Dangerous at all costs | FinancialTimes


Jay Newman was a senior portfolio manager at Elliott Management and is the author of Undermoney, a thriller about illicit money circulating in the global economy.

In 1965, Ralph Nader wrote Dangerous at any speed, exposing an auto industry that has consistently stifled safety features. Over the past two decades, the industry that peddles emerging market sovereign debt — the countries, their bank underwriters, and the lawyers who write the contracts — has peddled bonds that are dangerous at all costs.

Sovereign debt is back on the front pages in part because economic sanctions are pushing Russia to the brink of default. This makes investors realize the risk that a dozen or more developing countries could follow.

Bill Rhodes and John Lipsky, co-chairs of the Bretton Woods Committee’s Sovereign Debt Task Force, have warned that 60% of low-income countries are at high risk of debt default and argue that existing mechanisms to deal with with debt restructuring are not up to par.

Fair points. Just as they observed that no one is quite sure how much debt there is, especially since China started flooding the developing world with huge belt and road loans. Sovereign debt defaults are an ongoing problem and the risk of a coming crash is real.

But the pillars of the established order offer hopeless ideas to solve a problem of their own invention. Debtor countries keep borrowing every chance they get because it’s free money. Thanks to Lipsky’s Sovereign Debt Task Force, a powerless IMF and the World Bank, repayment became optional.

Clause by clause, covenant after covenant, sovereign debt instruments have been intentionally and systematically stripped of almost all provisions that could protect the interests of creditors. Trust deeds are often hundreds of pages long. Heavy legalese suggests that sovereign bonds contain strong and actionable legal rights. But this is nothing more than magical misdirection: an illusion.

In the event of default, creditors have little choice but to accept whatever is offered to them, however outrageous or disconnected from the debtor’s ability to pay, as sovereign bonds have become functionally unenforceable.

The list of missing protections is long, to name a few: creditors once retained the right to act individually and assert their rights directly. Now they are forced to work with ineffective contract trustees. Once upon a time, every series of graded bonds past bet in priority of payment with all other series, so that a debtor could not unwittingly subordinate a set of bondholders by offering preferences to others: not anymore.

But the most significant and pernicious changes have been the inclusion of complex, multi-pronged collective action clauses that not only allow a subset of creditors to determine the economic rights of all, but also allow the debtor to manipulate who can vote on what, and when.

Navigating your way through a bond contract is only the first hurdle. Prosecuting recalcitrant rulers in court is fiendishly complex, extremely expensive, and can drag on for years. Even legal victories often end in frustration and failure.

Sovereign deadbeats, like others, try to shield themselves from judgment by structuring their affairs to evade law enforcement – using opaque alter ego entities and collateralizing money to voluntary facilitators such as the Bank for International Settlements and the Federal Reserve of New York. And skilful jurists have become masters in the art of advising sovereigns on the game of manipulating creditors, playing them off against each other.

In another universe, the creditors would act in concert to thwart these machinations. But such is the structure of creditor groups and individual egos that collective action seems impossible.

For most of history, lending to sovereigns has been perilous. Creditors without armies had little recourse, as sovereigns enjoyed absolute immunity. As a result, only the bravest lenders had been willing to lend money in the home currency of a weak sovereign, let alone risk the whims of taking a country to court.

It was precisely to address these concerns that in the mid-1970s the United States and the United Kingdom enacted legislative regimes — the Foreign Sovereign Immunities Act (1976) and the State Immunities Act (1977), respectively — which codified the circumstances in which a sovereign could waive absolute immunity, agree to be bound by American or English law, and submit to prosecution in New York or London if he waived his debts.

The FSIA and SIA were principled efforts to align best practices in law and finance, and these statutes were intended to create new opportunities for responsible nations to demonstrate their willingness to comply with international standards. Potential lenders might take comfort in the fact that if a country submitted to the jurisdiction of a developed country’s judicial system, there would be mechanisms to force even a recalcitrant sovereign debtor to pay.

It was the theory. The reality was that defaults on FSIA and SIA-based bonds began almost as soon as the ink was dry, starting 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 the most incorrigible debtor in emerging markets and brings opprobrium to lenders who have the temerity to insist on repayment.

The IMF, European Union, World Bank, United Nations, progressive NGOs and G-7 leaders are all joining the chorus in changing laws to protect some borrowers and intervening in legal proceedings to s oppose their own taxpayers. . For the public sector, there is only honor in helping Third World debtors to escape the obligations they have legally and contractually contracted. The moral hazard is clear: since the public sector aligns itself so evenly with debtors, there is little incentive for a borrower to do their best to pay what they owe.

Perhaps no one should really care about investors making bad decisions or countries playing games with the system. But sovereign defaults are not a victimless crime. New issues of emerging market debt securities are typically found in mutual fund and ETF portfolios widely marketed to retail investors. Rarely are retail investors quick enough to spot problems and dump funds holding bonds headed for default. More often than not, these investors bear the brunt of the first set of losses.

We could put stickers on flyers, but nobody reads them, so warning labels won’t be enough. And it’s not just about protecting investors. Western lawyers should not be drawn into the maze of awarding pseudo-contracts and so-called legal agreements. They should be relieved of the daunting task of judging complex and fundamentally political disputes that should never have been thrown into their courtrooms in the first place.

This 50-year experiment in expanding access to capital markets to countries without strong domestic institutions has been a failure: it has led to one default after another, with countries borrowing in currencies other than their own, encountering difficulties and giving up.

The simple and elegant solution is to give up the ghost: repeal the Foreign Sovereign Immunity and State Immunity Acts, and make it clear to everyone that – once again – countries have absolute immunity, and that anyone thinks otherwise does so at his own risk. and must rely only on the goodwill and probity of the debtor.

These laws do not work because politics has undermined the foundations of finance and taken primacy under a confederation of sovereign and supranational actors. But governments should no longer be activated in a loan-and-sham regime based on the false premise that choosing New York or English law offers protection, or that American or English judges will defend their right to be reimbursed.

It would be a different world, with so many salutary effects. Emerging market countries – indeed all weak public borrowers – would be prevented from feeding on the ill-informed fantasy that contracts offer meaningful protection simply because they are long. Investors would be forced to recognize that the only protection they really have is the full confidence and credit of the sovereign.

To induce investors to lend them money, nations should demonstrate probity: convince lenders that their social and legal institutions are sound, that they are responsible borrowers, that borrowed funds will be used for productive purposes and that the value of their currencies will be supported by sound economic policies.

It is certain that in the short term, many countries will not be able to cope – they will not be able to borrow as much as the national political elites would like. And, when investors really dig into the details, some countries won’t be able to borrow at all until they get their houses in order.

It was time.


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