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CIAO DATE: 8/01
Beyond IMF Bailouts: Default without Disruption
On The Issues
May 2001
Massive cash infusions to countries in financial crisis lead to larger and more frequent crises in the future. International lenders of last resort should instead implement a constructive default framework that encourages prudent policies and secure financial systems in borrowing countries.
Now it is one more last chance for Turkey. For the ninth time in the past six years, the arbiters of the international financial system have been confronted with two unpalatable options: bail out a threatened developing country and its lenders or risk a crisis that might spread and endanger the global economy. The probability of catastrophe may be small, but the penalty is intimidating. Intervention has always been chosen even when it was clear that the solution would be short-lived, that emergency funds would benefit speculators, and that promises of reform were unlikely to be kept.
A third and better option exists for the international lender of last resort. On the continuum between total bailout and abandoning the market to chaos, there is an effective new mechanism that can alter the approach to disruption.
Bailouts are costly. Since the Mexican rescue in 1995, $25 billion in risk has been transferred from private sector balance sheets to official lenders. With the exception of Russia in 1998, where the turmoil overwhelmed salvage efforts, the markets have not suffered a single dollar of loss on lending to large emerging governments.
Repeated intervention subverts the incentives that are the moving force of market behavior. Bailouts obviate the hard choices—default or reform for troubled borrowers; sound lending judgments or failure for investors—and substitute a free ride on taxpayers in the Group of Seven leading industrial nations. Capital markets have learned that there is an implicit International Monetary Fund guarantee for large emerging market borrowers and that a risk premium can be collected while avoiding the risk. Countries have learned that promises can substitute for reform and that every $10 billion of IMF loans will yield $1 billion each year in interest subsidies. Only the IMF seems surprised that the same old policies produce increasingly questionable outcomes.
Only default and the losses that follow will recreate the incentives that restore balance to the system. Yet the multilateral agencies fear default, more than either debtors or creditors, because it is seen as a catalyst of panic. In their nightmare scenario, prices of the borrower's bonds will plummet as all buyers withdraw. Forced selling and a further collapse will result as investors mark to market and lenders call for margin and liquidation. The need for cash will spread from the bonds of the crisis country to other emerging governments and finally to unrelated asset classes as investors sell whatever can be sold. Markets close.
To prevent panic while permitting the market to operate is the classic role of the lender of last resort. But past massive cash infusions to borrowers have moved beyond this mandate and encouraged larger and more frequent crises. The alternative is not widespread disruption and repudiation of contracts but constructive default that provides an orderly correction for the errors of borrower and lender alike.
We propose that the IMF, together with other official lenders, build an AAA floor of support by offering threatened governments a facility that stands ready to buy any and all debt to the private sector at a cash price well below its expected restructured value. With this floor firmly in place, the financial system would be insulated from contagion and the uncertainty that leads to panic. Private lenders would bear losses, but losses with predictable limits. At completion, debt burdens would be reduced to sustainable levels.
Three announcements complete the constructive default framework: first, a moratorium on all payments of interest and principal to the private sector; second, a prompt restructuring of the debt with a projected write-down that would make the debt burden sustainable; and third, an IMF commitment to protect other emerging economies affected by the crisis.
Preserving Market Discipline
At first, prices of the country's bonds would fall below the expected write-down level, but they would stabilize above the official guaranteed floor of support. As the market realizes that bailouts are over, a rational downward adjustment in the bonds of all emerging economies would reflect their true risk.
The IMF floor of support should be set low enough to be unattractive to all but the most desperate investors but high enough to forestall uncertainty and panic selling. There is a trade-off. The lower the floor, the less its stabilizing effect. The higher its value, the greater the probability that investors will sell to the IMF facility.
All debt repurchased would be pledged to the IMF as security, and half of the proceeds of all new borrowing would be channelled to facility repayment. As the borrower repays the IMF loan, a proportionate share of the bonds held as security would be released and cancelled.
It is highly unlikely that many investors would exercise the option to put their bonds to the IMF facility because, as bonds are purchased, the creditworthiness of the borrower improves, the value of the restructured bonds to be exchanged rises, and the position of the remaining creditors strengthens. Exposure would be limited for the IMF, even if all creditors accept the support offer. The private sector would absorb the entire cost of the write-down, balanced out by the high returns that emerging markets offer. The crisis country would reduce its debt burden to a sustainable level. The IMF would hold a secure claim on a now creditworthy borrower, rather than a mounting claim on a questionable borrower whose rollovers camouflage delinquent debt service. The intervention would be final rather than piecemeal and temporary.
How would the floor of support work for the Republic of Manana—a developing economy with a massive and unsustainable $90 billion debt to the private sector that holds the global system hostage through an excessive 25 percent share of emerging market bonds? Already trading at 80 percent of face value, the debt would require a write-down to 70 percent to make the burden sustainable. An IMF facility with a maximum value of $54 billion would guarantee a support price of 60 percent of face amount.
If the entire private sector debt were repurchased under the support offer, $36 billion of debt write-offs would be absorbed by investors, Manana's debt would be reduced by one-third, and the IMF would hold $90 billion in claims as security for $54 billion in loans, easily redeemed in a short time frame by the now-solvent borrower.
A credible prospect of default will alter behavior far more than IMF admonition. Capital would again weigh risk in the lending equation, and funds would flow at attractive rates to sound emerging governments. Countries would realize that only prudent policies and secure financial systems gain access to resources for growth. The official sector would step back from its role of guarantor of speculative capital to a true lender of last resort that responds to market failure yet preserves market discipline. Fewer crises would be the result.
Adam Lerrick is the director and Allan H. Meltzer is the chairman of the Gailliot Center for Public Policy at Carnegie Mellon University. Meltzer is also a visiting scholar at AEI. This article appeared on the Financial Times's website, FT.com, on May 9, 2001.
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