Crisis prevention in emerging markets has improved a good deal in recent years, says Josef Ackermann. But a stronger and more stable international financial system also needs better crisis management. –

As we move towards our shared goal of a more stable financial system, we need a recipe for an institutional framework that fits the global economy, especially the global capital markets.

The basis for this can only be an objective review of the status quo and how to improve it. This is particularly crucial in today’s climate of heightened uncertainty and investors’ aversion to risk – in particular, emerging market risk.

In recent years, crisis prevention in emerging markets has made much progress. Governments have strengthened investor confidence by enhancing data transparency and by recognizing and implementing uniform standards and codes on a growing scale.

Some emerging market nations have opened investor relations offices to establish a continuing dialogue with creditors. Furthermore, there are signs that many emerging markets are becoming more skillful at debt management.

At the international level, the financial sector assessment programmes carried out by the IMF and the World Bank are helping to improve crisis prevention.

In this process, the private sector has not been a passive observer but has actively helped to draft and implement practicable solutions. One example is the refinement of banks’ internal risk models through the incorporation of the standards and codes already mentioned.

But crisis prevention is not enough by itself; a stronger international financial system also needs better crisis management. Here, too, the private sector has not shirked its responsibility. This explicitly includes taking part in debt restructuring processes. It is only natural that private investors should bear the consequences of their investment decisions.

Effective crisis resolution calls for procedures to facilitate intensive dialogue between debtor countries and their creditors. Such dialogue would induce governments to talk to their creditors before a debt situation gets out of hand.

In the event of crisis, dialogue must turn into negotiation on debt sustainability, creditor needs and on the action to be taken by those involved – debtor governments, creditors and the international community.

Negotiation is the only way to reach acceptable compromises. It is not acceptable for borrowers to impose conditions unilaterally. The final outcome can only be debt rescheduling.

Apart from early and effective negotiations, another essential condition for successful debt restructuring is a quick and orderly administrative and legal process to implement the negotiated restructuring terms. This is in the interests of borrowers and creditors.

A key element of a contractual approach to debt restructuring, which is supported by the action plans of both the Institute of International Finance and the G7 nations, is the collective action clause (CAC) in bond contracts.

CACs – which have been part of bond contracts in UK law since the end of the 19th century – are a market-based, private-sector tool for effectively resolving various problems that could impede the debt rescheduling process.

There is broad consensus today that CACs should become a global market standard. This is in response to the fundamental shift away from syndicated loans and towards bonds in the financing structure of emerging market countries in recent years.

With the growing use of bonds, the number, diversity and anonymity of creditors have also increased substantially. This poses the problem of coordinating divergent interests and, consequently, creates the risk of a necessary debt restructuring being delayed.

It also raises the problem of individual creditors holding up the debt restructuring by taking legal action. In all these cases, a debtor country’s credit standing would deteriorate further, ultimately depressing the price of its bonds.

In practice, these difficulties have proved surmountable as a rule; in recent years, participation rates of almost 100% have been achieved in debt restructurings (such as Russia and Pakistan). Nevertheless, the problems mentioned are latent obstacles to debt rescheduling and can therefore cause unnecessary uncertainty.

CACs could provide help here as they would lead to a majority-driven debt-rescheduling agreement binding on all bondholders. Thus, CACs can give the necessary certainty in cases where debt restructuring is unavoidable. Creditors benefit from a predetermined, orderly procedure, while borrowers can prevent the crisis from getting worse.

This positive view of CACs is evidently shared by the public sector. At the same time, though, the public sector is seeking a complementary, statutory framework for debt rescheduling – known as the sovereign debt restructuring mechanism (SDRM).

The IMF and some G7 governments are already using substantial resources to flesh out the proposals originally tabled by IMF deputy managing director Anne Krueger.

It is questionable, though, whether these resources are being employed efficiently because the solutions that this procedure is intended to achieve can be obtained to a large extent with CACs. So CACs and the SDRM are substitutes, rather than complementary tools.

Furthermore, the SDRM may even be counter-productive as it does not allow for informal, partial solutions. Once invoked, all sovereign debt outstanding would have to be renegotiated, even though a temporary payment stop or rescheduling for some debt might be sufficient to restore market access.

At the same time, the SDRM does not cover a sovereign debtor’s domestic, multilateral or Paris Club debt, or debt issued by the private sector. This not only gives rise to adverse incentives but also ignores the fact that these other forms of debt must be included in any assessment of debt sustainability.

Indeed, recent debt crises were triggered by private sector external debt or sovereign domestic debt rather than sovereign external debt. In other words, the SDRM would create an unnecessarily bureaucratic procedure not capable of solving the problems identified.

The private sector, which must take the lead here, is working intensively on giving concrete form to CACs in order to ensure that they are consistent with these objectives. We must also consider how CACs can enter widespread use relatively quickly.

Some studies suggest that borrowers with a good credit standing would at least see no deterioration in their terms and conditions. At the same time there is reluctance to accept the use of CACs as a binding market standard. It would be helpful if all advanced countries followed EU members, who recently agreed in principle to include CACs in future in their own bond contracts. This would increase the acceptance of CACs as a market standard and the market’s familiarity with this instrument.

The detailed issues still to be resolved must not be allowed to obscure the fundamental consensus on the usefulness of CACs. This consensus should now lead to action, not only by private investors and issuing houses, but also by the G7 governments and the emerging markets themselves.

Josef Ackermann
Josef Ackermann is chairman of the group executive committee of Deutsche Bank AG.