IMF moves to get tough on private creditors in crisis-hit economies

News Analysis: Plans are afoot to ensure bondholders suffer their fair share of the losses when a country defaults on its debts

BY THE end of the annual meetings of the International Monetary Fund and World Bank in Washington last week, it was clear that reform of the "international economic architecture" had made steady progress in all areas but one.

BY THE end of the annual meetings of the International Monetary Fund and World Bank in Washington last week, it was clear that reform of the "international economic architecture" had made steady progress in all areas but one.

On one issue - how to involve private sector creditors in the resolution of future financial crises - there has been scant progress since Mexico devalued the peso in December 1994.

Stung by the taunt that the IMF's phone number had become 1-800-BAILOUT, the Fund and G7 governments want to ensure that in future private sector bondholders are "bailed in" and suffer their fair share of the losses during a crisis.

For while equity investors lose through a decline in share prices, countries in trouble have to perform somersaults to repay bondholders and bank loans. The alternative, default, is catastrophic because it causes new credit flows to dry up precisely at the moment they are most badly needed.

The crises in Mexico in 1994/95 and in East Asia, Russia and Brazil in 1997/98, however, have brought about the spectacle of the IMF paying billions of dollars into the affected countries so they can repay billions to their private creditors. The argument is that there is simply too much "moral hazard", or in other words too great an incentive for creditors to act in ways that will make the crisis worse, lending too much in the confidence that it will be repaid thanks to a sort of IMF guarantee.

The scale of the problem is enormous. Between 1996 and 1998, capital flows to the five affected Asian economies - Korea, Thailand, Malaysia, Indonesia and the Philippines - went into reverse by $125bn, or 12 per cent of pre-crisis GDP. About four-fifths of this swing was accounted for by commercial banks. Recent figures from the Institute for International Finance (IIF), the big banks' international trade association, showed that commercial banks withdrew a net $45bn from all emerging markets in 1998, and predicted these outflows will continue.

The IIF argued that part of the reason for the continuing withdrawal of funds, however, was the fear that the G7 and IMF will impose unfair forms of burden sharing on private sector lenders. Sir John Bond, chairman of the IIF and of HSBC, said: "There is anxiety that the IMF and other official authorities are supporting involuntary techniques involving the private sector, such as forced rescheduling of Brady bonds or Eurobonds." (These being the two main forms of private lending to emerging market borrowers.)

Not surprisingly, the banks favour voluntary involvement. They also argue strongly for an ad hoc, case-by-case negotiation in every crisis, rather than any sort of general principles of burden sharing. In this they have the strong support of Lawrence Summers, the US Treasury Secretary, who believes that every crisis is sufficiently different that each needs a new solution. It is his insistence that has essentially stalled progress on bailing in the private sector.

Other members of the G7, including the UK, favour a variety of methods, set out recently in a speech by Mervyn King, deputy governor of the Bank of England. One suggestion is that the IMF should set a minimum level of foreign exchange reserves for countries to which it is making emergency loans. Set at the right level, this will ensure that official finance is not used simply to pay off private loans, and engage the private sector in debt renegotiation.Another is that the IMF could endorse temporary loan standstills by providing new money to a country that has temporarily suspended its debt repayments. If this "lending into arrears" became the norm, countries would in future get a breathing space during which to renegotiate.

A third possibility would be the temporary imposition of capital controls on outflows of money. This would help limit capital flight on the part of residents too. While generally frowned upon by international authorities, Malaysia's exchange controls do seem to have helped stabilise its financial markets.

Finally, negotiations might be made easier by a shift towards sovereign debt contracts with "collective action clauses", which prevent a minority of creditors from blocking a resolution. But until the industrialised countries tag these on to their own debt, emerging market countries will not do so for fear of thereby signalling that they are more likely to default. The US has made it crystal clear it has no intention of doing this, so there is little prospect of it coming about unless other big countries such as the UK decide to set an example.

With little consensus on any of these possibilities, last week's G7 and IMF meetings ended up by asking officials for more work, to the despair of some who feel the work has been done, and what is needed now is some political leadership. However, the matter is coming to a head now that Ecuador has defaulted on its debts. This is not a default to rock the international financial system, but how it plays out carries important implications for more serious cases in future. It is the first test of bailing in.

So far, it is looking messy. The government of President Jamil Mahuad has said it will pay interest due on some but not all of its Brady bonds. The discrimination has angered investors who look like they might not get repaid, and they have threatened to demand full repayment immediately.

If they do, other classes of bondholders will probably follow. It does not set a good example of how to reach a voluntary agreement with private sector creditors. Although Ecuador has a letter of intent with the IMF - agreeing to tax increases and banking sector reform in return for a $350m stand-by loan - there is no clear indication yet from the Fund about how it plans to proceed. Private lenders are waiting for some decisions.

Other potential defaults are looming too. Romania sought a voluntary debt restructuring and is negotiating with the private sector for new loans. Negotiations are due to start soon between Pakistan and creditors over three outstanding bond issues. And Ukraine has recently achieved a partial debt restructuring but might need to come back to lenders for more money.The IMF concluded in a paper published last week: "We are at an early stage in this evolving policy."

Unfortunately, the problems first emerged in late-1994, and the solutions do not seem to be evolving all that fast. This is one aspect of the new international financial architecture still lacking a blueprint.