Sovereign Default and the Potential for an International Court of Bankruptcy

Tuesday, March 23, 2021
Matthew Soltys

The COVID-19 pandemic has been a trying time for countries across the world. Almost every country is spending more and earning less; this results in increased borrowing and debt strain. While this is less concerning for wealthy countries like China, Germany, and the United States, it is proving to be potentially disastrous for poorer countries. The financial strain is proving so strenuous that many countries are, or are at risk of, defaulting on their debts. Sovereign default refers to a country’s defaulting on its debts. But what is sovereign default, what countries are at risk, why is it such a disastrous event, and what can be done about it?  Here, I propose three potential solutions: the creation of a new international bankruptcy court; multilateral treaties adopting certain shared provisions; and giving the International Monetary Fund (IMF), World Bank, and World Trade Organization (WTO) increased power to negotiate on behalf of defaulting countries.

What is sovereign default?

A sovereign default occurs when a country’s government has borrowed money to the point it is insolvent. The government becomes unable to meet all of its financial liabilities and obligations.  Sovereign default is the equivalent of an individual becoming bankrupt.

Why is sovereign default a big deal?

Perhaps the most famous sovereign default in recent memory is the Greek debt crisis which began in 2009. This crisis devastated the Greek economy, caused massive unemployment, caused thousands of people to flee the country, resulted in the longest recession of any capitalist economy to date,1 and saw Greek bonds reduced to “junk” status. The Greek default resulted in three economic bailout packages funded by Eurozone countries and the IMF, totaling more than $265 billion USD.  In 2019, Greece’s total debt was more than $409 billion US dollars,2 or 176% of its GDP.3

As the Greek default demonstrates, a sovereign default is often incredibly costly. Additionally, a country’s debt restructuring is entirely driven by the whims of its creditors and often drags on for years—if not decades. For example, Argentina defaulted in 2001. Some of Argentina’s American creditors refused to accept anything less than 100% of the amount they were owed, and Argentina and these holdout creditors did not settle until 2016.4 Often, very little protection is available to protect defaulting nations; this often leaves the defaulting country in an even more precarious financial position and drives many citizens into poverty.5 A country’s lack of financial stability causes further political instability and may result in riots, revolts, or revolutions.

What countries are at risk of default?

The examples above show a macabre reality for both country and citizen when a nation defaults. Due to the COVID-19 pandemic, the number of countries at risk of default has grown significantly. However, these concerns predated the global pandemic. A 2018 report by the IMF found some 40% of Low-Income Developing Countries faced significant debt challenges. A September 2020 article by The Economist’s Intelligence Unit listed seventeen countries which were at risk of a sovereign default. In this article, Turkey is the lone European country identified.  Other important countries identified are Pakistan, Argentina, Brazil, Costa Rica, Egypt, and Tunisia.6 The widespread distribution of these countries demonstrates a massive problem which could prove catastrophic for the world economy if ignored. This begs the question, what can be done?

What can be done about the risk of sovereign default?

What may be done to address the sovereign default issue is a tricky topic. After all, countries are not subject to another’s system of bankruptcy or reorganization. However, some mechanisms within the United States’ bankruptcy code may offer some rudimentary solutions.  One solution— likely the most time consuming and costly—is to create an international court of bankruptcy to handle sovereign defaults and reorganization. This court could be organized in a similar manner as the International Court of Justice. A new court would provide a robust and consistent mechanism for countries to reorganize their debts. While this proposal is not new,7 it has faced difficulty in gaining traction.  Why is that the case, however?  Quite simply, it is difficult to get everyone to the table.8 Additionally, past proposals have, for one reason or another, seemed inadequate.9  Some proposals, such as Collective Action Clauses (CAC’s) have been utilized to address some of these inadequacies.  However, the disparity in bargaining power between creditor and debtor nations may prompt the debtor nation to agree to a contract which does not contain a CAC.  This, once again, leaves debtor nations vulnerable to holdout vulture funds. A new international bankruptcy court which operates independent of the IMF could address a number of the shortcomings of previous proposals.  By adopting procedures similar to a chapter 11 bankruptcy in the US, the court would be able to approve certain plans despite creditor objections.  Additionally, bad faith negotiations by vulture funds could be met with sanctions.  Provisions which require the debtor to file in good faith and ensure the creditor receives adequate payment would provide protections for creditors who are concerned with a debtor country filing in bad faith.  Finally, this new court would help to level the playing field between creditors and debtor countries. Given the financial stress due to the COVID-19 pandemic, 2021 is a particularly relevant time to reconsider the creation of an international bankruptcy court.

A second solution is potentially instituting treaties providing for guidelines when a country defaults on its debts. This solution could provide for certain provisions which countries would agree to follow if another member country defaults.10 Such treaties would give a defaulting nation greater leveraging power and would significantly reduce the amount of time a nation takes to reorganize their debts. While this second solution would not utilize a full bankruptcy court, it could establish international norms for the treatment of sovereign debts.11  Such solutions would be useful as an interim measure while the creation of the bankruptcy court is pending.  However, on their own they fall short of providing a comprehensive solution as bargaining disparity remains.

A third solution would be to give greater power to the IMF, WTO, or World Bank to assist nations with negotiating debt reorganization. In light of the recent appointment of Ngozi Okonjo-Iweala as the WTO’s next director-general, the WTO may be particularly suited to take on this task. Ms. Okonjo-Iweala previously served as Nigeria’s finance minister twice. Notably, in her first term as finance minister, she spearheaded negotiations with the Paris Club12 that resulted in the reduction of $30 billion USD worth of Nigeria’s $36 billion USD in debt— $18 billion of which was canceled.13 The precarious position the WTO finds itself in, however, likely makes this solution impractical at this moment.

I believe that the first proposal – the creation of a new international bankruptcy court – is the solution which makes the most sense for the present circumstances.  A new international bankruptcy court will even the bargaining power of creditors and debtors, provide mechanisms to protect debtor countries, and provide for a consistent and predictable restructuring process.  These procedures would, in turn, lead to more consistent and less predatory lending.  Such a court would allow international markets to continue operation despite a sovereign default occurring.  Additionally, this court would provide greater world stability – particularly in developing countries.

Endnotes
  1. The recession caused by the Greek financial crisis has been longer than the Great Depression of the 1930s.
  2. https://www.statista.com/statistics/270409/national-debt-of-greece/#:~:text=In%202019%2C%20the%20national%20debt,Greece%20is%20currently%20ranked%20second
  3. https://tradingeconomics.com/greece/government-debt-to-gdp
  4. Interestingly, this settlement occurred despite an American hedge fund seizing an Argentinian naval ship.  For further reading on this event see https://www.washingtonpost.com/news/business/wp/2016/03/29/how-one-hedge-fund-made-2-billion-from-argentinas-economic-collapse/.
  5. 36% of Greeks were estimated to live below the poverty line in 2014 by the CIA’s World Fact Book.  Greek unemployment peaked at 25% between 2014 and 2015.  Youth unemployment reached upwards of 50% in May of 2012.  25.7% of Argentinians were estimated to live below the poverty line in 2017 by the CIA’s World Fact Book.
  6. Perhaps the most concerning countries are Turkey and Pakistan.  Both countries have nuclear weapons and the instability from a default may jeopardize the security of these weapons.
  7. See https://www.marketwatch.com/story/why-cant-greece-just-declare-bankruptcy-2015-06-15; Hilgers, Michael T. (2003) "Debtor-States and an International Bankruptcy Court: The IMF Creditor Problem," Chicago Journal of International Law: Vol. 4: No. 1, Article 19; Jordan, Victor. "A BANKRUPTCY COURT FOR COUNTRIES: A New Approach to Sovereign Debt Restructuring." Social and Economic Studies 54, no. 3 (2005): 50-64. Accessed March 19, 2021. http://www.jstor.org/stable/27866429; https://www.un.org/press/en/2013/ecosoc6570.doc.htm.
  8. See https://www.un.org/press/en/2013/ecosoc6570.doc.htm (comments by Hans Humes).

  9. Past proposals have included IMF supervision of the proposed court which leads to the “IMF Creditor Problem” where the IMF is both a creditor and arbiter to the bankruptcy petition.  See Hilgers, Michael T. (2003) "Debtor-States and an International Bankruptcy Court: The IMF Creditor Problem," Chicago Journal of International Law: Vol. 4: No. 1, Article 19; Jordan, Victor. "A BANKRUPTCY COURT FOR COUNTRIES: A New Approach to Sovereign Debt Restructuring." Social and Economic Studies 54, no. 3 (2005): 50-64. Accessed March 19, 2021. http://www.jstor.org/stable/27866429.  Another consideration is the relationship between “official” and “private” debts.  When countries face debt issues, they often turn to the private sector for financial assistance.  This leads to further uncertainty when countries attempt to negotiate debt settlements as these “private” creditors may be US based “vulture funds” who hold out on restructuring and reap massive rewards for what – in the US Bankruptcy Court –  would be described as predatory lending.
  10. Certain provisions which may be helpful would be parallels to the US Bankruptcy Code’s provisions in §§ 362(d), 523, and 1129. § 362(d) provides that creditors must be adequately protected and receive adequate payment. § 523 provides for specific debts which are not dischargeable, but which may be renegotiated or reorganized. § 1129 is typically referred to as the “cramdown” provision and allows a debtor to force a creditor into taking an amount which is less than what the debtor owes.
  11. One such example of this solution is the adoption of CAC’s in all of Europe’s sovereign debt agreements beginning in 2022.  See https://www.theguardian.com/business/2020/jul/13/covid-19-is-no-excuse-for-sovereign-creditors-to-move-the-goalposts-argentina-debt.
  12. “The Paris Club is an informal group of official creditors whose role is to find coordinated and sustainable solutions to the payment difficulties experienced by debtor countries.” https://clubdeparis.org/.
  13. https://www.cgdev.org/topics/nigerian-debt-relief.
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About 
Matthew Soltys

Matthew is a third-year law student. He is originally from Omaha, Nebraska and after graduation this spring he plans to open his own solo-practice law firm. He plans to work primarily in bankruptcy, estate planning and criminal defense.