The crisis in Europe continues to fester. The weak global economy, distressed banking sectors and the absence of exchange rate policy have impeded resolution. But all of these problems were understood at the outset. The key shortcoming in the strategy for dealing with them was allowing unsustainable national debt burdens — of banks and governments — to sit on the books of the crisis-torn countries. This fundamental strategic error should not have occurred. Ten years ago, the International Monetary Fund (IMF) revised its rules for handling crises, precisely to prevent such errors. But the rules were scrapped, and the IMF was set adrift in handling the European debt crisis.
The debt burdens of the three countries that received official bailouts illustrate the problem. They ranged from 92 percent (Ireland) to 125 percent (Greece) of GDP at the outset and will rise to at least 112 percent (Ireland) to 150 percent (Greece) of GDP by the end of 2012 (despite Greece’s restructuring of privately held debt in early 2012). Official creditors now hold between a third and almost two-thirds of the debt.
Precedents from other debt crises pointed to the low likelihood that key prerequisites for recovery — reducing debt to a level where servicing debt would not absorb an inordinate amount of domestic income — could be achieved through adjustment and growth alone. The IMF failed to heed these precedents. Rather, bowing to the exigencies of European politics, it cobbled together low-probability assumptions about future growth, how quickly tax systems could be reformed, how rapidly government spending could be cut and when markets would re-engage in heavily indebted countries.
How could the membership of the IMF have put tens of billions of dollars into such fundamentally flawed programs? Ten years ago, a similar question was debated in the aftermath of the Argentine default. At that time, two issues were the focus of concerns.
One was that the IMF gets sucked into huge bailouts in hopeless situations, because there is no institutional framework for organizing orderly negotiations and practices for private debt restructuring. This view drove the 2002-2003 effort to introduce a statutory sovereign debt restructuring mechanism (SDRM) as an orderly process to accompany IMF support for heavily indebted sovereigns. Creditors and debtors alike rejected the SDRM, but settled on a scaled down initiative — collective action clauses (CACs) in international bond issues — to facilitate restructuring. CACs set up reasonable provisions for creditor agreement on changing the financial terms of the bond contract. Since 2003, most international bond issues have included CACs.
The second concern was that the IMF gets dragged into excessive bailouts because it is fundamentally unconstrained in deploying almost limitless financing, even when debt sustainability is questionable. Implicitly, the argument was that if the IMF were to be sensibly constrained, private creditors would find ways — voluntarily — to agree on restructurings.
The IMF has always had quantitative ceilings on access to its resources, but its history of ignoring them in crises is impressive. Recognizing this fact, proponents of the second view pushed for establishing qualitative criteria that must be met by countries requesting exceptionally large access to financing. Countries that could not meet these criteria would need to restructure their debt as one condition for IMF support.
In 2003, four such criteria — parsimonious, yet on the mark — were put into place: the country must face exceptional balance of payments pressures; there must be a determination, based on a rigorous and systematic analysis, of a high probability that the country’s debt burden will be sustainable; the country must have good prospects of regaining access to private capital markets while IMF resources are outstanding; and the policy program must have reasonably strong prospects of success.
From 2003 to 2009 — a period of reprieve from catastrophic debt crises requiring IMF support — these two concerns were largely dormant. The four criteria were, more or less, honoured in the few relatively straightforward and uncomplicated cases where they needed to be applied. And, contrary to the fears of SDRM advocates, “voluntary” approaches, often without activating CACs, proved successful in a few (relatively small) restructurings.
But now, following the handling of the Greek crisis, questions about provisions for restructuring and constraining IMF bailouts need to come back on the table. Greece patently needed to restructure its debt from the outset, but only did so two years later, when its IMF-supported program was wildly off track. The restructuring was more costly and less comprehensive than it would have been if undertaken two years earlier (because a large proportion of debt had been taken onto official books and was excluded from the restructuring). The debt restructuring was agreed in negotiations fraught with uncertainty about its success. Curiously, a debate about the causes for this failure of global governance has not started, but here is how it might be cast.
On the side of those who feel that the absence of an SDRM was the critical problem, the jury is out. True, the IMF, debtors and creditors may have been more willing to consider restructuring at the outset of the crisis if an institutional framework for negotiations had been in place. But once the decision to restructure was in place (in late 2011), the negotiations proceeded rather quickly and, ultimately, were successful in their limited objectives. It is impossible to say whether this had more to do with luck than with the robustness of new approaches to “voluntary” restructuring.
Those who stress the need for constraints on large IMF bailouts in unsustainable conditions have a clearer case. Greece was the first real test of the four criteria for exceptional access — and they failed. IMF staff determined that the second criterion was not met: it could not be stated with adequate confidence that Greece’s debt burden was sustainable. This should have meant that access to exceptionally large IMF financing had to be contingent on restructuring private debt. Instead, the IMF changed the rules. The second criterion for exceptional access was amended simultaneously with the approval of the Greek loan: a high degree of confidence in debt sustainability would no longer be necessary in countries where there was a risk of “systemic spillovers.”
This punt begged three questions. Would restructuring in Greece have significant systemic spillovers? Why are sustainable debt dynamics not essential when systemic spillovers are at stake? How could a country regain access to capital markets (the third criterion) if its debt dynamics were not sustainable?
Subsequently, exceptional access was granted to Ireland and Portugal (where debt sustainability also was not affirmed with adequate confidence) and was similarly justified by the risk of systemic spillovers. These precedents will not be forgotten in future debt crises in other parts of the world. In short, the IMF now effectively has no constraints on large bailouts in unsustainable conditions.
The role of the IMF and the private sector in debt crises — a critical global governance issue emerging from the European crisis — needs re-examination to answer several critical questions. In light of the European precedent, what will constrain the highly politicized IMF from supporting countries with unsustainable debt burdens and increasing the ultimate costs of restructuring? Is it time to reconsider a sovereign bankruptcy process as a safeguard for a failure of “voluntary” restructuring? Until the IMF’s position as an objective voice is secured through clear and respected procedures for handling debt crises, the institution will remain adrift.
This commentary is a longer version of an op-ed that appeared in The Guardian.