M. Chamberlin

Precipitated in 1982 during a period of high global interest rates and low commodity prices, the debt crisis seemed in 1989 to be intractable. Prior debt strategies averted a potential global financial collapse but still left debtor countries with unsustainable debt levels and ravaged economies. In Latin America, which largely lost access to voluntary capital market flows, the 1980s became known as the ‘lost decade’.

The debt crisis spawned a small cottage industry of secondary market trading activity in distressed loans. Only a small amount of debt actually changed hands or was extinguished, but it seemed a lot more interesting and productive than debt rescheduling.

Aimed at restoring debtor country access to the voluntary capital markets, the Brady Plan was simple in concept but difficult to execute. The Mexican Brady exchange took nearly a year to develop and complete. Others soon followed, but the process of completing them lasted through most of the 1990’s.

Measured against its immediate objectives, the Brady Plan was remarkably successful. By the mid-1990s, more than 20 debtor countries had implemented Brady-style debt exchanges, and more than $170 billion of Brady bonds had been issued. Most Brady countries quickly regained access to the primary capital markets.

Secondary market trading activity increased exponentially, from about $65 billion in 1989 to more than $2.7 trillion in 1995. Emerging-markets finance and trading became a big global business.

As a result, sovereign debt and its attendant risk were diversified throughout the global financial community as higher yields attracted new investor classes. Trade between developed nations and emerging market countries expanded, direct foreign investment increased, and in some cases, sweeping political and economic reforms took place.

However, the Brady Plan did not purport to ensure that all debtor countries would evolve in the same way or at the same speed, or that all would go smoothly. Mexico’s devaluation created ripple effects throughout the emerging markets, which stabilized only after the US government led a massive rescue package in early 1995.

Investor confidence rebounded as reforms in key countries continued and the remaining debt reschedulings, notably Ecuador, Peru and Russia advanced. By 1997, both the emerging market investor base and asset class had broadened considerably, and substantial capital flows were restored to many countries.

Secondary market activity reached nearly $6 trillion in 1997. Trading in Brady bonds, the most liquid emerging market debt instrument, expanded to about $2.5 trillion.

But great expectations for uninterrupted market growth and prosperity were dashed after the Asian financial crisis spread to Russia in 1998. Ecuador’s failure to pay interest on its Brady bonds in 1999, the first such default on any true Brady bond, upset investors in what was, for the most part, a successful year of recovery for major debtor countries in Latin America. Secondary market activity fell to $4.2 trillion in 1998, and appeared to decline further in 1999.

The Burden-Sharing Debate
Since 1995, G-7 policymakers have signaled the need for greater private sector participation in resolving emerging market financial crises.

These signals became increasingly apparent in 1998 and 1999 in what was widely perceived as official efforts in Russia, Pakistan, Romania and finally Ecuador to avoid ‘bailing out’ private-sector investors. These efforts have attracted considerable discussion over the need for a new financial architecture.

In the debate, the governments have argued that such bail-outs create the moral hazard that investors will invest imprudently. In particular, officials made various proposals for making emerging market bonds more easily restructurable.

Private-sector advocates counter that while burden-sharing is acceptable in principle, ‘bailing in’ investors by means of sovereign bond reschedulings ultimately drives investors away from the emerging markets, depriving countries of stable capital. The real hazard, they argue, is that by making bonds more restructurable, debtor countries will be tempted to restructure them.

Despite the remarkable progress made by many emerging-market countries in the 1990s, a string of financial crises show that investor confidence remains fragile in all but the strongest of them. A contributing factor to the risk of contagion is the growing perception among market participants that governments’ concerns about burden-sharing reflect a reduced commitment, and perhaps capacity, to take measures promoting financial stability in the emerging markets.

The Role of Market Discipline
Because the burden-sharing debate has been raised in somewhat theoretical terms, some attention may have been distracted from the more practical problems of preventing and resolving financial crises in the emerging markets, now that capital markets (and particularly the bond markets) have replaced commercial banks as the main source of external financing for many countries. While they provide a stable source of medium- and long-term funding for countries that retain investor confidence, bond markets are more sensitive than commercial banks to changing perceptions of creditworthiness, making bonds more expensive and difficult to refinance.

Structural characteristics of bonds, such as unanimous voting requirements and individual bondholder rights of enforcement, and differing investor objectives, make bonds more difficult to restructure. Various countries and their bondholders began to confront these difficulties in 1999.

However, the sensitivity of bond markets and the difficulty of restructuring bonds are not necessarily the evils that they are sometimes portrayed to be. Bondholders justifiably react to the economic policies and political events that affect a debtor country. By investing, they acquire a stake in the country’s prospects that entitles them to respond to changing perceptions in those prospects.

Just as the Brady Plan contemplated that debt reduction and structural reforms would be rewarded with access to the voluntary capital markets, it is natural for market reaction to influence governmental policies. Without this discipline, it is difficult to envision how the Brady Plan could ensure that structural reforms and sound economic policies in the emerging markets will be lasting. Greater awareness of these market forces may tend to lessen the dependence of some debtor countries on shorter-term sources of capital and encourage them and others to firmly stay the course in pursuing market-oriented policies.

To allow the bond markets to perform their role of providing capital and market discipline most efficiently, restructuring bonds should be difficult. If not, debtor countries may be too easily tempted to treat debt restructuring as an acceptable alternative to debt payment. Countries that are not committed to honoring their debts are likely to lose access to capital markets and depend increasingly on government support.

When Crisis Strikes
There is little apparent appetite among debtor countries or bondholders for lengthy negotiations with, or for imposing representative duties on bondholders. Although it is too early to predict whether any single model will predominate, it seems clear that more complex financial crises may require more formal negotiations to resolve the choices that debtor and creditors will need to make.

Mechanisms and procedures adopted earlier may or may not be appropriate in today’s environment, but many of the same issues and functions still need to be dealt with. Basic functions, such as gathering investor input, preparing economic and financial analyses, coordinating with the official sector, communicating information and final proposals to the market and marketing the final transaction, will need to be performed. These issues are likely to be resolved on a case-by-case basis.

The greater diversity of bondholder views and objectives are likely to make consensus more difficult to reach. Accordingly, some debtor countries and their bondholders have suggested looking to corporate debt work-outs for principles to guide sovereign debt restructurings, which are not subject to the jurisdiction of any established bankruptcy regime.

These ideas are not not new. Such proposals were previously never supported by debtor countries, their creditors or governments perhaps because they seemed impractical or politically unfeasible. Certainly, that is true for proposals to establish a formal global bankruptcy tribunal.

Applying corporate principles has considerable merit. They could bring greater order and certainty to the resolution of financial crises in the emerging markets. After all, principles such as standstills interim financing, fair treatment of creditors of the same class, transparent reporting and decision-making, were developed and have been successfully applied in many corporate debt restructurings. Resolving present and future sovereign crises in the uncertain bond environment may be unworkable without such guiding principles.

The greatest barrier to their successful application to sovereign crises is deciding which ones to apply and how to apply them in the absence of a binding tribunal. Applying them may require more subjective judgments than sovereigns and creditors, including official-sector creditors, are capable of reaching voluntarily. Nevertheless, it may be useful to develop a set of principles in a forum where debtors, their private sector creditors and the official sector are all represented.

Or it may be more consistent with practical realities that such principles be developed and applied on a case-by-case basis.

Private and Official Sector Roles
Ultimately, it will be necessary for each debtor country to assume greater responsibility for its growth and development by further developing its own internal capital markets and attracting greater foreign direct investment. If the private sector capital markets are to be the primary source of funds to finance growth and development until this can occur, it is the supporting role of the official sector to encourage continued structural adjustment, sound economic policies and the construction of stronger regulatory and market infrastructure.

Policy-makers can also promote realistic market expectations by working toward greater transparency. They should also be ready to show leadership at critical time to help restore market confidence and catalyze the flow of capital from the private sector.

Michael M. Chamberlin is executive director at the Emerging Markets Traders Association (EMTA), but the views expressed herein are his own and not those of EMTA or its members.