Investment agreements blocking sovereign debt restructuring measures, says study (May 2009)

Rethinking Bretton Woods | Tue, May 19, 2009

Center of Concern staff Aldo Caliari authors a study recently published by UNCTAD, "Risks Associated with Trends in the Treatment of Sovereign Debt in Bilateral Trade and Investment Treaties." The study, originally submitted at an UNCTAD consultation held in 2005, argues that in its  most recent bilateral Free Trade Agreements,  the US government has insisted on clauses that would restrict the policy autonomy that countries need to implement sovereign debt restructuring measures.

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Summary of "Risk associated with trends in the treatment of sovereign debt in bilateral trade and investment treaties" Free Trade Agreements (FTAs) increasingly include provisions that subject financial policy to specific legal disciplines and their associated dispute-settlement mechanisms. This trend places limits on the use by developing countries of several tools designed to build and preserve stable and healthy financial sectors responsive to national development priorities and supportive of trade. As a result, developing countries may face a growing vulnerability to financial and debt crises.  A review of recent FTAs negotiated by the US reveals at least two different approaches to the treatment of sovereign debt issued by the parties' principles. In the first approach, sovereign debt is explicitly excluded from application of the principles. For example, the Financial Services section of NAFTA specifies that a debt security issued by a party or state enterprise is not an investment. In the second approach, sovereign debt is explicitly included within the scope of application of investment principles. For example, in the US-Chile FTA, as well as CAFTA, "debt instruments" are listed as one form of investment; thus FTA provisions such as National Treatment and Most-Favored-Nation (MFN) Treatment are applicable to sovereign debts issued by the governments of the involved countries. However, the US-Uruguay FTA, while containing some language that mirrors the NAFTA language, then in an annex states that current or future negotiated restructuring of debt instruments can, in certain conditions, be considered a breach of obligation. Thus, sovereign debt in this case seems to be considered a type of investment even absent an explicit mention in the definition of investment, perhaps setting a precedent that, absent an explicit exclusion, this will always be the case.  National Treatment and MFN Treatment were included in the GATT as principles applying to trade in goods. The extension of these Treatments to sovereign debt is certainly controversial and unclear but its application to sovereign debt could be even more harmful. First, there are several reasons why a country restructuring its sovereign debt after a financial crisis might need to resort to offering preferential conditions to domestic creditors. National Treatment in this context means that foreign creditors are offered treatment in debt restructurings no less favorable than that offered to domestic creditors. The application of National Treatment to sovereign debt would restrict the ability of the debtor government to take some policy measures aimed at the recovery of the local economy in the aftermath of financial crises. Second, the application of National Treatment to sovereign debt means that the Government will be unable to prioritize domestic debt associated with meeting wages, salaries and pension obligations. The government is bound to treat these debts in the same way as foreign debts held by transnational banks and institutional investors, and as a result, may be unable to fulfill human rights obligations and social responsibilities.  Third, the offer of preferential conditions to domestic creditors is crucial to enhancing a government's leverage in negotiations over debt restructuring with other creditors. If the principle of National Treatment is applied to sovereign debt, this avenue is effectively foreclosed.  Fourth, application of National and MFN Treatment only to creditors of countries that are parties to bilateral investment treaties would have the discriminatory result of granting seniority to creditors from such countries over those from other countries. As a result of applying the principles of investment treaties to sovereign debt, governments that violate investor protections can face expensive lawsuits. CAFTA, like NAFTA and numerous bilateral investment treaties, grants private foreign investors the right to bypass domestic courts and sue governments in international tribunals. Such "investor-state lawsuits" are highly controversial, as arbitration tribunals are not required to pay regard to legal precedents or to appoint independent arbiters, and may lack transparency. The main rationale for a more systematic handling of sovereign debt defaults has been the need to provide greater predictability for debtors and creditors alike, and the arbitration tribunals would be a poor instrument for addressing those concerns.  The lack of a rule-based multilateral regime in dealing with sovereign debt crises leaves debtors vulnerable to power asymmetries. These asymmetries are only reinforced by the inclusion of debt instruments, particularly those for sovereign debt, as a type of investment. In view of these dangers, an approach that explicitly excludes sovereign debt from the definition of investment, is a superior model.

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