South Bulletin: Individual Articles

UN General Assembly Special Event on Sovereign Debt and Debt Resolution Mechanisms

[South Bulletin 70 Article]

By Bhumika Muchhala

The UN General Assembly's Second Committee held a special event on 25 October on lessons learned from debt crises and on the ongoing work on sovereign debt restructuring and debt resolution mechanisms, with the participation of all relevant stakeholders, including multilateral financial institutions. This followed a decision adopted by the UN General Assembly (UNGA) in February 2012, in paragraph 27 of resolution (66/189) on “external debt sustainability and development”. The UN’s debt sustainability resolution had specifically called for the “intensification of efforts to prevent and mitigate the prevalence and cost of debt crises by enhancing international financial mechanisms for crisis prevention and resolution,” and to assess the ongoing work on sovereign debt restructuring and resolution mechanisms so as to guide policymakers in shaping the future global agenda on international financial system reform. The event, titled “Sovereign debt crises and restructurings: Lessons learnt and proposals for debt resolution mechanisms,” held at the UN headquarters in New York on 25 October, aimed to fulfill a first step towards the goals of the resolution.

Organized by the UN Conference on Trade and Development (UNCTAD) and the UNGA’s Second Committee, the event highlighted five problems with the current approach to sovereign debt restructuring, based on the experiences and literature on sovereign debt and default. These problems were highlighted in a Background Paper prepared by UNCTAD. The first problem is that of lengthy debt renegotiations which, in some cases, do not restore debt sustainability. A study of 90 defaults and renegotiations on debt owed to private creditors by 73 countries found that debt renegotiations have an average length of over 7 years, produce average creditor losses of 40 percent, and lead to limited debt relief.

The second problem is the need to coordinate the interest of dispersed creditors and to deal with bondholders who have an incentive to hold out from debt restructuring deals. Even if creditors could be better off by writing off part of their claims, debt cancellation requires a coordination mechanism that forces all creditors to accept some nominal losses. In the absence of such a coordination mechanism, each individual creditor will prefer to hold out while other creditors cancel part of their claims. The third is the lack of access to private interim financing during the restructuring process. In the corporate world, interim financing is guaranteed by the presence of debtor-in-possession financing provisions, but sovereign debt lacks a mechanism able to enforce seniority. Lack of access to private interim financing may amplify the crisis and further reduce the ability to pay, because during the restructuring period countries may need access to external funds to either support trade (trade credit) or to finance a primary current account deficit.

The fourth issue is that of overborrowing caused by debt dilution, which refers to a situation in which, when a country approaches financial distress, new debt issuances can hurt existing creditors. And the final area of priority is delayed debt defaults. While most economic models of sovereign debt assume that countries have an incentive to default too much or too early, there is evidence that countries often try to postpone the moment of reckoning and may sub-optimally delay the beginning of the debt restructuring process. A prolonged pre-default crisis may reduce both ability and willingness to pay, making both lenders and borrowers worse off.

This special event aimed to address the following five questions:

1. Do the issues listed above adequately reflect past experience with the current system for dealing with sovereign defaults?

2. Are there other problems with the current system for dealing with sovereign defaults?

3. Can the problems listed above be addressed with a structured mechanism for the resolution of sovereign debt crises?

4. What would be the governance and organization of such a structured mechanism?

5. Would the costs of a structured mechanism dominate its potential benefits?

Ken Rogoff, Professor at Harvard University, opened his remarks by affirming that the UN is the appropriate forum to analyze issues pertaining to sovereign debt resolution. Rogoff recognized that the UN has played a significant role in sovereign debt proposals, including the G77 proposal in 1979 on an “International Debt Commission.”

Since the advent of debt, sovereign debt crises have been a recurring problem through history, he said. The first debt default in Europe occurred in 1431, and cyclical debt crises have occurred from 1800-2009. A historical spike in external debt default occurred in World War II and the Great Depression, when almost 40% of sovereign states worldwide were in debt default. Since then, debt defaults have decreased, and comparatively speaking, are actually quite low today.

There is a salient question of where and how disputes and problems of sovereign debt should be adjudicated. In 1995, Jeff Sachs made a particularly influential proposal, arguing that the IMF would be more effective if it functioned as an international bankruptcy court rather than a lender of last resort. This debate culminated in the 2001 proposal for a Sovereign Debt Restructuring Mechanism (SDRM), made by Koehler and Krueger at the IMF, which led to the development of Collective Action Clauses.

The UN Secretary General has rightly emphasized the importance of independence, which makes the prospect of the IMF simultaneously lending money and being a bankruptcy court very awkward. However, the trouble is that the IMF is not viewed to be an honest broker by the international creditor community because it is tantamount to a regulator proposing a new regulatory structure that puts themselves at the center in a lender role. Thus, Rogoff argued that it is the role of the UN body to put forward a process towards formalizing sovereign debt adjudication.

What problems does an international bankruptcy regime aim to solve, asked Rogoff. The “holdout problem” is one, as most recently seen in a creditor instigated internment of an Argentine ship in Ghana. Second, there is the idea of establishing seniority, which is very hard to enforce, especially when the senior creditor is big. Europe is going to soon realize that when there aren’t many junior creditors below you, there will be further debt restructuring. The positive aspect is that the Europeans are trying to tackle this problem and are talking of creating a European proposal for SDRM. In fact, Europe shows how much debt resolution is a governance problem, and how important it is to have a system that decides where and how transfers should take place, among other things. Europe might be able to help us with innovation and new ideas, Rogoff said.

The elephant in the room is that it is the advanced countries that are in trouble today – US, Japan and Germany. Mechanisms for resolving sovereign debt workouts have largely been envisioned for developing countries. But as unlikely as a default in one of the largest developed countries seems, it would be folly to build a mechanism that cannot handle a default in one of the world’s largest economies.

Rogoff stressed that a deeper question remains of why such a large percentage of international capital flows get channeled through debt, and whether it can be shaped in the future in a more balanced way. Equity and direct foreign investment are arguably somewhat more robust than debt. Thus an international bankruptcy regime that weakens creditors’ rights is not necessarily inefficient. Perhaps an ideal regime is one with strong creditor rights but with extensive indexation of debt to GDP, commodity prices, etc., depending on country circumstances.

A big challenge in re-doing the international financial architecture, Rogoff argued, is to try to redirect some of the financial flows that currently go through loans (about 75% of the international tradable market supply is funneled via debt), and instead channel it through other instruments such as indexation, commodity prices and so on.

The Secretary-General of UNCTAD, Supachai Panitchpakdi, began his remarks by recognizing the salience of this first special event of the General Assembly on sovereign debt restructuring to the international debate on debt resolution. He highlighted the increasing demand for re-opening the discussion on the SDRM proposal, an insolvency mechanism for sovereigns proposed by the IMF in 2002 but abandoned when opposition was voiced by some large developed and developing countries.

As an alternative to the SDRM, countries started issuing bonds with Collective Action Clauses, postulating that a majority of bondholders (usually 75% of principal) can amend bond terms and conditions, including payment terms. Recent debt restructurings were also facilitated by the introduction of exit clauses which reduced the incentive to holdout on a debt exchange offer by impairing defaulted bonds.

However, the April 2012 communiqué of the G20 stated the “the Euro area crisis has also highlighted the need for further study of sovereign debt restructuring mechanisms.” The UN Secretary General’s 2012 report devoted special attention to debt restructuring and provides an outline of key points of contention in this debate. Three of the most important points are worth highlighting.

The first key objection to the creation of a structured mechanism for solving sovereign debt crises is grounded in the economic concept of “moral hazard.” It is the idea that by reducing the costs of default, such a mechanism would reduce willingness to pay, make sovereign debt riskier and ultimately result in higher borrowing costs.

Indeed, Supachai said, this fear of borrowing costs was one of the key reasons why several developing countries were opposed to the IMF’s proposal of an SDRM.

However, Supachai argued this fear of moral hazard is not compelling. First, in economic theory it can also be argued that the current system with its debt overhangs and delayed defaults leads to a loss of value for both debtors and creditors and thus to higher borrowing costs. From this perspective, a mechanism that addressed these problems could increase recovery value and potentially lead to lower borrowing costs.

Second, and perhaps more importantly Supachai argued, empirical studies have not found evidence of higher borrowing costs from improved debt resolution mechanisms. For example, the introduction of Collective Action Clauses (CACs) in certain bonds did not lead to an increase in borrowing costs.

A second objection is based on the argument that such a mechanism is no longer necessary because CACs successfully address creditor coordination and holdout problems. Indeed, CACs have helped to address some of the issues, but it can also be argued that they do not completely solve coordination problems, as they cannot aggregate the claims of different classes of creditors, nor do they provide a more structured mechanism that could increase the equity of burden sharing among different classes of creditors.

Supachai said the third objection to the creation of a resolution mechanism is the absence of well-defined criteria for establishing the “capacity to pay,” subjecting assessment to political pressures, making it a serious issue for any proponent of the creation of such a mechanism. Any proposal should therefore include “capacity to pay” criteria as well as safeguards guaranteeing the independence of a body in charge of adjudicating sovereign claims.

Maria Kiwanuka, Minister of Finance, Planning and Economic Development for Uganda, said that the international financial architecture should reflect a coherent set of processes for financial management. In today’s interdependent economy every nation has a vested interest in managing their sovereign debt problems. The proliferation of individual country decisions disrupts unity and coherence.

These are times when both the demand and supply of sovereign debt in developing countries is very high. On the one hand, the demand side comes from financial pressures such as meeting MDG goals, infrastructure investment and coping with the fallout from the global financial crisis. Kiwanuka said Africa needs $93 billion per annum to address the infrastructure deficit.

The pressure governments face to increase financing has led to a proliferation of non-concessional lenders where there is higher return for less risk. This is especially true for countries like Uganda with many natural resources. “We can all here echoes at the sovereign level of what we hear on an individual level: ‘You have been pre-approved for a credit card,’” said Kiwanuka.

A missing link in the international financial architecture is the need for effective standard procedures in debt acquisition and management, which would address increased systemic risks and spillovers, and debt restructuring and difficulties, especially with multiple lenders who all have different priorities. The UN should facilitate intergovernmental discussions for guiding sovereign debt discussions based on global linkages. The problems of lenders charging higher interest charges and of low absorption capacity on the country level raises the cost of debt in developing countries.

The Ugandan experience shows the need for a harmonizing framework to address debt problems. Three of the biggest creditors to the country have enabled debt reduction of almost 50%. However, Kiwanuka asked pertinent questions as to what this debt reduction means? Does lower debt increase the stock of infrastructure financing? Or does it add value to an economic product or process? Does it lower the cost of doing business by the private sector, and if so by how much?

Kiwanuka argued that these questions must be answered in order to build a debt process. Uganda restructured debt through the Highly Indebted Poor Countries (HIPC) initiative with the IMF and World Bank. However, debt must also be restructured for infrastructure financing which will enhance agricultural and industrial activity.

A general uplifting of people and the state is necessary, Kiwanuka said. Money that is coming in on commercial terms must go into commercial ventures. For social initiatives, Uganda is looking increasingly toward bilateral grants and soft financing.

“But we are not going to make the mistake again of using commercial financing for social financing, it simply does not generate sufficient returns,” Kiwanuka said, adding that “from the Ugandan perspective, we are in a new era where sovereign nations are in a position of increased power to manage debt.”

Arvinn Eikeland Gadgil, State Secretary for International Development, Norway, said that current times are ripe for a serious discussion on sovereign debt resolution mechanisms. The HIPC and Multilateral Debt Relief Initiative (MDRI) are the cornerstones of Norway’s development finance policies, and should not be dismissed from the debate. Norway also has a broader idea of what a debt resolution mechanism should ideally contain.

First, it should cover all debt, both private and commercial. Second, it should be an instrument that includes all creditors, including the Paris Club, but is beyond that as well. It is now well known that the Paris Club has a diminishing share of sovereign debt responsibilities. A mechanism should be able to react quickly, so as to avoid situations where defaults are being prolonged, as the costs of default are enormous. A mechanism should also be able to follow the entire resolution process from default to relief.

Gadgil stressed that the fairness or justice element of this process is important as well, in that we have to end the current regime where the only factor considered is debt sustainability. After all, debt is not just technical, it is also very political. Looking at how the debt originated in the first place is very critical.

The importance of an independent institution that can handle debt arbitration in a neutral and credible manner cannot be stressed enough, said Gadgil. Norway is eager to be an active part of this process, and has thus decided to have a full debt audit to review if any of Norway’s sovereign debt can be considered illegitimate. In so doing, Norway aims to be a role model for other countries.

Norway is also signing a three-year contract with UNCTAD to frame a process forward. Innovations are not easy, but history shows that if there is political will, all sorts of things can go forward in a short amount of time.

Part 2 of Debt Event

The second part of the day-long panel event included speakers from Argentina’s Finance Ministry, the intergovernmental organization, the South Centre, the World Bank and the UN Department of Economic and Social Affairs.

Adrian Cosentino, Secretary of Finance in Argentina, said that debt rescheduling has to carefully ascertain the sovereign capacity to pay in a context where sovereign debt complicates the ability of countries to normalize its economic relationship with the rest of the world.

In the Argentine experience, organizing debt swap offers required as a reference point an evaluation of debt sustainability, which in turn looked at fiscal and external surpluses as reference points. Starting in 2005 Argentina has continuously worked on a debt management strategy which has vigorously pursued the goal of clearing non-performing liabilities and solving outstanding problems.

Cosentino said that Argentina has restructured 92% of its total debt default, where the proportion of holdouts was not even 40%. Argentina has not only restructured but has also carried out debt reduction processes based on financial policies that used internal resources. This allowed Argentina to lower the debt-to-GDP ratio to a present figure of 43%. Half of the total sovereign debt is held by the public sector, including public agencies whose financial risk capacities are very broad. In comparison, the private-debt-to-GDP ratio is 12%.

Cosentino said that unstable macroeconomic policies are a key driver of debt crises, which has to be taken into account particularly in the aftermath of the recent global financial crisis. “In Argentina,” he said, “we have understood that we need to ensure a path to the use of resources that could otherwise be affected by debt payments. We have also understood that we have to give priority to building macroeconomic sustainability, before starting to work on proposals for debt repayment.”

Perhaps a conclusion we can reach, especially by looking at what is happening in the Euro region which is facing a liability restructuring process, is that the lessons learned from Argentina are significant. One key lesson is to prioritize macroeconomic stability, because debt default is economically destructive and leads to a protracted debt resolution process over time.

Another lesson is that fiscal policy has to be very responsible in its allocation of resources, which requires serious parliamentary discussion on how this has to be carried out. A central problem that has emerged from the Argentine experience is that of the “legal vacuum.” The importance of making progress on dispute settlement mechanisms cannot be overstated. Such mechanisms must lead to innovations where rules and procedures place creditors and debtors on an equal footing.

A lot remains to be done, Secretary Cosentino concluded, although there are many good initiatives which already exists and which will hopefully quickly become real measures and options that all countries can use.

A day after Secretary Cosentino’s remarks at the UN General Assembly, on Friday, 27 October the Second US Circuit Court of Appeals in New York declared that Argentina had discriminated against bondholders who refused to take part in the nation’s two large debt restructurings.

The Court of Appeals said that Argentina’s decision to pay holdout bondholders later than bondholders who agreed to participate in the 2005 and 2010 debt swaps violated provisions that required the country to treat bondholders equally.

Argentina vowed to fight the court’s decision, and Secretary Cosentino told the state news agency Telam, “Today’s ruling is not in any way the end of litigation” on the relative treatment of bondholders, and that it had no immediate impact on debt payments. However, prices of Argentine government debt fell on that day, and the cost of protecting the debt against default surged higher.

Former Argentine Finance Secretary Guillermo Nielsen, who helped oversee the 2005 debt swap, said that the court action “corners Argentina into a new default, potentially forcing the country to pay holdouts while it services restructured debt.”

The court proceeding was steered by NML Capital and the Aurelius Capital Management funds, both holdout bondholders who owned $1.4 billion of defaulted debt. Earlier in October, NML Capital won a court order to detain the Argentine naval ship ARA Libertad in a port in Ghana, demanding that it be paid some of what it is owed.

A Reuters report on the case concluded that the court decision against Argentina could make it harder for other countries to extricate themselves from sovereign debt crises and fend off angry creditors that may sue the country from United States courts.

Martin Khor, Executive Director of the South Centre, said there is an urgent need for an internationally coordinated system of debt workout today, which is a key missing pillar of the international financial architecture. The world has now seen all the weaknesses in the present system and all the ways in which it doesn’t work. The need to make new efforts for an international solution has never been more important.

What are the features of an international sovereign debt workout system? Some of the features can be borrowed from the US Bankruptcy Chapter 11 law as well as Chapter 9 relating to public sector municipalities.

Khor outlined six major pillars or elements of such a system:

First, a temporary standstill on external debt servicing which will provide breathing space for debtor countries to formulate a viable debt servicing plan. Such a plan should cover all debt servicing, including those due to solvency problems in which the debt has to be reduced, or liquidity problems in which the debt has to be rolled over.

There should also be an automatic stay on litigation during the standstill in order to avoid problems for both debtor country and creditors, and in particular to avoid a scenario where creditors are scrambling for exit or to sue the debtor. The process should be similar to the World Trade Organization (WTO) feature, in that if there is a balance of payment difficulty in the country that can be demonstrated, the country can unilaterally suspend its tariff obligations in the WTO while receiving assurance that other WTO member states cannot take it to court.

Second, an independent panel of legal and economic experts should be established, and independence should be safeguarded by ensuring that panel members are neither debtors nor creditors. The IMF, in particular, cannot sit on such a panel because the institution is itself a creditor, which compromises the independence of such a panel.

Third, selective capital controls should be implemented in order to prevent capital flight. Fourth, new loans should be provided to the debtor country, in a process of lending into arrears. This enables countries to continue their trade, and in particular to be able to import essential items. Possible lenders for new loans are the IMF, the World Bank and other donor and lender countries. However, such lenders should not finance debt payments, which should be discussed strictly in the debt workout reorganization and mechanisms. If new money is lent to the debtor in order to repay old creditors, the whole point is moot.

Fifth, new debt contracted after the standstill should not be counted in the original debt amount. If the problem is primarily a liquidity problem, there should be a rollover of existing loans. If it is a solvency problem there should be a partial debt writedown. The precise method of such workouts should be the result of negotiations between the debtor and the creditor, and the negotiations process should be guarded by a statutory mechanism. Operationalizing the Collective Action Clause should be part of the entire exercise. When creditors and debtors cannot reach an agreement, an independent panel should arbitrate.

Some elements of such a process were in the Sovereign Debt Restructuring Mechanism proposal by the IMF.

Recently, South Korea expressed support for a debt standstill and restructuring process when it said to the G20 that “Many who have analyzed Korea’s 1997 and 1998 financial crises have found that Korea could have solved its liquidity problem sooner had a debt standstill programme been in place at the time Korea requested IMF assistance at the end of 1997.”

Khor stressed that the UN can take the lead in the debt restructuring exercise. In watching the Euro area debt crisis, there is an evolution of many ideas, especially from political leaders who are recognizing that there are far more efficient and effective processes and mechanisms than the ‘muddling through’ process the world is currently witnessing.

What is important for developing countries, especially Least Developed Countries that have experienced the Highly Indebted Poor Countries program, is that they do not become complacent when sovereign debt is low and sustainable, when times are good.

Khor highlighted that many factors indicate that the favorable global economic conditions that led to high capital inflows and high commodity prices are going to phase out in the coming years. Most economists are currently predicting that in the next 3-5 years there are very difficult times ahead for most developing countries. There may be shocks to export and remittance earnings, and this may cause difficulties for debt sustainability.

This is why, Khor emphasized, the current time is an opportune time to set up a debt restructuring mechanism. When countries are in the middle of a crisis, it will be much harder to establish a large-scale internationally coordinated mechanism.

Shamshad Akhtar, Assistant Secretary-General for the Department of Economic and Social Affairs (UN DESA) in the United Nations, outlined the proposals, perspectives and collective wisdom towards a sovereign debt resolution framework. Parallel to UNCTAD’s “Principles on Promoting Responsible Sovereign Lending and Borrowing,” the private sector has started discussing amendments to the “Principles for Stable Capital Flows and Fair Debt Restructuring.” The private sector’s objective is to incorporate the new developments associated with debt restructuring into the capital flows regime.

Meanwhile, UN DESA has launched a range of multi-stakeholder consultations on sovereign debt restructuring to solicit views of distinguished experts from academia, policymakers and private sector representatives. At the October meetings of the World Bank and IMF in Tokyo, experts acknowledged the virtues of a statutory debt restructuring mechanism but also recognized the complexity of designing an acceptable and enforceable framework.

The magnitude of the recent financial crisis might explain a perceived general willingness, including among private sector representatives, to entertain a more rules-based approach. Such an approach, while constraining private sector creditors, would also protect them from arbitrary actions by sovereigns, said Akhtar. The hope is that the recent round of debates might result in a balance between contractual and statutory instruments.

Akhtar highlighted that an important and cross-cutting issue is that of transparency and availability of data. One proposal to enhance transparency and data access is the creation of an international registry of debt, reported by creditors and reconciled with debtors. Another perhaps more ambitious option would be the creation of a neutral Sovereign Debt Forum, which would help assuage the information and analytical issues associated with the question of debt sustainability, as well as provide a space for negotiations and consultations.

In situations of debt distress borrowers would benefit from “breathing space,” which is not available currently, before identifying a sound policy framework to promote “sustainable adjustment, preserve asset values and support growth, to the mutual benefit of both debtors and creditors.” In practice, sovereigns can impose de facto standstills through the exercise of ‘force majeure,’ given the absence of credible means to enforce judgments under sovereign immunity.

A fundamental issue, Akhtar stressed, is whether a more formal process for the declaration of a standstill, in conjunction with lending into arrears by the IMF, would enhance the debt resolution framework. Such a process would provide a stay on all litigation by individual creditors, preventing a panicked rush to the exits that usually triggers a rollover crisis and a race to the courthouse.

Two proposals have been discussed in this regard. First, the inclusion of terms for standstills in bond and loan contracts under the voluntary approach and second, the amendment of article VIII 2b of the IMF Articles of Agreement to include capital account transfers under the statutory approach.

Otaviano Canuto, Vice-President of the Poverty Reduction and Economic Management Network in the World Bank, said that various World Bank studies have concluded that sovereign debt restructuring tends to be disorderly and prolonged. Official interventions can sometimes help, but sometimes it can worsen sovereign debt situations.

This conclusion was consistent across countries with striking similarities such as fixed exchange rates, open capital accounts, weak growth prospects and concerns about fiscal solvency. A common sovereign narrative is that fiscal fundamentals play a crucial role. Even though all these crises typically involve abrupt economic disruptions, their seeds were sown over long periods, and reflect policies in national and global political economy.

A common thread across sovereign debt crises is the rise of a relatively new set of complications, namely that of private capital flight moving from the core to the periphery and now back to the core. In the 1980s there was a proliferation of black market premia for hard currency, and the rising risks of convertibility have become a serious concern. However, despite the disorderly nature of some debt writedowns, at the end of the day there is some acknowledgement for the need to write down debt.

Canuto compared the 1980s debt crisis in Latin America, after the Brady Plan was formulated, to the debt crisis in Russia and Argentina, where the usefulness of official intervention was questionable. Financial engineering occurred in the form of voluntary debt swaps and the lesson was learned that procrastination is costly for all stakeholders.

For any official intervention to be catalytic, Canuto said that private holders of government debt must get involved, fiscal and structural reform must take place, and the interest rate must come down after risk stress declines. “Intuition is simple,” he said. “There is an understanding that solvency means that the present value of primary fiscal surpluses must be less than outstanding debt.”

With regard to the Greek debt crisis, bond spreads in the country continued to rise even as the interest stayed stagnant. The debt had to be adjusted even higher and a haircut has to come to the fore. Against this backdrop of recent experiences in the Euro area, there are many desirable features underpinning any orderly debt restructuring when a fiscal solvency problem is detected and when the market is in significantly high default risk.

First, private creditors receive an upfront haircut; second, vulnerable systemic banks are protected to get back on track; and third, the official money is loaned at risk-free rates which reflect its senior status. The question would arise whether an upfront haircut for private creditors would incur more hazard.

What the data in the World Bank shows, according to Canuto, is that the supposed moral hazard risk on the debtor country has been overestimated starting from the various debt crises in the 1980s. The kind of smoothing required in a debt restructuring mechanism is one that would avoid the aspects of disorderly and procrastinated debt restructuring.

Nigeria said that defaulting countries are not focusing enough on the ways in which creditors can behave more responsibly. There is a lot of discrepancy in the figures presented by the IMF, the World Bank and the countries themselves.

The international community also has to address the important question of how these sovereign debts have been amassed by developing countries in the first place. Has the debt been used for the purpose originally stated? There are often no proper records, no statements and no evidence as to the actual use of the debt. For some developing countries, sovereign debt becomes deeper and deeper because they don’t export industrialized goods.

How will developing countries stimulate exports of higher value added manufactured and industrial goods? Many African countries have a taste for imported goods from abroad, and do not put the priority on building a deeper domestic industrial base. But, Nigeria stressed, if developing countries have nothing to export there is nothing with which to pay the debt.

The International Monetary Fund stated that when discussing issues countries currently face in debt sustainability, there are successful examples of how the international community effectively cooperated to establish the Multilateral Debt Relief Initiative and the Highly Indebted Poor Countries initiative.

Since SDRM proposal, the IMF has been involved in many national debt restructuring initiatives, where the IMF is guided by its policies on debt restructuring and private sector involvement. The mandate given to the IMF by the international community is to provide an independent assessment of the economic reform programme of the government to ensure debt and economic sustainability analyses.

The Fund is also mandated to provide financing and more importantly play a catalytic role to help unlock financing from other countries. Even though the SDRM discussion was stalled at the IMF’s Executive Board, the Fund has been involved in a number of sovereign debt restructuring processes, and within each of these, the IMF has been following international protocols.

Bhumika Muchhala is a researcher for the Third World Network.

South Centre-NGOs Forum on Debt Workout Mechanism at IMF-World Bank Meeting

[South Bullein 70 Article]

The South Centre co-organised a side event that saw a lively exchange of views on proposals towards a global sovereign debt workout mechanism during the 2012 World Bank-IMF meetings, held on October 11, 2012 in Tokyo.

By Mariama Williams

The South Centre co-sponsored the side event Beyond HIPC - towards a fair and transparent debt workout mechanism at the the WB/IMF Annual Meetings, Tokyo, Japan, October 11, 2012. The side-event, which was attended by policymakers, civil servants, private sector and NGOs, generated a sharing and exchange of views regarding the implementation of reform proposals for dealing with sovereign debt. The event was designed as a roundtable with short and sharp inputs, mainly on the political process, its challenges and next steps, but also on the substance of the various proposals from academia, international institutions and NGOs for a fair and transparent and formal international regulatory mechanism to facilitate sovereign debt restructuring. The event was co-sponsored with EURODAD, LATINDADD, AFRODAD, SLUG, 11.11.11, EED, Jubilee USA, erlassjahr.de and TWN.

Moderated by Mr. Eric LeCompte of Jubilee USA, the side event opened with the presentation of a joint statement of the global debt movement by Ms. Øygunn Brynnildsen, EURODAD, which noted that sovereign over-indebtedness has become a major challenge for global financial stability, with four countries in Europe turning to multilateral rescue financing and others potentially to follow. Furthermore, according to the IMF, almost one fourth (16 out of 72) of low income countries, including seven countries that have only recently obtained substantial debt relief through the Heavily Indebted Poor Countries (HIPC) and the Multilateral Debt Relief (MDR) initiatives along with several severely indebted countries, particularly, Central Eastern European and Small Developing States are at high risk of debt distress. Many of these countries, given the present financial and economic crisis, may experience rising primary deficits contributing to a new round of borrowing and higher debt-to-GDP ratios.

The statement also noted that the current ad-hoc and piecemeal system for restructuring of official sovereign debts is messy, incur lengthy delays in debt restructuring and/or cancellation and costly. The negative effects of the growing risks of free-riding, hold-outs(i.e. investors who refuse to negotiate and demand that the debt instruments be honored in full) and vulture funds (funds which have purchased debt at low prices, driven down by payment problems, may include hold-outs) activities have further complicated as well as compromised the system.

Proponents of the statement argued for a single, rules-based, universal debt workout framework covering all creditors and debtors-at-risk and all instruments, and which is impartial both with regard to decision-making over the terms and conditions of debt restructuring and the assessment of the validity of individual claim and of the sovereign’s overall debt sustainability. Given the partiality of current creditor cartels, such as the London and Paris Clubs and the Bretton woods Institutions, the UN could play the role of host for the reform process as well as oversee a fair and comprehensive sovereign debt restructuring mechanism.

Respondents from three governments, Norway, Germany, Argentina and the UN shared their perspectives on the substance of proposals, the political process, challenges and next step towards an independent debt reduction mechanism. A representative of the South Centre closed the discussion with a moderator's summary that also outlined the future political process.

Mr. Heikki Holmås, Minister of Development, Norway supported the need for a sovereign debt workout mechanism. He highlighted Norway’s long standing involvement in debt relief efforts and said that debt relief was a part of the platform of the Norwegian government. Norway supports the HIPC and MDRI as cornerstones of the debt relief process.

Any new mechanism must build on the good aspects that currently exist. Mr. Holmås noted that the HIPC initiative was at a mature stage and that there is growing debt risk for some of the countries involved in HIPC and that other countries do not have access to HIPC or similar debt relief process. Norway has consistently supported the prevention of sovereign indebtedness and supports UNCTAD’s Principles for Responsible Borrowing and Lending Initiative (a set of international standards for borrowing and lending among countries) which has so far received endorsement from 13 countries.

Norway is now integrating debt auditing and the consequential indicated revisions to its developing countries’ debt portfolio based on the UNCTAD principles.

Mr. Holmås noted that there was an asymmetric relationship between debtors and creditors and so Norway welcomes the discussion of a rules-based system that would change who judges debt processes and how debts are judged and adjudicated. He said that in this context support must continue for the poorest countries and there may be need for two parallel tracks: one track focused on improving the current approach and another track focused on constructing a new mechanism for international debt workout.
Holmås argued that debt cancellation is not only about sustainability, it is also about responsible lending. Therefore, the global community needs to address the issues in a more predictable, honest and transparent way.

As a further demonstration of Norway’s commitment to moving forward on the processes toward an effective and sustainable debt system for the management of sovereign debts, Mr. Holmås announced that the Norwegian government is signing a new three year programme with UNCTAD for technical assistance geared at producing guidelines based upon the principles for responsible lending and borrowing, and the implementation of the initiative.

Mr. Ludger Schuknecht, Department Head, Ministry of Finance, Germany said that, in principle, Germany was in agreement with the idea that there needs to be improvements in the current system for the management of sovereign debt problems. The development of a debt work-out mechanism seems well justified given the debt issue is rising and recent events showed that even industrialized (OECD) countries are not immune to debt crisis. However, Mr. Schuknecht said, there was no silver bullet to this challenge, hence trial and error processes must also continue and the economic perspective maintained.

Mr. Schuknecht argued that there already exists a history of prevention in the form of IMF lending with conditionalities to prevent unsustainable debt accumulation. He argued that while there is need for improvement, it was important not to lose sight of the effect of such process on lending market conditions. He said that the existing framework relies on the London and Paris Clubs, and that collective action clauses (CACs), while not a substitute for the debt restructuring, are very important; they can help to speed up debt restructuring. He pointed out that the Eurozone has agreed to CAC having a feature in all new euro government securities and that CACs are also good for developing countries with debts instruments denominated in local currency. [Editor’s note: as per paragraph 3, article 12 of the European Stability Mechanism treaty, CACs will become mandatory in all new euro area government securities with maturity above one year issued on or after 1 January 2013. A model CAC has been developed for the zone.]

Ultimately, Schuknecht said, that though there are justifiable issues about how to deal with the debt accumulation, he was skeptical of a legally binding arbitration framework/international debt arbitration court on two grounds: it has significant budgetary implication; and, it would require political agreement that would be difficult to find. He also voiced concern that the fundamental balance between creditors and debtors in contractual agreements has to be honoured. The system is biased toward contractual fulfillment and that the baby must not be thrown out with the bath water by protecting the interest of the debtor and tilting the balance against creditors. This outcome could backfire, leading to high risk premiums and the withholding of credit for some countries. On the whole, a legally binding framework is very tricky and the balance should not shift too much as it may be detrimental to poor countries.

Mr. Schukenect in his closing remarks said that despite his reservations, it is important to continue making proposals for, and engaging in the work of reforming the international debt architecture, despite the challenges ahead, including the distributional issues between countries as well as between private sector actors and the wariness of the private sector and the banking system.

Mr. Adrian Cosentino, Secretary of Finance, Argentina, illustrated the case of Argentina (which defaulted on its debt, due to a financial crisis in 2001, and restructured about 92% of this by 2010) and the lessons learned from that experience to highlight: 1) the pending issues that do not allow completion of debt restructuring process for a country such as Argentina, and 2) key elements and the necessary conditions for successful sovereign debt for restructuring.

Cosentino gave some highlights of the particular case of Argentina which had achieved a 92% participation rate of its creditors in support for its debt restructuring. After 10 years of achieving significant progress on all fronts (such as lowering the market risks of both its public and sovereign debts and consistently meeting its primary surplus target), the country continues to face consequences from hold-outs and vulture funds. These are crucial issues that need to be dealt with in the international legal reform framework for sovereign debt work-out.

Mr. Cosentino said that a permanent debt reduction process is important for the optimization of internal resources for social good. He pointed out that debt indicators should not only validate debt reduction process but also give countries the possibility of revising social goals and macroeconomic objectives.

Cosentino argued that from the perspective of the Argentinian case, the key elements of institutional reform for debt restructuring framework include the acceptance that: first, sovereign debt crisis is always the consequence of unsustainable macroeconomic conditions. Hence a sustainable process must pivot around defining macroeconomic conditions that is needed for a growth path consistent with debt sustainability. In general, creditors and sovereign debtors’ discussions don’t always include this process as well as neglect definition of the correct timing and conditions for macroeconomic sequencing in their deliberations; instead, attention is often focused on microeconomic technicalities such as haircuts.

A second element critical to institutional reform of the debt restructuring system must revolve around debt composition and the necessity for very careful liability management strategy that takes into account the importance of projecting into the future: the next 10, 20 and 30 years. Despite all of its achievement, Cosentino said that Argentina is still castigated for not following international rules. At the same time, various banking entities come, almost on a weekly basis, to entice the countries with loan offers, while insisting that the country cannot remain outside the market channels. Despite the many different judgments about its debt sustainability, if Argentina maintains its current macroeconomic and debt management strategies, including sustained primary surplus, in 10 years, its debt to GDP ratio will be only 15%. Hence Argentina is on the right track.

From its experience, Argentina concludes that a crisis resolution mechanism should include, at the very least, the following key elements: impartiality; independent evaluation of macroeconomic fiscal and other conditions; independent process of channeling all claims, and the right of domestic party to take into account the needs and considerations of all stakeholders.

From the perspective of Argentina, successful sovereign debt restructuring requires consistency among objectives, priorities and sequencing, financial policies integration with macro policy, including social policy, sustained inclusive growth process and debt management strategy. The latter should consider the debt composition in the framework of a dynamic liability management strategy focused on the next 20-30 years. Ultimately, there is an imperative to close the existing gaps in international legal framework. Argentina will support advances in this process.

Ms. Yuefen Li of UNCTAD’s Debt and Development Branch expressed appreciation and thanks to Norway for its confidence, trust in, and support of UNCTAD. Li argued that the work to secure a sovereign debt reduction mechanism will be a long hard struggle. She said that a mechanism that is statutory is not a panacea but is necessary as currently there is no predictability and there is increasing cost of debt resolution which is causing human suffering. The road towards the Sovereign Debt Restructuring Mechanism (SDRM), with the efforts of the UN and CSO, will have to take baby steps.

There are also setbacks. Currently there are two schools of thought on the issue of reform of the debt management system. There are some that believe that without the mechanism, there is a gap—a missing link in the international architecture and those that believe the current system works quite smoothly.

Ms. Li said that there must be debt relief and there must be economic growth. She pointed out that collective action clauses (CACs) and debt exchanges cannot solve the debt problem. In the first case, not all bonds have CACs, and, in the second, CACs do not provide interim financing. Debt exchanges may provide liquidity but do not address the insolvency problem, whereas indebted countries need a fresh start.

Ms. Li argue that there should be no fear of the willingness of governments to pay as governments do not default easily; they tend to go for austerity and debt resolution. There also should not be fear of reputational lost as this is not borne out by the historical evidence. Finally, Ms. Li argues that there is need for more discussion and sharing to ward off the worst fears and enhance explanations as to why a sovereign debt restructuring mechanism is needed.

A lively exchange of ideas flowed between the audience and the presenters. The interactive discussion highlighted the following observations, concerns and directional signals for the forward momentum on the debt issue for developing countries:

· Countries from the HIPC initiative are bearing heavy debt some of which may be due to irresponsible borrowing hence there was a need to address the causes of the debt crisis;

· The need to support countries in implementing policies and increase growth and improve debt management;

· The importance of solving the crisis early;

· How and to what extent the new mechanism can address emerging domestic debt and the high level issue of international sovereign bonds;

· The need for establishing the principle that where there is a high majority of all creditors that accepts a deal, then, the deal is done. This speaks to the issue of dealing with hold-outs and vulture funds;

· In this context it was also pointed out that most often those lenders with low interest rate debts are the ones who are willing to restructure their debts, while those with high interest rate are the reluctant ones. So even though high interest rate is to reflect high risk premium, these lenders, in reality, do not take the risks because they block the resolution of the debt;

· The CAC and SDR mechanism are not mutually exclusive but should be complementary. CAC should have aggregation clauses that mandate co-ordination across different instruments of external and domestic debt;

· The question of the off-loading of private sector debt that drives the indebtedness of the public sectors (the socialization of private debt) must be addressed. In this context, concern was voiced about a recent World Bank report that encourage more private sector involvement in developing countries without acknowledging or seeking to address the issue of the profit seeking profligacy that often result in private sector indebtedness which are ultimately repaid by the public sectors;

· Participants also raised the issue of the differential treatment of private sector as well as municipalities (in the US) debts, where there is an orderly debt workout through the bankruptcy proceedings. The question was raised as to why can this system not be feasible in the global community?

· It was also pointed out that a macro prudential framework that allows countries to deal with capital flows is important to debt management and high international liquidity. Often international liquidity does not have any relationship with a country’s need and can drive up debt.

Mariama Williams of the South Centre closed the session by summarizing that the present system, where many of the solutions, such as SDRM, have failed or else are inadequate, does not address the situation of severely indebted middle income countries. Williams said that there is need for a system that can take into account all of these issues including the proliferation of new debt instruments such as ‘… bonds, syndicated loans, through a new wave of aggressive marketing by Export Credit Agencies and the greatly expanded multilateral post-crisis lending’. The current system has many shortfalls and is creditor-dominated with politically biased decision making – and has no formal procedure for ensuring fair burden between creditor and debtor. She pointed out that according to the IMF (2011) ‘the HIPC Initiative is largely complete’ and could potentially end in 2014 unless the sunset clause is further amended. Additionally, low income countries have even greater vulnerability due to the financial and economic crises, the volatility of commodity prices and frequent natural disaster and climate change. Thus even as the idea of debt restructuring is being debated, a quiet crisis, even a (debt) bomb is actually ticking away in the wings.

Williams further notes that the present architecture does not favor either prevention or early debt resolution as key decision makers continue to exhibit reluctance to tackle issues of insolvency. Williams cited Anne Krueger, the first managing director of IMF:

We lack incentives to help countries with unsustainable debts resolve them promptly and in an orderly way. At present the only available mechanism require the international community to bail out private creditors. It is high time this hole was filled.

She said the lessons from the 1980s debt problem of Latin America and the Caribbean show that the debt problem dragged out causing that region to lose at least a decade of advancement. Due to foot dragging, it took almost seven years to recognize the solvency issues and another couple of years to actually implement solutions. By then the various initiatives from Baker plan to Brady plan were too little, too late and not enough.

These lessons points to the need to urgently remedy the missing part in the international financial architecture with a debt workout mechanism that is orderly and that is independent, comprehensive (include multilateral, bilateral creditors); based on human needs, human rights, and accountable and which recognizes and honours the rights of all stakeholders.

Many countries, especially those in the Caribbean are in need of a fresh start; for these countries fiscal consolidation is not the answer; they need the fiscal space that comes with debt restructuring and cancellation.

Finally, Williams said that there was a need to demystify and de-mythologize many of the concepts, deeply held fears and myths that dominate discussions of sovereign debt. In particular, the sanctity of contracts: in the domestic economy, households and business alter and modify loan contracts within a legal framework that recognize the importance to society and the economy of the orderly work out of debts and the imperative of fresh start for overly indebted economic agents.

She cited Albert Einstein who said that ‘Insanity is doing the same thing, over and over again, but expecting different results’: This, Williams remarked, is certainly, unfortunately, more than reflective of the approach to sovereign debt today. It is, she concluded, certainly time to fix this gaping hole in the international global financial architecture. Developing countries, who are indebted, need to step up to the plate and make demands and articulate what they need from creditors and from the system, as a whole. Hopefully, the UN General Assembly event will help to activate more learning and understanding for developing countries enabling them to become more proactive on this issue.

Mariama Williams is Senior Researcher of the South Centre.

Growth in the South: Resilience, Decoupling, Recoupling

[South Bulletin 70 Article]

By Yilmaz Akyuz

Rapid acceleration of growth in developing countries (DCs) and the widening of their growth gap with advanced economies (AEs) before the outbreak of the global financial crisis were widely interpreted as decoupling of the South from the North. In the early days of the crisis, there were also widespread expectations that growth in the South would be little affected by the difficulties facing AEs. In fact, DCs slowed considerably in 2009 as a result of contraction of exports to AEs and financial contagion. However, they recovered rapidly, with growth rates in 2010-11 matching or exceeding the levels seen before the crisis, while recovery in the US has remained weak and erratic, and Europe has gone into a second dip. This has again revived the decoupling thesis, notwithstanding the sharp slowdown in many major DCs over the course of the current year.

This change of sentiment about decoupling reflects lack of sound knowledge and understanding of the evolution of growth fundamentals in DCs and their global linkages. In an earlier IMF Working Paper Kose, Otrok and Prasad (2008) analysed global business cycles and found decoupling between DCs and AEs, but increased coupling within each group. Wälti (2009) challenged this and argued that assessment of decoupling should not be based on actual growth rates but deviations from trend (or potential output). On that basis there is no decrease in the synchronicity between DCs and AEs. Rose (2009) came to broadly the same conclusion, while Yeyati (2009) showed that in fact the 2000s witnessed an increase in the correlations of DCs and G7 cycles.

In a recent paper I argued that a more important question that needs to be examined is whether the acceleration in DCs in the new millennium suggests an upward shift in their trend (potential) growth relative to AEs. After examining global conditions, linking them to policies in AEs and reviewing the evidence regarding some key determinants of long-term growth in major DCs, I came to the conclusion that the unprecedented acceleration of growth in DCs in the new millennium is due not so much to improvements in their underlying fundamentals as to exceptionally favourable global economic conditions, shaped mainly by unsustainable policies in AEs.

Moreover, the only developing economy which has had a major independent impact on global conditions, notably through commodity prices, is China. However, growth in China has been driven first by a rapid expansion of exports to advanced economies and more recently, after the global crisis, by an investment boom, neither of which is replicable or sustainable over the longer term. To maintain catch-up growth, DCs need to reduce their dependence on foreign markets and capital and commodity earnings.

The IMF (2007; 2008) generally subscribed, with usual caveats, to significantly weakened dependence of growth in the South on the North in the early days of the crisis, underestimating the adverse spillovers from the US housing debacle. It has now revisited the issue in its latest World Economic Outlook (Chapter 4) under “Resilience in Emerging Market and Developing Economies: Will it last?”

Lumping together more than 100 emerging market and developing economies (with per capita incomes ranging from $200 to over $20,000) and examining their evolution over the past 60 years, it has found that “[t]hese economies did so well during the past decade that for the first time, [they] spent more time in expansion and had smaller downturns than advanced economies. Their improved performance is explained by both good policies and a lower incidence of external and domestic shocks: better policies account for about three-fifths of their improved performance, and less-frequent shocks account for the rest.” Interestingly the Fund does not seem to argue that good policies would be enough to decouple DCs from the North as it cautions that “should the external environment worsen, these economies will likely end up “recoupling” with advanced economies.”

“Good policies” found to have improved performance in DCs include “greater policy space (characterized by low inflation, and favourable fiscal and external positions)” created by “improved policy frameworks (countercyclical policy, inflation targeting and flexible exchange rate regimes).” However, the analysis ignores the role of positive external shocks, notably the surge in commodity prices, capital flows and remittances, in creating the policy space in DCs. There is ample evidence from IDB and ECLAC that much of the improvement in the fiscal situation in Latin America after 2002 was the result of the commodity boom while the policy was mostly pro-cyclical. This is also true for improvements in current account and reserve positions (Calvo and Talvi; Ocampo).

All these created space for subsequent counter-cyclical policies in response to fallouts from the global crisis. Even disinflation in countries such as Brazil and Turkey owed a lot to exchange rate appreciations made possible by large inflows of capital. These positive shocks provide a better explanation of the exceptional performance of many DCs in the past decade than “good” orthodox policies such as inflation targeting, single-digit inflation and flexible exchange rates.

Interestingly, the WEO could find no robust links between structural factors – including trade patterns, financial openness and capital flows and income distribution – and the “resilience” of DCs. The Fund staff has clearly spent a lot of time and effort (and hence public money) demonstrating what we all know: that the performance of DCs in the past decade is unprecedented. The analysis sheds no light on how growth dynamics in the South may have changed. Nor does it provide a useful guide to policy over and above what has already been professed.

Yilmaz Akyuz is Chief Economist of the South Centre. He wrote the above as a blog for the Triple Crises Website.

The Plurilateral Services Game at the WTO

[South Bulletin 70 Article]

By Chakravarthi Raghavan

With the World Trade Organization's (WTO) Doha Round of Negotiations at a complete impasse, those who launched it in 2001, appear to be trying to find a way of burying the "corpse", and looking for other ways to achieve their neo-mercantilist agendas.

The air has been thick in recent weeks of "news" of the talks and tentative agreements among the "Really Good Friends of Services" (RGFS) for an International Services Agreement (ISA), with a new architecture of sorts and a heavy dose of liberalisation. Some of the contours of the intended ISA, and the progress in negotiations, have been spelt out in testimony before the US Congress in September, by Ambassador Michael Punke, the deputy US Trade Representative (USTR) and US ambassador to the WTO, as also in more recent statements by the Australian minister and some other participants about "tentative accords".

There is talk of the "ISA architecture", as involving "conditional plurilateral" agreement, to be lodged at the WTO, with other members enabled to accede to it, on the analogy of the existing plurilaterals (in Annex 4 of the Marrakesh Treaty). There is also a projected scenario of the ISA, as a GATS Article V services integration agreement of the participating countries, or of an Information Technology Agreement (ITA)-type agreement, with MFN (Most Favoured Nation) treatment for all WTO members, provided the major emerging economies join such an ISA and liberalise their markets.

The RGFS countries are said to be: Australia, Canada, Chile, Colombia, Costa Rica, the European Union, Hong Kong, Israel, Japan, Mexico, New Zealand, Norway, Pakistan, Peru, Singapore, South Korea, Switzerland, Taiwan and the US. More recently, it has been reported that Singapore has withdrawn from the group. And several of the leaked reports also underline the absence from the RGFS of the BRICS, in particular of Brazil, India and South Africa - the major emerging economies, whose services markets are greedily eyed by the US and EU services industries - and attempts to persuade them to join the RGFS.

All these moves, and the high-level PR approach and publicity given to them, appear to have the air of a further parody of the 1829 poem "The Spider and the Fly" by Mary Howitt (1799-1888), parodied by Lewis Carroll (real name, Charles Dodgson, 1832-1896); or, to change the metaphor, in the coming winter and its snowfalls in the Alps attempt a snowball effect, panic major emerging economies (Brazil, China, India and South Africa) to join the process and open up their services markets to the US and EU service industries, in particular the financial firms receiving trillions of dollars in subsidies.

The Howitt's poem opening with the line, "Will you walk into my parlour?" said the Spider to the Fly, is the story of a cunning Spider who ensnares a naive Fly through the use of seduction and flattery, gets the fly into its web and devours it - a cautionary tale to children by Howitt, warning children to beware of those who use flattery and charm as a front for potential evil.

Howitt's poem was further parodied by Lewis Carroll in the tale of "The Lobster and the Snail" (ch. 10 of "Alice's Adventures in the Wonderland", 1865). In Carroll's tale, the whiting invites the snail to walk faster to join the lobsters and tortoises waiting on the shingles on the shore for the dance, and tempts the snail with the ‘delightful' culmination to the dance, "in everyone being taken up and thrown with the lobsters, out to sea!". When the snail balks that it would be "Too far, too far", the whiting responds, "What matters it how far we go? ... There is another shore... upon the other side... The further off from England the nearer is to France."

From leaked information about the "ISA architecture" and its liberalisation contours, it is clear that the moves, whether for a stand-alone "plurilateral" outside of the GATS/WTO, or as an agreement to be lodged in Annex 4 of the Marrakesh Treaty, or as an Article V GATS integration agreement to be notified to WTO, the ISA would be prima facie WTO/GATS illegal - an open-and-shut case for the Dispute Settlement Understanding (DSU), unless the panel and Appellate Body turn perverse to favour the US.

The ISA, as a plurilateral agreement on trade in services, applicable only to its members, is legally inconceivable under the WTO. There is no way to do this, unless such plurilaterals are excepted as a clear departure in the multilateral agreement itself, like in the cases of free trade agreements (FTAs) in the GATT and the GATS.

In the days of the old GATT, a provisional executive agreement among governments, at a media conference during the Uruguay Round, when confronted with the view that the European Commission's proposals were contrary to the Punta del Este mandate for negotiations, the EC negotiator responded with "anything is possible in GATT among consenting adults."

The WTO is now a Rules-based international organisation, set up under an international treaty, with binding rights and obligations for members, with a Dispute Settlement process, and specific provisions for any amendments to the treaty and agreements annexed to it, and for their entry into force after acceptance of members.

Under the provisions of Article II:1, and Article III:2 of the WTO, any negotiations for any trade accord on any of the agreements in Annex 1 (1A in goods trade, 1B in services trade and 1C on TRIPS) are to be conducted with the WTO "as the forum for such negotiations." Article II, paragraph 1 of GATS, the MFN Treatment provision, relevant to the ISA issue, reads: "With respect to any measure covered by this Agreement, each member shall accord immediately and unconditionally to services and services suppliers of any other Member, treatment no less favourable than it accords to services and services suppliers of any other country."

Paragraphs two and three of this Article II set out some exceptions and limitations, but they are not relevant to the consideration of the ISA issue. They provide for derogation from MFN, if it is listed in a particular way in a Member's GATS schedule, as also for ability of two adjacent countries, conferring advantages to services locally produced and consumed in contiguous frontier zones.

Thus, under WTO Rules, the parties to the ISA cannot make liberalisation of their services markets applicable only to ISA members. Nor can they extend it to other WTO members on any conditional basis. The liberalisation (reduction of barriers) in any sector has to be unconditionally extended to all other WTO members, whether ISA or non-ISA.

For the ISA to co-exist with the GATS and for its lodgement for this purpose in Annex 4 of the WTO, there needs to be an amendment of the Marrakesh Treaty. And since the ISA is intended to cover "service transactions" across sectors and modes of supply and involves non-MFN treatment to those not members, for such an amendment to be adopted and come into effect, it needs the acceptance of all WTO members.

For any agreement to be viewed as an Article V one (as an FTA in services trades of its members, or an integration agreement in services among its members), the agreement must satisfy the terms of Article V of GATS. Among others, Article V:1 (a) requires that the ISA have "substantial sectoral coverage"; and a footnote explains "This condition is understood in terms of number of sectors, volume of trade affected, and modes of supply. In order to meet this requirement, agreements should not provide for the a priori exclusion of any mode of supply."

Article V of GATS provides for negotiations when the services integration accord involves modification of scheduled commitments of its members. Irrespective of any Working Party consideration and recommendation, or decisions by the Council on Trade in Services (CTS), any non-ISA WTO member can raise a dispute and get a ruling via the DSU. Such a grievance could arise for a WTO member, if the ISA does not comply with Article V.1 (a), or the member finds its existing access to the service markets of the ISA members reduced as a result of the infringement of the provisions of Article V.4. The latter provides that any Article V.1 agreement, in respect of a non-member "shall not... raise the overall level of barriers to trade in services within the respective sectors or subsectors compared to the level applicable prior to such an agreement."

Thus, all the current noise about the planned ISA can be understood only as a big bluff game and an attempt to panic the major emerging economies (and/or their particular service sectors or subsectors) that have stood out but fear loss of markets, or loss of competitivity vis-a-vis other trading partners and their suppliers, into joining the ISA negotiating process.

When the Marrakesh treaty was signed in April 1994, developing countries accepted onerous commitments in advance as the price for bringing the agriculture sector under normal GATT trading disciplines, and for the initiation of an irreversible, longer-term reform process that envisaged gradual elimination over time of governmental aid and support to domestic producers. There were also other reform measures that the major industrial countries were required to undertake over a period of time, and for time-bound negotiations after WTO enters into force within specific agreements.

At the Singapore Ministerial meeting of the WTO in 1996, the EC sought to put spokes in the wheel, by injecting extraneous issues (the so-called studies and negotiations on four Singapore issues), so that further agricultural trade reforms could be delayed or subverted. The EU has more than achieved that objective, through the impasse in the Doha Round. And the US and EU now balk at any further cuts in agriculture subsidies and want to bury the Doha Round, and move on to new agendas.

At the turn of the century, to avoid more agriculture reforms and subsidy cuts, the EC mooted the millennium round with the Singapore issues, asking everyone to put any issue they wanted on the table. Along with a number of other issues and negotiations in terms of various WTO agreements, a new round of services negotiations (mandated every five years) also came up, and was actually agreed upon and started in 2000, at the WTO Council on Trade in Services. (This was rolled into the Doha Round in November 2001, at the instance of the EU and US).

Just before the December 1999 Seattle ministerial, the US had indicated its reluctance to engage in further services talks, while the US and EC also clashed over further agricultural reform. And both wanted further opening up of agricultural and non-agricultural products markets of developing countries. The collapse of the Seattle meeting resulted in 2000 of the General Council decision to start a programme of confidence-building. But this did not suit the US or the EU (or the WTO Secretariat), and the process was subverted.

In this stalemate, using the opportunity of the terrorist attacks on the US, the US and EC forced the launch of the Doha negotiations with a large range of issues, as a single undertaking. Soon after its launch, then EC Trade Commissioner, currently the WTO Director-General, Pascal Lamy told the EU Parliament members at an informal meeting that through the Doha Round, he had got the EU countries ten years’ time to gradually adapt to and change the modes of subsidies (from "blue" or "amber" boxes to the "green" box).

Any prospects for concluding the Doha Round were lost when in 2006, at the meeting of the G-6 (Brazil, India, EU, US, Australia and Japan) trade ministers near Geneva (as a follow-up to the St. Petersburg G-8 meeting), Pascal Lamy abruptly adjourned the talks, not only of the G-6 but of the Doha negotiations too and announced it to the media present near the meeting. Lamy subsequently came to Geneva and got the World Trade Organization's Trade Negotiations Committee to endorse it at an informal session.

The G-6 talks had been adjourned by Lamy when the US found itself cornered on some key issues - including the issue of cotton subsidies. Lamy had hoped perhaps that after the 2006 US Congressional elections, the US would be able to make concessions and the talks could be concluded. But the George Bush administration and the Republican Party lost control of the House of Representatives, and could no longer make any concessions. The Congressional Fast Track authority to the administration to conclude trade deals also expired. Since then (and more so after Barack Obama became president in 2009, and the Democrats lost control of the House of Representatives in the 2010 elections), the US system has become non-functional.

To believe that in this situation, the US and EC, and their service industries, could recover ground and through a new ISA capture the service markets of the developing countries and via a new financial services accord dump the toxic securities held by the US Fed or EU central banks on the markets of major emerging economies, is to chase the fool's gold, and in the process wreck the WTO.

Chakravarthi Raghavan, the Editor-Emeritus of the SUNS, contributed this article. An edited version is in the Economic and Political Weekly, Vol. 47 No. 43, October 27, 2012, under the title, "The Plurilateral Service Agreement Game at the WTO”.

Economists Debate State of World and Their Science

[South Bulletin 70 Article]

By Martin Khor

With the world engulfed in the aftermath of a financial crisis and the midst of another one, have mainstream economists changed their theories and policy prescriptions to be more accurate in depicting reality and relevant to policy makers?

To a large extent the big crisis sparked by the Lehman Brothers collapse of 2007 and the Euro crisis sparked by the Irish and Greek debt problems have shaken the dominant assumptions that the financial markets are efficient and governments should leave them alone and not regulate.

These assumptions should have already been questioned as a result of the Asian financial crisis of 1997-99. But Western governments and the International Monetary Fund were able to divert the blame away from developed countries’ speculative funds and recipient countries’ deregulated credit markets to allegations of crony capitalism and government mismanagement in the affected countries.

With the crises in the US and Europe, it is more obvious now that the financial institutions and markets themselves are the cause. The belief in the theory of the efficient market that can do no wrong, and the policy of financial liberalisation and deregulation based on this theory facilitated the freedom of the markets that then led to the recent and present crises.

At a conference held in Izmir, Turkey from 1 to 3 November 2012 , well known economists and policy makers debated the state of the global economy as well as of Economics.

Most speakers concluded that the crises were caused by deregulation that unleashed the beast of financial speculation by big banks and investment firms, but also that economists and policy makers have not yet learnt the right lessons. As a result, the needed basic reforms have been avoided while wrong policies are being pursued, and the world is on the brink of new financial crises and a recession.

The Turkish Economic Association has a record of organising stimulating international conferences. The 2012 event in Izmir saw many sessions on the dynamics of financial crises and the policy responses.

Joseph Stiglitz, the Nobel laureate and former World Bank chief economist, gave a blistering critique of how the standard Economics model had failed to predict or deal with the financial crisis because they had wrong assumptions and asked the wrong questions.

The orthodox model also could not handle current issues being debated, such as the multiplier of government spending, the nature of deleveraging and the liquidity trap. In the aftermath of the crisis, orthodox economists and the policy makers in the US made wrong policies.

He called for a new Economics model that asked the right questions and that should anticipate abnormal times, the sources of shocks and is able to properly describe what is happening.

On the sidelines of the conference, the Turkish Central Bank and the International Economic Association organised a roundtable on capital flows, which Stiglitz chaired.

The central bankers and international institutions seemed to agree that volatile short term flows were having damaging effects on developing countries, including financial instability, housing price and stock market bubbles, currency appreciation that made exports uncompetitive and destabilising effects of sudden stops or reversals of the inflows.

Turkey’s Central Bank Governor Erdem Basci spoke of new policy tools being used by Turkey to avoid short-term capital inflows from generating excess liquidity. For example, banks can now include their holdings of foreign exchange and gold as part of their required reserve holdings with the Central Bank, up to a certain percentage.

The G24’s director Amar Bhattacharya summarised developing countries’ concerns over the effects of capital inflow surges and outlined the range of policies they were taking to address these, including macro-economic policies, prudential measures including market intervention and capital controls.

While most of the discussion on capital controls were on regulating inflows, I brought up the successful Malaysian example of controlling outflows selectively and accompanied by several other measures.

The position of the IMF, which traditionally has championed free capital flows and which once wanted to prevent countries from using capital controls, was interesting.

Its official recognised the adverse effects that free capital flows can have, and the possible benefits of capital controls, which is a significant change from the Fund’s old rigid view. But he also argued for caution in using these measures as they could have bad effects on the country itself and on other countries, for example by diverting the unwanted funds to other countries that did not regulate.

The counter-argument made to this was that more attention or even blame should be placed on the “source countries” that allow its banks and investment funds to move their massive funds around the world in search of quick profits, with devastating effects on recipient countries, rather than prevent or discourage the targeted countries from taking defensive measures.

At sessions on developing country issues, He Fan of the Chinese Academy of Social Sciences analysed the present imbalances in China’s economy and the prospects of future growth driven by urbanisation and consumer spending on services to offset falling exports.

The South Centre’s chief economist Yilmaz Akyuz argued that the developing countries had not de-coupled their economies from the developed countries. With the prolonged global slowdown, they have to change their export-dependent development strategies.

Malaysian economist Lim Mah Hui gave an outline of measures being taken in Asia towards regional financial and monetary cooperation.

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