The epic battle between Argentina and a group of U.S. hedge funds illustrates a fundamental flaw in the sovereign bond market: There's no orderly, well-established way for financially troubled governments to get relief from their creditors.









United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default

After defaulting on its debt in January 2002, the Argentine government wore down its bondholders into accepting a 75 percent reduction on their claims. Among the few who refused the deal, Elliot Management Corporation aggressively pursued its legal rights for full repayment.

United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default.

While almost no one has sympathy for the rogue Argentine government, U.S. courts have been criticized for undermining global financial stability. Elliott vs Argentina may have severely narrowed the options for reducing the debt obligations of distressed sovereigns. Official international institutions will need to provide greater financial support, stretching their resources.

Criticism of U.S. courts is not warranted. They were only interpreting and enforcing a contract, not trying to promote international public policy. Sovereign debt contracts have an inherent contradiction. The contract creates a firm commitment to timely repayments but renegotiation requires that the contract not be so firm after all.

For this reason, sovereign debt restructuring has had inevitable legal and financial uncertainties, making the process messy and fractious. Policy makers have therefore been inclined to delay the default decision, as recently was the case in Greece. The delays have increased the eventual cost of the default and created huge inequity in the eventual arbitrary imposition of losses.

But all proposals for resolving the built-in conundrum of sovereign debt continue to fiddle on the margins. The latest by the International Capital Market Association (ICMA) involves writing a complex set of covenants, which will remain subject to interpretation and challenge.

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation.

The economic basis for this radical change is compelling. As many—among them Nobel Laureate, Christopher Sims—have pointed out, the phrase “sovereign debt” is a misnomer. The value of equity held in a private company falls when economic conditions deteriorate. Sovereigns need similar, contractually-transparent leeway to deal with the inevitable adversities. In such eventualities, forgiving some part of the debt makes sense even from the creditor’s perspective because that makes it more likely that the rest of the debt will be repaid. That is why bondholders eventually do renegotiate. But, because they can gain by holding out for full repayment, especially when others are likely to do so, the process is chaotic.

Here is how a more flexible sovereign debt contract may work. The debtor would have the option to defer repayment when, say, the 100-day average risk premium on its debt (the excess interest rate above US treasuries or German bunds) rises above a pre-agreed threshold. Thus repayment obligations would be automatically and predictably eased to handle contingencies, avoiding the angst associated with renegotiating the contract. Such contingent sovereign contracts (“cocos”) would be similar to those in increasing use by banks.

The built-in risk of payment standstill in the cocos would require that the sovereign debtors pay higher risk premia, which would be a prime benefit, not a flaw. The pressure would be to reduce public debt ratios and practice greater fiscal discipline. The present system generates unreasonably low premia on the sacrosanct “sovereign debt” because of the implicit but unreasonable reassurance of full repayment in those contracts. The consequence is that governments pay higher premia on their other obligations—or worse, payment obligations proliferate under the illusion of low premia, creating an unsustainable burden. When eventually all payments cannot be made, losses are imposed on such vulnerable groups as pension holders while well-heeled bondholders pay no, or a small, penalty.

The cocos would also eliminate the endemic incentives to delay restructuring. Under the current system delays occur, in part, because the threshold at which debt restructuring should occur is fuzzy. That fuzziness is compounded by prolonged and uncertain negotiations, which elevates the further risk of contagion to other sovereigns. For these reasons, international financial institutions are inclined to legitimize the delays with optimistic forecasts. The theme always is: restructuring is a good idea, but not in the midst of this crisis. The eventual restructuring imposes higher costs on all.

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor. The standstill would need to be triggered well before insolvency is imminent and, hence, the likelihood of a return to normalcy is high. Economists Charles Calomiris and Richard Herring have made a similar observation for cocos issued by banks. Thus, the process would be incremental and automatic instead of arbitrary and spasmodic.

For example if a risk premium threshold of, say, 5 percent had been in place, Ireland, Portugal, and Spain could have initiated standstills and hence required less fiscal austerity, with reduced hardship on the most vulnerable and a more rapid return to growth. Creditors would have waited but would have eventually benefited by lending to more robust debtors. The sovereigns would have paid a penalty via higher risk premia for their new borrowing and, hence, would have been subject to the more reliable market vigilance rather than being guided by the illogical and fractious centralized system based in Brussels. Perhaps, the European Central Bank’s legally and politically fragile Outright Monetary Transactions would have been unnecessary.

With cocos, it would be in the sovereign’s interest to prevent the risk premium from reaching the threshold and, once reached, to restrain from exercising the option. If the threshold is reached often and standstill triggered, the terms of future access to the market will worsen. Official financial agencies called on to help if standstills persist will also have an incentive for credible monitoring rather than indulging in serially optimistic forecasts.

Today, the elevation of the sovereign bondholder to a privileged creditor reflects a self-serving mystique fostered by financial lobbies and policy elites. As such, undoing the system will meet more than the usual resistance. However, the technical challenges of introducing sovereign cocos are no greater than that of the ICMA proposal. In fact, cocos are much simpler in design. The novelty of cocos will make the pricing initially more difficult, but will lead ultimately to greater public and private benefit.

The eurozone nations will gain much-needed flexibility in their rigid macro management apparatus by fostering a critical mass of cocos. While the existing overhang of eurozone debt cannot be so resolved, the further tendency to over accumulate debt can be curbed and a more mature future relationship with creditors can be established.

No contract is perfect. The current system, however, generates egregious outcomes

No contract is perfect. The current system, however, generates egregious outcomes. And all the so-called reform proposals retain the traditional implicit guarantees of repayment along with the contractual uncertainties and incentives to delay restructuring. In contrast, sovereign cocos would induce more realistic pricing of debt and help reduce public debt ratios. By automatically triggering a standstill, cocos would diminish the likelihood of reaching the point of no return. Paradoxically, the greater flexibility of cocos will create more predictability—and, hence, greater efficiency and equity.

Republished from Bloombergview with permission