Select Committee on International Development Appendices to the Minutes of Evidence


Memorandum submitted by Professor Kunibert Raffer, Department of Economics, University of Vienna, Austria

  Justified calls for a fundamental change in "debt management" by important G7-members, first by the Secretary of the US Treasury, Paul O'Neill, shortly later by the Chancellor of the Exchequer, Gordon Brown, and the Canadian Finance Minister have finally been heeded by the IMF. A publication by the Bank of England and the Bank of Canada (Haldane & Kruger 2001) had also proposed a standstill arguing that sovereign debtors need the safe harbour which bankruptcy law provides in a corporate context. The decision to go on exploring possibilities of sovereign insolvency is thus a very important outcome of the Autumn Meetings. The UK played an important and commendable role in changing the international financial architecture, both by demanding debt reduction within the Paris Club, and more recently by incorporating clauses regarding creditor actions into debt contracts in a helpful attempt to bring about useful changes.

  While sovereign insolvency is hardly a new approach—Adam Smith already advocated it—Anne Krueger's initiative is laudable. Its merit is finally breaking the taboo at the IMF, bringing a long needed change in the Fund's own attitude. Unfortunately it is not going to work. Totally shaped by the IMF's narrow institutional self-interest it is simply a continuation of unsuccessful debt management since 1982. Strong reservations are therefore heard from creditors, including the US Treasury, debtors and NGOs. The SDRM is likely to become another unsuccessful IMF attempt at debt management, a Simply Disastrous Rescheduling Mechanism for all but the Fund. Its results are likely to match those of HIPC I, HIPC II, "Structural Adjustment", Paris Club Terms, and the Miyazawa/Brady deals, all characterised by a leading role of the IMF and the fact that they did not resolve the debt problem.

  The fundamental difference between the SDRM and all earlier proponents of sovereign insolvency (cf Raffer 2001, Rogoff & Zettelmeyer 2002) is that it would make the IMF the undisputed overlord of sovereign insolvency, also legally enshrining its present de facto treatment as a preferred creditor by treaty. And it will not work. The SDRM's main problems are:

  1.  The IMF's Executive Board alone determines sustainability and decides on the adequacy of the debtor's economic policy. These decisions cannot be challenged. Determining sustainability the IMF would automatically determine the amount of debt reduction. This most important decision would be taken by the Fund, a creditor both in its own right and dominated by a majority of official creditors. Other creditors have no say. Debtor ownership would not be encouraged.

  The IMF (2002, p8) meanwhile suggests that debtors may choose which part of debts to include into an SDRM, a choice to be "influenced" by the Fund, whose conditionality would "enhance" the "incentives to assure equitable treatment" of creditors (ibid., p16) The IMF (2002, p10) suggests the creation of many creditor classes with classification rules part of the amendment of the IMF's Articles of Agreement, each class vested with "effective veto power over the terms offered to other classes". One may safely assume mutual blocking and the need for good services. It would be a surprise if the IMF would be unwilling to provide these good services. Considering the number of cases in the near future might tempt minds more critical than I to speak of a substantial employment programme for the Fund.

  The Fund is to decide on a temporary standstill. Activating the stay by creditor decision—as now suggested as one possibility by the IMF (2002, p6)—is clearly unrealistic, considering how long it would take for creditor committees to be formed. The Fund would evaluate relations with creditors, which raises the question: are creditors themselves unable to judge whether their relations with a debtor are good? Krueger's (2002, p4, emph. mine) statement "The Fund would only influence the process as it does now, through its normal lending decisions" sums up, in a nutshell, the problem with the SDRM.

  2.  The whole mechanism is to be enshrined into the IMF's statutes. The problem of so-called "vulture funds" is used to claim that the Fund would be necessary to implement sovereign insolvency as laws barring disruptive litigation must have the force of law universally. This argument is altogether flawed. Not all countries and territories are IMF members. If creditors were actually as eager to shop for jurisdictions without collective action clauses (which is unlikely) they could still choose jurisdictions which, not being members of the IMF, offer this option. When arguing against the Tobin Tax this point has routinely been used to prove that universal implementation could not be assured and that this form of taxation would therefore not work. The same concern holds logically in the case of the SDRM, even though it is conveniently "forgotten".

  Legally it is not absolutely clear whether vultures would prevail in future cases, but there are several suggestions how to preclude vulture funds from disturbing the process of bona fide negotiations. There is one water tight way of doing so shown by Raffer (2002). Changing sovereign immunity laws in the very few jurisdictions stipulated by loan agreements by inserting a clause voiding or suspending waivers of immunity during sovereign insolvency proceedings would solve the problem of disruptive litigation. "Vultures" are equally bound by existing contracts, including clauses stipulating which law applies in the case of disputes. If the US and the UK changed their laws governing sovereign immunities by inserting one short sentence vulture funds would be put out of business in most cases. This sentence could, eg, read: "Starting international insolvency procedures voids/suspends all waivers of immunity relating to this case." In the UK State Immunity Act 1978, Chapter 33, this could, eg, be inserted in Part I. More elegant formulations than mine are certainly welcome. If those few "exotic" places whose laws are occasionally agreed on, such as Frankfurt, followed, disruptive litigation would be impossible. This small change in sovereign immunity laws would have the advantage of preserving sensible and tested solutions in domestic contexts, such as the US preference for excluding majority action clauses to protect small investors.

  From an institutional point of view the statutory approach is vitally important to the Fund, giving it the sole mandate on sovereign insolvency, also ending joint "debt management" of IBRD and IMF and thus the long turf war between the two about which is in charge.

  3.  Multilateral debts, especially the IMF's own claims, remain exempt. The present de facto status of International Financial Institutions (IFIs) is to be legalised. This makes the ongoing discussion about "bailing-in" the private sector—or Private Sector Involvement—particularly obfuscating. Under various Brady schemes private creditors granted generous debt reductions, eg 35 per cent in the case of Mexico, or 45 per cent in Ecuador. These reductions did not solve the problem as new official money—protected against losses—immediately increased debts again. In 1999 Ecuador was unable to honour her Brady bonds, the first undeniable failure of the Initiative demanding only one group of creditors to "take a haircut". If all creditors had reduced by 30 per cent commercial banks would have saved 15 percentage points and Ecuador would in all probability have been economically afloat again—a prime example of the necessity of equal treatment repeatedly demanded by the private sector, of fully bailing in the international public sector.

  4.  The arbitration mechanism proposed—meanwhile called Sovereign Debt Dispute Resolution Forum (SDDRF)—is totally under IMF control. The SDDRF would have no authority to challenge decisions made by the Executive Board regarding, inter alia, the adequacy of a members policies or the sustainability of the member's debt. Claiming that the SDDRF would be "independent" of the IMF, Krueger (2002, p4) clarifies "The flipside of this independence is that the role of the dispute resolution forum should be strictly limited."

  While its authority over the IMF and public creditors is indeed quite limited, its decisions resolving disputes between the debtor and its creditors or among creditors are binding irrespective of what creditor "super majorities" might decide. They could not be challenged (IMF 2002, p28). The panel's powers over private creditors and debtors would not be limited.

  A complicated, clumsy, and unnecessary five-stage process dominated by the IMF is proposed. Nominees—one per member country—are vetted by a "neutral" committee established by the IMF's Executive Board in order to reduce the roster from 183 names to 21, incidentally a number that would allow a list exclusively consisting of nominees from Northern creditor countries. The vetted and reduced list is passed to the Governors for approval, who can only vote on the entire list as a package. If approved the Managing Director appoints the members for a renewable term. The appointed elect a president, who—when needed—would "impanel" three members of the roster to form the panel for an actual case. The IMF's weighted voting structure establishes clear creditor majorities. Creditors would be able to determine the committee, and to check its proposal. Once again, debtors would be under the thumb of their official creditors.

  The IMF's model violates the fundamental principle of the Rule of Law that one must not be judge in one's own cause In spite of repeated assertions that creditors or creditors and the debtor should be empowered, the IMF would determine the outcome down to details. Private creditors already complained about undue preference.


  A mechanism able to solve sovereign debt overhang problems must comply with minimal economic, legal and humane requirements. It must respect the fundamental pillar of the Rule of Law that one must not be judge in one's own cause, and it must incorporate the principle of appropriate debtor protection. Also, present preferential treatment of IFIs allows them to profit from their own errors and negligence. This appalling case of institutional moral hazard must be abolished.

  The Fair and Transparent Arbitration Procedure (FTAP) proposed by Raffer (1990, 2001) and seconded by Raffer & Singer (1996, pp.203ff; 2001, pp.243ff) provides an economically efficient solution with a human face. It is based on the principles of the US municipal insolvency, so-called Chapter 9 of Title 11 of the US Code, the only procedure protecting governmental powers, and thus applicable to sovereigns 904 titled "Limitation on Jurisdiction and Powers of Court" states with outmost clarity that the court—let alone creditors—must not "interfere with—

    (1)  any of the political and governmental powers of the debtor;

    (2)  any of the property or revenues of the debtor; or

    (3)  the debtor's use or enjoyment of any income-producing property."

  The concept of sovereignty does not contain anything more than what 904 protects. The court's jurisdiction depends on the municipality's volition, beyond which it cannot be extended, similar to the jurisdiction of international arbitrators. Unlike in other bankruptcy procedures liquidation of the debtor, receivership or change of "management" (ie removing elected officials) by courts or creditors is not possible in the case of US municipalities—nor should it be in the case of sovereigns.

  Public interest in the functioning of the debtor safeguards a minimum of municipal activities. US municipalities are allowed to maintain basic social services essential to the health, safety and welfare of their inhabitants. The affected population has a right to be heard. The procedure is as transparent as befits a public entity. The US Chapter 9 provides viable solutions protecting the governmental sphere of the debtor as well as the interests of creditors. This is essential, as only a totally fair mechanism would be universally accepted, and rightly so. Naturally, only the basic principles not all details of domestic Chapter 9 should form the basis of arbitral proceedings. Evidently, some important and necessary details of domestic Chapter 9 are unnecessary and inapplicable internationally.

  Respecting the Rule of Law: In contrast to the SDRM where the IMF, itself a creditor and controlled by a creditor voting majority, would decide on debt reductions and other important issues, all civilised legal systems require a neutral entity without any self-interest to preside legal procedures, and to decide if and when necessary. It is also economically sensible, as someone with a vested interest is unlikely to decide objectively and efficiently. The IMF's role in debt management since the mid-1970s drives this point home. This minimum of fairness has been denied to sovereign debtors and their poor so far. Creditors have been judge, jury, experts, bailiff, occasionally even the debtor's lawyer all in one—with highly unsatisfactory results. The SDRM is also unfair vis-a"-vis other creditors forced to pay for the consequences of wrong or negligent IFI decisions by losing more money.

  In my model the parties—debtor and creditors—would establish ad hoc arbitration panels. Creditors and debtors would nominate one or two persons, who in turn would elect one further member to reach an uneven number, as is traditional practice in international law. The whole clumsy process proposed by the IMF is unnecessary and unduly restrictive. Arbitrators would have the task of mediating between the debtor and creditors, chairing and supporting negotiations by advice, providing adequate possibilities to be heard for the affected population, and—if necessary—deciding. This would be done obeying the main principles of domestic US Chapter 9, such as protection of the debtor's governmental powers, the right of the affected population to voice their views, but also the best interest of creditors. The entities and NGOs representing the affected population—as the right to be heard could not be exercised individually in the case of countries—such as trade unions, entrepreneurial associations, religious or non-religious NGOs, would present opinions and data, arguing in an open, transparent procedure before the panel. Sustainability would emerge from the facts presented and discussed. It would not be determined by the IMF whose record of estimating sustainability is anything but good.

  The Principle of Debtor Protection: The basic function of any insolvency procedure is solving a conflict between two fundamental legal principles: the right of creditors to interest and repayment and the human right recognised generally (not only in the case of loans) by all civilised legal systems that no one must be forced to fulfil contracts if that causes inhumane distress, endangers one's life or health, or violates human dignity. In the case of a debt overhang these principles collide. Although claims are recognised as legitimate, insolvency exempts resources from being seized by bona fide creditors. Debtors—unless they happen to be Developing Countries—cannot be forced to starve themselves or their children in order to pay more. Human rights and human dignity enjoy unconditional priority over repayment, even though insolvency only deals with claims based on a solid and proper legal foundation. A fortiori this is valid for less well founded claims. By contrast, Malawi—a case discussed in the Treasury Select Committee on 4 July 2002—was forced to sell maize from her National Food Reserve to repay loans, which left seven million of a population of 11 million severely short of food according to Action Aid. This priority of creditor interest over survival—nowadays unique to Southern debts—must be abolished. None of the IMF's papers so far contains the smallest hint of any debtor protection. My proposal would precisely make cases such as Malawi no longer possible. The life and the human dignity of people must be equally respected and protected in the South.

  Besides preserving essential services to the population my proposal gives the affected population and vulnerable groups a right to be heard, and exempts resources necessary to finance minimum standards of basic health services, primary education, and an economic fresh start. Briefly put: it applies the decent principles of modern law worldwide. A transparently managed fund financed by the debtor in domestic currency and monitored by an international board or advisory council consisting of members from the debtor country as well as from creditor countries should administer these exempt resources. Its members could be nominated by governments (including the debtor's) and NGOs. This fund would be a legal entity of its own. Checks and discussions of its projects would not concern the government's budget, which is an important part of a country's sovereignty.

  Multilateral Debts: The most basic rule of a market system demands that decisions be inseparably linked with risk. Making those taking decisions accountable this link promotes economic efficiency. It was severed in the former Eastern Bloc where largely unaccountable institutions took decisions. In the case of IFIs the problem is even worse: decisions are not simply delinked from financial responsibilities, IFIs even gain financially from their own errors and negligence. Extending new loans necessary to repair damages done by prior loans increases their income streams. IFIs insist on full repayment, even if damages are caused by their staff because of grave negligence or disregard for minimum professional standards. A high rate of IFI-failures might therefore render adjustment programmes necessary, which IFIs administer, just as failed programmes are likely to call for new programmes, as long as unconditional repayment to IFIs is upheld. Since prolonged and aggravated crises increase the importance of IFIs as "crisis managers", there is an incentive not to solve debt problems. An institutional self-interest in crises is part and parcel of the present system. If IFIs have learned in the past, poor countries and vulnerable groups in particular have paid their tuition (cf. my submission to the Treasury Committee in 1997, published as Annex 12). Unconditional exemption of the IMF's own and other multilateral claims as demanded would legalise this economically and ethically unjustified malpractice. While private creditors are supposed to grant debt reductions, feeling the sting of the market mechanism, IFIs could increase their exposure, knowing that they will be protected.

  By contrast my proposal would introduce financial accountability of IFIs for their own decisions, similar to the way consultants are accountable. Equal treatment with other creditors if debtors acting on IFI-advice become insolvent is the easiest way to do so. The statutes of all multilateral development banks already foresee default of sovereign borrowers and appropriate ways of recognising losses. As conditionality was initially not foreseen loan loss provisions were unnecessary for the IMF. When conditionality was introduced, no appropriate changes making the Fund financially accountable were made. It is necessary that a minimum of market discipline be brought to the IMF. In the case of HIPCs the need to reduce multilateral claims is already accepted. The "argument" that IFIs cannot reduce their claims is no longer upheld.


  While some form of sovereign insolvency is urgently needed, the IMF's self-serving SDRM-proposal is no solution. Economic efficiency, respecting human rights and the Rule of Law, and fairness to both debtors and all creditors convincingly demand a specific type of insolvency appropriate for sovereigns—a process based on the principles of the US Chapter 9. Using existing mechanisms my proposal can be applied immediately if important creditor countries agree. It is to be hoped that no further delays imposing unnecessary costs on debtors and the international community will occur.

  Haldane, Andy & Mark Kruger (2001) "The Resolution of International Financial Crises: Private Finance and Public Funds", November, (mimeo).

  IMF (2002) "Sovereign Debt Restructuring Mechanism—Further Considerations", (14 August) (mimeo).

  Krueger, Anne (2002) Sovereign Debt Restructuring and Dispute Resolution" (6 June),

  Raffer, Kunibert (1990) "Applying Chapter 9 Insolvency to International Debts: An Economically Efficient Solution with a Human Face", World Development 18(2), pp.301ff

  Raffer, Kunibert (2001) "Solving Sovereign Debt Overhang by Internationalising Chapter 9 Procedures", updated version via link on¥rafferk5

  Raffer, Kunnibert (2202) "Shopping for Jurisdictions—A Problem for International Chapter 9 Insolvency?" (24 January)

  Raffer, Kunibert & H W Singer (1996) The Foreign Aid Business: Economic Assistance and Development Co-operation, E Elgar, Cheltenham (UK) and Brookfield (US).

  Raffer, Kunibert and H W Singer ("001) The Economic North-South Divide: Six Decades of Unequal Development, E Elgar, Cheltenham (UK) and Northampton (US).

  Rogoff Kenneth and Jeromin Zettelmeyer (2002) "Early Ideas on Sovereign Bankruptcy Reorganisation: A Survey", IMF Working Paper WP/02/57.

  Treasury Committee, House of Commons (1997) Fourth Report: International Monetary Fund, ordered to be printed on 5 March 1997, Stationery Office, London.

Professor Kunibert Raffer

Department of Economics, University of Vienna, Austria

Senior Associate, New Economics Foundation, London

October 2002

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