Public Indebtedness. An analysis of its implications and international experiences in debt restructuring processes.

Summary:

On 13 March 2023, the Rafael del Pino Foundation and the Queen Sofía Spanish Institute organised a meeting entitled "Public indebtedness. An analysis of its implications and international experiences in debt restructuring processes". The event was attended by Tano Santos, Robert Heilbrunn Professor of Asset Management and Finance and Director of the Heilbrunn Center for Graham and Dood Investing at Columbia Business School, and Jaime A. El Koury, senior legal advisor to the Financial Oversight and Management Board for Puerto Rico and former partner at Cleary Gottlieb Steen & Hamilton LLP.

Tano Santos: The Spanish economy has greatly increased public indebtedness since the global financial crisis. On the eve of the crisis it was between 30% and 40% of GDP and has reached a maximum of 120%. Last year it fell to 5% thanks to the strong growth of the real economy and the inflation process we are experiencing.

High indebtedness is not a problem as long as the debt burden does not increase, i.e. as long as interest rates are low. The problem we are experiencing now is that interest rates are being increased to combat inflation. This creates problems in terms of debt financing that are more important depending on how high nominal interest rates are, how much debt a country has, how sustained the period of high interest rates is and the maturity structure of the debt.

Any hope that the inflationary process will deleverage the sovereign is not going to happen. Inflation helps, but the interest rates at which to refinance debt incorporate inflation expectations and, from there, higher interest rates start to be paid.

On top of this, growth prospects are not good at all. We are going to have to make a fiscal effort in a situation where growth is not going to be very high. So we have to start thinking about debt sustainability.

There are important biases stemming from the interpretation of our last crisis and, in particular, how the sovereign debt crisis was resolved. It is now seen as a positive experience. It was messy, but it didn't turn out so bad. However, there are many doubts that this is the right reading of what happened with the Greek sovereign debt and its restructuring.

The second is that in the European Monetary Union there is no formal debt crisis resolution process that covers all aspects of the debt crisis and, in particular, a process that takes into account all the interests involved in a debt restructuring process. As a country in a monetary union, we may benefit from having a more ambitious formal sovereign debt restructuring process than has recently been proposed. There are several reasons for this. First, the formalisation of a restructuring process allows for the clarification of how losses will be discovered and how they will be shared fairly among all parties involved in a restructuring process, i.e. not only taking into account the interests of bondholders but also those of all those who have an asset vis-à-vis the state, such as pensioners, civil servants, etc.

It should not be forgotten that the Greek restructuring was a very diffuse process where the only interests represented were the bondholders and then the Greek authorities were in charge of negotiating with their electorate the write-offs they were going to make for pensioners, workers, civil servants, etc. There are many officials in Brussels who like that possibility because it gives them a bit of flexibility, more room for manoeuvre ex post once sovereign debt crises occur. This is going to be different in the next crisis.

Second, a formalisation of the restructuring process allows the credit quality assessment of the different member countries to be adjusted. The problem we have in the Eurozone is that there is an implicit subsidy that does not allow for the clarification of the credit quality of the issuer. This is extremely serious because it does not provide incentives either to the issuers or to the traders who buy the sovereign debt of the member countries because, in essence, there is a subsidy that allows countries to over-indebt themselves and allows traders to think that, if there is a problem, someone will come along and solve it ex post. There are episodes that seem to suggest that the market sometimes does not give a fair assessment of the different risk premiums of Eurozone countries, but it is precisely because there is this implicit promise of rescue through various mechanisms, which is why the premium at which Spain was financed, with a debt of 30%-40%, was very similar to that of Italy, which had a 100% of debt over GDP.

The market likes the clarification of the institutions that will allow for a more formalised resolution process. For example, many of the bonds that have been issued with collective action clauses trade at lower prices than those without, even though the credit risk appears to be higher, because the fact that they have a collective action clause clarifies how the resolution of the relevant debt will proceed in the event of a restructuring process.

There is something strange in the way this sovereign debt restructuring problem is being thought of, as if clarifying the renegotiation structures would induce the crisis it is intended to avoid, when it is precisely the opposite. It is the lack of clarity about the process to be applied in the event of default that led to the over-indebtedness of Puerto Rico and the willingness of bondholders to continue buying, because they thought that someone would come to their rescue in due course.

This well-done formalisation of a restructuring process can be supported by the incipient federal structures we have in the Eurozone, which allow leveraging federal structures to increase the range of possible agreements that can be reached in a debt restructuring context.

The Greek case is very peculiar. They managed to get certain things done, but one thing that is forgotten is that the sovereign debt resolution structures we have in Europe focus exclusively on the case of bondholders. When this is done, bondholders alone are given priority over other holders of government liabilities.

The argument that is always put forward as to why we don't want to restructure sovereign debt is contagion. But the problem we had in the Eurozone crisis is that we were all becoming contagious, the good and the bad. So to argue that the problem is the possibility of contagion seems absurd, given the experience we had during the global financial crisis when contagion did occur, even though we did not have a restructuring process.

What is proposed is a form of debt restructuring process for the Eurozone that includes all those who have assets vis-à-vis the state. In the Puerto Rican case this is what is being done.

Jaime A. El Koury: Puerto Rico is not a tropical paradise in the sense that the big industry is tourism. Its economic base is manufacturing, which contributes 40% of GDP. That is Puerto Rico's problem, in relation to globalisation.

Puerto Rico had a very dynamic manufacturing sector, which began to deteriorate in 1996 because of changes in US legislation. It is a prelude to what began to happen in the world in the 2000s with the migration of the manufacturing sector to Asia. This meant a deterioration in Puerto Rico's GDP, which lasted for ten years, because it began to lose its manufacturing base and, therefore, employment. In these circumstances, a government must adjust public spending. Puerto Rico does not do so and that is the increase in its debt.

In 2016, it starts to go to extreme levels of debt and soars above the most indebted US states. With a debt of $13,000 per capita, it even surpasses Greece's level of indebtedness. Puerto Rico had great access to the US capital markets and had 70 billion in debt with three million inhabitants. The debt was out of orbit.

The second aspect of Puerto Rico is that this year it celebrated the 125th anniversary of the change of sovereignty from Spain to the United States. The time that has passed has produced an anomalous political situation, in which Puerto Rico is treated as a territory, not as a state, with no access to organised bankruptcy proceedings, Chapter 11 or Chapter 9 of US bankruptcy law. Therefore, in 2016 it finds itself in an apocalyptic situation, with no possibility of being able to carry out a receivership.

There is panic in Washington, a very difficult moment is approaching for the United States because its territory Puerto Rico could go into economic chaos. An agreement is reached between Republicans and Democrats, where each realises that they have to give some kind of support in terms of a process. A special process is created that allows Puerto Rico to have access to a bankruptcy court to carry out this process. The body that is created is the Fiscal Oversight Board to be able to order the suspension of payment as the government's fiscal accounts.

The United States had gone through a series of municipal and state crises, including New York, Washington and Detroit. Each of these cases was dealt with either as an audit of the accounts in the case of New York and Washington, or as a receivership in the case of Detroit. In the case of Puerto Rico it was treated both ways by giving the powers to the Fiscal Oversight Board. Technocrats are sought to form this institution that seeks the welfare of the territory, not the interests of the financial system. In Puerto Rico, the board is created with the mandate of the welfare of Puerto Rico, that is, to have a sustainable level of debt, clean and transparent accounts and to be able to meet the commitments to pensioners and citizens who want an efficient state. This restructuring process has never been done before.

There are seven lessons from this case. The first is to create an apolitical body that is independent of the government, independent of financial interests, independent of everybody, and it is given quite broad powers to create a fiscal plan for Puerto Rico. That fiscal plan is given legal immunity, that is, the bondholders cannot challenge it in court; nor can the government because the fiscal plan is going to dictate how Puerto Rico's budget is going to be distributed. If you have to cut, you do it, if you have to close schools, you close them, and you can't sue the board members in their personal capacity. The situation is ironclad. At the end of the bankruptcy, a judge has the power to review the fiscal plan and determine whether it is fair and equitable. There is some safeguard.

The second lesson is that the process that Puerto Rico went through is not simply one of financial readjustment. All the liabilities are part of this process: the bonds, the pensions, the contracts that the government has with the unions, the public employees. This makes it a very sensitive situation in the political sense and negotiating with everyone to reach an understanding. The difference with the IMF is that they have a conditional plan in which they lend money if the country carries out an economic adjustment programme, but it doesn't always work. In the case of Puerto Rico, all the liabilities are part of the lump sum to be distributed.

The third lesson is that once you make an agreement with bondholders, with pensioners, with civil servants, those agreements that the federal court authorises are agreements that stay permanently. If Greece reaches an agreement with its creditors to do certain things with pensions, the next day it could revoke it. In the case of Puerto Rico, because it was a court order, it could not be done. The IMF itself has proposed that an international court be set up to have this kind of power.

The fourth lesson is that bankruptcy proceedings are very litigious. A creditor is going to ask to be given 100%, but the litigation does not always occur in the place where the restructuring of liabilities is being done. In the case of Puerto Rico, all litigation has to be done in the same court, which has three consequences. The first is that it makes the process more efficient. The second is that it makes the parties behave in a certain way, being able to reach certain agreements that would not be reached otherwise. Third, you can make instruments that are quite innovative, for example, tell the creditor that you get fifty cents on the dollar but if you decide to go for litigation you get zero.

Fifth lesson. Having these more flexible instruments can provide benefits that do not occur within a bankruptcy process. For example, in Puerto Rico the fundamental complaint of the creditors was that the fiscal plan was too conservative. So they were offered that if Puerto Rico did better, the creditors would win, and if it did not do better than the projections, the creditors would keep the hard debt. This was done with bondholders, pensioners and public servants. It gives much more flexibility to create special instruments.

The sixth lesson follows on from the previous one. If you are going to give them these special benefits in terms of the projections that are made, you have to protect the institutions that are going to decide whether there is a surplus, whether more has been collected. So there was a process of depoliticisation of many authorities in Puerto Rico, for example, to make sure that the accounts are not going to be manipulated.

Finally, in Puerto Rico, collective action is codified as part of its restructuring process.

The Rafael del Pino Foundation is not responsible for the comments, opinions or statements made by the people who participate in its activities and which are expressed as a result of their inalienable right to freedom of expression and under their sole responsibility. The contents included in the summary of this conference are the result of the debates held at the meeting held for this purpose at the Foundation and are the responsibility of their authors.

The Rafael del Pino Foundation is not responsible for any comments, opinions or statements made by third parties. In this respect, the FRP is not obliged to monitor the views expressed by such third parties who participate in its activities and which are expressed as a result of their inalienable right to freedom of expression and under their own responsibility. The contents included in the summary of this conference are the result of the discussions that took place during the conference organised for this purpose at the Foundation and are the sole responsibility of its authors.

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