CIGI and the UN Financing for Development Office are co-sponsoring a panel discussion on sovereign debt restructuring and international adjustment at the IMF/World Bank Group annual meetings in Tokyo. The panel reflects the importance of this issue, which CIGI has been exploring for some time.
Debt restructurings are typically messy affairs. They result in protracted periods of negotiations during which the country loses access to capital markets, forcing an abrupt compression of imports and consumption. This reduction in domestic absorption is, of course, the natural, ineluctable result of the fact that balance of payments must "balance."
But this period of adjustment results in output losses and higher unemployment that frays the social fabric — look at Greece, and, more recently, Spain. Growing social cleavages can lead countries to adopt beggar-thy-neighbour policies "destructive of national and international prosperity;" in the 1930s, these policies propagated global economic stagnation. That is why the IMF was created to assist its members strike a judicious balance between financing and “adjustment,” or the reduction of absorption that was the quid pro quo for IMF financial assistance.
Of course in the Bretton Woods period, most countries maintained capital controls. This limited the size of balance of payments to the difference between national investment and savings rates — typically, a few percentage points of GDP. In these circumstances, the IMF literally had the resources to “fill balance of payments gaps” in order to meet its mandate of facilitating that judicious balance.
In the highly-integrated global economy of today, marked by capital account liberalization and massive private capital flows that dwarf the IMF’s resources, the size of the capital account crises has grown. This has impaired the IMF’s ability to assist its members strike the right balance between financing and adjustment.
At the same time, crises today can unfold over a matter of weeks — not quarters, as was the case with the current account problems of the Bretton Woods era — as financial market confidence is lost and the country is locked out of international financial markets. In effect, the capital account crises the IMF is now asked to resolve resemble a bank run, in which a panicked “rush for the exits” magnifies the output losses and dissipates asset values to the creditors. In this respect, creditors are conflicted. They want to punish the sovereign by withholding credits, but doing so reduces the value of their claims (ultimately, the value of their claims are a function of current and future output).
Meanwhile, the dislocation created by the crises increases the risk of beggar-thy-neighbour policies.
In any event, these effects combine to create deadweight losses on the sovereign borrowers and creditors alike. They reflect the fact that debt cannot be restructured quickly — in effect, sovereigns and their debtors are in a war of attrition as each side tries to get the other to concede first.
Good public policy would reduce the "frictions" that prevent timely, orderly restructurings.
In some sense, the problem is the absence of complete state-contingent contracts and the inability of governments to credibly commit to sharing upside outcomes. Were that not the case, governments could ask their creditors to reduce their claims in bad ("restructuring") states in return for higher returns in good (“upside”) states. In the real world, however, sovereign immunity means that there is very little creditors can do if governments renege in the good times after benefiting from the state contingent contract in bad times.
If there was a public policy intervention that facilitated a timely, orderly restructuring — reducing some of the deadweight losses above — without transferring risk from either the sovereign government or the private creditors, wouldn't it be foolish not to pursue it? Such an intervention should meet three key conditions:
- First, no risk transfer — risk should not be passed to the balance sheet of the IFI (strong form), or without adequate compensation (weak form);
- Second, adequate risk mitigation and management — there has to be sufficient controls that cap and contain the risks associated with intervention consistent with the weak form of the first condition; and
- Third, respect principles of inter-creditor equity/market efficiency.
Providing a well-structured intervention that meets these conditions could result in a restructuring that takes six weeks instead of six months, six years (or even six decades — the case of Czarist bonds) and might fill a gap in the international “architecture,” which I argue still doesn't adequately reflect the fact that we have moved away from Bretton Woods era capital controls and created highly integrated capital markets. If doing so would help countries deal with the vagaries of international capital markets by filling in the "contracting space" it might well be worth considering.
To be continued…