The economic crises that began with Greece and spread through Ireland and the southern periphery of Europe were path-breakers. They occurred in countries embedded in a major currency area (the euro zone), they dispelled the notion that debt crises are the provenance of emerging market countries and they have proved remarkably resistant to global bailout assistance. Now, as G20 leaders prepare to meet in St. Petersburg, Russia — more than three years into the crisis and without an obvious endgame in view — a serious question they should consider is whether these are the first of a bigger, more complex, and more-difficult-to-resolve kind of crisis that will define the future global landscape.
The global economy and its supporting institutions have hobbled through the challenges thrown up by the European crisis. Many factors have contributed to the slow recovery of the worst-hit European countries, but faults in crisis management are certainly one of them. The mistakes do not have to be repeated. These are early days for choosing the key issues that need attention, but the process must begin with issues that are now obvious. This note raises five aspects of crisis management that need the attention of global economic leaders.
The Euro Area Debt Crisis — Essential Facts
The basic contours of crisis management in the euro area were set with Greece. Initially, the intention of European leaders was to handle and finance the crisis internally. After the size of the problem — both the adjustment and the financing required — became clear, the European Union turned to the International Monetary Fund (IMF). That request came late. A large amortization payment due six weeks later brought the threat of a disorderly default to the doorstep. European demands put to the IMF were stark and difficult to reconcile: Greece must stay in the euro area; there would be no debt restructuring, which, it was thought, would deprive Greek banks of funding channels and stir up intensely feared contagion to other weak euro area countries; and the IMF would negotiate, monitor, and contribute one-third of the financing of the adjustment program in a joint relationship with the European Commission and the European Central Bank — a grouping known as “the troika.”
To be part of this arrangement, the IMF had to change its own framework for exceptionally large loans. The IMF determined that even with the unusually strong fiscal and structural adjustment policies planned, a rigorous forward-looking analysis raised significant doubts about whether public debt would be sustainable without a restructuring. In other words, IMF funding would not be a bridge to a level of debt that could be financed and repaid, it would only extend the period of uncertainty about how debt would be lowered to manageable levels. Since being on a track to debt sustainability is one of the criteria that a large borrower must meet, the IMF had to introduce a waiver (the systemic risk waiver) of that criterion to approve the loan. Greece restructured its privately held debt two years later.
Greece paved the way for handling other debt crises in Europe. Although the facts surrounding each of the four countries (Greece, Ireland, Portugal and Cyprus) that received official bailouts for their creditors differed, the basic parameters for handling the crises were similar: each country should stay in the euro area, restructuring would not (initially) be countenanced, the IMF participated in the troika and lending proceeded on the back of the systemic risk waiver, without a high probability of debt sustainability. Greece remains the only country to have restructured its debt — all except Ireland continue to experience falling output and employment.
Where Does the Euro Area Crisis Leave Us? Five Early Issues for Action
The IMF needs arms-length protection from pressures that prevent it from openly considering and advocating actions that fix a problem early, at its source.
Again focussing on Greece, two fundamental problems were at the root of the crisis — unusually high and rising public debt and weak competitiveness. The adjustment program aimed to address these issues through severe fiscal retrenchment and structural reforms. But this strategy was not realistic in view of the depth of the problems and the lags in responses to, in particular, structural policy. In turn, the optimism embedded in the initial three-to-five-year forecasts (for example, of GDP, employment and exports) contributed to an unrealistic picture of the costs of the strategy. Ultimately, after private holdings of debt had fallen substantially, debt had to be restructured, while the slow pace and response to structural reforms meant that the real sector strategy had to shift from a structural-reform-led to a recession-led improvement in competitiveness.
Admittedly, the constraints posed by membership in a currency union were formidable, but almost every crisis has its own set of constraints that seem immutable at the outset. The critical role for the IMF as an outsider with enormous experience in handling crises is to force a reality check on the parties closer to the crisis. Reconsidering the management and decision-making structure of the IMF so as to strengthen the arm’s length distance from the intense political pressures that inevitably surround a crisis is critical.
The IMF needs to provide more thorough analyses of spillover effects.
The fear of contagion arises in all crises, most intensely in regional partner countries. These fears are warranted, as all serious twenty-first century crises have spillover effects. A critical error in handling the euro area crisis was succumbing uncritically to the view that financing a program without a high degree of credibility would minimize spillover effects. For example, the program for Greece approved in May 2010 did not satisfy markets’ desire to see a clear endgame to Greece’s large debt and competitiveness problems. Without providing such clarity, the strategy of lending to Greece without a high probability of sustainability actually exacerbated negative contagion to other weak peripheral countries.
Having the IMF undertake a rigorous and transparent analysis of likely spillovers from alternative strategies for crisis resolution is the best approach for choosing spillovers with the lowest costs. Of course, these would involve many judgment calls on likely responses to different courses of action. In the case of Greece, for example, spillover analyses of the actual strategy chosen, a restructuring strategy and a temporary exit from the euro strategy, to name a few alternatives, should have been carried out and made public. Unless the IMF is able to get all strategic options on the table with a clear analysis backing each, it will not perform the essential function of a more objective participant in program negotiations.
The IMF must be protected by a sensible framework for lending into crises.
The IMF changed the framework governing exceptionally large loans in order to go ahead with assisting Greece, Ireland and Portugal. The framework consisted of four criteria that a country must meet to receive exceptional access: it must have a balance of payments need; a high probability of debt sustainability in the medium term; good prospects for regaining market access; and a program of policies that is likely to be successful. To approve the Greek loan, the option of a permanent waiver was introduced into the second requirement — that related to debt sustainability — when there are risks of international systemic spillover effects. The use of the waiver effectively undermines the avowed role of the IMF — to lend as a bridge to market access. Without sustainability, market access is unthinkable.
The waiver should be eliminated. It was established in the heat of the moment of an impending Greek default. This critical and permanent change in IMF policy was not discussed by the Fund’s executive board, but merely made part of the approval of the Greek program. It makes little sense. Sustainability is always basic to the objectives of an IMF lending arrangement and no more so than for a country important enough to have international spillover effects. Moreover, that the IMF continues to invoke the systemic risk waiver three years after the start of the crisis for Greece, Ireland and Portugal, speaks to the licence the waiver gives for delaying crisis resolution.
That said, it is important for the IMF to have some flexibility or discretion in its initial response to severe crises. In the case of Greece, it is arguable that a default in mid-May 2010 (which was the likely outcome of the absence of IMF participation) would have been unduly costly. The IMF should have the option to lend very large amounts for short periods even when conditions do not meet the four criteria for exceptional access. This could take the form of an emergency financing facility with maturities capped at a short period (say under six months) that would provide a bridge to a longer term, strategically tight program that meets the four criteria.
Debt restructuring arrangements are still precarious and need formalization.
That the Greek restructuring of privately held debt in early 2012 worked so well was fortunate. The decision on the parameters of the restructuring was reached in October 2011, a negotiating group lead by the Institute for International Finance (IIF) was formed and a deal was reached in February 2012. Although the fate of the negotiations was a cliffhanger, a large writedown with a small number of holdouts was achieved. Creditor coordination problems were mostly successfully overcome. But the circumstances were special. Most debt was issued under domestic law, and retrofitted collective action clauses (CACs) were put in place to secure adequate participation. Holdouts in the foreign law debt were eventually paid off.
These special features of the Greek deal leave doubts about future restructurings. Problems, well rehearsed during the 2001-2002 debate over the Sovereign Debt Restructuring Mechanism remain potent obstacles to smooth restructuring as the lingering problems with Argentina’s creditors show. CACs, which are now common in bond contracts, continue to be too narrow to ensure timely participation of all creditors. And while the IIF did a commendable job in negotiating the Greek restructuring, it is an organization of bankers without formal channels of representation by hedge funds and other non-bank bond holders. If a full bankruptcy-type body is not favoured, at the very least a new look at CACs is needed.
The IMF’s relationship with regional partners in debt crises needs clearer boundaries.
The troika arrangement has been a novel test. Cooperation between the IMF and regional groups has frequently occurred, but joint responsibility for negotiating, monitoring and financing an adjustment and reform program had not, until the European crises. And, though the logic of the joint effort is clear when the crisis country is a member of a currency union, it has presented problems. Apart from obvious differences in institutional perspectives and responsibilities of the European and IMF teams, there has persistently been at least the appearance of a more direct channel for political influence. Although crises of the severity of Europe’s are unlikely in other currency unions including multiple IMF members, the troika will set an example that could well be viewed with interest in future crises in other regions.
The IMF needs a clear set of principles to guide any future cooperation with regional groups during crisis resolution. These need to partition responsibilities, reinforce the senior creditor position of the IMF (perhaps even formally) and fortify the constraints on the IMF’s discretion in lending into crises.
Action on these five issues is critical to avoiding the mistakes that have led to prolonged crises in Europe, and is an important matter for leaders at the G20 summit to consider. The list of issues requiring action will surely expand as the European crises are eventually resolved and studied further; at this stage, however, a minimum list is clear:
- The management and decision-making structure of the IMF needs to be reexamined to foster some arms length distance from direct political pressures.
- Prior to approval of any lending arrangement, the IMF should be required to carry out and release to the public rigorous analyses of international spillover effects from different strategies for addressing the crisis.
- The option for waiving the requirement of debt sustainability in exceptionally large lending arrangements should be revoked. The very high costs of leaving markets to guess how debt sustainability will be restored are an unacceptable drag on the resolution of a crisis.
- Formal arrangements — whether through enhanced CACs or a bankruptcy-style process — for debt standstills and restructuring are needed.
- Procedures for cooperation between the IMF and regional institutions in debt crises should be codified, with an aim of enough separation between the two to ensure institutional integrity.