This information note explains the sovereign debt restructuring process which is based on a document released by the IMF as the first comprehensive attempt to describe each step of the process.
All sovereign debt workouts are painful — for the debtor country, its citizens, its creditors and its official sector sponsors. If mishandled, a sovereign debt workout can be incandescently painful. A mangled debt restructuring can perpetuate the sense of crisis for years, sometimes even for decades. A return to normal economic activity may be delayed, credit market access frozen, trade finance unavailable, capital flight endemic, financial sector instability chronic and foreign direct investment withered. Adding to this inherent difficulty, sovereign debt crises rarely come in isolation. They are often the cause of, or are caused by, or at the very least are accompanied by, political crises, banking crises, social crises and occasionally humanitarian crises.
A sovereign debt restructuring can fail in several ways. It can take too long to execute; it may not provide sufficient debt relief; it may extract debt relief that most creditors see as excessive and confiscatory; or the creditors may view the operation as unnecessarily coercive and hold a grudge that can affect future market access for the sovereign. The history of debt restructuring is littered with examples that fail to find a reasonable balance among these considerations. Long after the memory of the financial pain inflicted on creditors in a debt restructuring has faded, the capital markets will remember whether the debt workout process was conducted efficiently and fairly. The extent of the longer-term damage to the sovereign’s credit reputation may well depend on the market’s perception of whether the country behaved maturely and professionally during the period of its debt crisis.
The negotiation process
Once a sovereign debtor concludes that restructuring is inevitable, the challenge becomes reaching a deal with creditors. This can sometimes be relatively easy if the sovereign has a simple debt profile and a relatively homogenous creditor base.
In the context of a complex debt structure and widely diverse creditors (with banks, bondholders, hedge funds, suppliers, trade creditors, contractors, etc.), however, arriving at an agreement on restructuring terms palatable to all creditors may be extraordinarily challenging.
In the context of a sovereign debt restructuring, the debt of other state-owned or state-affiliated entities may also need to be restructured, either because those credits have been explicitly guaranteed by the sovereign or because attempting to draw a distinction between the finances of the sovereign and the related entity is essentially meaningless. Treating sub-sovereign debt may also become unavoidable as a result of the negotiating process. Creditors of the sovereign may insist that lenders to state-owned enterprises bear a proportional burden of the restructuring for reasons of inter-creditor equity.
Methods and techniques
Open the toolbox of a sovereign debt restructurer and you are likely to find these tools:
- change the maturity dates for amounts of principal or interest falling due under the affected debts and introduce grace periods,
- reduce the principal amount of the debt (in the jargon, a principal “haircut”), and
- reduce the interest rate on the debt (in the case of bond indebtedness, a “coupon adjustment”)
- mix and match these techniques (this is indeed the norm in most sovereign debt restructuring packages)
For their part, creditors can be expected to express strong views about the method chosen to address a sovereign’s debt problem. Principal haircuts are particularly disfavored by commercial creditors. When the restructuring involves only a maturity extension and/or a coupon adjustment, a post-closing improvement in the sovereign’s financial prospects and credit rating will directly benefit creditors because the secondary market value of the entire principal amount of their claims against the country will increase.
Principal haircuts, however, involve a forfeiture by the creditor of portion of that claim. A subsequent improvement in the credit rating of the country can therefore lift the value of only the residual principal amount of the claim. This explains why transactions calling for principal haircuts are more likely to involve the issuance of some form of “value recovery instrument” that will permit creditors to recoup a portion of their loss if the economic fortunes of the sovereign debtor improve in the future.
One restructuring technique that has received recent attention involves a “reprofiling” of maturities (that is, a relatively short extension of the maturity dates of affected debt instruments), often with interest rates left untouched during the extension period. In 2016, the IMF endorsed the use of a reprofiling technique in situations where the Fund is providing exceptional access to its financing, and cannot determine with high
probability whether the sovereign’s debt is sustainable. The reprofiling shifts the maturities of existing debts out of the IMF’s program period, thus obviating the need to fund those maturities with official sector resources.
If a debt restructuring ends without full participation by the affected creditors, the sovereign will need to decide how it will treat the non-participants. A very small number of holdouts may allow the sovereign to pay them according to the original terms of their debt instruments. A more-thantrivial holdout population, however, probably portends a disagreeable bout of litigation with holdouts.
Full document: The Sovereign Debt Restructuring Processchapter-8-the-debt-restructuring-process