been an effort to persuade the creditor community that the debt relief being requested is proportional to what is needed, and that can sometimes end badly.

When bondholders approach a discussion, do they have a yield in mind they like to achieve from a practical point of view?

Yes to a degree, the bondholders will assess the situation and they will form a collective judgement of what they call a recovery value.

So I hold a piece of paper and that is to receive $100. The country is in debt distress and that piece of paper is trading in the secondary market for $40. The bondholder will go into the debt restructuring, and says, I’m prepared to provide debt relief and hopefully the market will perceive well that debt relief, together with the fiscal adjustment that the country is undertaking with the assistance of the IMF and official sector support, that the country is getting. Those elements will improve the country’s credit position, such that, the $100 bond, while it might call for a payment of only $70 following the restructuring, will nonetheless be higher than the value in the market of $40 that I am currently holding. The valuation of the new piece of paper is called recovery value.

Exiting the debt restructuring, this is the yield, or the discount rate the market will apply in valuing the bonds. Bondholders collectively will have a view and they will reach a consensus, more or less, on what that recovery value is and the negotiation comes down to whether that recovery value expectation is consistent with what the country feels it needs by one way of debt relief. That’s the negotiation.

What are holdouts and in the current sets of negotiations around credit restructuring, how common are holdouts and how do you deal with them?

This is a perennial issue in this business. Starting in 1976, in the U.S. and two years later in England, creditors of sovereigns, for the first time, sued those sovereigns in domestic courts, the US and English courts.

A debt instrument issued in the last 45 years by a sovereign means that the holder of that instrument is theoretically entitled to decline any debt restructuring offer and if it is not paid in full and on time, to sue and to try to extract a preferential recovery at the sharp end of a lawsuit. That’s the reality.

It wasn’t a problem much in the 80s and early 90s because the commercial banks were the universe of creditors. Commercial banks either responded to peer pressure; so other bankers would say to them, you’re breaking ranks with us. And when that failed, they got a phone call from their regulators asking them to go along with the debt restructuring. But when the banks left in the late 90s and were replaced by bondholders, you’re talking about thousands of individual bondholders every one of which is holding a piece of paper that is legal, valid, binding and enforceable in a New York or English court.

Now you hear about CACs’ (collective action clauses) and that’s how CACs’ came into debt restructuring, recognizing that, by definition, the debt restructuring is about to impose a loss on them. It was in response that collective action clauses came about. There was and still is a competing theory promulgated in 2002, that what we need is a transnational sovereign bankruptcy code. We don’t have this problem in corporate debt workouts. Because insolvency codes say that if a supermajority of similarly situated creditors agreed to the restructuring, it binds everyone else.

So there was an effort to develop what the IMF called a sovereign debt restructuring mechanism, but it didn’t prosper for political reasons. The alternative was the use of collective action clauses, but they have their limitations. Determined holdout creditors can stymie the use of a collective action clause.

How do you deal with holdout creditors?

I’m going to be candid about it. It ultimately comes down to the sovereign saying to the prospective holdout creditor, if you want to, you can get a judgment. We probably can’t stop you from getting a judgement. But think carefully, because that judgment will convey to you emotional satisfaction, it will not convey a financial satisfaction, unless and until you can find some external asset of the debtor country that you can seize, and pay yourself back. However, there are very few such assets in the name of the debtor country, and what assets they do have in our embassies, consulates, and so forth, are clothed with immunity by your law, by US law, by English law and by international law. So think carefully. You can get your judgment, but then you’ll tire of searching the world trying to find an asset that you can seize to pay yourself back. And you won’t find it, so think carefully before you decide to spend all of your money on legal fees. This could end in 10 years, with you having nothing but your regrets and your legal bills. That is the sovereign’s ultimate argument.

Louis XIV used to emboss on his cannon, a Latin phrase, which translated as the ‘King’s last argument’. This is a sovereign’s last argument

There are distressed credit buyers, who do so in the hope of getting a big payoff. Are they still common?

Most of the creditors still understand the reality that if you lend money you take a risk and occasionally the risk materializes. Most institutional investors will expect a sovereign to behave maturely and responsibly and not to try to use a debt crisis as a tool for stirring up domestic political popularity. A sovereign that behaves responsibly can expect support from the vast majority of its commercial creditors.

There will be some, however, who will approach the process with malice of forethought, who will say that they don’t care about restructuring terms and they are going to try to pressure the sovereign into a preferential recovery. Collective action clauses can be extraordinarily useful in defanging creditors that have that view.

They do exist, and the long tortuous Argentine saga, which lasted 15 years between default and final settlement, attests to that. The holdout creditors who were still standing at the end of those 15 years got a very generous payout and there is a sovereign debt community for whom that memory, of what happened in Argentina, may induce holdout creditors in future debt workouts.

We don’t have a perfect solution to this problem. It is a zerosum game. If a creditor succeeds in preferential recovery from the sovereign, they are not just injuring the sovereign they are affecting all of their fellow creditors. They are depleting the pool of resources that will be used to pay those other creditors, so this is an inter-creditor equity issue as well. Emotions run very high on this subject.

ACTORS AT THE DEBT RESTRUCTURING TABLE

Who else besides the sovereign and let’s assume the IMF, will sit around the table to discuss debt restructuring?

This will depend on the geopolitical significance of the debtor country. Take a country with enormous geopolitical significance, for example, Mexico. The 2000 mile border with the United States means that Mexico is a matter of acute concern to the U.S. and always has been. Take Russia in the early or the mid-1990s.

These are countries with great geopolitical significance and therefore, their partners will be interested in what’s going on. Let’s take something more recent, Greece, in 2010. So Greece, a member of the European Monetary Union, found itself shut off from the markets and could not refinance its maturing bonds, starting in the fall of 2009 and faced the prospect, perhaps of having to leave the European monetary union.

It would be a first; it would be a crack in the Eurozone. The prospect of which was unsettling to many of the European grandees of the day. So Greece relied upon its geopolitical leverage in that context, to get support from its official sector sponsors, both bilateral and multilateral. So it will depend.

Take your country, Sri Lanka. Without a lot of geopolitical leverage, you will receive a degree of support from the IMF, and maybe from your regional development bank. But otherwise, you’re given a pat on the back and will have to go into your commercial debt negotiations and your Paris Club negotiations and do the best you can.

Is it typical to also have advisors, lawyers and bankers around the table?

Typically, the country will be encouraged by the IMF to hire both legal and financial advisors. And they will have a role in the overall transaction. The extent of that role is very much up to the country. In some instances, the country will wish its advisors to be the principal spokespeople, in conversations with creditors. In other countries, the officials themselves will want to do it and the advisors will be kept in a wholly advisory role. So that can differ.

In the 1980s and 90s, when commercial banks were the creditors, they quickly formed what they call Bank Advisory Committees. The 14 largest lenders to the country would form a committee, and that committee would purport to represent the broader banking community. They would negotiate the terms of the restructuring, and then the committee would use its influence with the banking community to try to get them to go along with it.

In the bond era, sometimes and not always, bondholders will form their own representative committees. This can be as few as three, which was the case in Belize’s pending restructuring or it can be a much larger committee. And that committee will undertake to negotiate a deal with the creditor or the debtor country.

When the deal is announced, the committee will say we support it, we encourage all the rest of you to support it. And that’s how it’s done. And those committees will typically have their own legal advisors, and sometimes their own financial advisors.

Let’s take a modern negotiating room, you would expect to see creditor representatives of the investors sitting over there bookended by legal advisors and financial advisors and you would expect to see on the debtor side of the table something similar.

Are negotiations done by proxy as far as the sovereign is concerned, as in do they have their bankers’ lawyers sit at the table? Have you found instances where central bank governors and finance ministers spoke to creditors?

Yes. And again, this will depend on the country. The creditors will at some point want to see the government authorities, they won’t listen to a group of hired advisors only. But you see, in the face to face negotiations, there is a sensitivity. You’re talking about a sovereign and a hedge fund manager who will be sitting on the other side of the table. For the hedge fund to wag his or her finger at the sovereign state is unseemly.

And so it very often happens that the hedge fund manager can wag their finger and look at the adviser, the lawyer, the financial adviser to the minister who’s sitting right next to them. They will be saying, you should be raising taxes. But he’s not saying it to the minister. And that little bit of camouflage can sometimes ensure that there isn’t any lasting damage to the relationship.

Remember, many of these institutional investors hope that they’ll be doing business in the country next year when things are better. The last thing they want is to unintentionally bruise the authorities so that they are no longer persona grata in the debtor country. One way of doing that is to direct harsh comments to the advisors as though they were intended for the ears of the advisors.

Typically how much will advisory services and legal services cost? Let’s assume it’s a sovereign with creditors totalling $35 billion, how do you price for services you require?

It’s expensive. I don’t think I can give an estimated figure. If it’s wrapped up in a year, it will be in the millions of dollars of expenses that will be incurred. Typically, a creditor committee would ask the sovereign to reimburse its legal and financial advisor expenses. So the sovereign will be paying for its own lawyers and its own financial advisor too.

So it’s expensive. And it is an inherently disagreeable process, remember what you’re doing, we’re going to perfectly sensible people and asking them to do something that no perfectly sensible person would ever do, which is to reduce or stretch out their claim against the country. It’s an inherently difficult task.

IMPACT ON PRIVATE COMPANIES

In terms of foreign trade and imports, are private sector actors likely to be affected?  

For so long as the sovereign is trapped in the debt restructuring, it is likely to make it more difficult or impossible for private enterprises to tap international markets and therefore they would also want the process to be finished as quickly as possible.

Very often when the IMF comes into a situation like this. The IMF will want to achieve things quickly. First, stimulate exports and you do that by devaluing the local currency. And to reduce imports you do that by devaluing the local currency and it will affect trade.

What rendered the Greek problem particularly difficult in 2010 was of course Greece’s belonging to the monetary union. Euro is the currency in Greece and Greece itself could not devalue the Euro and therefore that traditional technique of a currency devaluation as a means of stimulating exports and reducing imports could not be used. As a result, economists had their own euphemism, they call it the internal devaluation, meaning you have to cut pensions, public payroll and raise taxes, do all of these other things to restore competitiveness in your trade position.