Over the past year, the International Monetary Fund (IMF) has raised the profile of 'sovereign bankruptcy' proposals to restructure unsustainable country debt. This has coincided with increasing calls over the last few years to improve the international financial architecture to better prevent and resolve financial crises.
The IMF has been progressing work on a sovereign debt restructuring mechanism and this issue is to be considered by members of the IMF's International Monetary and Financial Committee in April 2003. Given the attention devoted to developing the sovereign debt restructuring mechanism, it is timely to explore where the debate currently stands in the context of the Fund's role in crisis resolution.
Introduction
Since the IMF was established, its broad purposes have remained largely unchanged, namely, the promotion of financial stability and economic growth among its members. However, its operations - which involve the monitoring and consultation on economic developments and policy decisions of its members (surveillance), the temporary provision of financial assistance to members facing balance of payments needs, and the provision of technical assistance and support for members' efforts at capacity building - have evolved in line with changes in the international financial system and the changing needs of its member countries.
This evolution has been manifest following the Asian financial crisis, with increased recognition that the IMF needed to further advance its capacity to prevent and resolve financial crises. The imperative for such ongoing efforts has been reaffirmed by the more recent emerging market crises, most notably Argentina, Brazil and Turkey, which have demonstrated the changing nature of crises.
A key element of IMF efforts is the emphasis on crisis prevention as the most effective way to promote financial stability. In particular, the Fund has moved to strengthen its bilateral surveillance function in order to promote better policies and identify potential economic vulnerabilities in member countries as well as enhancing the multilateral and regional aspects of surveillance in recognition of the growing interdependence between economies and the risks of contagion. In addition, the IMF, in conjunction with other international groups such as the Financial Stability Forum and the World Bank, has developed and promoted the use of international standards and codes that set out good financial and economic management practices.
Realistically, it is difficult to totally eliminate the possibility of financial crises from occurring. The objective is to reduce their frequency and impact. Consequently, effective crisis resolution strategies are also necessary. A particular focus over the past year or so has been to improve the framework for dealing with situations where a country's public debt levels are unsustainable and need to be restructured. In this regard, the IMF is currently considering a sovereign debt restructuring mechanism (SDRM) and the widespread use of collective action clauses (CACs) to facilitate sovereign debt restructurings.
The intention of this article is to review these two proposals and set out the context from which they emerged.
Crisis prevention
Given the social and economic dislocation caused by financial crises, prevention is always better than cure. As such, crisis prevention has always been a key feature of the IMF's reform agenda. More recently this has involved: improving Fund surveillance, both in terms of the its quality and effectiveness, encouraging greater country transparency on an ongoing basis across policy frameworks, promoting the dissemination of economic data, and developing and disseminating internationally accepted standards and codes of good practice.
Effective IMF-supported programs, which involve the temporary use of IMF resources, are also an important part of crisis prevention and resolution. Over recent years the IMF has sought to improve program effectiveness by streamlining and re-focusing its conditionality (that is, the commitments a country undertakes when it borrows from the IMF) and reviewing the range and terms of its financing facilities. These efforts have included the objective of improving country implementation through greater program ownership and tailoring Fund programs to address the specific circumstances of its diverse membership (see Fischer 2002 for additional information on crisis prevention).
Central to the concept of crisis prevention is the promotion of domestic policies consistent with economic and financial stability. There is now broad consensus that the best defence against financial crises is to establish sound economic fundamentals and to have a credible policy framework able to deal with economic and financial shocks.
At the heart of the Fund's efforts to encourage its members to adopt sound policies are the Fund's surveillance operations. The coverage of Fund surveillance has expanded significantly from an initial focus on monetary, fiscal and exchange rate issues to cover external vulnerability assessments, financial sector vulnerabilities, and a range of structural and institutional policies. An important development aimed at strengthening countries financial systems and reducing their vulnerability has been the in-depth financial sector surveillance undertaken through the joint World Bank and IMF Financial Sector Assessment Program.
A further important initiative has been the development, dissemination and adoption of internationally accepted standards and codes in the economic and financial areas. These standards and codes help to spread and encourage the adoption of best practice in terms of economic and financial policies. To this end, the IMF, along with several other international institutions, prepares reports on their observance by member countries.
Although emphasis must remain on the Fund continuing to pursue strategies to reduce the frequency and severity of crises, they will still occur. If investors sense shortcomings in domestic economic policies, they can retreat quickly and in large numbers. When confidence is lost, capital inflows can dry up and large net capital outflows can occur, resulting in major dislocation within the economy. A key element of the Fund's mandate is to promote the speedy resolution of financial crises when they occur. However, as the greater part of international capital flows are private flows, the private sector must have an important role in both preventing and resolving financial crises.
Changing nature of crises
Notwithstanding the increased focus of the IMF on preventing crises, which gained prominence following the Mexican financial crises in 1994-95, over the past eight years there has been an average of one crisis every year in emerging market economies.
A general distinction can be drawn between the crises of the late 1990s and those of earlier decades (Parkinson, Garton and Dickson 2002). 'Old style' current account crises tended to be driven by excessive current account deficits resulting from macroeconomic policy settings that were usually inconsistent with maintaining pegged, or at least not freely floating, exchange rates. Under conditions of lower capital mobility, such crises tended to unfold gradually as foreign reserves steadily drained away.
In contrast, financial crises of the last decade have tended to be capital account crises. These have been characterised by large external financing gaps that were the result of a combination of large pre-crisis current account deficits and large reversals of capital flows. These 'sudden stop crises' are driven more by balance sheet imbalances (maturity, currency and capital structure imbalances) rather than just traditional flow imbalances. The key factor in explaining the nature and severity of most recent crises has been the presence of financial vulnerabilities and the sudden loss of creditor confidence,
leading to a 'rush to exits' as the crises rapidly evolves.
The shift generally from current account crises of the 1980s to capital account crises of the 1990s has led to crises that emerge more rapidly and are increasingly severe. Chart 1 shows that since the 1990s, private capital flows have become larger and more volatile, sometimes being subject to dramatic swings. This has led to both increased demands by individual countries on IMF resources and increased questioning of the role the IMF in resolving these crises.
Chart 1: Emerging market economies: capital flows
Source: International Monetary Fund, World Economic Outlook, September 2002.
Impact on the IMF's role
The IMF's mandate is to promote stability in the international financial system and, under adequate safeguards, to make IMF resources temporarily available to members in order to correct adverse movements in their balance of payments. Safeguards such as program conditions encourage recipient members to undertake policy reform. These conditions try to ensure that the provision of financing is associated with policies appropriate to the attainment of external viability and sustainable growth. Program 'conditionality' seeks to ensure that IMF resources will be returned to the Fund and be available for future assistance to other Fund members.
In cases where a country has had access to international capital markets, this approach has also traditionally been based around the IMF playing a catalytic role. That is, the provision of resources accompanying Fund endorsement of a program - and by extension the policy reform proposed - sends a strong signal to the private sector that the IMF is confident that the program will be successful and the Fund will be repaid at the conclusion of a program. This traditionally had the effect of mobilising private sector financing and allowing a country to regain normal market access.
Chart 2 shows the cumulative growth of capital flows in emerging markets over the past two decades. The size and increased volatility of private capital flows compared with limited official resources highlights both the role that the private sector can play in preventing and resolving crises along with the limitations the IMF faces in attempting to directly bridge countries' financing gaps when they emerge.
Chart 2: Emerging market economies: cumulation of capital flows
Source: International Monetary Fund, World Economic Outlook, September 2002. Chart 2 represents cumulative net capital flows to emerging market economies since 1982.
Private sector involvement
There are a number of aspects of the role of the private sector in crisis prevention and resolution. The volatility of private capital flows can be reduced through enhanced risk assessments by investors and closer and more frequent dialogue between countries and private investors. Of course markets can only make better risk assessments if they have adequate information about countries' economic and financial conditions. However, the involvement of the private sector in both crisis prevention and resolution is enhanced through encouraging market participants to appropriately assess risks and base their investment decisions on such assessments, including bearing the consequences of such decisions. Such behaviour would limit moral hazard, that is, the possibility that the private sector may lend to a country on the belief that potential losses will be limited by official rescue packages, particularly by the IMF (see Roubini and Setser 2003 and Cline 2002 for further information on private creditor behaviour).
As noted earlier, the magnitude of recent capital account crises has resulted in exceptionally large Fund financing packages, which has in turn led to concerns that the size of such financing arrangements may raise moral hazard concerns. In an effort to ensure that the private sector has a clear understanding of the 'rules of the game' when it comes to access to the Fund's resources in capital account crises, the IMF has attempted to clarify its policies on 'exceptional' access along with lending to a country in arrears with payments to private sector creditors. The conditions that have been set for exceptional access to IMF resources include: exceptionally large need; a sustainable debt burden under reasonably conservative assumptions; a judgement that a country will be able to return to the private capital markets in a reasonable period; and indications that the government has the ability to deliver on an agreed economic program.
The above criteria involve difficult judgements, particularly as to when a country's debt levels are considered sustainable. Judgements about debt sustainability will determine decisions as to whether IMF financing is appropriate, the size of such financing, or alternatively whether the sovereign's debt burden needs to be reduced through restructuring.
During the 1980s, achieving debt restructures was more straightforward than is currently the case given the smaller number of large private sector creditors, as well as the homogeneity of commercial creditors (usually banks), the contractual provisions in syndicated loans, and, on occasion, moral suasion applied by lender country central banks. Incentives for an orderly restructuring process were reinforced by banks' interests in maintaining good relations as a means of safeguarding future business.
The shift away from syndicated commercial lending towards a variety of tradeable financial instruments has led to a diffuse broad base of creditors spread out in different jurisdictions. This has benefits in terms of increasing the financing options of emerging market economies. However, the diversity of claims and creditor interests has the potential to generate significant coordination problems across claims and claimants in cases, should a sovereign need to seek a debt restructure (see Krueger 2002 and Sachs 2002).
There is increasing recognition in both the official sector and private markets of the need for a more orderly process for the restructuring of unsustainable sovereign debts. Disorderly restructuring can impose undue costs to both creditors and debtor countries.
Costs to debtors can be magnified by delaying an unavoidable debt restructuring and the interests of most creditors can be damaged by difficulties in securing majority agreement (also known as collective action) on sovereign debt restructuring. Due to the uncertainty of the outcome, debtors may also delay approaching their creditors until they are forced to do so.
Some creditors may also consider that their individual best interests are served by not participating in the debt restructuring (that is, choosing to 'hold-out') in the hope of subsequently receiving full repayment in line with their original contracts. A more extreme form of hold-out action is where certain creditors decide to pursue litigation to recover the full value of their contract.
If crises are not addressed at an early stage the delay can result in larger falls in GDP, downward overshooting of asset prices and exchange rates, substantial capital flight, depletion of official reserves and possible contagion to other markets (RBA Bulletin 2002). The challenge therefore is to establish a more orderly restructuring mechanism that resolves collective action problems while creating incentives for sovereigns and creditors to reach rapid agreement on a restructuring that preserves asset values as much as possible and facilitates a return to medium-term viability. Securing a restructuring before there has been an interruption of payments is the best way to minimise the dislocation and the loss of
asset values that occurs following a default.
Proposals
In order to encourage concerted debtor and creditor coordination and to provide a more predictable framework for restructurings, the IMF is currently considering two complementary proposals.
- The first proposal, based on a so called 'statutory' approach, involves the development of a sovereign debt restructuring mechanism (SDRM), that would provide something akin to bankruptcy provisions at the sovereign level.
- The other approach, based on contractual provisions, involves encouraging the widespread use of collective action clauses (CACs) in sovereign bond contracts aimed at facilitating the same outcome as the SDRM. That is, to lower costs for creditors and debtors during a restructuring.
Sovereign debt restructuring mechanism
The SDRM proposal was put forward in November 2001, by the IMF's First Deputy Managing Director, Anne Krueger (see Krueger 2002 and Rogoff and Zettelmeyer 2002 for a historical survey), and has evolved over the past year.
As proposed, a SDRM would provide bankruptcy style provisions at the sovereign level under a statutory framework. Although there is not unanimous support for a specific proposal and all the details are yet to be settled, some of the main features of the mechanism that have been discussed include:
- activation of the procedures by the debtor;
- possible provisions for the temporary cessation of debt repayments;
- measures to address incentives for disruptive creditor litigation (partial or general stay on enforcement);
- measures to facilitate creditor coordination, including dispute resolution mechanisms; and
- safeguards to protect creditors' interests during the restructuring process.
It is envisaged that the SDRM would only be activated by the sovereign on a voluntary basis and only if external viability was unsustainable. That is, the SDRM would only be activated if there were no feasible set of sustainable economic policies that would allow a country to resolve the current crisis and return to medium term viability, without a significant reduction in the net present value of the sovereign's debt. There has, however, been some discussion that an external, independent arbiter may be needed to determine whether a sovereign's debts were unsustainable.
Collective action clauses
Complementary to the SDRM, is a contractual approach that involves promoting more widespread use of CACs in individual sovereign bond contracts.
These clauses allow for a qualified majority of creditors to block legal action by a minority to force payment, and for a qualified majority to bind the minority into the terms of a restructuring. That is, CACs would allow creditor majorities to change bond terms in order to assist restructuring agreements (Buchheit and Gulati 2002 detail historical developments of CACs).
John Taylor of the US Treasury, has also proposed the addition of contingency clauses (Taylor 2002) describing the process that would be followed if a restructuring proved necessary, allowing for an initial period to initiate the restructuring talks and covering debtors and creditors representation issues.
Although CACs are already incorporated into most sovereign bonds issued in the Euromarket, they are not a feature in most other markets, including the United States where the majority of sovereign bonds are issued.
The IMF has been exploring the design and effectiveness of these CACs in facilitating restructurings, and ways to encourage their wider use in sovereign bond contracts. The official sector, including the international groups of the G-7 and G-10, has also actively encouraged the use of CACs in international sovereign bond contracts. Mexico also successfully issued bonds with CACs into the US market on 26 February 2003.
Potential challenges
The SDRM proposal has two main advantages over CACs in that it solves the problems of aggregation and transition (Krueger 2002). That is, CACs are unable to bind creditors across a range of different bond and debt issues, and cannot deal with outstanding claims that do not already include a CAC provision. This is largely due to the variety of sovereign debt instruments, the extent of anonymity of holders of the debt, and the variety of legal jurisdictions in which debt is issued.
The SDRM is intended to be called upon in only the most extreme circumstances. Furthermore it is argued that the mere presence of this mechanism in the international financial architecture should encourage creditors and debtors to reach agreement on a voluntary basis, or to operate in the 'shadow of the law' (Boorman 2003).
The existence of a SDRM may encourage creditors and debtors to circumvent the system by issuing debt in jurisdictions that are not covered by the mechanism. A SDRM must therefore involve universal application. This can be achieved through a universal treaty or through an amendment to the IMF's articles of agreement, in which a majority of members could bind all members to the treaty. A key difficulty in implementing a SDRM proposal will be garnering the necessary support for such a change from the IMF's membership.
The concept and specific design issues of the SDRM has attracted a lot of debate. In particular, the SDRM has not been supported by a number of emerging markets nor large segments of the private sector. Concern has been raised that a SDRM would lead to unnecessary restructurings, that it may affect the willingness of the private sector to lend to emerging markets, and that it is not necessary as there have been successful restructurings in the past. In addition, there are concerns about the impact of a SDRM on existing contractual rights for holders of outstanding sovereign debt.
In terms of the design of a SDRM, there have been debates on the range of debts that would be covered under such a mechanism. The latest proposal is that the SDRM would apply only to sovereign debt issued in external jurisdictions and not domestic debt (covered by domestic law courts) or official bilateral debts (subject to Paris Club negotiations). However, debate is continuing on the debts to be covered under the proposed SDRM, including the involvement of official debt and Paris Club activities.
Although the international community has been encouraging the widespread use of CACs as a means of facilitating debtor and creditor workouts, there has been little progress to date in their take up outside of their traditional areas. In 2001, sovereign bonds governed under English law constituted 17 per cent of the face value of bonds in the Emerging Market Bond Index, and 50 per cent of the number of bonds issued. However, the take up of CACs could be rapid. For example, if CACs had been introduced to all new emerging market bonds in 1996 following their endorsement by the G-10, by 2001 they would have been included in 70 per cent of all bonds outstanding (IMF 2002).
There might have been a number of possible disincentives driving the reluctance to extend the use of CACs, including: market practice and convention; and the short-term costs associated with 'first mover' disadvantages, including the potential signalling that a restructuring may be more likely. However, recent empirical evidence on the pricing of bonds with and without CACs (Gugiatti and Richards 2003) suggests that the reluctance to adopt CACs in bonds contracts is not well founded. Indeed, Mexico's successful sale of US$1 billion worth of bonds with CACs into the US market earlier this year suggests an acceptance of CACs by the market.
Although the SDRM and CACs have been at the centre of the debate on crisis resolution mechanisms, additional proposals such as voluntary codes of conduct to facilitating sovereign debt restructurings have recently emerged. These proposals are evolving rapidly and can be expected to be a continued focus of international debate in the period ahead.
Australia's position
Australia is a strong supporter of efforts to reform and strengthen the international financial architecture so as to reduce global financial instability. As such, support has been given to efforts to develop the SDRM and CAC proposals as a means of providing more orderly arrangements for sovereign debt restructurings. Debate on the SDRM has helped to generate additional momentum for improvements in this area, including the need to encourage the wider use of CACs. Australia will continue to support parallel efforts in order to build on the substantial progress that has been made to date.
Notwithstanding this support, these proposals should not be seen as providing a 'silver bullet' solution for addressing financial instability in emerging markets. Rather, they should be viewed as useful tools for use in the extreme situations where sovereigns have to restructure debts.
Even with more effective mechanisms for involving the private sector in crises prevention and resolution, there will be a need for official financing in crises. Debt restructuring may be able to avoid a disorderly 'rush to exits' by creditors, but it will not ensure that pre-crisis levels of capital inflows will be resumed. The standard rationale for official financing to cushion adjustment will still apply. Importantly, the involvement of the private sector in crisis resolution is but one element of a broader agenda, and it is essential that international momentum continue to advance reform of the international financial architecture.
References
Boorman, J, A New Approach to Sovereign Debt Restructuring: An IMF Proposal Panel, Transcript of an IMF Economic Forum, January 2003.
Buchheit, L and Gulati, M, Sovereign bonds and the collective will, Georgetown University Law Centre, Washington, March 2002.
Cline, W, Private sector involvement: definition, measurement and implementation, Institute for International Economics, July 2002.
Fischer, S, Financial crises and reform of the international financial system, NBER working paper, Cambridge, October 2002.
Gugiatti, M, & Richards, A, Do collective action clauses influence bond yields: new evidence from emerging markets, Reserve Bank of Australia, March 2003.
International Monetary Fund, IMF Board discusses collective action clauses in sovereign bond contracts, IMF public information notice, July 2002.
Krueger, A, A new approach to sovereign debt restructuring, International Monetary Fund, April 2002.
Parkinson, M, Garton, P, & Dickson, I, Regional financial arrangements: What role in the international financial architecture?, Australian Treasury, March 2002.
Reserve Bank of Australia, Recent proposals for reform of sovereign debt restructuring, Reserve Bank of Australia Bulletin, August 2002.
Rogoff, K, & Zettelmeyer, J, Bankruptcy procedures for sovereigns: a history of ideas, 1976-2001, IMF staff paper, International Monetary Fund, 2002.
Roubini, N, & Setser, B, Improving the sovereign debt restructuring process: problems in restructuring, proposed solutions and a roadmap for reform, New York University, February 2003.
Sachs, J, Resolving the Debt crisis of low income countries, Harvard University, 2002.
Taylor, J, Sovereign debt restructuring: a US perspective, US Treasury, April 2002.