What If Ireland Defaults? (28 page)

The first half of the 1980s saw an explosion in the number of debt restructurings, including Turkey in 1982 and virtually the whole of Latin America.
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The IMF played a critical role by providing crisis lending to members, securing commitments from debtors that set the stage for financing a recovery, and assessing countries' ability to repay their debts. It prevented many countries from defaulting outright and contributed to the US-led Brady Plan in 1989 that eventually resolved the crisis.
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The Plan offered liquid bonds to banks in exchange for their illiquid claims on insolvent nations, so long as banks accepted a substantial haircut on their existing claims and suffered delays in repayments.

The IMF certainly contributed to the resolution of the Latin American crisis but found itself criticised from both sides of the debt dilemma. On one hand, creditors accused it – somewhat ironically – of contributing to a series of short-term fixes in the early stages that held out the prospect of a complete bail-out and, therefore, delayed the harsh settlement that was ultimately required. On the other hand, the IMF was accused of acting as a debt collector for the banks, mainly because it insisted that countries had to clear any existing arrears to creditors before they could negotiate. In response to these accusations, the IMF became more conservative in its lending in the 1990s – insisting on early debt rescheduling before lending its own money – and became more lenient in its treatment of debtor countries – insisting only that they demonstrate ‘good faith' before entering negotiations.
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More generally, charges that creditors from the developed world, led by the IMF, heaped debt on third world nations for their own enrichment became increasingly vocal in the early 1990s. This led to a realisation that some countries were indeed overly burdened and had little chance of escaping from an effective ‘debt trap', where any growth was halted by debt service. In response, the Heavily Indebted Poor Countries (HIPC) Initiative was launched in 1996 by the IMF and World Bank. A comprehensive approach to debt reduction was designed to ensure that no poor country would face an unmanageable debt burden. To date, debt reduction packages under the HIPC Initiative have been approved for 36 countries, 30 of them in Africa, and a further 4 countries are eligible for assistance.
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The Fallout from Globalisation

But the sovereign debt problem only got worse as the millennium approached. A severe financial crisis hit Asia in 1997 and, even though only one country in Asia defaulted (Indonesia in 1998), the repercussions, direct and indirect, were felt across the globe. The governments of Russia (in 1998) and Ecuador (in 1999) were forced to default on parts or all of their debt while Pakistan (1999) and Ukraine (2000) sought a restructuring in the face of imminent default. These events, and an evolving crisis in Argentina in 2001–2002, prompted the IMF to undertake a comprehensive review of sovereign debt crises in a globalised world. And some surprising conclusions emerged.

First of all, the review prompted a rare statement of the principles guiding the IMF's approach to (especially commercial) debt restructuring, including avoiding the risk of contagion to other countries from undermining obligations to repay debt where possible, preserving market discipline by making creditors bear the consequences of the risks they take, a clear recognition that debt restructuring can often be a necessary solution, and the need to continually promote dialogue and regard all creditors as equal. The review noted that private sector creditors did not expect to be bailed out every time and were more concerned with establishing an efficient process to achieve debt restructuring. It repeated the need for the IMF to support problem countries, even when they were in arrears to creditors.
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The IMF looked closely at some recent episodes and concluded that the potential costs of sovereign default had risen to catastrophic levels. Many countries were reluctant to embark on a restructuring because domestic creditors also held local debt and there was a danger of the economy imploding due to secondary effects in domestic markets. Whatever about the damage to reputation and external financing prospects, it was increasingly difficult to target a restructuring at foreigners only, and countries hesitated until it was too late. At that stage, a country could lose the ability to control the domestic fallout from its own actions and the ability of the international community to soften the impact was also limited.
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There was a danger of complete collapse and capital flight could suddenly reveal an economy that was highly indebted, uncompetitive and unable to meet its obligations.

The main lesson the IMF took from these episodes was that countries delayed debt restructuring for too long. ‘[T]he negative implications of a forced debt restructuring for the domestic economy [were] perceived to be so traumatic that policy makers [would] delay this option until all other possibilities [were] exhausted.' And attempts to resolve the problem in other ways – such as a fiscal contraction in Argentina in 2001 – could be counterproductive and simply delay and magnify the inevitable credit event.
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Of course, the interests of creditors were also undermined by such delays: the more catastrophic the economic decline, the more severe the erosion of the government's revenue base and the less would be available to contribute to repaying even some of the debt.
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So, the IMF's long-standing policy of striking a balance between preserving the obligation to repay and insisting that some risk remain had effectively been turned on its head. Now, because of the spread of private financing into every corner of the globe, the potential costs of default had soared and
debtors
were reluctant to default while
creditors
had a greater interest in securing an early rescheduling. Anne Krueger, the Deputy Managing Director of the IMF, noted that like ‘a toothache sufferer delaying a visit to the dentist until the last possible moment, governments frequently try to put off the inevitable. The result is that the citizens of the defaulting country experience greater hardship than they need to, and the international community has a tougher job helping pick up the pieces.' The lesson was that ‘we need better incentives to bring debtors and creditors together before manageable problems turn into full-blown crises.'
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Procedures to Restructure Debt

Not only had the debt dilemma been turned on its head, but countries increasingly relied on bond markets for financing and its creditors were, therefore, ‘more numerous, anonymous and difficult to coordinate'. This magnified the free-rider problem, and made it difficult to reach agreement with creditors, even if most of them would benefit from a collective restructuring. Moreover, individual creditors increasingly resorted to legal gambits that would give them an advantage; a ‘vulture fund' held Peru to ransom by preventing it servicing its debts to other creditors. There was a need to ‘create stronger incentives for creditors to stay engaged, rather than rush for the exits'.
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So, in 2002, IMF staff proposed the setting up of a Sovereign Debt Restructuring Mechanism (SDRM) that would encourage an early restructuring when ‘there [was] no feasible set of sustainable macroeconomic policies that would allow the member to resolve the current crisis and regain medium-term viability without a significant reduction in the net present value of the sovereign's debt.'
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The staff argued that the ‘current process imposes undue costs on both the debtor country and its creditors, because it is prolonged and unpredictable. It may also risk contributing to contagion, with associated costs and risks for the stability of the international financial system.'
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This second concern – that a delay in default could lead to contagion – ran counter to the traditional argument that default in one country would lead to speculation against others. However, it recognised that markets are spooked more by the prospect of a large default – when they will bear most of the costs – than by the need for a small adjustment, which can usually be handled with the help of friends. To avoid panic, markets needed to see that a credible resolution mechanism was in place.

In designing the mechanism, the IMF looked to corporate bankruptcy regimes for inspiration. It sought to:

[P]ut a better set of incentives in place by creating a predictable legal framework … [where] … a country would have legal protection from its creditors for a fixed period while it negotiate[d] a restructuring. In return, it would be under an enforced obligation to negotiate in good faith and to adopt policies that [would] get its economy back on track. Finally, once a restructuring [had] been agreed by a big enough majority of creditors, any dissenters would have to accept the same terms on offer.
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Countries would themselves activate the mechanism and put into motion an agreed set of procedures and conditions that would be recognised in international law.
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IMF staff were essentially proposing that there would be international legal protection for bankrupt sovereigns while they undertook negotiations with creditors and this major departure from existing practice would have significantly increased the power of the sovereign
vis-a-vis
its creditors. At the same time, the IMF recognised that this would only be one element of the strategy needed to resolve capital account crises—it would need to be ‘complemented by measures to resolve balance sheet problems confronting the financial and corporate sectors'.
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The IMF was encouraged in late 2001 when US Treasury Secretary Paul O'Neill ‘surprised the world, and his own staff, with his call for a new international sovereign bankruptcy law'. The US had long been opposed to such a regime, however, and ‘O'Neill's isolation inside the Bush Administration made it impossible for him to ever close the deal.' Six months later, ‘his own deputy for international affairs, John Taylor, made it clear that O'Neill had not brought the rest of the Treasury department along with him, let alone the broader Administration. Taylor's speech effectively signaled that no IMF design was ever going to win the support of the Bush Administration, let alone the US Congress.'
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Taylor admitted that reform of the existing uncertain process was long overdue but suggested market participants were simply too divided in their approaches to make such a significant and centralised proposal acceptable. In his view, ‘the most practical and broadly acceptable reform would be to have sovereign borrowers and their creditors put a package of new clauses into their debt contracts.' These collective action clauses would ‘describe as precisely as possible what happens when a country decides it has to restructure its debt' and would include provisions for a majority of bondholders to change the financial terms that would apply to all. The free-rider problem would be solved, but in a decentralised manner that was ‘determined by the borrowers and lenders on their own terms.'
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The joint opposition of the US, major emerging market economies and private creditors doomed the SDRM proposal in the spring of 2003. In any event, Mexico led a series of other emerging market countries to introduce collective action clauses and this became the accepted approach, by default. And while it could be claimed that such clauses would help resolve the free-rider problem, it was clear to some observers that they would ‘not fundamentally transform the existing sovereign restructuring process'. The IMF, these observers noted, might have more important goals than quick agreement on an external debt restructuring, such as ‘financing to support macroeconomic stabilization and [trying] to mitigate the loss of output'.
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In other words, collective action clauses would not define a clear process to resolve sovereign insolvency in a very dangerous world where everybody needed to proceed quickly and carefully. For the IMF, this had been the lesson of the 1990s: that, left to their own devices, debtors and creditors could increase the cost of default. But this lesson was lost on some who still believed that prevention could obviate the need for a cure. Anna Schwartz, the well-known monetary economist, argued that ‘when a financial crisis exposes a sovereign debtor's bankruptcy, it seems wrongheaded to focus on resolving its dishonored obligations rather than expanding efforts on preventing debtors from accumulating excessive obligations.' She, and others, berated the IMF for trying to reduce the cost of default and encourage reckless lending!
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In an intriguing postscript to this debate, the main author of the IMF staff proposals on the SDRM in 2001–2002 was Timothy Geithner who, at the time of writing, has become the US Secretary of the Treasury. He must be exasperated that the world economy has stalled on his watch, mainly due to Europe's failure to resolve its sovereign debt problems.

Conclusions and Interpretations

The main conclusion about the IMF's approach to sovereign default is that it is ever practical: it tries to resolve problems with as little overall cost as possible. There can be no absolutes in the process of debt resolution – it is not a morality play – and a constant balance must be struck between the rights of creditors and the necessity for debt restructuring; when it is required and when creditors have been negligent. There is no IMF manual on sovereign default because its approach has to evolve over time.

Moreover, the IMF does not always get its way, as demonstrated by the SDRM debate. It tries to be forward looking and clearly saw that in an era of global and liquid credit markets sovereign default could become a very serious problem and that there needed to be more immediate access to debt restructuring – both to streamline the resolution process and to act as a deterrent to exuberant lending.