Preferred credits and the IMF

May 9, 2014
IMF Director of External Relations Gerry Rice makes a statement to the press regarding approved funding (about US$36.7 billion) under the EFF for Greece (March 15, 2012.). IMF via Flickr CC

CIGI Senior Fellow, Susan Schadler, has an interesting post, here, on the IMF's preferred creditor status. Briefly, this refers to the fact that the IMF enjoys a senior status among creditors in the case of sovereign debt restructuring. As Susan notes, this is a legal convention that is agreed to in practice but is not supported in treaty or international law. As a convention, it is subject to change should the implicit understanding that has supported it be eroded.

Susan makes the case that we may indeed be moving to that world. Her argument is that the IMF has undermined its preferred creditor status by violating its own requirement that it not lend into unsustainable debt situations in the case of Greece. While I, too, worry about the sustainability of the IMF's preferred creditor status, I have a somewhat different take. The risk to the fund's preferred creditor status stems, I'd argue, from the evolution in the global financial system.

In contrast to the Bretton Woods era, in which capital controls limited the size of private capital flows, the international financial system today is dominated by flows of private capital that swamp the meager resources that the IMF can mobilize in times of crisis. In this environment, the Fund's preferred creditor status was deemed necessary and appropriate in that the IMF lends to distressed members when private creditors do not.

In this respect, the convention is analogous to the debtor-in-possession (DIP) financing that a commercial bank will provide to a firm undergoing a restructuring. The DIP lender is prepared to lend to a distressed borrower only because it receives senior status in the event of bankruptcy; existing creditors are subordinated, in that their claims are serviced only after the DIP financier. All creditors can benefit from the arrangement if the firm uses the breathing spaces provided by DIP financing to reorganize and return to profitability, generating a return to creditors higher than the alternative.

The analogy goes only so far, however. At the domestic level, well-defined corporate bankruptcy regimes provide clarity on procedure and creditor rights. Existing creditors have some degree of confidence in how the process will unfold and face less uncertainty about the likely outcome. A firm that fails to implement a restructuring plan that is likely to preserve or enhance asset values will be forced into bankruptcy, with management replaced by a court-appointed liquidator and assets sold off and the proceeds distributed to the firm’s creditors. In a sense, creditors have a stop-loss provision that limits the extent to which DIP financing subordinates their own claims.

This is clearly not the case in the context of sovereign debt restructuring. A sovereign borrower cannot be put into bankruptcy and “management” replaced. Gone, thankfully, are the days of the gunboat and occupation of the customs house. Indeed, as argued in previous posts, here for example, the IMF was created, in part, to help nascent democracies — many of them former colonies — weather the vicissitudes of the global economy. There is no equivalent “stop-loss provision” for private creditors dealing with troubled sovereign borrowers.

This leads to footloose and fickle capital. Private lenders lacking legal protection or certainty in terms of process in the event of payments suspension tend to flee as the economic situation deteriorates. Traditionally, lending to emerging markets has been marked by bouts of excessive optimism, with an in-rushing tide of capital, followed by waves of pessimism and the withdrawal of capital. Moreover, foreign investors have an incentive to maintain short-term portfolio positions, which can be liquidated as economic conditions deteriorate; foreign direct investment, which is tied more directly to investment and employment, meanwhile, is side-swiped by sudden stops and reversals of capital flows. The fact that the IMF’s preferred creditor treatment subordinates private claims only exacerbates these effects.

Consider a purely hypothetical case of sovereign distress: total outstanding debt is €100, which is initially held by the private sector. Assume that as a result of a rescue package, the value of private claims is reduced by €50 (50 percent haircut), while official loans of €50 are provided in an attempt to avert default. Total claims on the sovereign remain €100. Assume, however, the rescue effort fails and the sovereign defaults. In the possibly-unrealistic case that the sovereign can sustain the same debt-service payments of € 75 pre- and post-default, private creditors are unambiguously worse off. Had there been no rescue attempt, private bondholders would have recovered €75 on their claims with a face value of €100, or a recovery rate of 75 percent. After the rescue attempt, private creditors get paid out only after official preferred creditors are compensated. This implies that private bondholders receive €25 (= €75-€50), for a recovery rate of 50 percent (= €25/€50) of post-haircut claims, but only 25 percent (= €25/€100) on pre-rescue package claims.

From my perspective, therefore, the threat to the IMF's preferred creditor status comes from the fact that, as the size of Fund (and other official creditors’) claims have increased over the past two decades, the prospective degree of subordination has similarly increased. If IMF claims represent a small share of outstanding claims, the convention is justified and, indeed, likely supported by private creditors — the risk of subordination is warranted, given the potential stabilization that the IMF can help promote. If official sector claims are no longer de minimus, however, this trade-off becomes more difficult to sustain.

So, what is the conclusion to be drawn from all this?

Well, rather than introduce additional uncertainty to sovereign lending, a better framework for the timely, orderly restructuring of sovereign debt might help sustain the IMF’s preferred creditor status and enable the Fund to better assist its members strike a felicitous balance between financing and adjustment.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

About the Author

James A. Haley is a senior fellow at CIGI and a Canada Institute global fellow at the Woodrow Wilson Center for International Scholars in Washington, DC.