Every country has some form of domestic bankruptcy procedures, whereby debtors who are unable to repay can come to some equitable collective settlement with their creditors. International debt, however, has no such set of resolution procedures. As international capital flows have increased dramatically over the past two decades, this lacuna has become more serious. Former International Monetary Fund chief economist Olivier Blanchard sees substantial progress in new measures developed in the IMF. How much of a breakthrough is this in practice?
The new procedures address a problem that occurs when a country needs emergency support from the IMF. As Blanchard explains it, the country is either illiquid or it is insolvent. If illiquid, the Fund can provide transitional funding to tide the country over until normal times return and foreign creditors (and the IMF) are repaid. Alternatively, an insolvent country requires a debt restructure, with 'haircuts' (debt reductions or deferred repayments) all round for foreign creditors.
Of course the practical problem is that it's rarely possible to know, at the time of a debt crisis, whether the issue is illiquidity or insolvency. More importantly, the political pressure is on the IMF to go ahead and provide assistance, whatever the prospects of repayment. If, however, the Fund provides assistance to a country which turns out to be insolvent, the IMF money has been used to repay creditors who should have been 'bailed-in' to help the resolution process by taking a haircut on their debt.
This scenario played out in Greece in 2010. It was obvious that Greece could not repay its debt, but nevertheless the IMF and the European Union provided funding to allow debt falling due to be repaid in full. By the time the issue of restructuring was addressed in 2012, many of the private creditors had already been repaid in full. Those private creditors still with outstanding debt in 2012 took a haircut but the overall effect was to leave the debt (still unresolved, still unsustainable) in the hands of the EU and the Fund, to be sorted out later.
This is a long-standing problem. It was relevant in 1997 when Australia contributed to the IMF-organised support for Thailand. We didn't want to see Australia's contribution used to repay foreign private creditors who had been so eager to provide Thailand with more borrowing than it could afford to repay. But the Fund doctrine at the time had no place for such niceties. IMF deputy managing director Sugisaki, chairing the donors' meeting, insisted that no attempt should be made to bail-in the foreign creditors (including large debts owed to Japanese banks).
Subsequently, IMF senior manager Anne Krueger laboured mightily to put some sense into sovereign debt resolution, but was rebuffed by the big creditor countries, led by the US.
Is the new Fund policy the breakthrough that Blanchard implies? Time will tell. He says if there is doubt as to solvency, the outstanding debt will be 're-profiled' i.e rescheduled for delayed repayment, but not written down. Perhaps in some cases this might be as successful, such as the Korean debt 'stand-still' in 1997-98, during the Asian crisis, when creditor countries worked together through their central banks to ensure that repayments to foreign creditors were delayed until the Koreans were able to make full repayment — which was achieved within a few months. But this was a once-off, highly interventionary process which would be hard to repeat successfully (and was not attempted in any of the other Asian crises countries).
Meanwhile, another development seems to be taking sovereign debt resolution in an unfortunate direction. The new Argentine government has reached an agreement with the hold-out creditors from its 2001 default. A debt negotiation in 2005 ultimately reached a settlement with over 90% of the creditors to accept 30 cents per dollar of debt. Much of the balance of the debt was picked up cheaply by so-called 'vulture' funds that subsequently sought legal redress through various courts, including seizing the Argentine naval training barque. These bond-holders were hugely assisted by a maverick US court ruling that prevented Argentina from making any payments to those creditors who had already agreed to take the substantial haircut. With the change of Argentina's government, the US court ruling has softened, and a deal with the hold-outs seems likely. But what message does this send to any country attempting a sovereign debt resolution in the future? Those who agreed to the 2005 settlement took a 70% haircut while the 'vultures' will make a profit of upwards of 400% on their investment. Next time a debt rescheduling is needed, why won't all creditors be hold-outs?
The Fund hopes that revised provisions in future bond contracts (inter alia, covering collective action clauses limiting the ability of hold-out creditors to resist an overall settlement) might prevent a repeat of the Argentine mess.
But collective action clauses have been included in earlier contracts, and sharp bankers and smart lawyers may find ways around the new versions. Of course debt should be repaid in full, as a matter of principle. But there comes a time when restructure is the only way forward. Given the new Argentine precedent, the unsettled Ukraine negotiations and Greece's unsustainable debt overhang, to leave these issues in the hands of the exigencies of domestic legal process seems inadequate. It's hard to share Blanchard's view that 'the world is now a safer place'.
Photo courtesy of Flickr user Jim Howard