A Study On Foreign Debt Reduction Options For Heavily Indebted Development Countries

A STUDY ON FOREIGN DEBT
REDUCTION OPTIONS FOR HEAVILY

INDEBTED DEVELOPING COUNTRIES
Joseph Lim, Ph.D.
March 2006
DISCLAIMER
“The views expressed in this report are strictly those of the authors and do not necessarily reflect those of
the United States Agency for International Development (USAID) and the Ateneo de Manila University”.
Abstract
This paper focuses on the need for a new international financial architecture that will
benefit countries at risk of facing debt and financial crises. This is triggered by the fear
that the Philippines may enter an Argentine-type crisis caused by its fiscal problems.
The paper shows clearly that a bankruptcy mechanism similar to those that protect
individuals, corporations and municipalities is not available for heavily indebted
sovereign countries. This makes them bear most of the risks and burden when their debt
conditions are adversely affected by volatile and exogenous shocks.
A Study on Debt Restructuring and Debt Reduction for Heavily Indebted
Developing Countries During Periods of Financial Crises
Executive Summary
This paper focuses on the need for a new international financial architecture that will
benefit countries at risk of facing debt and financial crises. This is triggered by the
fear that the Philippines may enter an Argentine-type crisis caused by its fiscal
problems.
sovereign countries. This makes them bear most of the risks and burden when their
debt conditions are adversely affected by volatile and exogenous shocks. In the end,
it is the poor and vulnerable population of the countries that suffer most. The
volatilities and vulnerabilities of countries to exogenous shocks and contagion had
increased substantially with the open capital account markets that allow ‘hot’ and
quick money to enter and exit the countries easily.
Thus another aspect of the international financial architecture should be a country’s

right to limit and control short-term capital flows into and out of the country.
Furthermore, in times of financial and debt crises, emergency funding is vital for the
countries. These financing sources should not exert undue contractionary and
stringent conditionalities on the indebted countries inasmuch as during crises of
confidence, countercyclical policies and social spending for the vulnerable are vital
elements to resuscitate and heal the economy.
Inasmuch as the current international financial system is not yet conducive to the
aforementioned needs of indebted countries, it is recommended that the following
policies be implemented by the Philippines:
1. Rely less on deficits and debt to finance vital government expenditures. This
requires improvements in the tax collection system. It is the belief of the author
that a permanent improvement in the tax collection system should go over and
beyond the currently heavy reliance on the new expanded value-added taxation to
generate new revenues. In the end, direct and progressive taxation of income and
wealth should be the main source of tax revenues as it is in most of the successful
economies in the world. Progressive taxation of real property, for example,
provides a big source of additional revenues that has remained untapped.
2. In line with no. 1, the government should set a public debt ceiling and debt
service ceiling to lessen the reliance on debt financing of vital expenditures. The
technical nature of this debt ceiling requires another paper and should be based
on new concepts of debt sustainability which incorporates the social and
economic financing needs of the country.
3. Rely more on domestic debt rather than on foreign debt. This is not simply
because domestic debt is not exposed to dangerous foreign exchange risks. The
lesson of South Korea showed that a sovereign government can effect a more
successful debt workout mechanism during debt and financial crises the bigger
the share of domestic creditors in the economy’s debt. This is because foreign
creditors are not subject to any debt workout or international bankruptcy
proceedings, and are not under the jurisdiction of the sovereign government.
This is even wiser for the Philippines now inasmuch as the yields of domestic
treasury bills had gone down significantly as to match the interest charges of
foreign debts.
4. Institute market-based taxes on short-term capital flows so that there will be

higher tax rates (and possibly higher required reserves) the shorter the term of the
financial investment. (This is the well-known Chilean tax).
5. Participate and perhaps even initiate united stands and policy advocacies with
other Third World debtor countries and to call for the institution of the key
elements for a new international financial architecture. The most promising
avenue for this would be the United Nations. Kofee Annan had tasked the UN
Department of Economic and Social Affairs (DESA) as the leading body to take
over the task of designing debt workout and debt restructuring mechanisms after
the IMF SDRM proposal was shot down by the US.
A Study on Debt Restructuring and Debt Reduction for Heavily Indebted
Developing Countries During Periods of Financial Crises
1. Objectives of the Study
The objectives of this study are:
1. To provide civil society organizations a clearer understanding of the foreign

debt situation of the Philippines, especially in the light of the current fiscal
problems of the country.
2. To describe the various debt arbitration and negotiation options for
developing countries allowed by the international financial system during
times of balance of payment and debt crises.
3. To discuss the inadequacies of the international financial architecture in
addressing the needs of developing countries during debt and financial crises.
4. To document and analyze other debt reduction possibilities within and outside
the perimeters allowed by the international financial system.
5. To draw out lessons and policies that the Philippines can undertake on its own
and in conjunction with other developing countries.
2. Background and Rationale
2.1 The Current Fiscal Problems of the Philippines
Almost all countries adversely affected by the 1997 Asian financial crisis reduced
their debt burden from the peak values reached in 1997 and 1998. Only the
Philippines entered a fiscal crisis as fiscal positions deteriorated instead of improved
as economic growth turned positive after the crisis. Table 1 shows the deterioration
of the national government deficit from 1.9% of GDP in 1998 (and this was a surplus
from 1994 to 1997) to 5.3% of GDP in 2002. Both the public sector borrowing
requirements and consolidated public sector deficit – which, apart from the national
government deficit, includes the deficits of government corporations -- increased also
alarmingly to dangerous levels. Public sector borrowing requirements increased from
4.2% of GDP in 1998 to 6.8% of GDP in 2002.
Although there were improvements in the deficits from 2002 to 2005, the current
situation is still significantly worse than in 1998. Furthermore, the fiscal position has
not really improved for the Filipino people. First, the main causes of the fiscal
problems, at least by 2005, had not been sufficiently addressed. The losses of
government corporations continue, and Table 1 shows that the government revenue
and tax collection, as % of GDP, continued to deteriorate from 2002 to 2004, and
only marginally improved in 2005. Table 1 shows that the deficit was reduced,
especially in 2004 to 2005, mainly through expenditure constriction. Total
expenditure fell from a constant 19% or so from 1998 to 2003 to 17.5% in 2005.
Table 1: Public Finance and Fiscal Indicators: 1998 - 2005
Item 1998 1999 2000 2001 2002 2003 2004 2005
A. National Government (NG)

r
Revenues, of which: (P Billion) 462.5 478.5 514.8 563.7 567.1 626.6 699.8 795.7
r
(as % of GDP) 17.4 16.1 15.3 15.5 14.3 14.6 14.5 14.8
Tax 416.6 431.7 460.0 489.9 496.4 537.4 598.0 684.4
r
(as % of GDP) 15.6 14.5 13.7 13.5 12.5 12.5 12.4 12.7
r
Non-Tax 45.9 46.8 54.7 73.9 70.8 89.3 101.8 111.3
(as % of GDP) 1.7 1.6 1.6 2.0 1.8 2.1 2.1 2.1
r
Expenditures, of which: (PB) 512.5 590.2 649.0 710.8 777.9 826.5 886.8 942.2
(as % of GDP) 19.2 19.8 19.3 19.6 19.6 19.3 18.4 17.5
Non-Interest 412.7 483.9 508.1 535.9 592.0 600.1 625.9 642.4
(as % of GDP) 15.5 16.3 15.1 14.8 14.9 14.0 13.0 11.9
(as % of Expenditures) 80.5 82.0 78.3 75.4 76.1 72.6 70.6 68.2
Interest 99.8 106.3 140.9 174.8 185.9 226.4 260.9 299.8
(as % of GDP) 3.7 3.6 4.2 4.8 4.7 5.3 5.4 5.6
(as % of Expenditures) 19.5 18.0 21.7 24.6 23.9 27.4 29.4 31.8
r
Surplus/Deficit(-) (P B) -50.0 -111.7 -134.2 -147.0 -210.7 -199.9 -187.1 -146.5
(as % of GDP) -1.9 -3.8 -4.0 -4.0 -5.3 -4.7 -3.9 -2.7
(as % of revenues) -10.8 -23.3 -26.1 -26.1 -37.2 -31.9 -26.7 -18.4
-
B. Public Sector Borrowing Requirement (PB) 111.3 -138.0 -174.6 -189.8 -268.3 -275.0 -280.8
r
(as % of GDP) -4.2 -4.6 -5.2 -5.2 -6.8 -6.4 -5.8
C. Consolidated Public Sector Financial Position

(PB) -83.2 -102.1 -155.1 -174.3 -220.2 -221.7 -232.0
r
(as % of GDP) -3.1 -3.4 -4.6 -4.8 -5.6 -5.2 -4.8
Source: Bangko Sentral ng Pilipinas.

But the level of expenditure constriction is worse than what the above figures imply.
Table 1 also shows that, interest payments for debt since 2000 comprised a bigger
and bigger percentage of GDP and of the national government expenditure. The
share of interest payment increased from 19.5% of national government expenditures
to almost a third of the total expenditures. This means that expenditure constriction
is even more severe starting in 2003 to 2005 due to the encroachment of interest
payments in government expenditures.
Table 2 shows this expenditure constriction in more detail. Expenditures (as

percentage to GDP) of all categories of economic and social services, as well as
defense and public sector services declined across the board since 2000. Similar to
Table 1 1 , the biggest declines for the non-interest payment items were in 2004 and
2005. The above translates to greater constraints to building infrastructure, providing
basic social and economic services, and general public safety and administration of
governance. If government revenues do not significantly improve starting 2006, it is
expected that further expenditure constriction will continue and may be more and
more inimical to economic growth and provision of welfare to the populace. Thus it
is imperative that government revenues improve. Significant reduction in the debt
burden (as shown in the interest payment for debts discussed above) will also
contribute to reducing the constraints to vital public spending for the country.
2.2 From Fiscal Deficits to Public Debt and Debt Servicing Problems
The increase in total public sector deficits had increased the size and burden of public
sector debt, particularly for the national government. Table 3 gives us the levels of
national government and public sector debts, and their percentages to GDP. One can
see that the national government debt had continuously increased from 56.1% of
GDP in 1998 to 79% of GDP in 2004.
The total public sector debt, which zoomed to 110% of GDP in 1998 (after the
massive currency depreciation) remained at the same level in 2004 because of the
high fiscal deficits.
But the biggest indicator that the fiscal problem is really severe is the national
government debt service payments as a proportion of national government revenues,
shown also in Table 3. Principal and interest debt payments of the national
government comprised 35.6% of national government revenues in 1998. This
increased tremendously and is now 85.3% of national government revenues in 2005.
This means that 85.3% of national government revenue is eaten up by debt payments
alone. This leaves less than 15% of the revenues to fund vital spending of the
government. The rest will have to be financed by new debts. The results of this are a
continuing rise in public debt and a continuing expenditure constriction happening at
the same time. Again the only solutions are significant increases in government
revenues and significant reduction in the debt burden.
1
The exact totals of Tables 1 and 2 do not match perfectly but follow mainly the same basic trends.
Table 2: National Government Expenditures by Services, as % of GDP
PARTICULARS 1997 1998 2000 2001 2002 2003 2004 2005

(Prelim)
ECONOMIC SERVICES 5.43 4.86 4.98 3.89 3.82 3.96 3.49 2.94
Agriculture, Agrarian Reform, 0.00
and Natural Resources 1.69 1.18 1.04 0.77 0.88 0.92 0.72 0.61
Trade and Industry 0.20 0.13 0.14 0.08 0.10 0.06 0.07 0.06
Tourism 0.04 0.05 0.05 0.03 0.03 0.03 0.03 0.03
Power and Energy 0.07 0.07 0.04 0.04 0.04 0.03 0.04 0.03
Water Resource Development
and Flood Control 0.27 0.13 0.14 0.11 0.16 0.16 0.16 0.12
Communications, Roads, and Other
Transportation 2.00 2.18 2.25 1.46 1.36 1.56 1.38 1.00
Other Economic Services 0.14 0.11 0.13 0.23 0.07 0.04 0.06 0.11
Subsidy to Local Government Units 1.02 1.01 1.19 1.17 1.19 1.15 1.02 0.99
SOCIAL SERVICES 6.55 6.57 6.35 5.98 5.81 5.53 5.18 4.73
Education, Culture, and Manpower
Development 3.91 4.01 3.48 3.35 3.16 3.00 2.67 2.52
Health 0.58 0.51 0.44 0.38 0.37 0.29 0.30 0.24
Social Security and Labor Welfare 0.83 0.85 0.79 0.76 0.92 0.91 0.93 0.75
Housing and Community Development 0.00 0.00 0.11 0.11 0.02 0.07 0.03 0.03
Land Distribution (CARP) 0.10 0.10 0.25 0.07 0.07 0.02 0.15 0.08
Other Social Services 0.03 0.03 0.03 0.07 0.02 0.02 0.02 0.07
Subsidy to Local Government Units 1.08 1.07 1.26 1.24 1.25 1.22 1.08 1.04
ECONOMIC & SOCIAL SERVICES 11.98 11.43 11.33 9.87 9.63 9.49 8.67 7.66
DEFENSE 1.20 1.18 1.08 0.90 0.98 1.04 0.88 0.82
GENERAL PUBLIC SERVICES 3.81 3.80 3.65 3.30 3.35 3.29 2.89 2.64
TOTAL EXPENDITURES EXCL.

NET LENDING & INTEREST 17.00 16.41 16.06 14.08 13.96 13.82 12.44 11.12
NET LENDING 0.06 0.01 0.08 0.19 0.07 0.13 0.12 0.13
INTEREST PAYMENTS 3.21 3.74 4.20 5.00 4.69 5.27 5.41 5.57
TOTAL 20.27 20.17 20.34 19.27 18.72 19.22 17.96 16.82
Source: Department of Budget and Management (DBM).

Table 3: Public Debt Indicators: 1998 - 2005
Item 1998 1999 2000 2001 2002 2003 2004 2005
Total Outstanding Debt of the

National Government (P B) 1496.2 1775.4 2166.7 2384.9 2815.5 3355.1 3812.0
r
(as % of GDP) 56.1 59.6 64.6 65.7 71.0 78.2 79.0
Domestic Debt (P B) 850.9 978.4 1068.2 1247.7 1471.2 1703.8 2001.2
r
(as % of GDP) 31.9 32.9 31.8 34.4 37.1 39.7 41.5
Foreign Debt (P B) 645.3 797.0 1098.5 1137.2 1344.3 1651.3 1810.7
r
(as % of GDP) 24.2 26.8 32.7 31.3 33.9 38.5 37.5
Sep
p
Total Public Sector Debt 2951.5 3020.2 3623.8 3850.2 4369.1 5074.0 5297.6
r
(as % of GDP) 110.7 101.5 108.0 106.0 110.2 118.2 109.8
p
Domestic (P B) 1721.2 976.5 1076.5 1187.1 1361.8 1531.1 1708.7
r
(as % of GDP) 64.6 32.8 32.1 32.7 34.4 35.7 35.4
p
Foreign (P B) 1230.3 2043.7 2547.3 2663.0 3007.3 3543.0 3588.9
r
(as % of GDP) 46.2 68.7 75.9 73.3 75.9 82.5 74.4
NG Debt Service Payments (P B) 164.5 205.4 227.8 274.4 358.0 470.0 601.7 678.9
(as % of revenues) 35.6 42.9 44.3 48.7 63.1 75.0 86.0 85.3
Interest 99.8 106.3 140.9 174.8 185.9 226.4 260.9 299.8
(as % of revenues) 21.6 22.2 27.4 31.0 32.8 36.1 37.3 37.7
Principal 64.7 99.1 86.9 99.6 172.1 243.6 340.8 379.1
(as % of revenues) 14.0 20.7 16.9 17.7 30.3 38.9 48.7 47.6
Source: Bangko Sentral ng Pilipinas
3. The Philippine’s Risk of Entering a Debt or Financial Crisis
Fig. 1 shows us that the national government deficit as a percentage of GDP is, in
2003 (when the fiscal crisis started yielding credit downgrades), higher than the
national government deficit in 1982, 1990 and 1996, critical years prior to either a
financial crisis or recession. The disturbing thing is that the deficit in 2003 exceeds
slightly the one in 1982, the year prior to the start of the harshest economic collapse
of the country, which entailed a debt default and moratorium. This deficit, as we saw
earlier, improved in 2004 and 2005
Fig. 1: National Government Deficit, % GDP
1.00
0.29
0.00
Philippines1982 Philippines1990 Philippines1996 Philippines2003
-1.00
Percent
-2.00 Series1
-3.00
-3.45
-4.00
-4.54
-4.70
-5.00
Fig. 2 shows also that the external debt to GDP ratio is also alarming. In 2003, the
external debt to GDP ratio also exceeded all the years identified as years prior to a
major crisis or recession. This ratio improved to less than 70% in 2004, but is still in
the danger zone compared with our crisis years.
Fig. 2: External Debt to GDP Ratio
80.00
72.47
70.58
70.00
63.92
60.00
50.00 48.14
Percent
40.00
30.00
20.00
10.00
0.00
Fig 3 compares the external debt ratio of the Philippines in 2003 to other countries
the year prior to their financial crises. The more than 70% external debt to GDP ratio
was higher than the ratio attained by Argentina, Turkey and Thailand before their
very severe and major financial crises.
Fig. 3: Debt to GDP Ratio
250.00
206.06
200.00
150.00
P e rc e n t
105.16
100.00
72.47
63.47 62.67
50.86
50.00
0.00
Philippines2003 Argentina 2001 Turkey 2000 Thailand 1996 Korea 1996 Indonesia 1996
Is the Philippines then about to become another Argentina and enter a debt crisis if it
does not fix its fiscal house? To answer this, let us review the Argentine crisis and
the recent Asian crisis.
Recent financial crises had involved in chronological sequence:
- Initial overvalued currency
- High exposure to short-term external debts
- Large portfolio flows
- Speculative bubbles
- Sudden loss in confidence / exogenous shocks
- Speculative attacks and massive currency devaluations
- Capital flight
- Loss of international reserves
- Increases in interest rates to stave off currency depreciation
- Deterioration of financial balance sheets
- Private (bank, corporate and GOCC) debt defaults
- Assumption of private and GOCC debts by national government
- :Possible public debt default (such as Argentina in 2001, Philippines and

Latin American countries in 1982-83)
Fortunately, the Philippines government deficit and debt ratios, though historically
high, do not have many of the above features such as a pre-crisis overvalued
currency 2 and high exposure to short term external debts.
Fig. 4 shows that the ratio of short term debt to international reserves of the
Philippines in 2003 was way below that of in previous critical years immediately
followed by financial or economic crises.
Fig. 4: Short Term Debt To International Reserves
1,400.00
1,279.66
1,200.00
1,000.00
800.00
P e rc e n t
600.00
400.00
338.51
200.00
86.96
45.25
0.00
Fig. 5 again shows that the Philippines’ ratio of short term debt to international
reserves in 2003 was way below that of Argentina, Turkey, Thailand, South Korea
and Indonesia in the years prior to a major financial crisis.
Fig. 6 gives us the debt service to exports ratio for the Philippines in 2003, compared
to critical years prior to a major financial and economic crisis.
Here, the picture is more disturbing. Although the debt service ratio is far from the
very high debt service ratio in 1982, it is almost as high as in 1990, and much higher
than in 1996.
2
The appreciation of the peso from P56 to P51 between December 2005 to March 2006 may have
disturbed many exporters, but was accompanied by similar appreciations in other competitor countries
such as Thailand, Indonesia, India.
Fig. 5: Short Term Debt to International Reserves
200.00
180.00 176.59
160.00
137.53
140.00
129.57
126.46
120.00
Percent 97.99
100.00
80.00
60.00
45.25
40.00
20.00
0.00
Fig. 6: Debt Service to Exports Ratio
45.00
41.92
40.00
35.00
30.00
25.00 24.14
22.10
Percent
20.00
15.00
12.75
10.00
5.00
0.00
Fig. 7 gives us the debt service to export ratio of the Philippines in 2003 compared to
other countries ratios in the year prior to a major financial crisis. It can be seen that
the current debt service ratio of the Philippines is in the intermediate range – higher
than Thailand and Korea before the Asian crisis, but much lower than Argentina,
Turkey and Indonesia prior to their major crisis.
Fig. 7: Debt Service to Exports Ratio
70.00
66.12
60.00
50.00
40.53
40.00 37.14
Percent
30.00
22.10
20.00
12.59
10.00 8.63
0.00
Fig. 8 gives us a picture of the debt service to export ratio of the Philippines over
time from 1991 to 2003. One can see that the improvement in the debt service ratio
from 1994 to 1997 had been reversed since 1998, and had gone up to the 22% level
from less than 10% in 1997. This is a reflection of the steady increase in the
Philippines’ external debt to GDP ratio, which leads to higher interest payments,
even if the debts are not short-term. This debt service ratio is supposed to have
improved to below 20% in 2004, but whether the improvement in 2004 is temporary
or not remains to be seen.
4. The Need to Study Debt Arbitration and Sovereign Debt Restructuring

Mechanisms: The International Setting
The picture that emerges is one wherein a debt and financial crisis does not seem to
be imminent in the short-term, but fiscal deficits, external debt to GDP ratio and the
external debt service ratio are sufficiently high and point to a crisis in the medium
term if the trends are not reversed.
Even if the current indicators are not strong for a debt or financial crisis in the
immediate short run, there may be adverse exogenous shocks that may quickly
deteriorate into a debt and financial crisis. A scenario may be a prolonged and
extreme political instability which may lead to sharp currency depreciations and high
interest rates. Together with the relatively high debt service ratios, the sharp currency
depreciations may lead quickly to debt defaults as the recent financial crises of other
countries had demonstrated. Another scenario may be the inability of government to
increase the tax effort (or tax collection) leading to a loss in confidence and
abandonment of Philippine sovereign debts. This will lead to capital flight and
extreme currency depreciations that may lead to a sovereign debt default.
Fig. 8: External Debt Service as % of Exports of Goods and Services
30.0
25.0
20.0
15.0
10.0
5.0
0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
This possibility makes it imperative that the Philippines study and explore various
debt arbitration and sovereign debt restructuring mechanisms in case such an adverse
shock and crisis occurs. Debt workouts and successful debt restructuring allows the
country to reduce debt payments during a crisis. This will result in two positive
things: 1) Funds are released from unproductive debt payments to economic and
social spending vitally needed during an economic recession and/or financial crisis;
2) It increases confidence in the economic system and prevents a sharp recession and
financial collapse as debt default is avoided and creditors and domestic debtors come
to an amicable agreement on debt restructuring and rescheduling.
4.1 Debt Workouts: Experience from South Korea
When debt workouts, debt standstill agreements and debt rollovers were proposed as
a result of the East Asian crisis, one main concern was to prevent a liquidity problem
degenerating into an insolvency crisis (see Akyuz (2000)). A temporary standstill on
debt servicing was needed to stop accelerated payments demanded by creditors and
“an asset-grab race” during crises of confidence and liquidity. Debt standstill,
rollovers and liquidity funds (sans the traditional IMF-type of conditionalities) would
directly address the liquidity problem, and debt workouts and restructuring would
complement these and restore confidence to the system, and ensure that the required
new money would go to social safety nets, development financing and fiscal stimulus
so direly needed during crises of confidence. This was part and parcel of the call to
correct the current pro-cyclical policies that reinforce and aggravate recessions
during periods of crises of confidence towards a counter-cyclical one that provides
funds and economic stimuli during periods of illiquidity and low confidence.
In Sept. 1998, when the East Asian crisis was still going on, Canada proposed an
Emergency Standstill Clause to be mandated by IMF members and to be invoked
during times of liquidity crises. Akyuz (2000) also invoked Chapter 11 of the US
Bankruptcy Code in the context of a liquidity rather than insolvency problem since it
was “designed primarily to address financial restructuring rather than liquidation.”
This is to prevent exogenous shocks and crises of confidence to deteriorate into
sovereign insolvencies and economic collapse. In the current moves by the IMF for
SDRM and CACs, this objective is not so clear, and seems to be geared towards
countries that already have suffered financial and economic collapse.
Another important difference between the earlier vision of debt workouts and the
ones being proposed today by the IMF and by the developed countries is the fact that
the earlier call had the obvious point of view of saving a country from financial and
economic distress after exogenous shocks and crises of confidence. The current
initiatives by the IMF and the developed countries (G-7 or G-10) on SDRM and/or
CACs center on collective action problems among creditors and focus much on
creditors’ rights. This is indicative of the power balance in the current initiatives.
The current plans for SDRM, CACs and voluntary codes of good conduct (CGCs)
depend critically on the basic principle of contract enforcements. Debt restructuring
therefore requires acquiescence and agreement of the majority of creditors. Little is
paid to the principle of sovereign debtor protection, and protecting its citizenry from
the damage of continued debt payments in harsh circumstances.
Another basic assumption of the current mainstream initiatives is the assumption of a

collective action problem among the creditors. This assumes that there is a common
objective function for the debtor and the creditors in aggregate, so that the problem is
to rein in the ‘rogue’ or ‘vulture’ creditors. This may be true if everybody maintains
a medium and long run view where the creditors as a whole would benefit if the
debtor country doesn’t become insolvent.
Another variant of the collective action problem is that, left on their own, each
creditor will opt for holding out against debt restructuring, which, if collectively done,
may result in the country defaulting and unable to pay all its debts, to the detriment
of all creditors. Thus the common good of the creditors may be to undertake and
cooperate in debt restructuring.
But the literature of ‘herd mentality’, ‘self-fulfilling prophecy’ and the revival of
Chapter 12 of Keynes’ classic book all point to the shift in objective function during
uncertain and pessimistic periods. The objective of the creditors and investors during
crises of confidence would be to ‘get out as fast as you can with as much as you can.’
The collective action problem here is not getting a big majority of creditors to tame
the few ‘rogue’ creditors, or getting the majority to decide among themselves to go
against their gut-feeling of ‘jumping ship’, because the majority of them will be in a
‘panic’, and would like to cut their losses and leave. Long-term vision is lost. This
calls for extra-market interventions by international institutions and mechanisms to
stop the ‘panic’ and return the system to longer-term rationality.
Another way of looking at it would be the fact that developing countries unfairly bear
all the risk burdens in exchange rate and interest rate fluctuations (see Stiglitz (2003)).
In times of extreme exogenous shocks that cause violent fluctuations in exchange
rates and interest rates, which in turn bring about a deterioration in the debtor
countries’ balance sheets, there must be some mechanisms for automatic debt
standstill and debt workout arrangements that will spread the risks more evenly
between debtors and creditors.
Thus, the problem is how to institute some arm-twisting and involuntary mechanisms
to force a standstill and an agreement. This of course is possible only: 1) if the
debtor country has sufficient power to force a standstill and debt workout, 2) if some
powerful third party force a standstill and debt workout, 3) if there are institutional
mechanisms and arrangements that call for automatic standstill, debt rollovers and
debt workouts during exceptional circumstances defined clearly. This is part of the
real change in the international financial architecture that is needed as a result of the
numerous financial crises in the past.
In the most successful debt workout during the Asian crisis, the South Korean
government strongly and aggressively ordered the chaebols and their creditors in
early 1998 (just a couple of months after it was hit by a financial crisis) to undertake
a debt workout arrangement, called the Restructuring Accord. The scheme, done
outside the IMF program and hailed as one of the reasons for Korea’s early recovery
from the crisis, worked partly because of the following components:
a) For each chaebol restructuring, a ‘lead bank’ – the one most exposed to the
chaebol -- took charge of the Council of Creditor Financial Institutions tasked
with negotiating with the chaebol in its financial restructuring. The ‘lead
bank’ of course had the biggest stake and highest desire to keep the company
solvent and performing.
b) A Corporate Restructuring Coordinating Committee whose members were
designated by the major banks arbitrated differences among chaebol creditors
and provided technical support.
c) The Accord imposed a freeze on all creditor enforcement action as soon as
the Creditor Council was formed.
The Accord also succeeded because the major creditors were local Korean banks and
so the government was able to exert influence on both creditors and debtors. South
Korea was fortunate that the chaebols during the crisis owed around $500 billion to
the Korean banking sector and only $25 billion to foreign banks and bond creditors.
This was unlike the case of Thailand and Indonesia. In this respect, the Korean
experience is a case against complete financial and capital account liberalization. The
foreign creditors were also held at bay by pressures from the US Treasury. Thus the
first two elements of debtor country strength and third party intervention were
present in the Korean debt accord.
Most countries do not have the strength and clout of the South Korean government
and do not hold strong sway over the United States. Many countries also are more
exposed to foreign creditors. Thus, successful workout arrangements would
critically depend on having pre-crisis international arrangements on debt standstills,
debt rollovers and debt workouts.
It is in this context that we review the current initiatives in the areas of CGC, CAC
and SDRM.
4.2 CGC, CAC and SDRM

The various complementary elements required for debt workouts from the IMF
perspective consist of: 1) a voluntary code of good conduct (CGC) agreement
between the debtors and creditors on matters concerning sovereign debts; 2)
collective action clauses (CAC) in sovereign bonds that give statutory and legal
international framework for the CGC to be carried out: The CAC would enable the
creditors of that sovereign bond, through a pre-determined level of majority vote
among them, to effect a debt standstill and debt restructuring agreement with the
debtor country for during exceptional circumstances. However, most sovereign
bonds in the past and present, as well as most foreign bank lending, do not have
CACs. Thus, there is a need to aggregate external debts of a country and create a
mechanism of arbitration between the country debtor and the bulk of its overall
creditors -- and among the creditors themselves -- that will deal with the country’s
external debts comprehensively. This would be: 3) the comprehensive debt
restructuring framework, which is the IMF’s SDRM.
4.2.1 Codes of Good Conduct (CGCs)
The most interesting CGC that has come out from conventional sources is that from
the Banque de France (the Trichet proposal). It is much closer to the original intent
of the debt workout proposals based on the East Asian crisis, and a lot more
reasonable from the perspective of debtor nations than the CGCs coming from the
Institute of International Finance (IIF) and other international financial associations,
which concentrate on strong conditionalities, transparency of the sovereign country,
information access and creditors’ rights and very little and very nebulous creditors’
obligations and responsibilities (see EMCA, IIF et al (2003)) 3 .
Jubilee 2000 views the Banque de France CGC proposal positively (Kaiser (2003a)).
The positive aspects of the proposal are examined, but the enormous limitations and
obstacles to the adoption of the proposal point to the inherent problem of relying on
voluntary mechanisms and hoping for ‘good faith’ among commercial creditors to
internalize the concerns of debtor countries.
The Banque de France proposal includes the following codes of good conduct, lifted
from their document (Banque de France (2003)):
• “An early engagement with creditors before and when debt-servicing problems
arise, whatever their nature.
• A fair information sharing among all interested parties. The CGC should specify
which information is to be provided to stakeholders for them to make an
informed assessment of the debtor’s financial condition.
3
Roubini and Setser (2003) had said that the proposed code of conduct of the international private
financial players (EMCA, IIF et al (2003)) is “long on requirements for the debtor and short on
credible commitments by creditors. In effect, it is a very extensive code of debtor conduct to be
enforced by IMF conditionality.”
• A fair representation of creditors. The organisation of this representation
should be based as much as possible on existing or agreed modalities, such as
those included in Collective Action Clauses (e.g. majority clauses ).
• An expeditious and cooperative process, possibly resorting to instruments and
techniques aimed at accelerating the renegotiation process and at discouraging “holdout
creditors” (e.g. a voluntary stay on litigation).
• A comparable treatment among creditors. This implies agreeing on the scope of
the debt to be renegotiated and on specific voting procedures to be used across a
large range of situations.
• Fair burden sharing between the debtor and its creditors.
• Negotiating in good faith from all participants. Procedures will be defined ex-
ante to achieve this aim (e.g. mediator or arbitrator, etc.).
• The debtor’s financial situation should be preserved. A number of avenues
could be explored (concerted rollover; status of new money; concerted standstill,
etc.).
• Restoring, as soon as possible, debt sustainability should be the ultimate
objective of debt re-negotiation. The IMF program and its debt sustainability
analysis will provide the various parties involved with the background
information to work out a sustainable solution.”
“The Code of Good Conduct is intended to address a whole range of debt re-
negotiation situations. Three illustrative scenarios are presented in the paper:
• In a first scenario ( “alleviating tensions on a sustainable debt”) characterised

by a sustainable debt over the medium-term, a country faces short-term financial
tensions and there are increasing expectations that the situation could deteriorate
further. In order to prevent an unsustainable debt dynamic from developing, pro-
active debt management or debt re-negotiation might be contemplated by the
debtor. In this context, creditors and debtors could usefully implement several
principles of the CGC.
• In a second scenario (“re-negotiating unsustainable debts, while “remaining

current”) characterised by an unsustainable debt, the debtor triggers a debt re-
negotiation process, while still being able to service debt payments. An IMF program
aiming at restoring debt sustainability over the medium term is designed. The principles
and best practices of the CGC are expected to provide a comprehensive framework
which would allow debtor and creditors to renegotiate expeditiously new terms and
conditions, before the situation of the debtor deteriorates further.
• In a third scenario (“renegotiating unsustainable debt under a payment

standstill”) characterised by an unsustainable debt and temporary payments
standstill, the main objective of the CGC is to reduce the risk of a non-
cooperative debt restructuring process. Its implementation aims at ensuring
debtor’s good faith and a fair burden sharing among participants. The
combination of an IMF adjustment program and lending into arrears is to be used
as a critical instrument to reduce the severity of the crisis and ensure a fair
implementation of the CGC, including the good faith criterion.”
“Three categories of stakeholders should be involved in the design of the CGC:

- Representatives from the different categories of public and private creditors as well
as other market participants or rating agencies;
- Sovereign issuers, notably emerging markets;
- The IMF which should act as a catalyst in designing the CGC, in coordination with
other relevant organisations (e.g. the World Bank, BIS, FSF, etc.). “
Kaiser (2003a) gives us the positive elements of the Banque de France proposal or
what he calls the Trichet 4 proposal:
• “The proposal acknowledges that the borderline between debt sustainability and
debt unsustainability is all but clear. It does not build on pre-defined criteria and
definitions, but foresees a high degree of flexibility, which would allow
negotiators to tailor a solution to the particular needs of the debtor country.
• The CGC would also mandate a comprehensive solution, including all pre-cut-
off-date debt. It is interesting to note that no reference is made to any preferred
creditor status of any individual creditor or group of creditors.
• The principle to restore debt sustainability as soon as possible implies that the
creditors accept the principle that an agreement that would not restore debt
sustainability is not viable and therefore that the net present value of their asset
cannot be guaranteed. (p.11) This seems to indicate some readiness to turn away
from the eternal “too little, too late reschedulings” of the Paris Club – even if the
basic prerequisite for a realistic assessment of what debt sustainability actually is
– namely the independence of the one who assesses – is not considered. To make
sure that … the most stubborn bondholder will understand the signs of the time,
Trichet states explicitly: Similarly, creditors should recognise that the debt
restructuring might require a writing down of their claims. (p.10)
• Under “negotiation in good faith” Trichet is the first creditor to acknowledge the
overwhelming importance of neutral decision making, when under “best
practices” he suggests: To prevent mutual suspicion, a third party could be
designated to act as a mediator or an arbitrator (p.10).”
It is clear that the Banque de France CGC has the concern of the debtor countries in
mind when it wants to quickly avert debt unsustainability (with ‘an early
engagement’). It also points to the involvement of debtor countries as critical for the
process. The three scenarios obviously include the situation where liquidity problems
might degenerate into insolvency crises (the first two scenarios) and contrasts sharply
with the financial players’ concern of restructuring already unsustainable debts.
Kaiser (2003a) states that the Banque de France position mirrors the position of some
other central banks in Europe. In this regard, the proposal may have some influence
on creditors from these countries, if the central banks use some pressure and
persuasion on the private financial institutions in their countries and on their own
government. However, a critical country – the United States – has consistently taken
the side of the private creditors in resisting sovereign debt restructuring or debt
reduction on the grounds of contract enforcement, moral hazard and creditors’ rights
4
Jean-Claude Trichet was the Governor of the Banque de France when the proposal was made. He is
now head of the European Central Bank.
(as what had happened in its rejection of the IMF’s SDRM). Most likely, other
countries (such as Japan) will follow the US behavior. Thus, for the adoption of the
CGC, debtor countries would have to unite – together with the friendly European
countries and their central banks – to pressure the creditors to agree to the CGC by
threat of undertaking loan transactions only with complying creditors. We shall
discuss this in the last section of the paper. The major flaw therefore of the Banque
de France is in hoping that the private creditors will voluntarily adopt the CGC, or in
hoping that selected European central banks or governments can convince the
formidable coalition of the US, Japan and private creditors in giving in to the more
lenient terms in the CGC for the debtor countries.
The Banque de France proposal also correctly predicts that the CGC will work only
if complemented by Paris Club debt agreements and liquidity flows from the IMF,
given that these are the only major institutions providing official debt restructuring
and emergency liquidity funds, respectively. Again a basic flaw here is that, given
that the CGC is largely aimed at confidence-building during crises of liquidity and
confidence, the role of Paris Club members and the IMF in imposing stringent
conditionality of fiscal and monetary austerity, high interest rates and blanket bank
and firm closures – all proven to have aggravated the economic and financial crises
and deepened economic uncertainties in various countries -- should be addressed, if
confidence-building is to fully succeed.
4.2.2 Collective Action Clauses (CACs)
The voluntary CGC, if generally agreed upon, needs statutory mechanisms to be

realized. If the Banque de France proposal, or another acceptable CGC, was
generally adopted, the code could be explicitly enshrined in the sovereign bond
contracts with the exceptional circumstances defined carefully. However, since there
is no consensus yet on a CGC, and no strong desire for creditors to legally bind
themselves to a strong CGC that might dilute their ‘creditors’ rights’, the furthest the
private creditors are willing to go (see IIF website) would be to allow collective
action clauses in sovereign bond contracts.
These CACs would allow, through a pre-determined level of majority and

representation of creditors to call for: 1) Majority restructuring clauses: a qualified
majority can bind all creditors of the sovereign bond issue to the financial terms of a
financial restructuring of the sovereign debt; 2) Majority enforcement clauses:
limitations on enforcing accelerated claims of particular creditors by requiring: a) a
vote by a minimum percentage of creditors to be able to accelerate their claims
during debt workouts, and b) a pre-specified majority can reverse such acceleration;
3) Exit consents: This allows bondholders to agree to amend, through a pre-
determined majority creditors’ vote, changes in non-payment terms of the bonds
from which they are exiting and impairs the bonds left in the hands of holdouts.
Most bonds carry the less important second component of limiting accelerated claims
by certain creditors during defaults or debt standstills. This is standard practice with
the usual sovereign bonds governed by either New York or English law. Most
sovereign bonds do not have the first and more important component of the CAC
since most bonds are being governed by New York law, which does not carry these
clauses, while the less frequent ones being governed by English law do have. The
New York law, however, usually does contain exit consent clauses.
Last March 2003, Mexico was able to issue, for the first time, a $1 billion bond issue
under the New York law with CACs comprising both majority restructuring and
majority enforcement provisions. This followed a G-10 Working Group report
recommending CACs in sovereign bonds in September 2002, and an IIF (and
financial industry) draft CAC proposal issued in February 2003. Table 1 reproduces
a table from the IMF (2003a) paper on CAC, summarizing the differences in
provisions under English law, New York law, G-10 recommendations, financial
industry proposal and the recent Mexican bond issue. An analysis of the table
reveals the following points:
1) The financial industry draft requires an unreasonable 90% of creditor consent

(based on outstanding principal, and not based on votes in a duly constituted
meeting) for financial restructuring and debt standstill. This is because it
requires 85% vote for changes to terms of payment, but any opposing camp
comprising more than 10% of the outstanding principal would have veto
power. This means that at least 90% of the creditors should agree with the
changes in the terms of payment. As the IMF paper correctly states, this
defeats the purpose of CACs. This 10% veto power of a small minority also
allows ‘vulture’ creditors to demand repayments and destroy constructive
debt workouts. What is clear is that the IIF and financial industry members
are reluctant to have quick and timely standstill and debt restructuring
agreements with the debtor country. Their required 75% of creditors’ vote to
reverse an acceleration of particular creditors’ claims during default also
points to their preference for less restrictions on individual creditor’s behavior.
The IIF’s interpretation of ‘vote’ is based on outstanding principal, rather
than the English law practice of votes cast at a duly convened meeting.
2) The IIF draft of requiring the debtor country to provide information requested
by 5% of creditors also puts too much restriction (not currently existing) on
the debtor country. The debtor country can be sued if it cannot provide
information demanded by the 5% of creditors, especially information that it is
legally bound to keep in confidentiality or information that is hard to get. The
country has to prove in a foreign court that the information requested is
‘unreasonable’. Furthermore, non-compliance would mean technically a
default for the debtor country and a crisis of confidence may be triggered.
3) The closest thing to arbitration being proposed in the CAC process is the
‘engagement’ provision. The G-10 proposal recommends the adoption of the
English law practice of establishing a trust structure where the trustee can act
as bondholder representative for the life of the bond. The G-10 proposal also
alternatively recommends a two-third majority vote to appoint at any time a
representative for the bondholders in negotiation with the issuer (the debtor
country) or other creditors. The engagement provision is also seen as a
deterrent to litigations after a default and during a restructuring process. The
G-10 proposal implies a bondholder committee (with representatives from
each bond issue) that cuts across different broad issues to negotiate with the
issuer and individual or groups of creditors. Thus the G-10 proposal has
some sort of aggregation, which is discussed later.
The industry draft rejects a trust structure and instead allows a simple
majority of creditors to form a bondholder committee – one for each bond
issue. The industry members do not believe in the aggregation of
representatives into one bondholder representative committee (for all the
bonds) to negotiate with the debtor country after default and restructuring.
Representatives of the individual committees are voted by a simple majority
of creditors, but 25% of creditors would have veto power. Furthermore the
debtor country will pay all legal, financial, administrative and other fees and
expenses of the committee of the particular bond issue.
All other proposals, including the latest Mexican bond, do not have
engagement provisions.
4) The documents of CAC, especially the IMF and IIF drafts, refer to the CAC
process as a response to a post-default restructuring process. There is no
clear indication to trying to avert debt unsustainability or reducing the
dangers of insolvency crises.
5) The industry draft frowns on exit consents – changes in non-payment terms

that effectively dilutes creditors’ rights of the holdouts. The industry draft
would require unanimous approval for any exit consents that deprives
creditors of important enforcement rights (e.g. waiver of sovereign immunity
and change in governing law).
One problem with CACs is that since the majority of past and current sovereign
bonds do not have CACs, even if all new bonds would start to include these clauses,
it will take more than ten years for sufficient aggregation of bonds that would allow
debt standstills and restructuring during crises. Plans to convert the past and existing
non-CAC bonds to CAC bonds (e.g. the J.P. Morgan Proposal) are not feasible (see
Kreuger (2003)). Convincing creditors to accept the more reasonable G-10 version
of CAC for new bond issues is already extremely difficult enough that one cannot
imagine them allowing all existing non-CAC bonds to be converted to ones with the
proper CACs.
Successful aggregation or exchange of bonds into other types of bonds that allow
restructuring, or successful use of exit consents in debt restructuring so far is limited
to small countries (Ecuador, Uruguay, Moldova) with relatively small debts vis-à-vis
other countries, and only after some period of negotiation once extreme debt
unsustainability is evident. It is obvious that international creditors will not allow
such ease for larger sovereign debtors (e.g. Argentina, Brazil, Russia, Indonesia,
Pakistan).
But the more inherent problem of CAC is that its premise of collective action
problem among creditors and a conflict between the common interest of creditors in
the aggregate and debtor countries, on one hand, and rogue or holdout creditors on
the other, is fundamentally erroneous. Thus even if aggregation is achieved,
creditors in the aggregate, during periods of crises of confidence and liquidity, hold
short-run perspectives and want quick exits, accelerated payments, stoppage of debt
rollovers and minimum exposure to the country or countries at risk. The industry
resistance to diluting creditors’ rights during these crises periods, which we had just
analyzed, further confirms this behavior. Their interest in the aggregate usually
clashes with the interest of debtor countries during crises. The latter aim to achieve
sovereign debtors’ protection, minimize capital flight, maintain liquidity and provide
funds for counter-cyclical, social insurance and development needs during the
difficult and risky periods while the former want to get their money immediately, cut
their losses and reduce their exposures. Thus, one needs to create mechanisms for
debt standstills and workout arrangements that would distribute the burdens fairly to
both debtors and creditors, and take into consideration the adverse impact financial
crises impose on the citizenry of the sovereign debtor country.
4.2.3 The Sovereign Debt Restructuring Mechanism (SDRM)
The IMF SDRM Proposal
The benchmark of the SDRM and any insolvency arrangement proposal would
naturally be the IMF proposal. The latest IMF scheme, as of the time of writing
(April 2004) is sketched below (and summarized from IMF (2003d)):
I. Eligible claims would be claims by creditors included in the SDRM

except:
1. claims governed by domestic law and the domestic courts,
2. claims that are secured or collateralized,
3. claims held by international and multilateral organizations.
A related problem is whether to include official bilateral creditors’ debts in

the restructuring, which the IMF proposal doesn’t resolve. If they are
included, the IMF proposed that they be placed in a separate class from
commercial creditors. The two classes of creditors will receive different terms
but approval by the required majority in both groups would be needed to
legitimize the restructuring agreement.
II. A debtor member country of the IMF can activate the SDRM by claiming
that its debt was unsustainable. A key question the IMF leaves
unresolved is whether independent confirmation is required on the
accuracy of this claim, and which entity would investigate and decide on
this. There is a strong implicit assumption that the IMF will be strongly
involved in this confirmation and verification process.
The debtor will be required to provide relevant information regarding its

indebtedness, including claims not to be restructured under the SDRM.
Registration and verification of claims of indebtedness takes place and the
Sovereign Debt Dispute Resolution Forum (SDDRF) resolves disputes
arising from this verification process.
Activation would not automatically suspend creditors’ rights, including

those holding out on the restructuring. However, to prevent ‘rogue
creditor’ behavior, the amounts recovered by these creditors through
litigation “would be deducted from its residual claim…in a manner that
neutralizes any benefits of such litigation vis-à-vis other creditors.” The
IMF proposal also opens the option, upon approval of the majority of
creditors (those subject to the restructuring), for the SDDRF to “enjoin
specific enforcement actions in circumstances where such enforcement
could undermine the restructuring process.”
III. To encourage early participation of creditors in restructuring processes, a

representative creditors’ committee would be created to address problems
and disagreements between debtor and creditors, and among creditors.
Disputes on the representation of the committee would again be resolved
by the SDDRF. The debtor country would bear the costs associated with
the operation of the committee. Disputes concerning these costs would
also be arbitrated by the SDDRF.
IV. Creditor approval of restructuring or priority financing proposals would

require 75% of the outstanding principal of the registered and verified
claims. Alternatively an unspecified majority vote of the creditors can
terminate the SDRM after the verification process.
The restructuring or priority financing agreement, once approved and

passed with votes certified by the SDDRF, becomes binding on all
registered creditors and creditors notified about the restructuring of their
debts but failed to register.
False information, non-transparency, non-cooperation or inappropriate

use of SDRM by the sovereign debtor will be punished under the Articles
of Agreement of the IMF, including access to financial lending and
lending into arrears (LIA).
V. The SDRM would end with the certification of the restructuring

agreement by the SDDRF. As mentioned earlier, an unspecified majority
of creditors can vote to end the SDRM on the grounds that activation of
the SDRM was not justified. Alternatively, the sovereign can at any time
terminate the SDRM, although unspecified disincentives should be
imposed to prevent abuse of the mechanism. The SDDRF also can
terminate the proceedings without a restructuring agreement on an
unspecified basis of determination of lack of reasonable prospect for a
restructuring agreement.
VI. The selection of the members of SDDRF would follow the following
process:
i. The Managing Director of the IMF, upon advice by professional

associations and other international organizations, designate a selection
panel with 7 to 11 members.
ii. The selection panel identifies 12 to 16 candidates to form the members of
a pool of judges. The nomination process would be an open one.
iii. Once selected by the panel, the pool of judges is approved by the Board of
Governors. A President of the SDDRF will be selected.
iv. When the SDRM is activated, four judges from the pool would be
impaneled by the President of the SDDRF. One would be responsible for
making initial determinations. The remaining three would constitute an
appeals panel.
The powers of the SDDRF would have no authority to challenge decisions of

the Executive Board or make determinations on issues relating to the
sustainability of the sovereign’s debt.
The functions of the SDDRF are:
ii. notification of creditors, registration of claims and administration of

the voting process
iii. resolving disputes due to: i) claims verification, ii) the voting
process and disqualification of certain creditors, iii) the
representation and operations in the creditors’ committee. The
SDDRF will be reactive: it cannot initiate investigations regarding
potential abuses but will merely adjudicate allegations of abuse
brought by a party. It can request evidence but has no subpoena
powers
iv. if need be, issuance of an order that would require a court outside
the sovereign’s territory to stay specific enforcement actions based
on debtor’s and creditors’ approval.
VII. The SDRM and SDDRF can be established with an amendment of the
IMF’s Articles, which requires acceptance by three-fifths of the members
with 85% voting power. Since the amendment will involve establishing
new treaty obligations, most countries will need legislative authorization.
Critique of and Alternative Proposals to the IMF’s SDRM
There are some positive points to the IMF initiative. The most important is the clear
departure from old solutions to financial crises for developing countries which
usually comprise liquidity funds in exchange for: 1) stabilization and austere policies
that only deepen recession and the crisis of confidence, 2) financial reforms which
may include counterproductive cures such as closure of banks and unrealistic
privatization of banks during illiquid and confidence-less periods, 3) debt
reschedulings and restructuring with the Paris Club members that usually come ‘too
little, too late’, and tied to the stabilization conditionality. The move is closer to (but
still far from) what has been termed ‘a new international financial architecture’,
which implies an international arrangement to solving crises, rather than country-
specific, and oftentimes, country-punishing solutions to financial and debt crises.
The motivation is clearly a move from the first set of old factors blaming countries
for financial crises (discussed in the beginning of the paper) to a more enlightened
acceptance of ‘market failures’ and inherent systemic risks of the international
financial markets. Kreuger (2003), in her address to the Harvard Business Club,
clearly states that the object of SDRM is to avert debt unsustainability, and has in
mind reducing the risks during liquidity and confidence crises.
Kaiser (2003d) lists the other positive points:
1. The available venue for countries to declare unsustainable debt or
insolvency and ask for debt restructuring;
2. The flexible-enough framework of the process with ad-hoc panels or
committees;
3. An arbitration process where the sovereign debtor can dispute claims and
demands of the creditors.
The IMF’s SDRM proposal, however, had been heavily criticized by civil society
organizations (CSO)s.
First, it must be pointed out that proposals for sovereign bankruptcy/ insolvency
mechanisms, whether employing the model of US Law for corporate bankruptcy
(Chapter 11) or that of municipal bankruptcy (Chapter 9), had predated the IMF
SDRM proposal, dating as far back as the 1980s. Most notable of these proposals is
the proposal of Raffer (1986 and 1990), which was able to garner the support of the
Jubilee Movements in the United Kingdom, Germany, Switzerland, Austria and Latin
America and other national civil society organizations (CSOs), such as in Argentina
and Ecuador. It must also be pointed out that the IMF initially opposed these
initiatives, but once the SDRM was proposed, not much acknowledgment was given
to these earlier efforts 5 .
Some of the criticisms and alternative proposals to the IMF’s SDRM are being posed
by Kaiser (2002, 2003d), Pettifor and Raffer (2003) and Palley (2002, 2003)
representing civil society groups (Erlassjahr, Jubilee Research, and Open Society
Institute 6 respectively), and AFRODAD. Many CSOs call their suggested debt
standstill and workout procedure the Fair and Transparent Arbitration Process
(FTAP), in contrast to the IMF’s SDRM.
Their most serious criticisms, accompanied by their counter-proposals are:
1. The IMF roles in the proposed SDRM process, explicit in the selection of
the arbitration panel members and implicit in determining debt
sustainability of the sovereign debtor, are inappropriate given that the
IMF itself is a creditor of the sovereign debtor and may not be an
impartial stakeholder. The veto power of the IMF’s Board of Governors
on the arbitration panel composition is especially objectionable. Debt
sustainability and the economic and social conditions of the country
should be determined by an independent entity rather than the IMF. The
CSOs would prefer that a more neutral body, such as the United Nations,
take the lead in the selection of the arbitration panel.
2. The CSOs’ preference is to follow the US Chapter 9 Bankruptcy Law
(originally suggested by Raffer (1990)) for municipalities and local
governments rather than Chapter 11 for corporations. The Chapter 9
clauses allow relevant stakeholders (e.g. taxpayers, government
employees and labor unions) affected by debt payments and debt
restructuring to be heard and to affect the final outcome. Chapter 9 also
5
Other earlier proposals on sovereign bankruptcy mechanisms were made by Oechsli (1981),
Kauffmeyer (1987), Suratgar (1990), and UNCTAD (2001).
6
The Open Society Institute is associated with George Soros.
allows interested entities to intervene and testify on a general or specific
matter. An obvious implication of this is that interests of the poor and
vulnerable in a country hit by financial crisis or debt unsustainability can
be represented in the proceedings.
3. A related development is the proposal to include the issue of ‘odious’
debts in the proceedings. This can come in during the verification of
legitimate claims or in the arbitration process itself. For how to tackle
‘odious’ debts, see Adams (1991).
4. The SDRM process of the IMF is ambivalent about covering official
bilateral debts and explicitly excludes multilateral debts. For a
comprehensive treatment of the external debt, these elements should be
included. Raffer calls for equal treatment of all creditors (including
private, multilateral, bilateral and domestic creditors). It must also be
pointed out that bilateral creditors oftentimes are, oftentimes, more
reluctant to allow structured debt reduction and forgiveness for fear of
losing their political and economic leverage on developing countries.
Apart from the HIPC Initiative 7 , the infrequent Paris Club and bilateral
debt reductions had been clearly politically motivated (e.g. Poland,
Yugoslavia, Pakistan). The exclusion of multilateral debts further creates
a very biased and unequal treatment of creditors, and prejudices the
proceedings especially against private creditors. Seconding this, Palley
(2003) suggests that including multilateral loans in the debt restructuring
and standstill would tackle the moral hazard problem associated with IMF
bailouts. Other critics (AFRODAD and Kaiser (2002)) want to include
domestic debt in the proceedings 8 .
5. Ann Pettifor also suggests that savings derived from reduced debt
payments due to the restructuring be put in a special fund earmarked for
priority social expenditures.
6. It is obvious from the IMF concept of debt sustainability (see Kreuger
(2002)) that benchmarks and targets of debt sustainability indicators, such
as debt to GDP, debt to exports, and debt to government revenue ratios do
not incorporate a rigorous assessment of the needed caps in debt service
so that funds can be released to achieve the Millennium Development
Goals (MDG) of halving poverty and accelerating social and human
development in developing nations (see Kaiser (2003b)). One of the
objectives, of course, for sovereign debt restructuring and for a ‘new
international financial architecture’ is for developing countries to
prioritize their expenditures from available foreign exchange and
government revenues for development needs as well as human and social
needs of the country, instead of the automatic prioritization of debt
payments. This is exactly one of the main criticisms of the debt
sustainability analysis (DSA) of the HIPC Initiative. Thus there is much
room for coming up with a more MDG-oriented DSA and concept of debt
sustainability that nets out from foreign exchange and government
revenue bases the estimated financing needs for economic and social
development. These indicators can help direct the arbitration process
7
The current Enhanced HIPC Initiative has been criticized by the HIPC countries themselves as
inadequate and slow.
8
This is similar to criticisms of the HIPC Initiative, which does not include domestic debt in both the
debt coverage and debt sustainability analysis.
towards protection of sovereign debtors’ rights by taking into
consideration the welfare of their citizenry.
Despite the IMF’s attempts to win over the creditors and financial industry
players as well as developing countries and CSOs, nobody has sided with the
IMF in the SDRM initiative. Perhaps initiatives by the United Nations or the
United Nations Development Group (UNDG) organizing debtor countries to
consolidate a sovereign debt restructuring proposal – in consultation with
creditors, CSOs and multilateral institutions – may yield better results.
Resistance of Creditors
It would also be interesting to find out the official and not-so-official reasons for the
private creditors’ rejection of the SDRM proposal of the IMF. A document prepared
by the industry players, including IIF and Emerging Markets Trade Association
(EMTA et al (2002)), lists their major official objections:
i. “The SDRM rests on the false premise that there is an inherent collective
action problem among private sector creditors in sovereign debt
restructuring that precludes agreement. In fact, not one restructuring has
been prevented from moving ahead by the actions of holdout
creditors…as evidenced by the spontaneous formation of bondholder
committees in the cases of Argentina, Ecuador, Ivory Coast and Russia.
ii. Implementation of an SDRM would render collective action clauses
meaningless by overriding, in advance, the clauses’ intended operation
with a statutory mechanism.
iii. An SDRM, especially if accompanied by exchange controls that could
affect international credit lines, create conditions that could themselves
precipitate a crisis as creditors act defensively at the first sign of a
problem and advance the rundown of short-term exposures and even
accelerating long-term exposure.
iv. The analogy between an SDRM and private sector bankruptcy legislation
is fundamentally flawed: private companies are subject to jurisdiction of
the bankruptcy tribunal. Even under an SDRM the sovereign debtor
would inherently not be subject to the appropriate checks and balances
that legitimize and make a bankruptcy regime fair and effective.
v. The SDRM would force cases that may appear unsustainable, such as
Brazil in 1999, toward long, costly, comprehensive restructurings, when
informal, more surgical solutions might restore market access and growth
at a much earlier stage. Paradoxically, the SDRM could shift more of a
country’s financing requirements to the official sector.
vi. Using debt sustainability as a trigger for the SDRM is fundamentally
flawed. While the IMF has a useful role to play as an agent of adjustment,
its role as de facto judge of debt sustainability presents major problems
due to the acknowledged complexity of the task and the Fund’s vested
interest as a creditor.
vii. Despite its complex voting arrangements, the SDRM does not in fact
resolve the problem of aggregation across different classes of debt, which
is one of its principal goals. The private sector believes the issue of
aggregation can be better – and more simply – addressed through greater
transparency during the restructuring process.
viii. Capital markets are built on the fundamental principle of enforceability of
contracts. By making ‘structured’ default – without the appropriate
checks and balances such a regime normally includes – an alternative to
policy adjustment, as SDRM represents a radical departure from this
fundamental principle.”
The arguments of the private financial players give rise to more controversies and
debates. First, on point i, debt restructuring for countries in default had actually been
criticized as coming too late when the countries had already suffered economic
collapse, their assets had devalued, and the creditors faced no choice. Debt standstill
and workout arrangements, as previously discussed are necessary precisely to prevent
sudden shocks and liquidity problems from creating economic and financial collapse
of the developing country.
Secondly, the private financial players’ preference for a case-to-case, informal

approach to debt restructuring (point v) ignores the problems of systemic risks, ‘self-
fulfilling prophecies and panic’, coordination failures and equitable sharing of debtor
and creditors on the risks of the financial markets. These are precisely the main
reasons for coordinated interventions and global governance on this issue.
Thirdly, the private financial players present the lack of analogy between corporate
bankruptcy proceedings and sovereign debt arbitrations since, unlike bankruptcy
court cases, creditors cannot demand changes in management in the sovereign debtor
entity. This is precisely what Raffer and the CSOs try to address by following the
model of Chapter 9 Municipality Bankruptcy Law rather than Chapter 11 since it
reflects more of a public entity’s insolvency.
Fourthly, making enforceability of contracts (point viii) a basic principle should be

matched by including debtor protection as another fundamental legal principle. As
Raffer puts it, enforcement of contracts for the good of people in the North must be
matched by the same protection of the welfare of the people from the South.
Debtors’ insolvency, by definition, implies that enforceability of debt contracts can
no longer be applied. It is this realization that usually forces creditors to agree to
debt restructuring, but usually after much damage has been done to the debtor’s
economic and financial system.
Fifthly, the creditors are correct in points v and vi that the IMF’s SDRM proposal
doesn’t address the early tackling of financial crises, and that there is a conflict of
interest in the IMF being a major creditor and being the major power behind the
determination of debt sustainability and SDRM process. Coupled by the fact that
multilateral debts are exempted from the SDRM, this makes the whole process unfair
to both the private creditors and the sovereign debtor.
Finally, Kaiser (2003b) also reports that the Legal Department of the IMF thinks that
the private creditors feared the IMF would use the SDRM as an instrument to
withdraw from the large bail-out packages. This is very interesting since it brings the
moral hazard focus of IMF rescue packages on bail-out of creditors rather than on the
traditional complaint of bail-out of debtor countries (who, after all, will have to pay
back the emergency loan funds at market interest rates).
5. What Next for a New International Financial Architecture?
5.1 Improving International Mechanisms for Debt Workout: Need for Unity
From Debtor Countries
Most emerging market countries were lukewarm or rejected outright the IMF’s
SDRM proposal. This springs clearly from their fear of being stigmatized as
‘bankrupt’ or ‘insolvent’, which will affect their short-run, medium-run and long-run
access to credit lines. Kaiser (2003c) is correct, however, in pointing out that a good
sovereign debt restructuring and debt workout arrangement should result in more,
rather than less, debt sustainability for the sovereign debtor, and should improve their
credit standing. But, because of the lack of country ownership of the SDRM
proposal and lack of country consultation, most countries believe the financial
industry players’ threat that the arrangement will lead to more capital flight and less
access to credits (the third and fifth arguments of the industry players’ position listed
previously). This fear is not unwarranted especially if the financial creditors are
unified and the sovereign debtors are not. Credit rating agencies and domestic
partners of the international financial players can cause crises of confidence (even if
debt should be sustainable with the orderly workouts) by creating panic and self-
fulfilling prophecies. The developing countries also do not have good arbitration
experiences in the WTO-instigated arbitration of trade disputes. It is clear that
sufficient bargaining and negotiating power of the sovereign debtors over the
arrangements and their ownership of the proposal are key elements missing in the
IMF SDRM proposal. For developing countries to clearly benefit from
institutionalized debt workout arrangements, the following will have to be achieved:
1. Developing debtor countries, including the Philippines, will have to be united

in proposing: 1) a code of good conduct (CGC) for creditors and debtors; and
2) the process, content and circumstances of automatic debt standstills and
workout arrangements, where the CGC is made statutory. The UN
Development Group (UNDG) members, especially UNCTAD and UNDP,
can facilitate this process. CSOs can also give technical, financial and
lobbying support. There may be some differences in the financial needs and
processes of low-income countries and LDCs (Least Developed Countries)
compared to middle-income and emerging market countries. The main
difference may be the fact that middle-income and emerging markets might
have the advantage of getting more capital inflows, and the disadvantage of
getting more volatilities and exposure to commercial creditors. But the
essential processes of debt standstills and debt restructuring with bilateral,
multilateral and commercial creditors should be essentially similar. All in all,
a common framework for a voluntary code of good conduct and a statutory
mechanism for automatic debt standstills and debt workouts during crises of
liquidity or solvency (with interests of all types of developing countries
accounted for) should be agreed upon among a significant number of
developing countries. There may be different mechanisms and processes
proposed depending whether the situation is a problem of temporary
illiquidity, or real insolvency and unsustainable debt conditions. In the
aftermath of the latest High Level General Assembly Dialogue on Financing
for Development held in October 2003, the UN Department of Economic and
Social Affairs had been tasked with coming up with viable proposals for
sovereign debt restructuring.
2. Once a common framework and mechanism is proposed, the developing

countries, together with allied international agencies (e.g. UNDG, concerned
CSOs) should negotiate strongly and determinedly with the creditors and
multilateral agencies. With sufficient lobbying and leadership from key
debtor countries and international institutions such as the United Nations,
sufficient unity among developing countries may be achieved and threats of
boycotts of uncooperative creditors, and preferential treatment of cooperative
ones, will be open as possible options for the sovereign debtors.
3. There has to be clear and strong acceptance of the procedures proposed from
all stakeholders – particularly the commercial, official and multilateral
creditors – to ensure that the debt workout arrangements will not be
sabotaged by powerful financial players and big powerful countries.
The case of Argentina provides a clear case wherein debtor power can win major
debt restructuring and very significant debt reduction. In December 2001, Argentina
defaulted on at least $80 billion of its external debt, the biggest sovereign debt
default in world history. It then suffered its worst economic and financial collapse in
history in 2002, under the supervision of the IMF. But by 2003 to 2005, Argentina
had averaged growth of more than 9% annually, and had achieved current account
and fiscal surpluses and had accumulated a big arsenal of international reserves.
Argentina, which in end-2005 had $180 billion worth of debt, was the Third World’s
biggest international debtor. It also was the biggest debtor of the IMF, and the IMF
had to listen to Argentina for fear of losing its biggest loan portfolio.
With the external and fiscal surpluses and huge reserves, Argentina had lost its long-
held appetite for foreign debt. With its strong debtor power, President Nestor
Kirchner of Argentina demanded from its private creditors a 75% discount of it debt
– so that it will give only 25 cents to a dollar worth of debt. For most of 2003 to
2005, the international creditors balked and the there were severe confrontations with
the IMF. But, in June 2005, 70% of Argentina’s international creditors caved in and
reduced Argentina’s debt by $100 billion, with Argentina getting its 75% discount.
By January 2006, Argentina had also cleared its $14 billion debt to the IMF ahead of
schedule by using its large international reserves. The early payment saved it almost
$1.5 billion, but more importantly for many Argentines, it freed the country from the
yoke of the IMF, which they felt was responsible for the series of debt, economic and
financial collapses of Argentina.
The lesson to be learned here is that debtors have power if what they owe amount to
a significant portion of world debt. Debtors, if united, can demand international
bankruptcy proceedings and automatic debt workout mechanisms that can be
institutionalized in order to reduce the severe damage done by debt and financial
crises. A sort of debt cartel of Third World countries can also demand to improve the
international financial architecture so that they don’t always bear the risks and burden
of international financial transactions. Changing the international financial
architecture may also include the following components.
5.2 Other Vital Components of a New International Financial Architecture:

Tackling the Systemic Risks During Financial Crises
But balancing the power play in debt standstill and workout arrangements is just part
of the big gap in a new international financial architecture more conducive to the
needs of developing nations. Debt standstill and workout arrangements, possibly long
drawn, are not sufficient to stave off financial crises and currency runs or hasten the
return to normalcy during financial crises.
Systemic risks related to capital flow movements, which lead to crises in confidence,
financial malaise, and currency runs usually involve sudden changes in economic
mood, from one of optimism to extreme pessimism to downright panic. A debt
workout arrangement may not come about naturally if political will is not present and
powerful creditors block the process. In this event, something has to be done to stop
the deterioration in confidence and sudden rush for financial assets to leave the
country.
Because the systemic risk associated with countries that have opened up their
financial and capital accounts can be viewed in terms of ‘market failure’ and the
absence of contingent markets as well as ‘insurance’ mechanisms during currency
runs and capital reversals, two things are immediately necessary: 1) a mechanism to
regulate the capital flows going in and out of the country; 2) the availability of
international liquidity funds as sort of potential insurance against massive illiquidity
arising from sudden financial outflows and stoppage of traditional credit lines. These
are even more critical because: 1) developing countries unfairly bear most of the
exchange and interest rate risks that are beyond their control, 2) an impending
recession during financial crises require counter-cyclical fiscal and monetary policies
that require immediate funding, 3) there is a need to preserve and increase social
services and social safety nets during periods of financial and economic crises and
recessions.
5.2.1 International and Multilateral Acceptance of Capital Controls
As will be discussed more fully in other papers of the volume, the systemic risk
associated with financial crises require capital controls, both during times of
optimism and boom and during times of pessimism, currency runs, speculative
attacks and stoppage of credit. 9 Although some countries had undertaken and are
undertaking successful capital controls, usually quietly and without fanfare, it is
required, especially for weak developing countries, that capital controls be generally
accepted by the powerful multilateral institutions and international financial markets
as a standard practice and sovereign right of developing countries. This would allow
all developing countries, large and small, powerful and not, to undertake regulation
of capital flows without being stigmatized and punished by the multilateral
institutions and global markets. The IMF paper by Rogoff et al acknowledging
9
Most analysts would put more weight and importance on more preventive capital control of massive
short-term speculative inflows during times of optimism and boom since it will be harder to impose
capital control on capital outflows during times of speculative attacks and financial panic.
adverse effects of financial and capital account liberalization should provide the push
for the Bretton Woods Institutions to reverse the (often forced) financial and capital
account liberalization of many developing nations.
5.2.2 Availability of International Liquidity Funds Minus Stringent

Conditionalities
As mentioned above, the availability of international liquidity funds acts as insurance

during financial runs and crises and help reduce the systemic risk of self-fulfilling
prophecies and multiple equilibria situations, especially if debt standstill and workout
arrangements are not undertaken immediately. Speculative attacks against the
currency and stoppage of credit lines can be reduced immensely if liquid funds are
reasonably available to countries affected by contagion and crises of confidence. The
problem is that the IMF had, in past financial crises, taken this role, but imposed
unreasonable pro-cyclical conditionalities that aggravate the crises and further instill
losses in confidence. These conditionalities include:
a) Severe fiscal austerity that: i) reduce social and economic spending at a

time of recessionary tendencies; ii) reduce confidence even more since the
unreasonably tight fiscal targets are seen to be unachievable due to the
decline of fiscal resources during recessionary periods, depreciation of
currency and credit tightness, and so the country most likely will fail the
IMF program.
b) Exceedingly high interest rates and monetary tightness to stave off currency
speculation and inflationary tendencies, but instead: i) bring the
recessionary tendencies to actual fruition by creating a credit crunch; ii)
cause the deterioration of financial balance sheets and bring the financial
and banking sector closer to distress.
c) Unnecessary and harmful punishment of alleged wrongdoers in of alleged
wrongdoers. The view that domestic players are mostly to blame for the
crisis has led to closure of banks that led directly to bank runs and extreme
aggravation of the financial sector.
d) Pushing trade and financial liberalization, privatization and deregulation
when the domestic economy is weakest. These policies, of course, cannot
be successful if imposed when the country is in crisis, the financial sector
dislocated and investors’ confidence is nil.
These measures aggravate the pro-cyclical nature of policies during crises wherein
low confidence and downturns are met with further confidence erosion and cutbacks
in economic and fiscal stimuli. This ensures that the crises become very deep and
long-drawn. In a recent document (IMF(2003d)), the IMF itself has criticized
(though quite cautiously) such pro-cyclical and damaging policies in its programs
with Indonesia and South Korea.
Thus the need for a new international financial architecture requires: i) a fundamental
change in IMF conditionality; and/or ii) alternative sources of liquid funds with
reasonable conditionalities to stave off a country’s degeneration into insolvency
during crises of confidence. It is left to future papers and research on how the above
will be achieved.
Exceptional financing by the IMF during financial crises is usually accompanied by
debt rescheduling and debt restructuring by Paris Club creditors. If the
conditionalities are significantly improved, the Paris Club debt rescheduling and
restructuring (recall that we had recommended bilateral and multilateral debts to be
included in sovereign debt restructurings) will be most helpful in restoring
confidence, and in allowing badly needed liquid funds to go into social safety nets,
vital public spending and public investments to pump-prime the economy back into a
healthy condition.
Availability of liquidity fund with more reasonable conditionalities is very important

in the necessary switch towards counter-cyclical policies to address financial crises
and economic recession in developing countries.
5.3 Interlinking the Three Components
It must be emphasized that the three components are critically needed and linked10 .
First capital controls reduce the potential size and extent of the crisis by reducing the
amount of financial and capital flows. This eventually translates to a smaller level of
required liquidity funds as well as debt restructuring (if at all).
Also integrally linked are the two other components. Both international liquidity
funds and debt workouts reduce the net outflow of precious foreign exchange and
funds that may lead to sovereign insolvency. In times of real crises and recession,
debt standstills and workout arrangements ensure that the needed funds provided by
multilateral and bilateral institutions go to social and economic spending for the
country in order to resuscitate the economy and to provide social safety nets during
the crisis. A clear policy that the international funds will largely not go to debt
payments is the best way to ensure creditors’ cooperation in debt workouts and debt
restructuring arrangements, including the vulture and holdout creditors. It should be
made clear that international creditors will not get any automatic bailout.
There is a controversy as to whether international liquidity funds, on one hand, and

debt standstills and workout arrangements, on the other, should be substitutes or
complements. 11 The view in this paper is that, as long as international funds are not
targeted towards debt payments but to crucial non-debt budgetary and balance of
payments support, then the two are complementary. Making them substitutes may
expose the developing country to high risk wherein a long drawn-out debt workout
negotiation process, without current liquidity funding, will lead to default, insolvency
and prolonged economic and financial collapse. At the same time, debt standstills,
through workout arrangements and Paris Club debt restructuring, help in ensuring
that the liquidity funds will not go to debt payments.
10
In fact other international efforts might be needed during grave situations as in the Asian crisis.
These include coordinated actions by economically powerful countries: 1) to support massive currency
attacks on crisis-hit countries, 2) to jointly undertake counter-cyclical macroeconomic policies to
counter the recessionary tendencies of the spreading crisis, and 3) to refrain from tight monetary
policies to ease world interest rates.
11
In the parlance of bankruptcy and insolvency proceedings, a sovereign debtor’s access to
international liquidity funds and additional borrowing while debt restructuring (akin to bankruptcy
proceedings) is going on is called ‘debtor-in-possession financing, or, alternatively, granting a
‘seniority’ status to debt contracted after a bankruptcy petition is filed.
In the international financial system, there is unfairness in risk sharing against debtor
countries (in favor of creditors) with respect to adverse external shocks such as
exchange rate fluctuations, interest rate increases, world recessions, oil price shocks,
and domestic shocks (coups, political instability, natural calamities). They are forced
to continue paying their debt and interest payments even if they are faced by shocks
not of their making. The three components above will be very big steps in trying to
correct the current inequitable situation.
6. Other Debt Reduction Possibilites
Section 2 has shown clearly the need to rely less on deficits and public debt to
finance needed government expenditures. We had mentioned two key policies to
achieve this: 1) an increase in the tax effort, and 2) explore various debt reduction
options.
Debt Swaps and Debt Conversions
There are various debt swaps and debt conversion schemes that allow certain debts to
be paid by the government at a significant discount in exchange for equity in the
indebted country or for investments in social projects such as the environment, anti-
poverty projects. The debt-to-equity swap had been used in Chile and the Philippines
in 1987to 1990. This had had very minimal impact on Philippine debts and had been
criticized for reducing national sovereignty and giving foreign investors undue
discounts in their investments in the country
The debt-to-nature, debt-to-environment, debt-to-social services swaps had been

given much media attention in the late 1980s and 1990s, and had been used by
Bolivia, Madagascar and the Philippines (in 1993). Although such noble schemes
had provided funds for good projects, it had minimal dent in reducing the countries’
foreign debts. Some problems related to this approach are:
1. Only small country creditors (Italy, Netherlands, Scandinavian countries) are

interested in participating in such swaps. Important bilateral lenders such as
the US and Japan are usually not interested unless it involves a very small and
poor sub-Saharan or Central American country. The World Bank also had not
been very active in these schemes except in very selected countries. This has
resulted to little debt swaps in comparison to the total debts of the indebted
countries.
2. To effect a large debt reduction, the government should have large funds to
buy the debts at a discount. Many governments face fiscal constraints and/or
cannot create money due to stringent conditionalities in money supply
expansion to fight inflation.
3. To avail of large discounts for the debt swaps, the countries involved usually
should be already insolvent or in deep debt default (or close to it). The
market system will therefore have a natural tendency to discount the debt
papers of such a country. This option therefore is not so attractive to the
Philippines, given that it (hopefully) is not yet close to insolvency or debt
default. (Remember that when these schemes were applied to the Philippines
in the late 1980s and early 1990s, it was in a state of debt overhang following
the economic/ financial collapse in 1983-85.)
Lately, a similar proposal had arisen from Speaker Jose de Venecia of a debt-to-
MDG investment swap arrangements with creditors, supported by the current
Philippine government.
The proposal, presented to the UN, Paris Club, IMF and World Bank in September
2005, essentially calls for a voluntary conversion of creditors’ debts into either: a)
equities in new projects with prospective income streams, b) trust or endowment
funds for social investments or environmental programs, c) new lending with the best
possible terms for the Philippines for long term social reform programs. The projects
or programs that can benefit from such debt conversion schemes may include
environmental programs, energy conservation, mass housing, rural infrastructure,
educational institutions, hospitals and health care, micro-finance, ecotourism and
mining projects. The proposal specifically states that it will not call for debt
discounts to convert the debts into MDG investments.
This scheme now targets conversion of official bilateral debts of the government into
significant MDG financing. Upcoming studies by the Philippine Institute for
Development Studies (PIDS) and by a technical working group on Debt-for-MDG
Investments (headed by the Department of Foreign Affairs) will review possibilities
provided by the scheme.
7. Summary and Recommendations
This paper had focused on the need for a new international financial architecture that
will be conducive for countries at risk of facing debt and financial crises. This is
triggered by the fear that the Philippines may enter an Argentine-type crisis caused
by its fiscal problems.
sovereign countries. This makes them bear most of the risks and burden when their
debt conditions are adversely affected by volatile and exogenous shocks. In the end,
it is the poor and vulnerable population of the countries that suffer most. The
volatilities and vulnerabilities of countries to exogenous shocks and contagion had
increased substantially with the open capital account markets that allow ‘hot’ and
quick money to enter and exit the countries easily.
Thus another aspect of the international financial architecture should be a country’s

right to limit and control short-term capital flows into and out of the country.
Furthermore, in times of financial and debt crises, emergency funding is vital for the
countries. These financing sources should not exert undue contractionary and
stringent conditionalities on the indebted countries inasmuch as during crises of
confidence, countercyclical policies and social spending for the vulnerable are vital
elements to resuscitate and heal the economy.
Inasmuch as the current international financial system is not yet conducive to the
aforementioned needs of indebted countries, it is recommended that the following
policies be implemented by the Philippines:
1. Rely less on deficits and debt to finance vital government expenditures. This
requires improvements in the tax collection system. It is the belief of the author
that a permanent improvement in the tax collection system should go over and
beyond the currently heavy reliance on the new expanded value-added taxation to
generate new revenues. In the end, direct and progressive taxation of income and
wealth should be the main source of tax revenues as it is in most of the successful
economies in the world. Progressive taxation of real property, for example,
provides a big source of additional revenues that has remained untapped.
2. In line with no. 1, the government should set a public debt ceiling and debt
service ceiling to lessen the reliance on debt financing of vital expenditures. The
technical nature of this debt ceiling requires another paper and should be based
on new concepts of debt sustainability which incorporates the social and
economic financing needs of the country.
3. Rely more on domestic debt rather than on foreign debt. This is not simply
because domestic debt is not exposed to dangerous foreign exchange risks. The
lesson of South Korea showed that a sovereign government can effect a more
successful debt workout mechanism during debt and financial crises the bigger
the share of domestic creditors in the economy’s debt. This is because foreign
creditors are not subject to any debt workout or international bankruptcy
proceedings, and are not under the jurisdiction of the sovereign government.
This is even wiser for the Philippines now inasmuch as the yields of domestic
treasury bills had gone down significantly as to match the interest charges of
foreign debts.
4. Institute market-based taxes on short-term capital flows so that there will be

higher tax rates (and possibly higher required reserves) the shorter the term of the
financial investment. (This is the well-known Chilean tax).
5. Participate and perhaps even initiate united stands and policy advocacies with
other Third World debtor countries and to call for the institution of the key
elements for a new international financial architecture. The most promising
avenue for this would be the United Nations. Kofee Annan had tasked the UN
Department of Economic and Social Affairs (DESA) as the leading body to take
over the task of designing debt workout and debt restructuring mechanisms after
the IMF SDRM proposal was shot down by the US.

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A STUDY ON FOREIGN DEBT

REDUCTION OPTIONS FOR HEAVILY

Joseph Lim, Ph.D.

Thus another aspect of the international financial architecture should be a country’s

4. Institute market-based taxes on short-term capital flows so that there will be

1. Objectives of the Study

The objectives of this study are:

1. To provide civil society organizations a clearer understanding of the foreign

2. Background and Rationale

2.1 The Current Fiscal Problems of the Philippines

Item 1998 1999 2000 2001 2002 2003 2004 2005

A. National Government (NG)

C. Consolidated Public Sector Financial Position

Source: Bangko Sentral ng Pilipinas.

Table 2 shows this expenditure constriction in more detail. Expenditures (as

PARTICULARS 1997 1998 2000 2001 2002 2003 2004 2005

DEFENSE 1.20 1.18 1.08 0.90 0.98 1.04 0.88 0.82

TOTAL EXPENDITURES EXCL.

TOTAL 20.27 20.17 20.34 19.27 18.72 19.22 17.96 16.82

Source: Department of Budget and Management (DBM).

Item 1998 1999 2000 2001 2002 2003 2004 2005

Total Outstanding Debt of the

Source: Bangko Sentral ng Pilipinas

3. The Philippine’s Risk of Entering a Debt or Financial Crisis

Fig. 2: External Debt to GDP Ratio

Recent financial crises had involved in chronological sequence:

- Initial overvalued currency

- High exposure to short-term external debts

- Large portfolio flows

- Sudden loss in confidence / exogenous shocks

- Speculative attacks and massive currency devaluations

- Loss of international reserves

- Increases in interest rates to stave off currency depreciation

- Deterioration of financial balance sheets

- Private (bank, corporate and GOCC) debt defaults

- Assumption of private and GOCC debts by national government

- :Possible public debt default (such as Argentina in 2001, Philippines and

Fig. 4: Short Term Debt To International Reserves

Fig. 6: Debt Service to Exports Ratio

4. The Need to Study Debt Arbitration and Sovereign Debt Restructuring

4.1 Debt Workouts: Experience from South Korea

Another basic assumption of the current mainstream initiatives is the assumption of a

4.2 CGC, CAC and SDRM

4.2.1 Codes of Good Conduct (CGCs)

• In a first scenario ( “alleviating tensions on a sustainable debt”) characterised

• In a second scenario (“re-negotiating unsustainable debts, while “remaining

• In a third scenario (“renegotiating unsustainable debt under a payment

“Three categories of stakeholders should be involved in the design of the CGC:

4.2.2 Collective Action Clauses (CACs)

The voluntary CGC, if generally agreed upon, needs statutory mechanisms to be

These CACs would allow, through a pre-determined level of majority and

1) The financial industry draft requires an unreasonable 90% of creditor consent

5) The industry draft frowns on exit consents – changes in non-payment terms

4.2.3 The Sovereign Debt Restructuring Mechanism (SDRM)

The IMF SDRM Proposal

I. Eligible claims would be claims by creditors included in the SDRM

A related problem is whether to include official bilateral creditors’ debts in

The debtor will be required to provide relevant information regarding its

Activation would not automatically suspend creditors’ rights, including

III. To encourage early participation of creditors in restructuring processes, a

IV. Creditor approval of restructuring or priority financing proposals would

The restructuring or priority financing agreement, once approved and