For Immediate Release Contact: Tony Fratto

December 5, 2002 202-622-2016

**Using Clauses to Reform the Process for Sovereign Debt Workouts:**

**Progress and Next Steps**

**Prepared Remarks at the EMTA Annual Meeting**

**John B. Taylor**

**Under Secretary of Treasury for International Affairs**

**December 5, 2002**

Thank you for giving me the opportunity to speak here today. It is a
pleasure to engage with so many knowledgeable and experienced emerging
market participants in one setting. I have found that frequent and
candid discussions between the private and the public sector are
essential for good economic policy whether they take place on trading
floors, in government offices, on the phone, by email, or at formal
meetings like this one. And I want to say that I am grateful for the
useful analysis and comments provided by EMTA members and
staff---especially by EMTA Executive Director Michael Chamberlin. I hope
that my comments can be as useful to you today.

I would like to focus on a topic that many of us have been discussing
for the past year---incorporating new clauses into sovereign bonds,
clauses that can create a better process for countries and their
creditors to follow in the event of a debt workout. The lack of a clear,
well-defined process for sovereign debt workouts is a design weakness in
the emerging markets that impedes broader participation in the market.
The uncertainty prevents the market from accurately pricing the risk of
a restructuring event. The uncertainty also complicates official sector
and private sector decision-making thereby leaving emerging markets more
susceptible to costly and painful crises than they need be. For this
reason, incorporating such clauses into sovereign bonds is an important
component of the Administration's overall emerging market strategy.

The goals of the overall strategy are to increase economic growth and
reduce economic instability in emerging market countries. To achieve
these goals, strong and stable private capital flows to emerging markets
are essential. Unfortunately those flows declined markedly after the
increase in the frequency and severity of financial crises in the 1990s.

**PO-3672**

To restore these flows we are following an action plan that aims to (1)
better prevent crises, (2) reduce contagion from crises, (3) limit and
clarify official sector financial response to crises, and (4) improve
the process of sovereign debt workouts. The incorporation of new clauses
into bonds by sovereign issuers and creditors is a key means to achieve
the fourth part of this action plan.

**The Decentralized Approach**

Last April in a speech in Washington I outlined the Administration's
proposals for putting new clauses into sovereign debt and I asked for
action on its implementation as soon as possible. The proposals had been
under development in the U.S. government since last fall in response to
a request by Treasury Secretary Paul O'Neill to find a better process
for sovereign debt workouts. Others in the private and the public sector
had been developing similar proposals. Indeed, a G-10 working group
suggested such an approach way back in 1996. And, as you know, some
collective action clauses are already incorporated in emerging market
sovereign bonds governed by the laws of the United Kingdom and Japan.
About 30 percent of the total outstanding volume of emerging market
sovereign bonds now includes collective action clauses.

Under the U.S. proposal, sovereign bonds governed by the laws of the
United States, Germany, and other key jurisdictions would also include
collective action clauses. We stressed the need for a particular type of
a collective action clause---a majority action clause that would allow a
super-majority of bondholders to alter the key financial terms of a
bond. Over time, the 30 percent of debt with majority action clauses
would grow to 100 percent. The proposal also suggested including new
types of clauses---which we called engagement clauses and initiation
clauses. These new clauses would set forth the modalities of a sovereign
debt workout. The clauses would provide for early dialogue,
coordination, and communication among creditors and a sovereign and
limit disruptive legal actions. Each type of clause---majority action,
engagement, and initiation---had the purpose of better defining the
sovereign debt workout process and thereby making it more predictable.

We pointed out that this approach was market-based and decentralized in
two important senses. First, the clauses themselves would be developed
and agreed to by creditors and the issuers in a decentralized way. In
other words, within the parameters or guidelines in our proposal,
sovereign borrowers along with their creditors and their lawyers would
work out the details as new bonds would be issued. Eventually, new
templates with these clauses would replace existing templates without
the clauses. The second way in which this approach was market-based and
decentralized is that in the event of a restructuring, the sovereign
government and its creditors would work out the terms of the
restructuring on their own guided by the clauses but without the
involvement of a central group or panel.

**The Response from EMTA and Others**

Let me emphasize how pleased we were with the reactions to this
proposal. Representatives from the private sector stated their general
support for the introduction of clauses and have been working to develop
the details much as we had hoped. We have made much progress in the last
six months. I very much appreciate these efforts.

The EMTA Position Regarding the Quest for More Orderly-Sovereign
Work-Outs (October 17, 2002) is particularly helpful in this regard
because it endeavors to lay out a set of details that fit into the broad
parameters of the decentralized approach. The EMTA position emphasizes
two principles. First, the clauses must be "marketable" in the sense
that they must be acceptable by the marketplace of issuers and
investors. Second, to the extent that the clauses make bonds easier to
restructure, they should not also make defaults and/or restructurings
more likely. We agree wholeheartedly with both of these principles.

Regarding the particular clauses, the EMTA proposal includes a majority
action clause, which would permit the amendment and waiver of key bond
terms by approval of an appropriate super-majority of bonds outstanding.
The proposal also includes an engagement clause "to facilitate
constructive dialogue between a sovereign debtor and its creditors when
restructuring seems necessary." And there is also an initiation clause
"to inhibit precipitous litigation as a practical matter." With this
initiation clause "bonds should require 25 percent bondholder vote to
accelerate principal for event of default and provide for a 75 percent
vote to rescind acceleration." Note that this last suggestion is a type
of majority enforcement provision.

It is also very encouraging to see that many emerging market countries
have expressed their support for the decentralized approach. In early
September, the members of the European Union -- including Italy, Spain
and Sweden, which are all countries that regularly issue in foreign
jurisdictions -- committed to using collective action clauses in their
external sovereign bond issuances. Eventually we would expect new
emerging market members of the European Union such as Poland and Hungary
to do the same. Moreover, the G-7 has not only stated its strong support
for the clauses in emerging market countries, it has agreed that G-7
countries that issue bonds governed by the jurisdiction of another
sovereign will include collective action clauses. That is the strongest
statement of support for collective action clauses ever issued by the
G-7.

**2003 is the Year for Action**

With all this progress and show of support, the conditions now appear to
be ripe for issuers and their creditors, investment bankers, and lawyers
to roll up their sleeves and get to work writing new clauses into bonds
as they are issued. There are enough emerging market issuers---many with
investment grade ratings---expected to come forth in 2003 that the first
mover problem should not be a problem. Each issue that proceeds without
the new clauses delays the day when we resolve this uncertainty that
still hangs over the markets.

I recognize, of course, that there are still some concerns and
reservations about incorporating new clauses into sovereign bonds, and
that these concerns are holding some issuers and market participants
back. Let me try to address some of the concerns that I have heard.

**Concerns**

One concern is simply that the clauses are unnecessary---that the
current process for sovereign debt restructuring works just fine. It is
true that the market has found a solution in some recent sovereign debt
restructuring cases, including Pakistan and Ukraine. But even in cases
such as Pakistan and Ukraine, the process was by no means
straightforward. Uncertainty about how the restructuring would
unfold---or even if restructuring could unfold---complicated
decision-making and potentially left countries cut off from credit
markets for longer periods than they would have been if a more clearly
defined process for restructuring had been in place. Clarification of
the debt restructuring process would most certainly be helpful in more
complex situations.

Ukraine is an interesting case in point. Ukraine's restructuring is
frequently held up as a successful example. But even in this case,
complications arose because one of Ukraine's bonds in the restructuring
did not have majority action clauses. As a result, the authorities
needed to track down the bondholders and try to secure 100 percent
consent to amend the financial terms of their bonds. This proved
especially difficult because retail investors owned a large portion of
this bond. These problems were not insurmountable in the case of Ukraine
largely because the authorities had only a small number of external debt
instruments outstanding. But this is not the case for so many other
emerging market countries.

Others have raised concerns that the new clauses would not allow for
aggregation of debt across different instruments. It is true that most
proposals do not allow for collective action across different classes of
debt. But this does not mean that the process would not work or that it
would not provide sufficient clarity to attract additional investors and
greatly improve predictability. Even without aggregation, the clauses
can be helpful in describing a process for workouts without the added
delay of developing a complex aggregation procedure.

Another worry is that the clauses will raise borrowing costs. But this
is at odds with empirical evidence and with comments we have received
from many buy-side participants. By comparing spreads on bonds with and
without clauses studies have found that majority action clauses have not
raised borrowing costs. A key advantage, as I already mentioned, of the
clauses is that by providing a process for workouts the risk of such
workouts can be better priced. In fact, empirical evidence shows that
countries with good credit ratings have had their borrowing costs go
down with collective action clauses. Many investors have been favorable
towards collective action clauses and have indicated that they would buy
bonds with collective action clauses, provided such clauses do not
infringe upon the rights of creditors.

Another criticism is that the new clauses would only apply to new bonds
and would therefore impact a relatively narrow scope of debt. It would
take many years before the entire stock of outstanding bonds was
covered. To me this is a reason to get started now. Had the majority
action clauses been introduced in New York and Germany starting in 1996,
when the idea was first proposed, we would have dealt with a large part
of the problem by now. According to the latest IMF Global Financial
Stability Report, from 1996 through the present, there have been about
\$150 billion in sovereign bonds issued without collective action
clauses.

Some have criticized the decentralized approach because it does not
appear to be new. Well, not all old ideas are bad. But more to the
point, our decentralized proposals went well beyond traditional
collective action clauses to include both engagement and initiation
clauses. Still others have argued that the rogue creditor problem is not
so bad. To be sure, I did not even mention the rogue creditor problem in
my April speech. What we are trying to address is the current
uncertainty and lack of a well-defined process. Clauses requiring
agreements by 100 percent of bondholders create more uncertainty and
difficulty than clauses requiring 75 percent.

Yet another criticism is that the improved sovereign debt process will
only deal with some crises. It is certainly true that not all crises are
related to the sustainability of sovereign debt issued in foreign
jurisdictions. Currency and maturity mismatches in the private sector,
exchange rate pegs, poor supervision of financial institutions, and
indexed domestic debt are other potential sources of financial crises.
We are working in these areas too---and there have been
improvements---especially in the areas of exchange rate policy and
transparency. But even if only a few crises could be prevented,
reforming the restructuring process should still be a high priority.
Moreover, crisis prevention is not the only goal. The attraction of a
broader class of investors to the emerging markets would strengthen the
flows of capital and increase economic growth in these countries.

In recent months another concern has been raised about going ahead with
the clause approach now. Namely there are worries about the impact of
the recent work by the International Monetary Fund on a centralized
sovereign debt restructuring process---frequently called the sovereign
debt restructuring mechanism (SDRM)---which would create a
supra-national panel or court through an amendment of the IMF Articles.
This concern has been registered, for example, in the EMTA position
paper: "The possibility of an over-riding bankruptcy regime chills the
market-based approach because neither creditors nor issuers know what
changes can safely be made in existing documentation." I would like to
address this concern too.

First, let me state the U.S. position on the debate on the decentralized
versus the centralized approach. In our view, good public policy
requires carefully investigating all alternatives and pursuing the
option or combination of options that will work best. Regarding
sovereign bonds there are three main possibilities: (1) the
decentralized approach, (2) the centralized approach, and (3) a
combination of the two where clauses are inserted into new debt
instrument and a panel or court is created to deal with aggregation and
other issues not captured in the clauses.

If there is convincing evidence that the decentralized approach does a
better job of preventing crises and strengthening capital flows than the
centralized or the combined approaches, then the decentralized approach
will be the choice supported by the Bush Administration. Similarly, if
one of the other approaches can be shown to work better, then that
option will be the one supported.

There has been a lot of discussion of the SDRM over the past year, but
there is as yet no specific proposal. That is why the G-7 Finance
Ministers and Central Bank Governors called for such a proposal by the
time of the Spring IMF/World Bank meetings next year. The G-7 has not
endorsed the SDRM approach. It has simply asked for a proposal by the
spring of 2003 so that it can consider the pros and cons of this
proposal in a rational fashion.

Clearly there are differences between the clause approach and the SDRM.
As I have already mentioned, the clauses are much more decentralized
than the SDRM. Also, the SDRM would aggregate claims across different
issues while the clause approach would not. The SDRM would establish a
panel or court, while the clause approach would not. Obviously, the
establishment of such a group raises many issues about appointments and
accountability that need to be considered carefully. The SDRM would
override existing bond contracts; the clauses would apply to new issues
or perhaps to old issues if they are swapped for new issues. The clause
approach could be implemented quickly, while the SDRM approach would
require a good deal of time in light of its relative complexity and the
need to gain legislative approval, including in the United States. So
there are many questions left to be answered. What we, and others, have
urged is that work be done to raise these questions so that decisions
about an SDRM be made in light of a thorough analysis and a full airing
and discussion of the issues.

**Conclusion**

In sum, the introduction of new clauses into sovereign bonds offers an
effective approach to reforming the emerging market sovereign debt
restructuring process. We are very pleased about the positive support
for this approach expressed by the private sector during the last six
months and for the work that has gone into developing the details of
this approach. We are also pleased that a number of emerging market
countries have expressed interest in the decentralized approach. Given
this support and the work that has been done already, I think it is time
to begin actually including these clauses. Although strong reservations
about the alternative centralized approach have been expressed, ongoing
research on the centralized approach is no reason not to proceed with
the decentralized approach as soon as possible.