V Improved Handling of Actual or Potential Debt Crises
- Paul Mentré
- Published Date:
- April 1984
The ultimate expression of debt difficulties is the inability of a country to fulfill its commitments and the need for its creditors to agree to a stretching out of existing commitments under a rescheduling agreement. Some participants in the market, notably some investment bankers, consider debt rescheduling as a rather normal development in a system under which long-term development financing is provided without an adequate equity base and with a maturity pattern that is too short. Others, notably among commercial bankers, who have in some cases created special units to deal with rescheduling negotiations, consider that any breach of contractual commitments should entail a lengthy and difficult negotiation and a hardening of the terms of the loans subject to renegotiation.
From 1956 to 1974, there were 30 debt renegotiations involving 11 countries for a total amount of $7 billion. From 1975 to 1980, there were 16 renegotiations involving 9 countries for a total amount of $9 billion. In 1981 and 1982 there were 27 renegotiations involving 16 countries for a total amount of $15 billion and through early October 1983, 29 renegotiations involving 22 Fund members for a total amount of $60 billion. There was also a rapid increase in the number of countries incurring payments arrears, as noted in the Fund’s Annual Reports on Exchange Arrangements and exchange Restrictions: 13 at the end of 1975, 26 at the end of 1980, 32 at the end of 1981, and 35 at the end of 1982, when payments arrears amounted to $15 billion.
The analyses of these debt crises, and notably a study by the Fund,51 reveal a number of common elements in the experience of countries that have had to restructure their debt. These are excessive borrowing to finance consumption; economic and social rigidities; excessive credit creation; excessive debt accumulation and undue reliance on short-term credits; poor debt management and a deterioration in the debt service ratio; weak export growth; and outflows of capital. These analyses also show that fairly standard patterns for rescheduling have gradually been developed.
In the Paris Club (meetings of creditor countries, the debtor country, and observers and chaired by the French Treasury) there has been a growing tendency to apply fairly uniform rescheduling terms;52 in most cases 80–90 percent of public and publicly guaranteed debt has been rescheduled and repayment has been over a seven-to-nine-year period including a grace period of three to four years. Differences appear, however, in the period of debt payments covered by the agreement (with a tendency in recent agreements to limit the period to one year), in the treatment of interest (with generally a rescheduling of overdue interest payments) and more fundamentally in the types of debt included. As a matter of principle, previously rescheduled debt has normally been excluded. There tend to be variations with regard to short-term debt, which was included in some agreements but excluded in most, involving additional repayment obligations.
According to a study by the Overseas Development Council,53 these rescheduling terms, when measured quantitatively (by the difference in discounted value of the stream of debt service payments before and after rescheduling), normally imply only a limited amount of debt relief (from 1 percent to 10 percent of outstanding debt), but there have been significant exceptions where the relief exceeded 40 percent of outstanding debt (Ghana, Indonesia, Turkey). The grace period, in addition, gives the country a breathing space during which it can adjust its economy and restore its creditworthiness.
The negotiating process with banks is somewhat different. Instead of a general agreement implemented through bilateral negotiations, there is a need—after a lengthy phase of negotiation by a steering committee of seven to fifteen banks—for a detailed legal document acceptable to all bankers before the rescheduling agreement can be signed. In practice, last-minute difficulties raised by individual bankers have always been overcome, and the final outcome is to a large extent determined by the lead banks.
Here also standard patterns have developed. This is partly a reflection of the “equal treatment” policy of the Paris Club, which requires the country involved to obtain from its private creditors (bankers and suppliers) terms for their debt rearrangements at least as favorable as those granted by official creditors. More important, standard patterns facilitate the negotiating process between lead banks, with different relative exposures in different countries, as well as between the steering committee and the country, and between the steering committee and the other banks.
Under these standard patterns, all arrears, a part of short-term debt, and medium-term and long-term debt falling due during a one-year period are covered; interest is excluded. With a few exceptions, the percentage rescheduled amounts to at least 80 percent of the principal payments falling due during the consolidation periods, and in over half of the agreements since 1978 to 100 percent of the principal payments falling due. The repayment period has been up to seven to ten years, with a grace period of two and a half to three years. The interest rate is set at LIBOR plus about 1.75 percent on all rescheduled credits (plus a restructuring fee of 1 percent).
Commercial banks consider that the exclusion of interest payments from rescheduling is a fundamental aspect of debt rescheduling that should be integrally preserved, since it avoids a classification of claims by supervisors as nonperforming assets (a legal requirement with both federal and state bank laws in the United States) and protects ongoing financing flows from banks to borrowing countries. For various reasons, bankers do not consider Nicaragua (where interest payments beyond 7 percent were rescheduled) as a precedent in this respect. In extreme circumstances, however, bankers may grant new credits that help the country to meet its obligations, including interest payments (e.g., Poland in 1982, where new credits represented one half of the interest payments due in that year).
Scope for Improvement
In itself, the concept of standardized patterns of rescheduling appears inadequate. The balance of payments and debt patterns of each country are unique and, in conformity with corporate debt rescheduling, where future debt repayments are determined by cash flow projections compatible with the normal development of the restructured company, “tailored” solutions compatible with viable and sustainable balance of payments patterns would appear appropriate. Such an approach would be contrary to many precedents that have facilitated and continue to facilitate the negotiating process. In addition, commercial bankers stress that if a country restores its creditworthiness through adequate adjustment policies, through the avoidance of new arrears, and through the strict fulfillment of its obligations under the rescheduling agreements, it will find on the market the credits it will eventually need to smooth the repayment burden it is facing. The scope for improving the present rescheduling patterns is therefore limited. Nevertheless, there are means by which more predictability and more efficiency can be introduced in the system.
When a country applies for official debt rescheduling, it frequently raises the question of the provision of fresh money by governments at a time when it has no clear alternative source of funding. There has been constant pressure by developing countries to integrate development assistance into the process of debt relief and to grant terms of debt relief suited to the medium-term balance of payments profile and the overall financing needs of the borrower. Indeed, for lower-income countries there have been examples where a meeting of donor countries was convened in parallel to or shortly after the Paris Club meeting. The special features adopted for debt rescheduling in some cases also reflected the exceptionally difficult financial situation facing some low-income countries. But for most countries, and notably for middle-income countries, this solution is not applicable. Some investment bankers have suggested that official creditors should stand ready to refinance, when needed, interest payments that may impose such a burden on the borrowing country as to constitute a fundamental obstacle to a viable adjustment program. It is clear that, since governments do not have the same constraints as bankers, they should continue to be prepared, when appropriate, to reschedule interest payments on official debt, but it is difficult to conceive that they could, in addition, bail out the commercial banks by refinancing interest payments due to them.
A variant of this approach would involve the development of a secondary market for claims on borrowing countries with discounts for claims on problem countries and some kind of official support. In addition, several schemes aiming at a consolidation of existing debt into claims on an international organization have been proposed. Most of them would have the fundamental disadvantage of removing a major incentive for commercial banks to advance new money, which is the need to protect the quality of existing claims.
It has been suggested that a more explicitly trade-oriented approach would be more appropriate. There is normally a need for a rapid resumption of emergency imports at the time of the rescheduling agreement. Either the World Bank, through the quick disbursement of a program loan, or governments, by issuing guarantees for additional trade credits, should stand ready to step in at that stage, as they did in 1982–83 for some major financing packages.
To help participating governments contemplate such additional credits, it has been suggested that, at the same time, some alleviation of the financial burden falling on governments under the present rescheduling patterns could be contemplated. Since commercial banks stand ready to reschedule their own unguaranteed claims, they should stand ready, through adequate financial incentives (fees and additional interest charges), to reschedule under the same terms their claims guaranteed by governments. The guarantees would remain intact, and governments would repay their banks if the borrowing country were not fulfilling the terms of the rescheduling agreement. For the creditor governments, the financial burden would generally be deferred. There would thus be a good complementarity between governments rescheduling direct loans and interest payments on official claims and extending (together with the World Bank) some additional guarantees for trade financing and banks rescheduling all their claims, guaranteed or nonguaranteed, with full payment of interest due to them. However, export credit agencies have to determine their attitudes on additional exposure on the basis of viable adjustment programs aimed at restoring debt-servicing capacity, and no financial device can be a substitute for this fundamental assessment.
With the generalization of debt rescheduling agreements, there is scope for a more formalized process, and some steps have already been taken in this direction. First, there is a need to speed up the negotiating process, which normally takes place during a period of rapid deterioration in the country’s external situation. Borrowing countries should initiate earlier discussions with their bankers and maintain an accurate record of their various external debt commitments, with the help of an external advisor if needed. As far as banks are concerned, the Institute of International Finance might contribute to a more rapid selection of participants in the steering committees and a more rapid dissemination of information to other bankers.
Second, suggestions have been made to set up “guidelines for rescheduling.” In addition to a confirmation of the standard rescheduling patterns, they would introduce predictability and consistency with regard to the definition of credits to be rescheduled, which is the least satisfactory element in present policies, since in many cases (e.g., Turkey) the exclusion of some types of credit has harmed the country at the worst possible moment. Efforts to implement such a concept have, however, met with limited success, because many bankers fear that precise guidelines could confer respectability and normality to a process which, in their view, should be regarded as exceptional and penalizing. Nevertheless, they have narrowed the issues to three: short-term trade-related credits, interbank deposits, and bonds and notes.
There are some good arguments for excluding short-term trade-related credits from rescheduling, in particular to maintain normal trade financing patterns, but the exclusion should be narrowly limited to documentary credits. For interbank deposits, there is a fear that supervisors may treat them as credits if they are to be normally rescheduled, but clearly their exclusion is unjustified since they constitute the most volatile and destabilizing element in the whole picture. For bonds and notes, investment bankers (and the World Bank) stress that the rescheduling of bonds is a cumbersome process which would lastingly harm the ability of developing countries to issue bonds on the markets. Commercial bankers point out the limited difference between some syndicated loans and some floating rate note issues and insist on including the latter. The end result has generally been the inclusion of bank-held floating rate notes and the exclusion of those held by nonbanks.
Finally, there is scope for improvement in the treatment of suppliers’ credits. Banks insist on an equal treatment for suppliers, which means that, with the exception of minor claims, suppliers’ credits have to be rescheduled under the same terms as banks’ claims. In practice, however, the negotiating position of suppliers is weak, and in many cases suppliers have to accept conditions on maturities and interest that are unfair compared with the treatment applied to bank claims. In this area, more direct involvement of bankers, acting on behalf of their industrial customers, could be of help. The Fund could also pay greater attention to suppliers’ credits when assessing the outcome of debt rescheduling negotiations.
The Role of the Fund
The Fund is invited to attend Paris Club meetings as an observer. The Fund’s role was highlighted by Resolution No. 165, S-IX of the United Nations Conference on Trade and Development (UNCTAD) in 1978 (a compromise between developing countries seeking an independent and multilateral framework of negotiation and OECD countries seeking to protect the specific role of creditors), which indicated that the Fund, the World Bank, and UNCTAD should be invited as observers to Paris Club meetings and that the Fund and the World Bank should jointly provide a contact point through which debt problems could be addressed and channeled to the competent international bodies. In assessing balance of payments trends and prospects and in describing the Fund-supported adjustment program, which is now a standard prerequisite to any rescheduling agreement, the representatives of the Fund play a valuable role in the negotiating process.
The involvement of the Fund in discussions for the rescheduling of bank claims is more recent. There were some reschedulings of debt to banks in the 1950s and 1960s (Brazil, Argentina, Chile), but it was only in 1976–78, with Zaire, Peru, Turkey, Jamaica, and Sudan, that they became a standard feature in the treatment of severe debt problems. At the beginning of this process, commercial bankers tried to impose their own conditionality on countries (Zaire, Peru), but the experience proved short-lived. Commercial bankers were not in a position to monitor the borrowing government’s implementation of economic policy measures, and they gradually came to the view that the best approach was to ask the country to enter into an upper credit tranche stand-by arrangement with the Fund. When such an arrangement is negotiated, there is a clear need for Fund involvement in discussions between the bankers and the country to ensure a sufficient degree of compatibility. It took, however, some time for the Fund to move from a rather indirect involvement (Turkey) to a more direct one (Romania) in which Fund representatives supplied the participants with alternative balance of payments projections.
As an observer in both Paris Club meetings and meetings of banks, and as a supplier of Fund resources under an adjustment program, the Fund is in a unique position to obtain a reasonable degree of consistency between interrelated decisions. In particular, it seems appropriate for the Fund to advise banks to maintain a minimum level of new lending. This implies mutually agreed views on prospective current accounts, including interest payments, and on associated capital flows, including additional bank lending.
In addition to this approach, there might be a case for the elaboration by the Fund of an internal doctrine on rescheduling. While the situation of each country is unique, and while the Fund should not become involved in discussions between bankers that reflect their respective exposure in various types of credit, such a doctrine could be used as a benchmark against which to assess individual negotiations. The model should be based on an in-depth study of all recent rescheduling negotiations. Its basic components could be as follows:
The scope of the rescheduling agreement should be as wide as possible, including all types of credit, with the possible exception of short-term documentary credits.
All creditors should receive equal treatment. There has been a tendency in some recent agreements to treat suppliers less favorably than bankers. The Fund, through its policy on arrears, should ensure that suppliers are not unfairly treated.
The rescheduling should be tailored to the needs of the country, which might imply in some cases advance discussions between the Fund and Paris Club participants on patterns of reimbursement more differentiated between debtor countries. The option of partial rescheduling, limited to certain entities that are over-indebted, should also be looked at more carefully by the Fund.
While there is broad agreement that the Fund should be a more active observer or mediator in rescheduling negotiations, its possible role as an advisor to the country is more problematic and therefore controversial. The functions of advisors have developed gradually, with a leading role being played by investment banks in some countries (Indonesia, Gabon, Turkey, and Costa Rica). Views on the role of advisors differ widely. Some praise their ability to assemble data in a professional way, to give credibility to the figures supplied by the country, and to come up with imaginative schemes (the possible use of suppliers’ claims on Turkey for new investments or for reprocessing activities). Others would prefer to see the data collection functions left to accounting firms, and underline the significant fees charged by investment bankers. It has been suggested that the Fund, in order to present to member countries an alternative to their own assessment of the pros and cons of an investment bank, should offer its services under its technical assistance program as an advisor in rescheduling negotiations. It does not seem advisable for the Fund to go too far in this direction. The Fund should be neutral as between debtors and creditors. It would lose its ability to influence the position of creditor countries and banks if it clearly sided with the debtors.
There is still great validity in the view that rescheduling should not be looked upon as a normal development and that a penalty should be attached to it. At the same time, a smooth handling of debt problems might help to reassure the market in its assessment of sovereign risks and thus contribute to the maintenance of an adequate flow of international bank lending. The Fund, through an active role in negotiations, can contribute to this objective.
Individual Liquidity Crises
Debt crises have normally been associated with international imbalances aggravated by procyclical lending by commercial banks. However, in 1982 a new type of crisis emerged, induced by external developments, contagion effects, and a shift in the general attitude of bankers. This might be called a liquidity crisis and is typified by the cases of Hungary and Yugoslavia.
In such situations, there is normally a case for an adjustment program backed by the Fund. There is at the same time a need to avoid an immediate crisis and a rapid withdrawal of credit facilities, including deposits obtained through the interbank market. It is essential that the country take appropriate measures, such as the prudent use of the interbank market and maintaining an adequate debt profile, an appropriate level of reserves, and unused lines of credit. Collective action by commercial banks, the Fund, and other interested parties has proved to be equally important.
The Standstill Concept
Many bankers deplore the absence of a mechanism by which a standstill on existing exposure could be imposed on individual international banks—rather in the manner of Chapter 11 of the bankruptcy law for U.S. corporations. They see in such a collective agreement the fundamental answer to cumulative withdrawals, which may start with small banks (last in, first out) and spread to large banks that may be willing to maintain their own exposure but do not wish to bail out other banks. The ways of implementing such a collective freeze of existing credit lines are diverse. They include covenants in syndicated loans under which the central bank of a borrowing country would have to meet with the lead bank if the country’s short-term borrowing was falling below a certain limit; telexes sent by the lead bank to its partner banks inviting them to follow the lead bank’s example and to maintain their exposure; or national or regional meetings between individual lead banks and their national or regional partners. Such an approach implies that bankers feel that time is not running against them. Accordingly, some fresh money needs to be put into the system in the form of immediately available funds.
The Short-Term Facility Concept
A possible solution to the problem of cumulative withdrawals might be a short-term six-month facility in the Fund amounting to 102 to 125 percent of quotas. The facility would be open to a country whose liabilities to banks or current account payments were higher than a given percentage of its quota and who could meet such preconditions as (1) the selection by the country of a small coordinating group of major banks that would ensure that all of them stand ready to maintain an adequate level of exposure during a certain period of time; (2) immediate action by the country to take policy measures with the instruments that were readily available, particularly the exchange rate and interest rates; and (3) a judgment by the Fund staff that there was a reasonable assurance that the country would implement a comprehensive program of adjustment embodied in a stand-by arrangement with the Fund.
However, such an approach could be judged discriminatory among member countries, could unduly delay adjustment, and could impair the ability of the Fund to negotiate a comprehensive adjustment program since, through the short-term facility, some of its funds would already be at stake. In addition, the proper mix of adjustment and financing, which is the very essence of Fund-supported programs, could be impaired. The alternative, which was developed in 1982 for Hungary, Mexico, Brazil, Yugoslavia, and Argentina, is joint intervention by the BIS and the Fund on an ad hoc basis. In view of the understandable concern of the BIS governors with the avoidance of general commitments that may not be appropriate in all circumstances, it is natural that they should continue to wish to act on an ad hoc basis in this matter, and similar results can be achieved through this more pragmatic approach.
Overall Liquidity of the System
A pessimistic viewpoint is that one cannot exclude a crisis in the banking system itself. Because of adverse developments on the asset side of its balance sheet, a major bank could register on the liability side a large withdrawal of deposits and lines of credit. It would then be unable to meet its commitments either directly or with the help of its central bank, if the central bank did not have available commensurate foreign exchange reserves.
The decline in interest rates and the handling of the individual country crises of 1982–83 have made such a crisis more unlikely than could have seemed likely about the middle of 1982. Nevertheless, a strengthening of the system’s ability to cope with such a crisis would be the best way to avoid its occurrence, by injecting into the system much-needed confidence factors.
Individual Central Banks as Lenders of Last Resort
Internationally, as well as domestically, the best way to avoid a bank crisis is to show in advance that the central bank is prepared to act as lender of last resort if a liquidity squeeze were applied to an individual bank. However, central bankers do not want to commit themselves in advance to any precise action. It is considered that uncertainty is a necessary element in encouraging prudent behavior by banks; provoking a crisis and avoiding its spreading remains the essence of the central banking art, as described by Bagehot; the means available to cope with a particular situation are not known in advance, especially in countries where, besides central banks, other agencies (such as the Federal Deposit Insurance Corporation in the United States) or governmental funds are involved. This explains why in 1974, when central bankers had to face the first postwar crisis of confidence in the international banking system, the central bank governors of the Group of Ten and Switzerland stated that “. . . they recognized that it would not be practical to lay down in advance detailed rules and procedures for the provision of temporary liquidity. But they were satisfied that means are available for that purpose and will be used if and when necessary.”54
This statement was accompanied by some specific measures dealing with the supervision of individual banks (the creation of the Basle Committee on Banking Regulations and Supervisory Practices) and did help to restore confidence, the more so since it had not to be tested. Both the Herstatt failure in the Federal Republic of Germany,55 and the Franklin crisis in the United States,56 damaged the markets in 1974, but their size was not such as to strike a fundamental blow to the system.
If the ambiguity in the way in which central banks will deal with a crisis can be explained, a clear understanding of the respective responsibilities of individual central banks seems essential. While dealing with supervisory functions and not with lender-of-last-resort responsibilities, the “Concordat” of 197557 addressed this issue. While it clearly attributed responsibility for the supervision of solvency to the parent central bank as far as branches were concerned, it stated that “for foreign subsidiaries and joint ventures, primary responsibility rests with host authorities; but parent authorities must take account of the exposure of their domestic banks’ commitments to those foreign establishments,” leaving open differences of interpretation as to the responsibility for the supervision of solvency.
The Ambrosiano crisis showed the drawbacks of ambiguity. It prompted the Luxembourg supervisory authorities to ask from parent banks “letters of com-fort” along lines already followed by the Bank of England. But it cast an additional doubt on subsidiaries, consortium banks, and joint ventures operating in the market, led to some discrimination between locations, and may have added to the uncertainties in the summer of 1982.
Accordingly, the “Concordat” was revised in 198358 with greater emphasis being placed on consolidation and on control of nonbank subsidiaries performing banking functions. But it was stressed again that it was dealing with supervision issues and not addressing the question of the lender of last resort, on which the position remains deliberately ambiguous.
The Central Bank Network as a Liquidity Guarantee
When a central bank is facing a domestic liquidity crisis, it has an unlimited ability to provide funds to the market or to the banks running into difficulties. If one of its commercial banks were to face a dollar liquidity crisis, then it could still provide funds in its domestic currency which the bank could convert into dollars through the market; but if it wanted to offset the effect of these transactions on the market in order to prevent its currency from depreciating, then its ability to do so would be constrained by its own dollar reserves. In the end, the only lender of last resort in U.S. dollars is the U.S. Federal Reserve System and, while large and diversified dollar markets, such as the London market, and central banks with large dollar reserves have adequate resources to cope with a dollar crisis, the same is not true for all markets and all central banks. In addition, when in 1976 some banks had difficulty in funding their operations, the market was able to take over the claims of these banks when they matured, thus avoiding a net contraction of the market. Such an attitude would probably not prevail under present conditions.
It is necessary, therefore, to strengthen cooperation between BIS central banks to ensure collectively that adequate resources will be available to face potential liquidity shortages, while averting disruptive movements in the foreign exchange market. The instrument exists—namely, the swap network between central banks—but it has not been broadened or expanded in recent years and its present size, at $32 billion, has to be looked at in relation to potential risks.
The Role of International Organizations
The Fund, together with other international organizations, could play a role in a mutual endeavor. Since monetary stability in the world is one of the major goals of the Fund, it might envisage contributing to the avoidance of an international bank crisis developing into an overall liquidity crisis. Various ideas, such as the refinancing of commitments or claims resulting from the activation of the central bank swap network have been mentioned. They deserve further study, together with other possible avenues of cooperation among central banks aimed at additional stability and confidence on the international interbank market.
It is clear that borrowing countries have to adapt to trends prevailing in the international bank market. To ensure the proper mix of adjustment and financing required, at least during a transitional period, international financial organizations have an important role to play. An increase in the resources of the World Bank, allowing a spreading out of the graduation process which might have adverse effects in present circumstances, imaginative cofinancing techniques between the commercial banks and the World Bank, and adequate Fund resources appear to be necessary complementary elements. As far as the Fund is concerned, the quota increase and the associated borrowings that were agreed in late 1983 constituted a major contribution to efforts under way to restore confidence in the international banking system.