Jay Newman was a senior portfolio manager at Elliott Management and is the author of the financial thriller lower money. Matthew D McGill is a partner at international law firm Gibson, Dunn & Crutcher, which specializes in claims against sovereign governments
In the documentary film Waiting for Supermaneducator Geoffrey Canada describes his heartbreak when, as a fourth-grader living in a New York ghetto, he realized that Superman wasn’t real – that no one would come to rescue him. He should save himself.
Sovereign debt investors should learn from Canada’s revelation. If – as widely predicted – Sri Lanka’s recent default heralds a wave of debt and restructuring in emerging markets, creditors are in for some serious shocks.
Unlike previous debt crises, this two poses major new challenges.
First, the terms of most government bond contracts have deteriorated so drastically over the past 20 years that the bonds have become functionally unenforceable. Among other challenges, creditors will face the prospect of working through a jumble of onerous class action clauses that allow debtors to manipulate restructuring negotiations.
But even more threatening to recovery values is the fact that this will be the first debt crisis in which China holds the whip. Since 2014, Chinese institutions have become a major lender and investors in more than 130 countries through the mercantilist One Belt One Road (OBOR) initiative. Those bills are coming in now.
Despite the recent breathless announcement that China will work with the G-20 and the IMF to restructure Zambia’s debt, there is no objective indication of China’s true intentions for Zambia, let alone elsewhere. Historically, China has been secretive about the scope and terms of its dealings with countries that owe the money. It is imperative that OBOR transactions are fully and transparently part of restructuring – and that Chinese interests are explicitly supported – to protect the interests of everyone else.
Unsurprisingly, debtors will seek very high levels of forgiveness to reduce their debt service obligations to sustainable levels. It’s one thing to cancel principal, cut coupons, and extend maturities in the name of debt sustainability. But it is quite another to remain fatalistic about contractual terms that fail to ensure that restructured debts are actually paid in accordance with their terms.
The example is Argentina. In 2020, Argentina’s creditors were asked to – and they did – also accept infallible contract terms, even though they offered significant debt forgiveness. Now, less than two years later, Argentina has not implemented the structural economic reforms necessary to manage even this recently reduced debt – let alone $40 billion it owes the IMF. As Argentina passes its third economy minister in one month, bond prices imply that another international debt default – Argentina’s ninth – is on the horizon.
What can be done?
When creditors begin to seriously negotiate sustainable restructuring that will avoid the economic and social trauma of endless cycles of default and lawsuits, it’s time to push for contractual terms that are fundamentally different from what we have now. It’s time to push for enforceable instruments: a Superbond.
A strong bond contract — one that offers creditors a wide range of legal protections and overcomes many of the vagaries of current enforcement efforts — would make future restructuring significantly less likely and would structurally lower the cost of capital for sovereign borrowers. Borrowers who recognize that the playing field has been leveled to provide effective remedies to lenders can think long and hard about taking on more debt than they can comfortably repay and could make the difficult political choices to ensure their debts are repaid in a timely manner and be sustainable. And precisely because a Superbond is more likely to be repaid than inferior contracts, a Superbond would trade better on the secondary market.
So, what are the critical elements of a Superbond? In many cases restoring the contracts to a status quo ante.
In the days of syndicated bank lending to governments, banks pushed for full tax transparency and conventional credit agreements, such as debt repayment ratios and total debt limits. Today’s bondholders would need nothing less. Two other covenants are vital because OBOR loans threaten to subordinate other lenders involuntarily.
A strong pari passu clause — stipulating that payment obligations under restructured bonds will not be legally or practically subordinated to other debt obligations — is essential to ensure that the restructured bonds are not treated less favorably than debts owed to Chinese lenders and investors. The other is a robust negative collateral clause that prohibits debtor countries and their instruments from pledging sovereign assets as collateral or a source of repayment to certain beneficiary lenders. This is what happened in 2017 when Sri Lanka became forced to the port of Hambantota. to give up to Chinese interests. And it just might happen on a larger scale like Pakistan hands Gilgit-Baltistan over to China to settle his debts. When private creditors are asked to restructure claims against Sri Lanka, Pakistan, Lebanon, Zambia or other countries, they need a Superbond to avoid being involuntarily subordinated to Chinese interests.
Enforcement of these covenants requires transparency and information rights. But, as will soon be shown in the Zambian case, the IMF and the G-20 intend to dictate terms to private lenders: to present them with a fait accompli rather than seat them at the table. This kind of backroom dealmaking reflects one of the most disturbing aspects of OBOR. China has insisted on strict confidentiality of its loan terms, leaving other creditors in the dark about the debtor’s true financial condition. Even now, the Sri Lankan government cannot say for sure how much of its $51 billion debt owes to China.
A Superbond, on the other hand, would require debtors to fully meet all their debt obligations and involve the private sector in the whole process – no exceptions. This is the only way to get a country’s tax house in order.
Finally, there must be means to enforce these tightened covenants and the underlying payment obligations in court. Bondholders’ rights to enforce their contracts have been steadily eroded in recent government bond contracts. Not anymore. Bondholders’ right to sue directly should be restored; bondholders should not be limited to trading through an indenture trustee.
Indeed, under a Superbond, breach of key covenants could be dealt with independently, even before a payment arrears. The Superbond would have a comprehensive waiver of sovereign immunity with respect to the sovereign and all his instruments. The sovereign would further agree never to assert such immunity in respect of his debts and perhaps bolster that promise with a suretyship equal to, say, 10 percent of the principal. A bond could support the payment of damages if the sovereign breaches its “will not assert” obligations in bad faith. And because a sovereign’s assets can generally only be seized if they are used for commercial activity, the Superbond requires sovereigns to determine that property located outside the state is by definition commercial unless it is solely for diplomatic or diplomatic use. used for military purposes. Last but not least, a debtor’s central bank must guarantee government debt and waive immunity for both jurisdiction and assets anywhere in the world — including the funds held by the Bank for International Settlements and the New York Federal Reserve. .
Residents of the sovereign debt ecosystem – lawyers, G7 bureaucrats, experts, IFIs – will find these ideas anathema. But here’s the problem: either you want a contract to be enforceable or you don’t. In the first case, default should lead to liability – not easy exits, fraudulent use of proceeds, or optional compliance with covenants.
Of course, there is one huge practical barrier to creating a Superbond: the inability of the creditor class to unite around these ideas—and to exercise the only undeniable power they have left: collective action.
Sovereign debt investors have the power to turn a vicious circle of borrowing, defaulting and restructuring into a virtuous one. The 50-year experiment with hard currency loans in the private sector to low-income countries has failed. As the number of defaults mounts, Churchill’s warning comes to mind: a good crisis should never be lost. In the coming crisis, creditors could fundamentally change the relationship between the private sector, sovereign borrowers, the official sector, the IFIs – and even help unwitting borrowers find a way out of OBOR’s mercantilist debt trap. If only creditors could find the collective will.