With surprisingly little public debate, the International Monetary Fund (IMF) is on the verge of confronting one of the most sensitive issues in international finance: how to balance political and economic considerations when a country loses market access and needs to restructure its debt or its economy, or both. In the next several weeks, the Fund is expected to release a follow up to last year’s controversial staff paper on sovereign debt restructuring [pdf], which could dramatically alter how countries borrow and the risks for investors who lend to them.
The Fund’s initiative, though well intentioned, is flawed and likely to create more problems than it solves.
In its staff paper last year, the IMF floated a new general policy that would impose losses on creditors—whether banks, individuals, or other private lenders—as a precondition for financial assistance to a country in need of rescue. The rationale was that bailouts often take so long that by the time debt restructuring is called for, private investors have already liquidated their holdings and costs to the official sector have increased. The Fund seeks to address a problem they describe as “too little too late.”
The three policy goals enunciated by the Fund were “(1) increased rigor and transparency of debt sustainability and market access assessments, (2) exploring ways to prevent use of Fund resources to simply bail out private creditors, and (3) measures to alleviate the costs associated with restructurings.” In the IMF’s view, a more predictable regime for indebted countries would force them to face up to their problems earlier without investors keeping them afloat until it is too late.
These goals are laudable, and certain issues raised by the Fund are constructive, timely, and deserving of further exploration.1 But basing significant policy changes mostly on recent experiences in Argentina and Greece and, as a result, increasing the number of potential debt restructurings is misguided.2
Instead the Fund should step up its surveillance efforts, perhaps boosting its regular World Economic Outlook and the Global Financial Stability Reports to highlight potential vulnerabilities more effectively. Louder naming and shaming to force policy corrections is a better approach than promoting debt restructurings that could cause sharp and abrupt dislocations in sovereign funding markets and risk spreading contagion in world financial markets.
Sovereign debt restructurings requiring investors to accept less than they are contractually entitled to should never be easy or common. After all, a restructuring is a more diplomatic term for a fundamental breach of contract between a country and its lenders. But restructurings sometimes are needed, and, in spite of rhetoric to the contrary, have generally proceeded smoothly over the past decades, as a 2012 IMF research paper studying 60 years of restructurings concluded.3
The Fund’s proposals would increase the rigidity and inflexibility of the debt sustainability analysis (DSA), by which the Fund assesses a country’s ability to service and repay debt under a variety of scenarios. Current policy sensibly calls for DSAs not to be “interpreted in a mechanistic or rigid fashion.”4 The new policy would impose greater standardization and limit the Fund’s discretion.
Perhaps most important to investors and issuers, the Fund paper suggests a policy "presumption" in favor of creditor losses, or bail-ins—sometimes called private sector involvement (PSI)—as a condition for IMF financial support, applicable in cases where a country “has lost market access and prospects for regaining market access are uncertain.”
The Fund appears to argue that this is a more benign outcome to markets than a full reduction in the face value of bonds at issue. But this rescheduling (also known as a “stand-still,” “reprofiling,” or “maturity extension”) is nevertheless an event of default in its own right. It would reduce the net present value of the repayment obligation, amounting to a credit event warranting payment under credit default swaps. It is misleading to argue that rescheduling is something short of default.5 Such a step would increase the risks of lending to countries that could need IMF support in the future, almost certainly increasing their funding costs.
The political impetus for this proposal may well lie in the regret that many felt when German, French, and other investors holding Greek sovereign bonds were initially paid in full using official sector funds, avoiding responsibility for their poor lending decisions. No doubt these banks and investors benefited from extraordinary action to avoid a systemic breakdown.6 One possible inference is that some at the IMF are seeking to protect themselves from the political oversight and influence of the very countries that provide the Fund with financial support and legitimacy.
But the effort to constrain discretion in DSAs increases the risk of making even larger debt restructuring unavoidable, even in those cases where it may not be warranted. DSAs will always entail judgment and subjectivity. How could they not? Country circumstances are unique. It is impossible to determine in advance the sustainability of countries and the costs or benefits of a potential restructuring, including the political will of a country to act. It is hard to imagine a set of ex ante thresholds capturing the complexities of Greece, Portugal, Ireland, as well as Italy, or even Japan.
The IMF’s rationale is also flawed from an economic standpoint. Rescue decisions should achieve a resolution at the least possible cost, while accounting for the recessionary impact of steps to achieve sustainability. The Fund needs to use discretion to avoid a negative overshooting—discretion missing from the Fund’s current thinking.
If the appropriate crisis response involves a full bailout, then a full bailout should be provided (with appropriate conditionality). If a bail-in is more appropriate, the outcome must reflect a country’s needs and the systemic circumstances. Rules are necessary, but one-size-fits-all categories, however well intentioned, are impossible.
Worse, a presumption of preemptive PSI could actually undermine the stabilizing nature of IMF assistance. Countries under stress would be less likely to seek IMF involvement until they exhaust all other options. The IMF paper hints that it would address this risk by increasing its promised support, but that may require greater resources than are currently available.
A more rational pricing of risk in the markets should instead be achieved by earlier and more thorough surveillance, enabling the IMF to diagnose the sustainability of a country faster and more conclusively and to prescribe corrective actions at an earlier stage. Such surveillance could include better understanding of cross-border flows, corporate currency mismatches, and debt holdings. The Fund can include potential debt sustainability concerns in its “flagship” publications, such as the World Economic Outlook and the Global Financial Stability Report.
The recent euro area periphery experience demonstrates that markets interpreted the seniority of Fund financial support as subordinating their own positions in the event of a restructuring. Higher spreads resulted as markets considered the possibility of losses and concluded that the recovery rate for privately held debt had dropped. Accordingly, the prospect of IMF financial support became destabilizing rather than confidence building, as was seen in both Portugal and Ukraine last year.7
Making PSI the norm would also reduce the global supply of risk-free assets as more bonds become subject to risk of haircuts, causing a migration of the investor base from “rates” investors to “credit” investors. The “credit” investor bases his or her decision on default probabilities, political risks, and recovery value. Traditional riskless “rates” investors look at expected nominal GDP growth, maturity, and liquidity considerations. The “credit” investor base is much narrower and expects higher returns. As a result, the cost of funds for all but the safest countries will rise, increasing the odds that the behavior of interest rates will aggravate a crisis.8
Burden sharing, bail-ins, haircuts, or outright defaults should never be ruled out. Quite the contrary. But there is no reason to abandon the practice of determining what is needed on a case-by-case basis or to presume that a breach of contracts is necessary. As Greece and Argentina demonstrate, extraordinary circumstances arise in unanticipated ways. Ex ante formulas are doomed to be misapplied with unanticipated consequences. Instead of financial stability, they will create greater risk, uncertainty, and costs to the global financial system.
1. These include modifications of the Paris Club, the IMF’s lending into arrears policy, and modifications to collective action clauses.
2. Argentina and Greece represent unique outliers in sovereign debt restructurings and should not be used as catalysts for wholesale policy changes. These two examples hardly represent the norm of sovereign debt issuance. Rather, Greece and Argentina represent unique, specific, and very difficult to repeat, political, economic, and legal contexts.
In the case of Argentina, that country’s reluctance to engage with creditors and to respect the legal jurisdiction under which the bonds were issued has been so exceptional that the United States Court of Appeals for the Second Circuit explicitly stated that: “[T]his case is an exceptional one with little apparent bearing on transactions that can be expected in the future. [C]ases like this one are unlikely to occur in the future because Argentina has been a uniquely recalcitrant debtor.” In the case of Greece, its initial entry into the euro currency was accompanied by dubious accounting practices that went unacknowledged for years. Falsified reports of the size of the country’s indebtedness allowed the country’s debt to balloon to an outrageously large amount. Recognition of the true size of its debt came at a time of virtually unprecedented uncertainty and risk in global and European financial markets. As a member of a monetary union, Greece presented the IMF with a difficult dilemma. On the one hand, the Fund needed to present a plan to restore stability and sustainability for Greece, as an individual member of the IMF. On the other, the Fund needed to ensure that its plan for Greece did not cause even greater instability and damage to the broader European financial system. It was this conflict that led the Fund’s own ex post program evaluation of the first Greek program to note that the situation in Greece was “unique” and that the Fund’s response under the circumstances was “justified.” The ex post evaluation did not suggest that the entire sovereign debt restructuring regime be rethought. Instead, it suggested that the Fund should “explore the case for refining the Fund’s lending policies and framework to better accommodate the circumstances of monetary unions.”
3. “[M]ost bond exchanges since the mid-1990s have been smooth, in the sense that they were implemented quickly and with a creditor participation rate exceeding 90%. Creditor coordination problems, such as litigation and holdouts, seem not to have been a major problem in most cases, despite widespread concerns about these issues” (www.imf.org/external/pubs/ft/wp/2012/wp12203.pdf). [pdf]
4. Current policy requires that DSAs “must be assessed against relevant country-specific circumstances, including the particular features of a given country’s debt as well as its policy track record and its policy space” (www.imf.org/external/pubs/ft/dsa).
5. See International Swaps and Derivatives Association’s (ISDA) definitions of “credit event.” Moreover, the argument that the impact of this default could be limited is dubious. Almost all sovereign bonds include “cross-default” clauses that accelerate repayment for all bonds in the event of default of any such sovereign obligation.
6. The provision of financial support to Greece required the creation of an exception to the Fund’s prohibition from lending to countries without a “high probability of repayment.” The exception created was one in which the Fund was allowed to provide exceptional access to its facilities in cases where “there is a high risk of international systemic spillovers.” Given the systemic risks emanating from exposures of European banks to Greek debt and the overall fragility of the global and European financial systems, the Fund and its Executive Board believed that this was appropriate. The Fund now proposes to reconsider this systemic exception. But this exception will pragmatically always be implicit in the Fund’s actions. To affirmatively reject an assessment of broader systemic risks would, we believe, represent a foolish and myopic adherence to rules rather than recognize threats to the stability of the global financial system as intrinsic to the Fund’s overall mandate.
7. This quote from a Morgan Stanley report makes this point very strongly: “IMF deal may not be so positive anymore for bondholders…there is a non-negligible risk that the IMF might propose that funding be accompanied by some sort of debt restructuring. This would be in line with the conclusions of the review of previous IMF programs (IMF, Sovereign Debt Restructuring—Recent Development and Implications for the Fund’s Legal and Policy Framework [pdf], April 26, 2013), which suggested that additional ways, for example, maturity extension, should be explored to limit the risk that Fund resources will simply be used to bail out bondholders.” See Ukraine Economics and Strategy, Morgan Stanley, December 19, 2013.
8. In other words, if markets start pricing debt based on probability of default rather than on growth prospects, a weakening of the economic outlook will lead to higher interest rates, worsening the economic situation of the country. This procyclical behavior of interest rates is a key reason for the sharp and deep recession of the euro area periphery in the recent crisis.