Would Collective Action Clauses Raise Borrowing Costs?

"The authors find that collective-action clauses raise borrowing costs for less credit-worthy borrowers (by on average 150 basis points), while lowering them for more credit-worthy borrowers (by on average 50 basis points)."

In Would Collective Action Clauses Raise Borrowing Costs? (NBER Working Paper No. 7458), Barry Eichengreen and Ashoka Mody find that, contrary to the view of some policymakers and many market participants, collective-action clauses in fact reduce borrowing costs for the most credit-worthy borrowers. But for less credit-worthy borrowers, often the poorest countries, the authors find that the opposite is true.

Contractual provisions designed to facilitate the orderly restructuring of problem debts have been suggested as an alternative to expensive international rescue packages for developing countries experiencing a sudden outflow of capital leading to a sovereign debt crisis. Collective-action clauses, which are typically included in bonds subject to UK law, allow a qualified majority of bondholders to pass binding resolutions altering the value and timing of interest payments. This contrasts with bonds subject to US law (in practice, the law of the State of New York), under whose terms the unanimous consent of all bondholders is required. The addition of collective-representation clauses can thus be thought of as a small step in the direction of providing some of the functions of an international bankruptcy court. Doing so was suggested by the G10 following the Mexican crisis and endorsed in a series of G7 and G22 reports in the second half of the 1990s. U.S. Treasury Secretary Robert Rubin spoke out in favor of collective-action clauses in 1999, and G7 finance ministers endorsed them at their Cologne Summit.

At the beginning of 2000, the UK government issued an international bond including collective action provisions. And in an April press release, the Canadian government committed itself to include collective-action provisions in all its future international bonds. Yet despite the argument that making provision for restructuring could render emerging-market issues more attractive, developing countries have resisted the notion of adding collective-action clauses, arguing they would raise their borrowing costs.

This is the question examined by Eichengreen and Mody. Their study compares the spreads on British-style bonds in the London market, where collective-action clauses are typically present, and equivalent American-style instruments, where such clauses are typically absent. Their data, from the Capital Bondware database, contains 2,619 bonds, virtually every international bond issued by emerging markets between 1991 and 1998.

Focusing on bonds subject to U.K. and U.S. laws, Eichengreen and Mody analyze the impact of legal provisions on spreads, while factoring in such variables as the maturity of the issue, whether it was privately placed, whether the issuer was private or governmental, the currency in which the issue was denominated, whether the interest rate was fixed or floating, global financial conditions, and a variety of country characteristics (macroeconomic variables, financial variables, and a measure of political risk).

The authors find that collective-action clauses raise borrowing costs for less credit-worthy borrowers (by on average 150 basis points), while lowering them for more credit-worthy borrowers (by on average 50 basis points). These are significant numbers (relative to a typical emerging-market spread of 600 basis points). The authors' interpretation is that while more credit-worthy borrowers benefit from the ability to avail themselves of an orderly restructuring process, for less credit-worthy issuers those benefits are offset by the moral hazard and additional perceived default risk associated with the presence of renegotiation-friendly loan provisions and greater ease of restructuring. In the short run, mandating the inclusion of collective-action clauses would thus mean higher borrowing costs for low-rated sovereign borrowers, typically the governments of the poorest countries. In the long run, however, it would apply additional pressure, via market discipline, for them to upgrade their economic and financial practices and improve their credit worthiness.

-- Matt Nesvisky

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