Sovereign Debt Restructuring

The writer, Mr Lee Buchheit, is a lawyer who has represented many countries in sovereign debt restructurings.

Some countries have a compelling argument for why they should not be expected to join the planetary effort to fight climate change. These are countries facing the need to restructure their external debt. By definition, sovereigns that cannot pay what they are already contractually obligated to pay will not have excess cash to devote to environmental conservation or other measures to assist with limiting climate change. As incongruous as it may sound, however, it is precisely this subset of countries undergoing a debt restructuring that may have an alternative avenue for funding these projects.

Background
Most modern sovereign debt restructurings take the form of bond exchanges. The sovereign’s existing foreign currency-denominated bonds (which it cannot afford to service on their current terms) are exchanged for new bonds whose financial terms reflect the debt relief the bondholders have agreed to provide. That debt relief is normally conveyed through some combination of principal reduction, coupon adjustment and/or maturity extension. The objective of every sovereign debt workout, from the creditors’ perspective, is to grant debt relief sufficient (just) to permit the sovereign to regain market access and thus improve the collectibility of the lenders’ residual claims. The arguments heard around a sovereign debt negotiating table usually focus on how much debt relief will meet that threshold, how the relief is to be implemented (principal haircut, coupon adjustment, maturity extension) and how much of a contribution to the country’s adjustment is to be provided by other stakeholders — the citizens of the debtor country in the form of fiscal adjustment, the official sector players like the International Monetary Fund, and other creditor groups such as bilateral (government) lenders and domestic creditors.

The lenders’ primary negotiating objective is therefore to provide the minimal amount of debt relief necessary to improve the borrower’s debt dynamics so that the borrower can return to normal market refinancing of its remaining external debt. A secondary objective is to convey that debt relief in a way that will be the least inconvenient for the lenders. A serious flaw in conventional sovereign debt restructurings is the absence of any effective mechanism for the creditors providing debt relief to monitor or enforce how the sovereign debtor uses the savings that flow from the debt relief. Once the debt relief has been granted, the sovereign borrower is generally free to spend or misspend the savings as it sees fit. If the sovereign had entered into an IMF program in connection with the restructuring the Fund will monitor compliance while the program lasts, but Fund programs are of short duration. If a lender’s entire motivation in providing relief is to improve the borrower’s debt dynamics and thereby enhance the likelihood that the balance of the loan can be repaid on its restructured terms, there is little or nothing in the conventional debt restructuring arsenal to prevent postclosing backsliding by the sovereign debtor. Such a return to imprudent fiscal behavior will again erode the country’s debt dynamics, perhaps triggering the need for yet another round of debt restructuring. 

The Technique
A technique that would marry the dual objectives of emerging market debt relief and environmental conservation involves engineering the restructuring so that a portion of the debt relief granted to the sovereign both improves the country’s debt dynamics (the raison d’etre for the entire exercise from the creditors’ perspective) and funds approved conservation projects in the debtor country. 

In a garden variety sovereign debt restructuring involving an exchange offer, the sovereign debtor could be given an option to discharge a portion of the foreign currency debt service due on the new bonds it issues in connection with the transaction by paying the local currency equivalent of that portion to fund a conservation project within its own territory approved in advance by the lenders. The project could be monitored and administered by an independent third party such as an NGO or United Nations organization. A failure by the sovereign to fund the project with local currency on any payment date would mean that the sovereign debtor would owe the full amount of the foreign-currency debt service payment due under the new bonds on that date.

An illustration — the Republic of Ruritania owes a $10 million coupon payment every six months on the bonds it issues as part of its debt restructuring. Those bonds provide, however, that at Ruritania’s option up to $2 million of each of those coupon payments may be discharged in local (Ruritanian) currency by funding a creditor-approved environmental conservation or similar project in Ruritania. Failure to fund the project on any coupon payment date under the bonds means that Ruritania must pay the full $10 million — in U.S. dollars — to its bondholders.

Benefits
The benefits for the creditors:

• By allowing a portion of coupon payments in this example to be discharged in local currency, the bondholders are improving the country’s dynamics by reducing the call on its international monetary reserves.
• For at least this portion of the debt relief they provide to Ruritania, the creditors will be able to control and monitor how the savings are used. The beneficiary project must be approved in advance by the lenders and it will be monitored by an independent third party.
• The creditors can point to this feature of Ruritania’s debt restructuring as evidence of the lenders’ commitment to ESG principles.
• A feature allowing a portion of the debt service to be reinvested in the Ruritanian economy may help to mute any local resentment of the debt restructuring, thus lowering the political risk to the transaction.

The benefits for Ruritania:

• Ruritania’s external debt dynamics are improved.
• Unlike normal external debt service payments that immediately fly out of Ruritania, the portion of these payments that can be discharged in local currency will stay in Ruritania.
• The funded project should have ancillary benefits for the Ruritanian economy such as employment, protection of natural resources and possibly an increase in tourism.
• Ruritania should be able to bask in the warm approbation of the international community and official sector actors by taking a concrete measure to mitigate climate change.