Jay Newman was a senior portfolio manager at Elliott Management, and is the author of Undermoney, a thriller about the illicit money that courses through the global economy.
In 1965, Ralph Nader wrote Unsafe at Any Speed, exposing a car industry that systematically stifled safety features. Over the past two decades, the industry that peddles emerging market sovereign debt — countries, their bank underwriters, and the lawyers that write the contracts — has been peddling bonds that are unsafe at any price.
Sovereign debt is back on the front pages in part because economic sanctions are pushing Russia to the brink of default. That is causing investors to wake up to the risk that a dozen or more developing countries could follow.
Bill Rhodes and John Lipsky, co-chairmen of the Bretton Woods Committee’s Sovereign Debt Working Group, have warned that 60 per cent of low-income countries run a high risk of defaulting on their debt, and argue that existing mechanisms for dealing with sovereign-debt restructuring aren’t up to the task.
Fair points. As is their observation that no one is quite sure how much debt is out there, particularly since China began flooding the developing world with massive Belt and Road loans. Sovereign debt defaults are a perennial issue, and the risk of a coming crash is real.
But stalwarts of the incumbent order offer hopeless ideas for solving a problem of their own invention. Debtor countries continue to borrow whenever they have an opportunity because its free money. Thanks to Lipsky’s Sovereign Debt Working Group, a feckless IMF and the World Bank, repayment has become optional.
Clause by clause, covenant by covenant, sovereign debt instruments have been intentionally and systematically stripped of nearly every provision that might safeguard the interests of creditors. Indentures often run to hundreds of pages. Dense legalese suggests that sovereign bonds contain robust, actionable legal rights. But that’s nothing more than magical misdirection: a delusion.
In a default, creditors have little choice but to take what they are offered, no matter how outrageous or disconnected from a debtor’s capacity to pay, because sovereign bonds have become functionally unenforceable.
The list of missing protections is long, to name but a few: Creditors once retained the rights to act individually and enforce their rights directly. Now they’re forced to work through ineffectual indenture trustees. Once upon a time, each series of bonds ranked pari passu in priority of payment with every other series, so that a debtor could not involuntarily subordinate one set of bondholders by offering preferences to others: no longer.
But the biggest, most pernicious, changes have been the inclusion of complex, multipronged collective action clauses that not only allow a subset of creditors to determine the economic rights of all, but also permit the debtor to manipulate who gets to vote on what, and when.
Picking your way through a bond contract is merely the first hurdle. Pursuing recalcitrant sovereigns through the courts is fiendishly complex, massively expensive, and can drag on for years. Even legal victories often end in frustration and failure.
Sovereign deadbeats, just like the common sort, try to render themselves judgment-proof by structuring their affairs to evade enforcement — using opaque alter ego entities, and parking money at willing enablers like the Bank for International Settlements and the New York Federal Reserve. And clever lawyers have become expert at advising sovereigns on the game of manipulating creditors, playing one against another.
In another universe, creditors would act in concert to thwart those machinations. But such is the structure of creditor groups and individual egos that collective action seems an impossibility.
Throughout most of history, lending to sovereigns has been perilous. Creditors without armies had little recourse, because sovereigns enjoy absolute immunity. As a result, only the bravest lenders had been willing to lend money in a weak sovereign’s native currency, much less to risk the vagaries of chasing a country through the courts.
It was precisely to address those concerns that, in the mid-1970s, both the US and the UK enacted statutory regimes — the Foreign Sovereign Immunities Act (1976) and the State Immunities Act (1977), respectively — that codified the circumstances under which a sovereign could waive its absolute immunity, agree to be bound by US or English law, and submit to being sued in New York or London if they reneged on their debts.
The FSIA and the SIA were principled efforts to align best practices in law and finance, and those statutes were intended to create new opportunities for responsible nations to demonstrate their willingness to abide by international norms. Potential lenders could draw comfort from the fact that, if a country submitted to the jurisdiction of a developed country court system there would be mechanisms to force even a recalcitrant sovereign debtor to pay.
That was the theory. The reality was that defaults on bonds premised on the FSIA and the SIA began almost as soon as the ink was dry, beginning with Mexico in 1982. It became clear that investors faced challenges well beyond the four corners of their bond contracts. The geopolitical deck is stacked against investors because the international political class invariably sides with even the most incorrigible emerging market debtor and heaps opprobrium on lenders who have the temerity to insist on being repaid.
The IMF, the European Union, the World Bank, the United Nations, progressive-leaning NGOs, and the leaders of the G-7, all join the chorus by changing laws to protect some borrowers and intervening in court proceedings to oppose their own taxpayers. For the official sector, there is only honour in helping third-world debtors escape obligations that they have legally, contractually incurred. The moral hazard is clear: because the official sector lines up with debtors so uniformly, there is little incentive for any borrower to make its best effort to pay what it owes.
Perhaps no one should care very much about investors who make bad decisions or countries that game the system. But sovereign defaults are not a victimless crime. New issues of emerging market debt typically find their way into the portfolios of mutual funds and ETFs that are widely marketed to retail investors. Only rarely are retail investors quick enough to sense trouble and dump funds holding bonds that are headed for default. More often, those investors bear the brunt of the first round of losses.
We could sticker the prospectuses, but nobody reads those, so warning labels won’t do. And it’s not only a matter of protecting investors. Western jurists should not be drawn into the labyrinth of adjudicating pseudo-contracts and pretend-legal agreements. They should be relieved of the awkward job of judging complex, fundamentally political disputes that really should never have been dumped in their courtrooms in the first place.
This 50-year experiment in expanding capital market access to countries that lack robust domestic institutions has been a failure: it has led to default after default as countries borrow in currencies other than their own, run into trouble, and renege.
The simple, elegant solution is to give up the ghost: Repeal the Foreign Sovereign Immunities and the State Immunities acts, and make it clear to all that — once more — countries enjoy absolute immunity, and that anyone who thinks otherwise does so at their peril and must rely on the goodwill and probity of the debtor alone.
These laws don’t work because politics has undermined the foundations of finance and has taken primacy under a confederation of sovereign and supranational actors. But governments should no longer be enabled in a lend-and-pretend regime based on the false premises that choosing New York or English law offers protection, or that American or English judges will champion their right to be repaid.
It would be a different world, with so many salutary effects. Emerging market countries — really all weak government borrowers — would be cut off from feeding on the uninformed fantasy that contracts offer meaningful protection simply because they are long. Investors would be forced to acknowledge that the only protection they really have is the full faith and credit of the sovereign.
To induce investors to lend them money, nations would have to demonstrate their probity: convince lenders that their social and legal institutions are strong, that they are responsible borrowers, that borrowed funds will be put to productive use, and that the value of their currencies will be supported by sound economic policies.
To be sure, in the short run, many countries will not make the grade — they won’t be able to borrow as much as domestic political elites might like. And, when investors really dig into the details, some countries will not be able to borrow at all until — and if — they get their houses in order.
It’s about time.