Draft 07/07 Towards a Solution to Odious Debts and Looking at Creditors’ Incentives Stephania Bonilla1 Paper prepared for the 24th Annual Conference of the European Association of Law and Economics Copenhagen, 14-16th of September, 2007 This is a very preliminary draft, please do not quote or cite withotu permission. Comments are welcome! - Abstract - Rather than propose a solution to the problem of odious debts, this paper seeks to analyze the causes of odious incentives in international finance. It first disentagles the different incentives which guide different types of creditors to lend to sovereigns. It argues that the problem of odious debts is intrinsically political and that the non-transparent, political interests of official creditors sustain the status quo of irresponsible borrowing and lending in international finance, thereby leaving many developing countries in a trap of odious poverty. Their dependence on official creditors fosters inefficient incentives as well as leads them to lose policy capacity and autonomy. Cdious debt is most dangerous and harmful in the poorest countries who lack access to private credit and the efficient incentives that are provided by the market. Consequently, it is important to ask what is preventing many developing countries from acquiring access to private credit. This paper lays the basic groundwork for future research into the impacts of political instruments used and developed by the Paris Club in its renegotiation procedures to undermine the interests of private creditors. Specifically, two ad-hoc political instruments are looked at, one “old” and one “new.” The first is the Comparability of Treatment Clause in Paris Club Agreements. The second is the stay on creditors rights which followed the fall of the Saddam Regime and which led to the adoption of the Evian Approach by the Paris Club. It is probable that such instruments may have an effect on the dynamics of international finance and the access that different levels of developing countries have to the private market for credit. 1 PhD Candidate. Doctoral College of Law and Economics. University of Hamburg. E-mail: Stephania.Bonilla@public.uni-hamburg.de 1. Introduction If all parties in international finance were motivated by profit maximization, odious debt may not have resurfaced time and again as a popular subject of debate in mainstream and academia. The problem of looting of international funds is in large part due to the inefficient incentives fostered in international finance. Globalization has led to an increase in the number of parties engaged in international financial transactions as a result of increased technology, better communication and lower transaction costs. As more diverse parties come into play, these have different incentives which may be conflicting. The composition of developing countries’ debt has consequently become more complex as have international debt restructurings. This paper seeks to emphasize the diverging incentives that different types of creditors have at the time they make loans to sovereigns and at the time they renegotiate these loans in the face of default by the sovereign debtor. Disentangling the different interests of creditors serves two purposes. First, it allows for the root of the odious debt problem to surface, namely the intrinsically political environment which governs official lending to developing countries. Second, it raises the question, “What is preventing developing countries frought with odious debt to gain access to the private market for credit?” In attempting to lay the groundwork to answer this question, this paper looks at the potential role of political instruments developed by the Paris Club which, in effect, undermine private creditors rights during renegotiations of sovereign debt. Specifically, two ad-hoc political instruments are looked at, one “old” and one “new.” The first is the Comparability of Treatment Clause in Paris Club Agreements. The second is the stay on creditors rights which followed the fall of the Saddam Regimes and which led to the adoption of the Evian Approach by the Paris Club. It is probable that such instruments may have an effect on the dynamics of international finance and the access that different levels of developing countries have to the private market for credit. The paper is divided as follows: Following the introduction, Section 2 provides an overview of the changes in international finance as a result of globalization and describes the present picture. Section 3 discusses the different incentives that guide different creditors to lend to sovereigns. Section 4 argues that it is the intrinsically political nature that envelops official lending to developing countries which is the root of the odious debt problem. It draws some insights from Austrian economics while arguing that if all creditors were motivated by transparent incentives such as profit maximization, the dynamics of international finance would be more efficient and predictable and less corrupt. Section 5 discusses some of the complexities in international debt restructuring and looks at the potential impacts of instruments which coerce private creditors into restructuring. The section will look at the Comparability Clause in Paris Club agreements as well as the stay on creditors rights which ensued the fall of the Saddam regime in Iraq and which led to the adoption of the Evian Approach by the Paris Club. In Section 6 some conclusions will be drawn. 2. The Effects of Globalization on International Finance Several developments help explain the evolution of international financial markets. These include technology, deregulation, securitization and disintermediation.2 All of these have reduced the costs of international business transactions which has led to the emergence of both new market actors and an expanded range of financial instruments. Globalization has had a two fold effect on the developing world: on the one hand, there is an expansion in the number of actors that are interested in providing funds to developing countries. On the other hand, it has further stratified developing countries into two categories with very different access to international funds. a. New players Until recently, private credit to developing countries was predominantly in the form of syndicated bank loans. Today, the role of banks as a potential source of funds has become relatively smaller as a result of disintermediation and the rise of new actors.3 These new actors include mutual funds, unit trusts, insurance companies, pension funds and individuals. The regulations governing the activities of these new actors are more restrictive than those that are applicable to commercial banks.4 For example, insurance and pension funds may be restricted to extending credit to investment grade borrowers.5 This means that they have a lower tolerance for risk in their borrower countries and are more likely to change their minds and to take their resources out of the country than is likely to be the case with commercial banks.6 This makes funds from these new players more volatile and harder to manage. Another reason why these new private creditors are selective about who the lend to as opposed to during the 1970s, for example, is that due to deregulation in many developing countries, creditors had a wider choice of countries where to invest their capital. Transaction costs lowered, information flows were improved and this decreased the need for the middle man, the bank, thereby increasing the number of parties in international finance. b. Effects on developing countries Some developing countries have been able to get access to the increasing number of players and types of private creditors. UNITAR estimates that about 20 developing and transition economies are able to benefit from increased opportunities in financial markets. On the other hand, the poorest, less creditworthy, borrowers have not only been excluded from these new developments, but have become 2 UNITAR (2006) « Negotiations of Financial Transactions » Lesson 1 at 8. 3 To illustrate, bank lending fell from $30.7 billion in 1996 to 1.8 billion in 2005. Conversely, bond financing was 49.5 billion in 1996 and increased to an estimated $63 billion in 2004. 4 UNITAR. (2006) « Negotiations of Financial Transactions » Lesson 1, at12. 5 For information on ratings systems which determine which borrowers are considered “investment grade” see http://www.standardandpoors.com/ratings/sovereigns; http://www.bradynet.com/e870.html, http://www.moodys.com/moodys/cust/loadBusLine.asp?busLine=sovereign; http://www.fitchibca.com/corporate/sector.cfm?sector_flag=5&marketsector=1 6 UNITAR, « Negotiations of Financial Transactions » Lesson 1 at 12. even more dependant on a few official creditors than before. About 100 developing countries fit into this category according to UNITAR.7 There are two reinforcing effects which widen the gap between middle and low income economies. One is the greater options available to emerging markets which LDCs do not benefit from. The other is the effects of increased dependency on a few official creditors for their funds. This second effect could, in turn, be a consequence of official creditors being more selective as their choice increases becuase more and more countries require official funding. Furthermore, there is the question of whether their leverage with regards to their debtor countries has increased and given way for greater power which the can extert in the form of stricter conditionalities and policy influence. The result is a greater stratification between middle and low income countries with drastically different access to international funds. 3. Different Creditors: Different Incentives Are there better sources of funds for developing countries? Is all type of debt the same? Why has the increase in gap between rich and poor, both within and between countries been in part due to differential access to different types of credit? In a recent paper, Gelpern addressed the fact that the single term “sovereign debt” is misleading as it groups together very different transactions in the context of international finance.8 She explains that in form, “debt” can be both official and private and the two categories are similar in that there is a promise to repay. In substance, however, they are quite far apart from each other.9 Different types of creditors have very different incentives and expectations when they lend to sovereigns and consequently foster different types of incentives in the countries who borrow from them. This section will give an overview of the main differences between private and public creditors and thereby illustrate the significance of having differential access to different types of credit. Private creditors are primarily interested in profit maximization. They obtain signals from the market as to pricing and assessing risk. Their lending behaviour is guided by the available information in the market as well as their own judgments about a country’s probability of paying back debt. If all parties were motivated by pure profit maximization, the market for international lending would be much more transparent and predicatble. However, not all creditors are motivated by direct economic gain through arm’s length transactions. It is difficult to make a generalization about the large range of interests which guide official creditors to lend to sovereigns. It is more accurate to say that their interests lie on a spectrum and are often intertwined. . Gelpern argues that official debt lies somewhere between sovereign debt and foreign aid.10 It is not exactly debt, because repayment is not always the primary motivation behind the loans. While they are usually targeted at the poorest of countries with no tax base or savings, official creditors do 7 UNITAR, Lesson 1, at 14 8 See Gelpern, A. (forthcoming 2007) „Odious, Not Debt.” J.of Law and Contemp. Probs. Available at www.ssrn.com 9 Anna Gelpern. „Odious, Not Debt” at 3-4 10 Anna Gelpern. “Odious, Not Debt” at 18 not lend to them for pure benevolent reasons. Their interests are large and complex, but for the most part they are in it for indirect self interest in the form of a large range of policy interest through policy influence and control. Accordingly, while private creditors to risky countries like to get in, make money and get out, official creditors usually have long term relations with the debtor and in some cases their loans are a means to support the current regime in the debtor country. a. Enforcement There has been much analysis regarding what sustains the current equilibrium between creditors and debtors in international finance. The economics of sovereign debt builds on the following axiom: Unless default imposes costs on the debtor, not only will the debtor not pay the debt, the lender will not make the loan in the first place.11 Accordingly, economists have suggested two explanations to sovereign debt; the reputation theory and the enforcement theory. The reputation theory reflects the dominant view that the primary cost of default to the sovereign is exclusion from future borrowing.12 The theory is based on the assumption that national economies are cyclical and that people prefer to consume evenly across the cycles. Countries then decide to borrow on the downward cycle to fund consumption and repay the loans with returns generated on the upward cycle.13 If a country defaults on its debt during its upward cycle, it will come at a cost of being shut out of the credit markets and associated consumption constraints on the next downward cycle.14 Therefore, only countries that never want to borrow again will default under this theory. The enforcement theory, in turn, argues that even if a sovereign still needs a future source of finance it might still rationally repudiate its debts.15 The model looks at the choices a sovereign has at the end of an upward cycle, after having incurred debt in its previous downward cycle. It can either pay the debt, or it can default and invest the capital. If an investment opportunity is available, it would prove rational for the sovereign to default and obtain the higher return available from saving and investing than that which is available from borrowing and repaying.16 The intuition behind this theory is that sovereign debt cannot be sustained on reputational enforcement alone. Bulow and Rogoff develop this argument and provide a model in which they show that it is not the threat of exclusion from financial markets, but the creditor’s ability to seize a debtor’s foreign assets in case of non repayment, which sustains creditor-debtor relations.17 They do admit that the ability of creditors to seize foreign assets is limited and that sovereigns in default do not leave any obvious assets around for creditors to grab. However, they argue that the exercise of international creditor evasion 11 See Bratton, W. William and Gulati, G. Mitu. “Sovereign Debt Reform and the Best Interests of Creditors.” (2003) (hereinafter Bratton and Gulati, “Sovereign Debt Reform and the Best Interests of Creditors”) 12 Bratton,and Gulati. “Sovereign Debt Reform and the Best Interest of Creditors” at 14 13 Id. 14 Id. 15 Id. at 15 16 Id. 17 Bulow, J.. and Rogoff, K. “Sovereign Debt: Is to Forgive to Forget?” 79 Amer. Econ. Rev. 43 (1989) See also Bulow, J. and Rogoff K. “A Constant Recontracting Model Model of Sovereign Debt” 97 J. of Pol. Econ. (1989) carries indirect costs. Even if these are small in relation to GNP, are still large enough compared to the defaulted interest and consequently render repudiation undesirable.18 The evidence behind both theories suggests that both have a place in the dynamics of sovereign creditor-debtor relations. By and large however, these theories fit the dynamics of private sovereign debt relations. The dynamics are based on the assumption that creditors want to get repaid and that debtors value their access to the private international market and therefore the costs of default for the sovereign are greater than the benefits and this allows the lender to make loans in the first place. While this theoretical framework captures the dynamics of private lending, it fails to apply uniformly to the mechanism behind official lending. As discussed above, official sovereign creditor-debtor relations are not based on the primary interest of profit maximization and getting repaid. When a debtor country refuses to pay, an official creditor has several options. When choosing an enforcement or retaliation mechanism, however, rather than choosing on the basis of which option will maximize probability of repayment, the choice is often done taking first and foremost into account pubic choice considerations. As Gelpern points out, in the face of default by a debtor, official creditors may choose to lend the country its next coupon to avoid the domestic implications of of default for both governments.19 Finally, another important difference is worth mentioning regarding the role of conditionality in sovereign debt contracts. For profit maximizing credtors, the conditionalities in the loan are one way to deal with the principal agent problem inherent in creditor debtor relations and help secure the repayment of the loan. For official creditors interested in policy influence, the conditionalities in the contract are often the purpose of the loan. b. Reputation While official and private sovereign debt are grouped together a “debt” despite the different character of transactions, it seems generally accepted that in practice, each type of debt has separate reputations in international finance. Some scholars argue that arrears to official creditors do not have much impact on a country’s reputation with private creditors.20 The case of Nigeria, among other countries who were in arrears for years and maintained access to private credit seem to support these claims.21 The fact that debtor counties not paying back their official debt does not affect their reputation makes sense. This is because, as Guzman explains, a country does not suffer a bad reputation from not fulfilling a promise that all parties in international finance know is know supposed to be fulfilled.22 So, if it is widely known, that official creditors lend to poor countries with the primary interest being something other than getting paid back, a debtor’s country arrears to official creditors should not affect how private creditors view its reputation for paying back private debt. 18 Explanation of Bulow and Rogoff’s model in Bratton and Gulati, “Sovereign Debt Reform and the Best Interest of Creditors” at 16. 19 Anna Gelpern. « Odious, Not Debt » at 15 20 See Gelpern, ….Lex Rieffel Nigeria’s Paris Club Debt Problems explained in p. 16 21 Id at 16 22 See Andrew T. Guzman, How International Law Works. forthcoming However, it may still be the case that private creditors incentives to invest in certain developing countries may be affected by development in the official debt arena. This paper raises questions concerning how international debt retructuring instruments developed by the official sector bail in private creditors to coordinate sovereign debt in accordance with official creditors. In effect, such instruments undermine private creditors rights, and may potentially facilitate exit and crowd out private credit. Yet, research in this area has been limited. This paper is an initial attempt to address the possible consequeces ad hoc geopoloitical instruments developed by the official sector namely through the Paris Club can have in the dynamics of international finance. Accordingly, the paper will consider whether the composition of a country’s deb can provide signals to the market about its probability of paying back private debt. 4. Relevance to Odious Debt / Political Economy of Odious Debt Disentangling different types of debts allows the odious debt debate to focus on the problem more specifically. In accordance with the different incentives of official and private creditors outlined above, this section will argue that odiousness in the context of debt is more prone in a political context than in a market context. Insights wil be drawn from political economy and Austrian economics to explain why the dynamics of official debt not only create the environment for odious debt, but maintains the status quo of illegitimate borrowing and lending, stagnating many developing countries in a situation of odious poverty. a. The Odious Debt Literature Odious debt is an obligation incurred in the name of a sovereign nation by a despotic or illegitimate government, the proceeds of which only enrich the despot, or fund the repression of his subjects.23 Some governments take up these types of debts, only to leave it to the people and the successor government to repay them once they are out of office or overturned. The concept of odious debts dates back to the writings of Aristotle24 and was revived and formalized by Alexander Nahum Sack in an early 20th Century doctrine.25 Although its impact has been negligible, the doctrine and the problem of odious debt have sparked ongoing interest in academia and debt restructuring debates. Since its resurgence, the debate over odious debts has been subject to a lot of academic attention and analysis. The literature on the subject is ever increasing. Harvard economists Jayachandran and Kremer were the first to introduce the notion of odious debts to international financial institutions at an IMF Conference.26 Since then, they have argued for various proposals to tackle the problem, including 23 Feibelman, A, "Contract, Priority and Odious Debt” (Forthcoming Duke L. & Contemp. Probs. 2007) at 2 24 See Cheng, Tai-Heng. "Renegotiating the Odious Debt Doctrine” (Forthcoming Duke L. & Contemp. Probs. 2007) 25 Sack, A. 26 Jayachandran, S. and Kremer, M. “Odious Debt” Finance and Development (June 2002) the idea of having “loan sanctions” similar to trade sanctions applied to egreriously odious governments.27 Other scholars have concentrated on the institutional component of dealing with odious debts and proposed having an international judiciary or a body such as the United Nations Security Council to handle cases of odious use of international funds28. More recently this year, a new flow of literature has emerged as a result of two academic conferences held on the topic in the United States.29 Trends in the literature have evolved as quckly as the debate has become increasingly popular. While initially it was the moral dimension of the problem which attracted the most attention, today it seems that the concern lies more in the ties between odiousness and development. Secondly, the focus was concentrated at first on the debtor countries who incurred this type of debt while today the literature analyzes the active role that creditors play in the problem of odious debt. The new trend is moving in the direction of assessing the specific role of official debt and the intrinsically political dimension of the problem. Two recent articles are in the latter category30 and thîs paper is in line with the latest trend. b. The Political Context The Austrian school of economics emphasizes the importance of understanding the roles that active intentionality, subjectivism and competition play in discovering information in the market context.31 The market economy is condusive to entrepreneurial process which reveals information such as unexploited profit opportunities. In the political context, information is also produced, but only that which is relevant to political actors.32 As Boettke et al. point out, “...knowledge generated in the political context may enable individuals to survive in the competitive environment of politics, but it does not lead them to exploit the opportunities for gains from economically beneficial trades and eradicate economic inefficiencies.”33 They go on to explain how the political process generates incentives which are completely different from what is exhibited in the competitive market process.34 In contrast to the market environment which prods one to continually pursue new gains from trade, the political context lacks the feedback opportunities existent in the market and does not require one to continually learn about the best opportunities available.35 27 See Jayachandran, S. and Kremer, M. “Odious Debt” American Economic Review 96 (March 2006) and Jayachandran, S., Kremer, M. and Shafter, J. “Applying the Odious Debt Doctrine While Preserving Legitimate Lending.” Ethics and International Affairs (June 2006) 28 See for example: Hanlon, J. “Lenders not Borrowers are Responsible for Illegitimate Loans.” Third World Quarterly 27 (2006), See also Khalfan, A. King, J. and Thomas, B. “Advancing the Odious Debt Doctrine” Centre for International Sustainable Development Law, McGill University (2003). 29 Conference on State Corruption and Odious Debt held at Duke University Feb. 2007. See papers published in forthcoming 2007 issue of Journal of Contemporary Legal Problems and Colloqium on Odious Debt at the University of Chapel Hill, NC Feb. 2007 See papers published 30 Weissman and Gelpern !!!! 31 Richard M. Ebeling. Austrian Economics and the Political Economy of Freedom (2003) 32 Peter J. Boettke, Christopher J. Coyne and Peter T. Leeson. “Saving Government Failure from Itself: Recasting Political Economy from an Austrian Perspective” 33 Boettke, Coyne and Leeson, “Saving Government Failure from Itself: Recasting Political Economy from an Austrian Perspective.” at 8 34 Id. at 24 35 Id. at 25 c. Implications The political arena is, of course, not completely separate from the market. It often intereferes with market conditions. In the context of international credit, historically, governments have consitently hampered with the market incentives of banks when extending loans. In a recent paper, Pérez and Weissman draw attention to the relationship between finance capital in service of national interests and as an instrument of U.S. foreign policy.36 This analysis suggests that international credit, whether from private or public creditors, is a means of political control. The authors argue that this control is often to the detriment of internal interests of other countries.37 The harm associated with odious debt is therefore a function of the relationship between on the one hand, national interests and public policy and on the other, corporate influence and private gain. The changing nature of private creditors and an increasing secondary market for debt may have implications for the relationship between politics and international finance. On the one hand, it is more difficult for the government to have an influential relationship and to dictate the terms of thousands of individual bondholders dispersed around the globe. Also, the existence of an active and liquid bond market has the potential to reveal information necessary to tackle odious debts. Ben-Shahar and Gulati argue that if the market is active and recognizes that certain types of debts are less likely to be repaid because there was corruption involved or the population did not benefit from the debt, then the market will incorporate that information into the price.38 If odious debts are paid back less often, this could affect the threat of liability for the underwriter and consequently this will affect disclosure. Of course, this still leaves behind those developing countries with a debt composed largely of official credit. It is in these countries where the problem of odious debts proves most harmful and irrevocable and where politics are the most entrenched in the functionings of finance. While on the aggregate international finance is moving in the right direction, developing world stagnates and in an environment which is hostile to transition and where politics override efficiency and incentives are indirect and non transparent. 5. Old and New Instruments in International Debt Restructuring If it is the official and political dimension of public debt which fosters odiousness, what are some of the political instruments used by developed countries? This final section is a preliminary attempt to take a closer look at the impact of ad hoc political tools developed by official creditors in the Paris Club. Specifically, this section will address one “old” and one “new” tool, the Comparability Clause in Paris Club Agreements and the recent Evian Approach respectively. a. The Principle of Comparability of Treatment in Paris Club Agreements 36 Pérez , Louis A. and Weissman, Deborah M. “Public Power and Private Purpose: Odious Debt and the Political Economy of Hegemony” 37 Pérez et al. “Public Power and Private Purpose: Odious Debt and the Political Economy of Hegemony.” at 11 38 Ben-Shahar and Gulati. “Partially Odious Debts? A Framework for an Optimal Liability Regime.”at 33 The Paris Club Agreed Minutes include a clause of “comparability of treatment” (hereinafter; the Clause) which aims to ensure a balanced treatment among all external creditors of the debtor country.39According to this clause, the debtor commits itself to seek from its non Paris Club creditors a rescheduling which is comparable from that negotiated with its Paris Club creditors in its Agreed Minutes. These non-Paris Club creditors are official bilateral creditors which are not members of the Paris Club and private creditors, namely banks, bondholders and suppliers. The purpose of this principle is to ensure that the debt relief provided by the Paris Club membership does not accrue to the debtor’s other creditors and that all creditors share proportionately in the burden of helping the debtor resolve its payment problems.40 If the debtor fails to obtain comparable treatment from non Paris Club creditors, it risks losing its renegotiation agreement with the Paris Club. There are no specific guidelines to determine “comparable” treatment, rather the Paris Club creditors have traditionally taken a broad approach in applying the principle. They look at a range of factors inlcuding the types of creditor, the changes in nominal debt service, the net present value of the debt and the terms of the restructured debt in determining whether the treatment provided by the non- Paris Club creditors is comparable to that offered by the Paris Club creditors.41 The comparability is not so much in the form of the restructuring but rather the effective relief provided in cash flow and present value terms, as well as the maturities of the restructured claims as meausred by duration.42 Intuitively, comparability is easier to determine the more similar the types of loans are between creditors. Non-Paris Club official creditors generally make the same type of medium-long term loans that the Paris club creditors provide. Experience is that non-Paris Club official bilateral creditors often restructure on terms very similar to those agreed by the Paris Club. Conversely, it is more difficult to make a direct comparison between the loans and terms extended by private creditors which may differ substantially. This procedure is further complicated given the fact that private creditors have many more 39 See http://www.clubdeparis.org/en/presentation/presentation.php?BATCH=B01WP06 40 Multilateral lending insitutions such as the International Monetary Fund (IMF) and the World Bank are granted preferential status and are excluded from this clause. Historically the Paris Club has accepted that the debtor should continue to meet its obligations to these multilateral creditors in a timely manner and before servicing other creditors’ claims. One of the reasons for this is that both the debtor and the Paris Club creditors are members of these institutions and therefore both benefit from this excemption. All of the official creditors members of the Paris Club, despite the differences in terms and purposes of the loans they make, are expected to contribute on a comparable basis to the debt relief offered to the debtor. All credits extended prior to a specific date should be rescheduled with the same grace and repayment periods. What may differ is the interest rates that the creditors charge on this rescheduled debt within certain parameters. For example, there is a genereal understanding that concessional credits will remain concessional and that penalty rates may be charged on non performing debts. See Alexis Rieffel, The Role of the Paris Club in Managing Debt Problems at 12, Essays in International Finance, Princeton University (No 161 1985) 41 Paris Club website 42 See IMF, „Involving the Private Sector in the Resolution of Financial Crises – The Treatment of the Claims of Private Sector and Paris Club Creditors – Preliminary Considerations“ 2001. Duration provides a discounted weighted average maturity of paymntes falling due on a debt instrument. It is, in effect, the average maturity of the present value of the payment stream. different options to deal with a defaulting debtor besides restructuring than do Paris Club creditors. These include voluntary market based operations designed to reprofile debt service obligations.43 b. Economic Rationale: problems in international debt restructuring There are a number of rationales which justify instruments such as the Clause to intervene in the restructurings of international debt. Information assymetries, coordination problems and complex bargaining dynamics can be effective barriers to restructurings. Coercive instruments to lower the transaction costs of concluding an agreement may be warranted. First, upon default of a sovereign debtor, creditors face a collective action problem. An individual creditor prefers to hold out while the other creditors restructure. All creditors face this same incentive and restructuring is not possible. Although the transaction may make the group as a whole better off, opportunistic creditors have an incentives to hold out and free ride on the restructuring efforts of other creditors.44 While official creditors are willling to provide exceptional financing to support members’ adjustment efforts, they are not willing to provide new financing in a fashion that allows other creditor groups to unwind their exposure. This is intended to protect official bilateral creditors’ interests. Furthermore, it is unlikely that practices that lead to costs of resolving crises being borne disproportionately by taxpayers would be politically tenable. Another problem is that of moral hazard for non-Paris Club creditors, particularly private creditors. There is a concern that a willingness by the official community to extend exceptional financing on a scale that would, in effect, shelter private creditors from market risk and give private creditors a free pass on contributing to the resolution of crises could give rise to moral hazard. This could, in turn, increase the severity and frequency of of future crises. On the one hand, market failures such as collective action problems and moral hazard justify the intervention of coordinating instruments like the Clause. On the other hand, this section explores the trade offs of such instruments, in particular looking at the impact of coercive bail ins for private creditors incentives to lend to low income developing countries. c. Literature: The Clause has not attracted much attention by academics. This may be due to the fact that the countries who have their debt rescheduled by the Paris Club have a predominantly homogenous composition of debt from official creditors. They are mostly in the category of Least Developed Countries 43 IMF. “Involving the Private Sector in the Resolution of Financial Crises-The Treatment of the Claims of Private Sector and Paris Club Creditors-Preliminary Considerations” (2001) at 5 44 As a response to this problem, two proposals came to light and were highly debated in the debt restructuring literature; namely a top-down international bankruptcy style approach in the form of a Sovereign Debt Restructuring Mechnanism (SDRM) and a bottom-up market based approach in the form of Collective Action Clauses (CAC). Ultimately, the CACs have gained broader support. They were pioneered by Mexico in 2003 and have since become standard in emerging market sovereign bonds. While CACs are developing to coordinate the millions of sovereign debt bondholders dispersed around the globe, the problem remains for countries with a heterogeneous composition of external debt. (LDCs). This lowers the role and significance of the Clause. Secondly, until relatively recently, private debt was in the form of syndicated bank loans. Therefore, the Clause did not play a significant role even for countries with a more diverse composition of debt because banks typically negotiate restructurings via the London Club on similar terms than those agreed to by the Paris Club as they have similar structures.45 Today, given the more heterogeneous debt composition of countries and the increased types of private creditors, the Clause has the potential to play a more relevant role in the dynamics of international finance. Also, it is important to ask whether such a Clause may already play an idirect role in crowding out private credit to poor countries. Furthermore, the Paris Club has increasingly become more flexible in its agreements with LDCs and this may also make the Clause increasingly problematic.46 In face of the uncertainty regarding the Clause and after some recent cases where comparable treatment required private creditors to restructure their claims47 there is a demand by private creditors to have more predictable guidelines as to how and when the Clause will be applied. Some IMF papers have made several proposals48 but until now the definition is still broad and its application vague and ad-hoc in nature. While there is a broad literature which analyzes what catalyzes private flows to developing countries, by and large none addresses the potential role of coercive private creditor bail ins such as the Clause specifically. A recent paper by van der Veer and Jong discusses whether Paris Club involvement helps or harms attempts by the IMF to catalyze private capital flows.49 One interesting finding in their study shows that the decision of a debtor country to demand comparable treatment of its private debt is determined by the relative size of Paris Club and private debt.50 The larger the size of Paris Club debt, the greater a country’s incentive to abide by the Clause. They propose two reasons for this. First, when the leverage of the Paris Club is greater if its exposure in the debtor country relative to that of private creditors is large. Secondly, once private creditors have assets in the debtors country they have the choice of either leaving, agreeing to the comparable treatment or waiting it out. Their best option is to agree to comparable treatment since the Paris Club tends to forgive a big percentage of LDCs debt and this improves the economic condition of the country and increases the probability of paying back the remaining debt.51 On the other hand, countries with a lower Paris Club exposure tend to be middle incoe countries. The Paris Club usually does not forgive the debt of middle income countries but rather reschedules it. This changes the payoffs for the private creditors who may choose to exit rather than 45 IMF.”Involving the Private Sector in the Resolution of Financial Crises-The Treatment of the Claims of Private Sector and Paris Club Creditors.” (2006) at 10. 46 The Paris Club is more lenient with regards to repayment periods and than it was at its early agreements. Repayment terms did not use to exceed ten years including a grace period, whereas now they can be as much as 23 years for loans made on commercial terms and 40 years for credits on concessional terms. There is also an increased willingness to cancel debt rather than merely extend the repayment periods. See The Paris Club at: 47 These included Pakistan, Indonesia and Kenya. 48 See for example, IMF. “Involving the Private Sector in the Resolution of Financial Crises-The Treatment of the Claims of Private Sector and Paris Club Creditors-Preliminary Considerations” (2001) 49 Koen van der Veer and Eelke de Jong. “Paris Club Involvement: Helping or harming IMF’s attempts to catalyze private capital flows?” (2006) Radboud University Njimegen. Available at www.ssrn.com 50 See Veer and Jong. “Paris Club Involvement: Helping or harming IMF’s attempts to catalyze private capital flows?” (2006) at 14. http://www.clubdeparis.org/en 51 van der Veer and Eelke de Jong. “Paris Club Involvement : Helping or accept comparable terms. This is because rescheduling does not improve the long run situation of the country or its capability of paying back debt in the future.52 The rest of this section will attempt to provide the grounwork for developing some of the above results provided by van der Veer and Eelke. While they looked at the decision of creditors once they are in the renegotiation situation, they do not address the ex ante incentives that different renegotiation prospects have on creditors. d. When is the Clause problematic? i. Interests once debtor is in situation of “imminent default” The interests of official and private creditors are not only different at the time they issue a loan to a sovereign, but also at the time of renegotiation in the face of a debtor in “imminent default.”53 At this point, the primary concern of private creditors, such as bonholders, is in the secondary market value of their claims.54 Bondholders are now required to value their portfolios in line with prices prevailing in the secondary market. This forces them to recognize any losses in the secondary market value of their claims, and provides incentives to participate in operations that offer the prospect of immediate capital gains. Conversely, official creditors are more concerned with the face value of their claims and with the debtor’s debt service profile.55 The different interests affect the payoffs at the negotiation table and in turn the terms each are willing to accept. Official creditors prefer flow reschedulings of the debt while different types of market based exchange offers are popular with private bondholders. Another factor is that of the role of uncertainty. Private creditors want to minimize uncertainty ex-ante and prefer clear guidelines in order to efficiently price and assess risk. They would prefer a clear and predictable definition of when, if and how the Clause would play a role in negotiations. Paris Club creditors want to minimize disruption of financial markets but want to retain a certain degree of flexibility with regards to the interpretation of comparability and apply it ad hoc to the different situations that different debtor countries may find themselves in. ii. Potential effects and implications If we argue in line with van der Veer et al. that debtor countries abide by the Clause when the composition of their debt is largely from Paris Club creditors, this limits the potential cases when the Clause can come into effect during renegotiations. One case where the Clause does not play a role during renegotiations is of a typical low income country with no access to private credit and dependent on official 52 Id. 53 A debtor country must be in situation of “imminent default” to obtain a Paris Club agreement. This means that the creditor countries will not renegotiate debt unless there is evidence that the debtor country will default on its external payments in the absence of such action. See The Paris Club at: http://www.clubdeparis.org/en/ 54 IMF. „Involving the Private Sector in the Resolution of Financial Crises- The Treatment of the Claims of Private Sector and Paris Club Creditors.”(2001) at 12. 55 Id. At 14 loans. Further research can address whether the Clause may play a role in sustaining the situation of lack of access to private credit. Private creditors may not be able to know how the Clause will be interpreted in renegotiations, but they can predict whether a debtor will likely seek comparable treatment from its non Paris Club creditors. If, for whatever reason, private creditors decided to lend to an LDC, they know that because of that country’s debt composition, if it comes to a renegotiation situation they will have to accept comparable terms. Not only this, but because the Paris Club gives preferential status to multilateral financial institutions, such as the IMF, this means that private creditors claims will face high risk of default. The debtor country, in turn, has no incentive to want to give private creditors repayment priority in the rare case that they decide to extend a loan to it. This is because, given its dependency on official credit it cannot afford to do so. Consequently, LDCs are left in a vicious trap and are unable to gain access to the private market. A different case is that of lower or upper middle income countries who may have different ratios of private and official debt. Unlike an LDC, a middle income country, because it has access to private credit, still retains some degree of policy capacity. Even if it doesn’t, a middle income country with access to the market may regain policy autonomy and policy capacity by repaying official creditors under favourable market conditions. Poor countries that depend on official creditors rarely have this option. In essence, middle income countries, through their choices of debt composition, may be sending signals to private creditors about the probability that they will abide by the Clause in the event of the need for renegotiation. Therefore, countries with policy independence may decide to accept a higher degree of private credit, even if on less favourable terms that official credit in order not to send the wrong signals to the market. Furthermore, in the event thata a middle income country does decide to abide by the Clause, van der Veer et al. show that the private creditors will find it most beneficial to exit rather than reschedule. What they call the “retaliation effect” is indeed the private creditors punishing the debtor.56 This is a credible threat for a middle income country which can risk losing its access to the private market. Poorer countries are less affected by this threat because their access to the market is very little anyways and they would lose more if they lost access to official credit. This threat of punishment by private creditors also induces efficient incentives for the government regimes of middle income countries as they can assess the consequences of losing both policy autonomy and access to the market. LDCs, on the other hand, have for the most part already lost policy capacity and their debt composition forces them to place less weight on access to private credit. e. Evian Approach and Stay on Creditors’ Rights While the Clause is a relatively “old” instrument, the Paris Club has recently adopted the Evian Approach (hereinafter; the Approach) which is a “new” ad hoc mechanism which it may use in its renegotiations with debtor countries. Essentially, what the approach does is introduce a new strategy for 56 Koen van der Veer and Eelke de Jong. “Paris Club Involvement: Helping or hurting IMF’s attempts to catalyze private capital flows?” (2006) at 28. determining Paris Club debt relief levels that is more flexible and can provide debt cancellation to a greater number of countries that was available under prior Paris Club rules.57 While debt forgiveness was traditionally only granted by the Paris Club to the poorest countries on the basis of economic arguments58, the Approach now allows for debt forgiveness for those countries that do not qualify as LDCs on an ad- hoc, case by case basis.59 The events that led to the Approach began with the ouster of Saddam Hussein after which the international community began the process of helping Iraq rebuild its economy. Because of its substantial oil reserves, Iraq is considered a middle income country and not an LDC. Iraq would likely be able to service its existing debts once its petroleum industry was functioning. Therefore, many analysts argued that Iraq should not be eligible for complete cancellation of its debts but rather should have its debts rescheduled.60 Others were concerned that if Iraq’s future oil revenues were used to fund repayment of old debts, not enough would remain to fund its current and future economic needs.61 One of the first major developments following the end of the Saddam regime was a Resolution by the United Nations Security Council to grant a stay on the enforcement of any debt claims.62 In effect, this Resolution prohibits any country from initiatiing debt claims against the proceeds of Iraq’s petroleum or gas industries until December 31, 2007. Discussion of cancelling Iraq’s debt ensued soon after the stay was granted on claims of Iraq’s assets. Weiss explains that the Bush Administration led the negotiation of a consensus which agreed to grant Iraq debt relief on terms that were unique for its economic resources, but not unprecedented given the political situation.63 As a result of the strong support for Iraq debt relief by the Bush Administration, the Paris Club decided to reshape its approach to debt relief and thus came the Approach developed in the 2003 Evian G8 Summit.64 The debt relief provided to Iraq by its official creditors (which was of 80%), in line with the comparability treatment in the Clause, set the stage for the terms of the renegotiations between Iraq and its non Paris Club official creditors and private creditors.65 d. Comparing the Clause to the Approach The Clause has mainly affected the renegotiations of poor and lower middle income developing countries. The Approach, on the other hand, seems to be designed to be applicable to those middle income countries whose debt composition is more complex and where the Clause is unsuccessful in forcing private creditors to agree to comparable treatment. Like the Clause, the Approach is politics intervening in the market dynamics of international finance and undermining the incentives and interests of private creditors. Like in the case of the Clause 57 See Martin A. Weiss. “Iraq’s Debt Relief: Procedure and Potential Implications for International Debt Relief.” (2006) 58 The HIPC Initiative 59 Martin A. Weiss at 7. 60 Id. 61 Id. 62 U. N. Security Council Resolution (UNSCR) Number 1493, U.N. Doc.S/RES/1493, Section 22, May 22, 2003 63 Martin A. Weiss. „Iraq’s Debt Relief: Procedure and Potential Implications for International Debt Relief” (2006) at 6 64 Id.at 7 65 See Id. For details of the extent and composition of Iraq’s debt relief by its different types of creditors. where no clear guidelines have been developed as to its use and definition, the international community seems to accept some degree of uncertainty in exchange for greater flexibility in applying these instruments in an ad hoc manner, in line with whatever the political interests of the major developed countries are at the time. This is further stressed by the fact that such a standstill on creditors rights was attempted by the IMF when dealing with the debt of some Latin American countries in economic crisis, but it was ultimately rejected.66 It appears that after Iraq, however, such a mechanism is feasible if its is introduced in a political context such as the United Nations rather than economic/financial one like the IMF, and that it is an ad-hoc process, not attached to any formal mechanis, for debt resolution.67 What is shocking is that the stay on Iraq’s creditor rights happened rather innocously without much commotion or response by academia. 6. Conclusions Rather than propose a solution to the problem of odious debts, this paper seeked to analyze the causes of odious incentives in international finance. It first disentagled the different incentives which guide different types of creditors to lend to sovereigns. It argued that the problem of odious debts is intrinsically political and that the non-transparent, political interests of official creditors sustain the status quo of irresponsible borrowing and lending in international finance, thereby leaving many developing countries in a trap of odious poverty. Their dependence on official creditors fosters inefficient incentives as well as leads them to lose policy capacity and autonomy. The paper lays the basic groundwork for future research into the impacts of political instruments used and developed by the Paris Club in its renegotiation procedures to undermine the interests of private creditors. It is probable that such instruments may have an effect on the dynamics of international finance and the access that different levels of developing countries have to the private market for credit. 66 Id. At 11. 67 Anna Gelpern. “What Iraq and Argentina Might Learn From Each Other.” (2005) References Bratton, William W. and Mitu G. Gulati. 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