Increased Transparency, Adherence to Standards, and Data Dissemination

The increased importance attached by market participants to greater transparency in standards of policymaking and improved data dissemination is one of the legacies of the recent crises. Inadequate knowledge about the foreign currency exposure of the banking system (as happened in Korea), or about the level of a central bank’s forward foreign exchange position (as happened in Thailand), is widely regarded as having provided a case for improved transparency and data dissemination. An improved flow of information is viewed as vital if markets are to appropriately assess and price risks and if there is to be effective market discipline that encourages governments to undertake more open, predictable, and responsible macroeconomic and financial policies.

Given this consensus that there is a need to improve data dissemination and standards for policymaking, it is somewhat surprising that the staff’s discussions with officials and market participants indicate a “profound” lack of awareness in many markets regarding recent efforts by the official community to improve the quality and quantity of information available to the private sector. This is worrying from two different points of view. First, the lack of awareness may reflect the fact that the data actually provided under these initiatives are not market relevant,⁴ or, as some market participants pointed out, their quality is not reliable enough for them to use. Second, there is the concern that, if creditors are not interested in the information that is being developed, there will not be much emphasis placed on observance on the part of borrowers.

Improved Debt Management

Market participants regard improved domestic and external debt management as one of the keys to mitigating the severity and frequency of crises. Past crises have demonstrated that private and official foreign currency-denominated debt can create additional sources of vulnerability. From a debt management perspective for both the sovereign’s borrowing and the general borrowing done by its private sector, the key issues are typically seen as avoiding both a bunching in maturities and inclusion of derivatives in bond contracts (such as put options) that exacerbate debt service payments during crises.⁵ It is important for the sovereign to ensure prudent debt management by its private sector, especially in a fixed exchange rate regime, to stop private sector debt from exacerbating the country’s vulnerability to a crisis. This may imply a lower level of private sector foreign borrowing, but it would strengthen the country’s overall ability to withstand external shocks. Otherwise, the sovereign may find itself in a situation where it has to step in and socialize the private sector’s foreign borrowings to resolve the crisis. Throughout, a challenge is to convince any emerging market debtor that the up-front cost savings achieved by issuing short-term bonds or bonds with put options always have a cost—one that is harder to quantify—in terms of the additional vulnerability to shocks. If a sovereign not only successfully manages its own debt but also oversees the borrowing of its private sector it is well on its way to improving its ability to withstand future external shocks.

Improving Debtor-Creditor Relations in Normal Times

Improved debtor-creditor dialogue is perhaps the one proposed initiative that gains universal approval by both the official and private sectors. A continuing dialogue with the borrowing country is viewed by many market participants as a way to strengthen trust in the lending relationship and greatly facilitate negotiations in the event of debt-servicing difficulties. The benefit of such a dialogue is seen to be, in part, a removal of the uncertainty premium that emerging market borrowers have to pay when a lack of reliable information leads investors to assume the worst.

The main obstacles to better debtor-creditor dialogue, according to market participants, are the lack of preparedness and public relations skill of some sovereign borrowers, the sensitivity of some country information, the preference of some major individual investors for individual meetings, and the desire of some bondholders to remain anonymous.

Debtor-Creditor Relations in Crises: Creditor Committees

There are several ways debtor-creditor relationships can be organized in advance of a crisis. One early suggestion was the setting up of a standing creditor committee,⁶ which could play an important role in facilitating information sharing across creditors and negotiate on their behalf. However, some market participants dislike standing committees since they want to negotiate on their own behalf; they also fear that the committee may not be representative as the holders of the debt likely shifts when there is secondary market trading, and they have a concern that a standing committee may reduce the cost of default for the sovereign borrower, by making it more orderly, and hence increase the probability of default. Due to these and other private sector concerns, the official community has taken the position that standing creditor committees are “generally not considered practical”⁷ and has since sought to lay down some guiding principles in advance for the formation of “ad hoc” creditor committees, which mainly would serve the purpose of coordinating and sharing information across creditor groups. This approach is receiving some support from the private sector through discussions under the auspices of the Council of Foreign Relations. However, such a committee raises the difficult question of how to handle confidential information and whether the various different types of creditors would maintain adequate “Chinese walls” to avoid trading on the basis of confidential information. While some market participants are optimistic that the Chinese wall problem can be overcome, others have pointed out that a better approach would be to recognize that the problem could never be satisfactorily solved and the committee should only deal with simultaneously published information.

Some market participants take the view that the recent bond exchanges in Pakistan, Ukraine, and Russia show that there is no real need for setting up formal creditor committees. In fact, they additionally point to what they regard as the negative experience of Ecuador with its Consultative Group. This group, set up by the sovereign, and including only holders of international bond debt, was widely seen as a nonconstructive point of contact between creditors and the debtor, tending to “radicalize” creditors’ positions and potentially serving as a coordinating mechanism against the sovereign. Mostly recently, Ecuador has decided to meet with major holders of its external debt on an individual basis.⁸

Collective Action Clauses

Collective action clauses (CACs) are clauses that can be incorporated into an international bond’s legal documentation to facilitate the restructuring of that bond if needed. The clauses commonly referred to as CACs are a majority action clause (allowing a qualified majority of bondholders to bind a minority); a sharing clause (stating that any funds received through, for example, litigation by one bondholder have to be shared with the other bondholders based on their share of the outstanding bond); and a collective representation clause (allowing a trustee, for example, to represent bondholders at bondholders meetings facilitating majority actions). The presence of CACs could facilitate creditor-debtor negotiations following a crisis, since they reduce both the threshold from the 100 percent needed for achieving a restructuring agreement (the majority action clause) and the potential threat of litigation from “holdout” creditors (reducing their incentive to litigate through the sharing clause or implicitly from the inclusion of a trustee). Bonds issued under English law typically include CACs explicitly or implicitly. Since these clauses are not regularly contained in bonds issued under New York law,⁹ proposals have been made to include such covenants in all sovereign bonds issued internationally going forward, in an effort to facilitate orderly restructuring. (An alternative mechanism to CACs would be the use of exit consents, which have the advantage of also being applicable to bonds issued under New York law; see Buchheit and Gulati, 2000). To support the adoption of CACs by emerging market sovereigns, the United Kingdom has recently incorporated CACs in its own “Euro Treasury Note” program.¹⁰ Canada announced in April that in the future its international bond issues will include CACs.

Market participants have argued that the official sector has exaggerated the importance of CACs. Indeed, bond trustees have indicated that they would not call a bondholders meeting unless they had already reached a prior agreement with the required majority of creditors for approval of a restructuring. Without such a prior approval, creditor meetings are viewed as likely to produce “strange and exotic” outcomes, most of which would be bad for the debtor (for example, the bond holders’ meeting could be used to collect enough votes to accelerate the bond). While market commentary on the impact for emerging market borrowers on the wider adoption of CACs in bond contracts is mixed, empirical work¹¹ suggests collective action provisions tend to reduce the cost of borrowing for the more creditworthy issuers, who benefit from an orderly restructuring process. In contrast, lower-rated borrowers are shown to pay a premium if CACs are included. This suggests that for a lower-rated borrower, creditors would view the adoption of CACs as a signal of additional default risk that would more than offset the advantages the provisions afford by facilitating a more orderly restructuring process. The additional cost paid by lower rated borrowers and the implicit reduction in international debt financing available to them may also avoid the buildup of potentially destabilizing debt flows in the first place. In general, including these provisions in bond documentation going forward is widely regarded as a step in the right direction (see Table 5.1), but their inclusion will do little to help in the restructuring of already outstanding bonds.

Table 5.1.

Private Sector Involvement in Crisis Resolution-Summary of Positions of G-7/IMF, Institute of International Finance, and Emerging Markets Traders Association

Source: Published in Chase Manhattan (2000b). Based on Bank of England (2000)

Table 5.1.

Private Sector Involvement in Crisis Resolution-Summary of Positions of G-7/IMF, Institute of International Finance, and Emerging Markets Traders Association

I. Areas of Broad Agreement
Proposal	Cologne Principles/IMF	Institute of International Finance	Emerging Markets Traders Association
Burden sharing	Private creditors should bear consequences of investment decisions.	Agree.	Agree.
	Bonds not necessarily excluded from future restructuring.
Rules vs. case-by-case	G-7 framework offers guidelines, but flexibility retained for different cases.	Case-by-case essential, taking into account market expectations based on past experience.	Case-by-case approach must be guided by clearer and more consistent principles.
IMF Contingent Credit Line	Increases focus on crisis prevention. Provides extra incentive to promote standards	Potentially important vehicle for assuring private finance.
		Practical questions need to be addressed.
Debior/creditor dialogue	Encourages debtors to establish mechanisms for more systematic dialogue.	Proposes major borrowing countries to adopt proactive strategies of investor relations.	Plays a facilitating role in consultations between Ecuador and its creditors.
		Proposes to establish a Private Sector Advisory Council for the IMF.
Market-based tools	Facilitates access to the international markets in times of instability. Helps prevent liquidity crisis.	Credit enhancements such as World Bank “policy-based guarantees” are a helpful step that can lend credibility on polity reforms, and can catalyze new private sector flows.
II. Key Differences in Positions
Burden sharing	G-7 framework: promote more orderly crisis resolution in helping debtors and creditors find cooperative solutions.	Burden sharing is Hawed concept—changes in “ground rules” could upset balance in sovereign workouts.	Recognizes legitimacy of goal, but believes approach is flawed. Forced reschedulings will discourage capital flows. Market-oriented approach urged.
		Private lenders have different objectives (shareholder value) than official lenders.	Investors need assurance that emerging markets, and officiai sector in support of tile countries, are completely committed to honoring debts.
		Difficult to find evidence of “bailing out”; in medium-term context creditors have provided substantial net financing despite large losses.
		Few private lenders/investors can pre-commit to fill financing gaps.
		Involuntary approaches will delay eventual restoration of normal market access.
		Critical to ensure crisis resolution at voluntary end of spectrum.
Paris Club “comparability of treatment”	Applies to all categories of creditors other than IFIs.	Rigid application of “comparability of treatment” could damage future market access.	Paris Club governments did not participate in debt write-downs concurrently with Brady plan.
	No claims should be automatically exempt. Paris Club should take flexible approach, taking into account size and importance of claims.	Bonds should not automatically be exempt. Market-based solution chosen by the debtor is best.	No source of financing should be automatically exempt from burden sharing, but not ail equal.
		Lack of Paris Club transparency is serious obstacle to achieving comparable treatment in current cases.
Standstills	Capital or exchange controls imposed in exceptional cases in conjunction with IMF support	Litigation not significant obstacle to orderly workouts where authorities are implementing credible adjustment programs.
		Ability to litigate underpins all cross-border flows of finance.
		Stays on litigation would impede productive flows of private capital.
IMF lending into arrears	May be appropriate if debtor seeking cooperative solutions with creditors.	Likely to discourage private financing unless exceptional impediments exist and a broad spectrum of private creditors support such action.
Brady Bond restructuring (only)	No category of claims inherently senior.	Brady bonds embody past debt reduction. Adverse impact of restructuring Brady bonds in broad emerging market asset class/future Brady-style issues should be given appropriate weight by official lenders.	Misguided because: 1) previous haircut; 2) violates sound principles of work outs absent a comprehensive plan; 3) does not resolve moral hazard; 4) not comparable; 5) misuse of interest collateral; 6) terrible precedent.
Collective action clauses	Encourage as best practice. Consider including in G-10 bonds (at least FX) and as a consideration for access to IMF’s CCL or IMF conditionality.	Attempts to make qualified rescheduling clauses mandatory are counterproductive. Potentially fruitful area for public/private sector cooperation.	Initiative must not undermine legal responsibility of debtors. Sharing clauses objectionable-threaten the legal right of creditors to enforce claims. Majority voting of about 90 percent acceptable, but should be voluntary.
Trustees	Encourage wider use.		Add little in sovereign context. Provisions that would infringe on individuals’ rights (i.e., de facto sharing clauses not welcome).

Source: Published in Chase Manhattan (2000b). Based on Bank of England (2000)

View Table

Table 5.1.

Private Sector Involvement in Crisis Resolution-Summary of Positions of G-7/IMF, Institute of International Finance, and Emerging Markets Traders Association

I. Areas of Broad Agreement
Proposal	Cologne Principles/IMF	Institute of International Finance	Emerging Markets Traders Association
Burden sharing	Private creditors should bear consequences of investment decisions.	Agree.	Agree.
	Bonds not necessarily excluded from future restructuring.
Rules vs. case-by-case	G-7 framework offers guidelines, but flexibility retained for different cases.	Case-by-case essential, taking into account market expectations based on past experience.	Case-by-case approach must be guided by clearer and more consistent principles.
IMF Contingent Credit Line	Increases focus on crisis prevention. Provides extra incentive to promote standards	Potentially important vehicle for assuring private finance.
		Practical questions need to be addressed.
Debior/creditor dialogue	Encourages debtors to establish mechanisms for more systematic dialogue.	Proposes major borrowing countries to adopt proactive strategies of investor relations.	Plays a facilitating role in consultations between Ecuador and its creditors.
		Proposes to establish a Private Sector Advisory Council for the IMF.
Market-based tools	Facilitates access to the international markets in times of instability. Helps prevent liquidity crisis.	Credit enhancements such as World Bank “policy-based guarantees” are a helpful step that can lend credibility on polity reforms, and can catalyze new private sector flows.
II. Key Differences in Positions
Burden sharing	G-7 framework: promote more orderly crisis resolution in helping debtors and creditors find cooperative solutions.	Burden sharing is Hawed concept—changes in “ground rules” could upset balance in sovereign workouts.	Recognizes legitimacy of goal, but believes approach is flawed. Forced reschedulings will discourage capital flows. Market-oriented approach urged.
		Private lenders have different objectives (shareholder value) than official lenders.	Investors need assurance that emerging markets, and officiai sector in support of tile countries, are completely committed to honoring debts.
		Difficult to find evidence of “bailing out”; in medium-term context creditors have provided substantial net financing despite large losses.
		Few private lenders/investors can pre-commit to fill financing gaps.
		Involuntary approaches will delay eventual restoration of normal market access.
		Critical to ensure crisis resolution at voluntary end of spectrum.
Paris Club “comparability of treatment”	Applies to all categories of creditors other than IFIs.	Rigid application of “comparability of treatment” could damage future market access.	Paris Club governments did not participate in debt write-downs concurrently with Brady plan.
	No claims should be automatically exempt. Paris Club should take flexible approach, taking into account size and importance of claims.	Bonds should not automatically be exempt. Market-based solution chosen by the debtor is best.	No source of financing should be automatically exempt from burden sharing, but not ail equal.
		Lack of Paris Club transparency is serious obstacle to achieving comparable treatment in current cases.
Standstills	Capital or exchange controls imposed in exceptional cases in conjunction with IMF support	Litigation not significant obstacle to orderly workouts where authorities are implementing credible adjustment programs.
		Ability to litigate underpins all cross-border flows of finance.
		Stays on litigation would impede productive flows of private capital.
IMF lending into arrears	May be appropriate if debtor seeking cooperative solutions with creditors.	Likely to discourage private financing unless exceptional impediments exist and a broad spectrum of private creditors support such action.
Brady Bond restructuring (only)	No category of claims inherently senior.	Brady bonds embody past debt reduction. Adverse impact of restructuring Brady bonds in broad emerging market asset class/future Brady-style issues should be given appropriate weight by official lenders.	Misguided because: 1) previous haircut; 2) violates sound principles of work outs absent a comprehensive plan; 3) does not resolve moral hazard; 4) not comparable; 5) misuse of interest collateral; 6) terrible precedent.
Collective action clauses	Encourage as best practice. Consider including in G-10 bonds (at least FX) and as a consideration for access to IMF’s CCL or IMF conditionality.	Attempts to make qualified rescheduling clauses mandatory are counterproductive. Potentially fruitful area for public/private sector cooperation.	Initiative must not undermine legal responsibility of debtors. Sharing clauses objectionable-threaten the legal right of creditors to enforce claims. Majority voting of about 90 percent acceptable, but should be voluntary.
Trustees	Encourage wider use.		Add little in sovereign context. Provisions that would infringe on individuals’ rights (i.e., de facto sharing clauses not welcome).

Source: Published in Chase Manhattan (2000b). Based on Bank of England (2000)

Standstills and Stays

Standstills and stays¹² are primarily an issue for crisis resolution, but they clearly have ex ante effects in potentially limiting the number of crises that do occur. The analogy with domestic lender-of-last-resort facilities and bankruptcy procedures has led to the suggestion that in times of crisis a payments standstill should be declared. The issue then arises of whether the standstill should be voluntary or mandatory, how long it should last, and who should initiate it. Within the official community, there have been some arguments made that a sanctioned standstill could be seen as a last-resort measure designed to contain broadly based capital outflows from a country. However, so far no consensus has been reached within the public and private sectors, but some forums, such as the Council on Foreign Relations,¹³ have recognized, that in exceptional circumstances, a payments standstill may be desirable and necessary because panic can take hold and official financing resources are limited. Stays on litigation are, in this context, seen as another useful instrument to keep the resulting crisis resolution negotiations orderly.

Market participants are generally against involuntary standstills (see Table 5.1) and argue that stays and standstills would infringe on their fundamental contractual rights to receive payments and they would litigate in the event of a payment default. Furthermore, in their view, the way in which an involuntary standstill is imposed very much affects their reaction to it. It was argued that an involuntary standstill that is imposed while keeping the private sector creditors informed and looks temporary in nature would engender much less of a negative reaction than a blanket decree imposing a standstill for a longer period. Seeing a limited role for voluntary standstills, Corrigan (2000) makes the point that the only successful standstills have been the rolling over of interbank loans. Therefore, he questions whether voluntary standstills would constitute a “viable and generalized approach” to deal with other potential outflows. With regard to forced standstills, Corrigan sees them—especially if sanctioned by the official community—as a “clear and present danger” for the “culture of credit” in the international capital markets.

Nevertheless, involuntary standstills are likely to remain “a fact of life” of cross-border lending, and emerging market borrowers will make use of this instrument if they have to. Indeed, de facto standstills have been a feature of many of the recent debt-service crises (see, for example, Indonesia).

Market-Based Capital Controls

Marked-based capital controls are a potential crisis prevention instrument that has received increased attention following the Asian crisis. They aim to avoid destabilizing capital inflows in the first place. Chile’s introduction of market-based capital controls was motivated both by prudential considerations (including limiting the stock of short-term foreign currency obligations) and a desire to moderate the appreciation of the real exchange rate.¹⁴ Views on the effectiveness of the Chilean capital controls in achieving those objectives, and the overall usefulness of market-based capital controls have been mixed.¹⁵

Comprehensive Versus Limited Approach

The cases discussed in Box 5.2 suggest that the instruments to address a particular balance of payments crisis need to be tailored to the specifics of the country as the key channels of capital flight will differ. In Korea, maturing interbank lines were seen by the official community as the core issue that needed to be resolved to enable other crisis resolution mechanisms to work. In Indonesia, on the other hand, interbank lines played a much smaller role and were part of a comprehensive rollover package, including trade lines and corporate credits, since the resolution of one of the three credit sources was dependent on simultaneously achieving a maintenance of exposure for the others. Furthermore, in the case of Indonesia, private creditors were clear in expressing that they would have shown little forbearance if they felt another creditor group with a different or similar type of claim would have used the resources generated by the initial creditor’s forbearance to exit. For example, since international banks de facto maintained their exposure to most corporates through mounting arrears especially after the government sanctioned such an approach, they argued that they would not have agreed to the “Frankfurt agreement” if it would have been the case that other creditors did not at least roll over their claims for some time period.

Box 5.2.

Major Interbank Rollovers to Date¹

Korea

In December 1997, following intense pressure on reserves, four to five notch downgrades by the major rating agencies that triggered additional outflows, and the realization that much of Korea’s foreign exchange reserve was actually unavailable, Korea was close to facing severe debt-servicing problems. With only $6 billion in reserves, interbank claims amounting to $28 billion to be settled before end-February, and losses of $1 billion a day, Korea faced a daunting challenge. Short-term interbank credit lines, the main source of external credit exposure for Korea, as local banks acted as intermediaries for other domestic debtors, had been subject to cutbacks, which accelerated in November. As the macro situation worsened further, the withdrawal of credit lines rapidly accelerated, causing liquidity to dry up in the Korean interbank market. With interbank rollover ratios falling to near zero, capital flight rampant, the IMF-supported program failing to restore confidence, and the $20 billion sovereign guarantee of the Korean banking system proving ineffective, the international official community was trying to stabilize the situation. However, putting in the limited available official resources would have done little to ameliorate the situation as these resources would have quickly flowed out to pay down maturing interbank lines.

On December 22, 1997, the Federal Reserve Bank of New York called a meeting to convince key U.S. banks that a rollover of their maturing interbank lines was in their own interest as not all of them could exit at the same time. Furthermore, it was highlighted that failure to roll over enough of the credit lines would clearly pose a systemic risk to the world’s financial system and that, if agreement was reached, the official financial community would provide additional accelerated resources. Representatives of the U.S. banks agreed on Christmas Eve to maintain their interbank lines at current levels for at least a week, while a longer-term solution could be found. Similar meetings took place in all the major financial centers with Japanese, German, English, French, and other central banks trying to convince their respective commercial banks to agree to a rollover. After fierce negotiations, broad international agreement was reached on January 16, 1998 to roll over creditor bank exposure until March 31, 1998. A key component to enforce the agreement was a debt-monitoring system, set up by IMF and Bank of Korea staff, which helped solve the inherent collective action problem² present in any rollover operation.

Rollover ratios quickly recovered in the second half of January 1998, reaching an average of 80 percent for the month. The subsequent two months saw some leakage compared to the January agreement, as some small creditor banks exited and the approval of new credit lines suffered delays. Still, rollover ratios remained in the neighborhood of 90–95 percent, but borrowing rates widened substantially.

In addition to maintaining interbank lines, there were some efforts under way to find mechanisms to maintain trade credit and derivatives exposure. However, rolling over trade credits was deemed counterproductive, as it was likely to delay an export-led recovery, and the maintenance of derivatives exposure was later dropped as OTC derivatives and other potential “black holes” proved to be of less importance than anticipated.

Toward the end of January and beginning of February, signs emerged that the sharp depreciation in the Korean won had led to a rapid turnaround in Korea’s trade balance, stabilizing the macro situation and allowing Korea and its private creditors to discuss a longer-term solution for roughly $24 billion worth of debt. After several proposals were considered, it was agreed that interbank loans would be restructured into one-, two-, or three-year loans paying LIBOR + 225 basis points, 250 basis points, or 275 basis points, respectively, and that these loans would enjoy a sovereign guarantee while keeping the borrower of record intact. The final agreement also included call options for the debtors, allowing them to prepay the longer maturity debt if they so wished at a predetermined price.

Indonesia

While the sources of the immediate pressure on Korean foreign exchange reserves were few and relatively clear, Indonesia provided a completely different challenge. Starting in November 1997, the source of pressure on foreign exchange reserves stemmed from broadly based bank runs and domestic capital flight, causing Indonesian corporates to default on their foreign currency loans to international banks as the Indonesian rupiah plummeted. Only a fairly small portion of external debt was interbank debt³ and hence the subsequent rollover exercise focused on maintaining trade lines while a de facto standstill occurred vis-à-vis corporate debtors, leading to a buildup of arrears (forcing international banks’ exposure to these corporates to be maintained). Despite substantial differences in country exposures across creditor banks, which were estimated at $23 billion for Japan, $5.6 billion for Germany, $4.8 billion for France, and $4.6 billion for the United States (see BIS, 1998), no clear leadership emerged among the commercial banks as Japanese banks were seen as failing to take a leading role. Moreover, a sovereign guarantee was not forthcoming on corporate debt.

At end-January 1998, the Indonesian authorities declared a “pause” for private sector foreign currency-denominated debt service, while simultaneously guaranteeing the obligations of Indonesian commercial banks. This sanctioned the de facto standstill, but may, as was argued by some observers, have aggravated creditor relations and delayed the formation of any coordinating mechanisms among commercial banks until the “pause” ended. A bank steering committee was eventually set up and agreement on a scheme to handle corporate debt was finally reached in June. While the main challenge was to set up a private sector debt restructuring scheme backed by a preferential government foreign currency guarantee, creditor banks also agreed to maintain their trade and interbank lines. The latter agreements had to be reached before the clearance of all corporate arrears so that the clearing of the arrears did not spark another round of pressure on the currency. A debt-monitoring system, which was put into operation in March 1998, again played an important role in ensuring that the agreed-to international bank exposure to Indonesia was maintained.

Brazil

After managing to steer through the contagion from the Russian default in August 1998, in spite of an attack on its currency, and with the help of the IMF program, Brazil appeared capable of preserving its currency regime. However, throughout September to early November, international banks were actively cutting their exposures toward the country, reaching a cumulative reduction of $5.7 billion in the second half of 1998. After a calmer period following the announcement of the IMF-supported program, new pressures emerged in late December 1998, as the congress failed to pass key reform legislation and investors increasingly questioned the credibility of the exchange regime.

International banks with local operations were especially early and aggressive in cutting their interbank lines⁴ in the hope of avoiding both a forced rollover of their local operations’ holdings of domestic debt and interbank loans made to their subsidiaries. As the foreign exchange market became increasingly one-sided and a discrete devaluation became a near certainty, interbank rollover ratios fell as low as 20 percent.

Claims of Banks in BIS-Reporting Countries on Selected Emerging Market Countries

(In billions of U.S. dollars)¹

Sources: BIS; and IMF staff calculations.

¹On-balance-sheet claims, excluding claims on offshore centers.

²Data are for Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain. Data are not reported for Greece and Portugal.

Claims of Banks in BIS-Reporting Countries on Selected Emerging Market Countries

(In billions of U.S. dollars)¹

	All BIS-Reporting Countries	Japan	United Kingdom	United States	Euro Area2	France	Germany
Korea
June 1997	103.4	23.7	6.1	10.0	30.3	10.1	10.8
December 1997	94.2	20.3	6.9	9.5	26.8	11.1	9.6
June 1998	72.4	18.9	5.6	7.4	22.5	7.9	8.4
Indonesia
June 1997	58.7	23.2	4.3	4.6	17.9	4.8	5.6
December 1997	58.4	22.0	4.5	4.9	18.8	4.8	6.2
June 1998	50.3	19.0	4.0	3.2	18.0	4.0	5.9
Brazil
June 1998	84.6	5.2	5.8	16.8	37.6	7.9	12.8
December 1998	73.3	4.2	6.5	12.7	36.7	6.1	11.3
June 1999	62.3	3.1	4.2	12.8	30.2	5.8	9.5

Sources: BIS; and IMF staff calculations.

¹On-balance-sheet claims, excluding claims on offshore centers.

²Data are for Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain. Data are not reported for Greece and Portugal.

View Table

Claims of Banks in BIS-Reporting Countries on Selected Emerging Market Countries

(In billions of U.S. dollars)¹

	All BIS-Reporting Countries	Japan	United Kingdom	United States	Euro Area2	France	Germany
Korea
June 1997	103.4	23.7	6.1	10.0	30.3	10.1	10.8
December 1997	94.2	20.3	6.9	9.5	26.8	11.1	9.6
June 1998	72.4	18.9	5.6	7.4	22.5	7.9	8.4
Indonesia
June 1997	58.7	23.2	4.3	4.6	17.9	4.8	5.6
December 1997	58.4	22.0	4.5	4.9	18.8	4.8	6.2
June 1998	50.3	19.0	4.0	3.2	18.0	4.0	5.9
Brazil
June 1998	84.6	5.2	5.8	16.8	37.6	7.9	12.8
December 1998	73.3	4.2	6.5	12.7	36.7	6.1	11.3
June 1999	62.3	3.1	4.2	12.8	30.2	5.8	9.5

Sources: BIS; and IMF staff calculations.

¹On-balance-sheet claims, excluding claims on offshore centers.

²Data are for Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain. Data are not reported for Greece and Portugal.

Following the devaluation on January 12, 1999, rollover ratios recovered to 60–70 percent, as a key macro uncertainty had been resolved. In the weeks leading up to the mid-March voluntary agreement (formalized on March 31 and launched together with the strengthened IMF arrangement) between the international banks and the government to maintain exposures at end-February levels for six months, rollover ratios stabilized at a high level. After agreement was reached, all maturing interbank debt was regularly rolled over. In April, strong indications that the Brazilian economy was on track for recovery in the absence of a systemic banking crisis in the aftermath of the devaluation, and as most local commercial banks posted record first quarter profits, some international banks started to increase their exposures above what was required under the agreement. The overall reduction in international banks’ exposure toward Brazil reached $10.6 billion during the first half of 1999,⁵ with the total exposure bottoming out at $50.8 billion for the banks domiciled in G-10 countries.

In Brazil, a debt-monitoring system was also put in place to track the rollover ratios of interbank lines and later corporate credit lines. The system played an important surveillance role for the official community throughout the crisis and its resolution.

1

Main sources for this box, if not otherwise mentioned, are IMF (1998b, 1999a, 1999b), plus various press releases, Bloomberg wires, and articles from International Financing Review, Euroweek, and Euromoney.

2

To improve the success of the rollover agreements, one country’s banks had to be assured that their forbearance by maintaining their credit lines was being matched by other countries’ banks as well. The monitoring system allowed for daily reports of renewal and maturities loan-by-loan and bank-by-bank (see IMF, 1999a).

3

Market estimates at the time suggested that 90 percent of Indonesia’s $65 billion external debt was owed by 1,000–1,500 companies, the remaining 10 percent reflected short-term interbank debt.

4

See IMF (1999b).

5

See BIS (1999b).

From an analytical perspective, the actual experience in these crises as well as the views of market participants suggest the general conclusion that a crisis resolution package needs to be comprehensive in the forms of debt and capital flight that it covers when there are several important channels of capital outflows. This would be the case for most countries with an open capital account. As the experiences with capital controls show, capital that wants to leave will do so unless very strict and comprehensive controls are put in place. Therefore, in cases where creditor equality concerns are important and a broadly based hem-orrhaging of capital occurs, the rollover of interbank lines will have to form an important part of any crisis resolution package together with other instruments to stabilize the crisis situation.

Were the Rollovers Voluntary?

Rollover experiences of interbank and trade credit lines to date suggest that the rollovers international banks engaged in were more or less voluntary depending on the circumstances. Market participants argue that in Korea the official community’s approach was perceived as heavy handed in recognition of the fact that a Korean default had the potential of posing a threat to the global financial system. Following Korea, market participants have drawn the lesson that only if a country’s crisis is of a nonsystemic nature, monetary authorities of the main creditor banks’ home countries will not step in as urgently to encourage a rollover of their international banks’ exposures. In this, these authorities face a trade-off between trying to help a country in crisis and ensuring the credit quality of their own banking systems. However, banks involved in the Korean rollover exercise did receive several sweeteners to encourage their agreement. All loans with an original maturity of less than one year, about $24 billion, were given an explicit sovereign guarantee and, hence, what initially was a claim of an international bank on a Korean bank became a claim on the sovereign. This sweetener that in the end, according to most of the banks involved, clinched the deal may not be available for other countries facing a Korean-style crisis for the following reasons:

• Offering a sovereign guarantee may for most countries not be seen as credible as their fiscal situation and outstanding debt may already be under the specter of default. In Korea, an OECD country, the explicit sovereign guarantee provided additional value in that it allowed the international creditor banks to free up capital set aside against the loans, as current Basle rules stipulate that no reserve capital be applied to a loan extended to an OECD sovereign. Market analysts argued at the time that this feature was especially attractive to Japanese banks, which were trying to raise their capital adequacy ratios. However, the drawback of extending a sovereign guarantee included the possible moral hazard implications for the Korean banking system and international banks, which mainly interpreted the guarantee as a form of government bailout of their claims.

• If most of a country’s external debt stems from corporate sector borrowing abroad, a sovereign guarantee may not be attractive for a sovereign-in-crisis to extend. Most creditor banks therefore did not expect a guarantee of their corporate Indonesian exposure. However, later in the crisis the obligations of Indonesian banks were guaranteed by the government, at the same time an overall “pause” in corporate debt service was in place as the payment system was freezing up. At that time, neither interbank lines nor overnight credit was available to most Indonesian banks. Before guarantees covering deposits in commercial bank and payments were extended, the central bank had to take an active role in the normal operations of the payments’ system to ensure that economic activity did not stop completely.

A country in crisis may see a mandated rollover of interbank claims as a last resort, as the coercive nature of such an instrument would cause reputational damage going forward. In Brazil, the outflows generated by the cutting of interbank lines were only a relatively small part of total outflows at the time. According to market participants, the defense of the currency by the sovereign aided by the official community resulted in most of the capital outflows. By the time the currency peg was abandoned, it was clear to all that the provisioning of fresh interbank lines and trade credits by international banks would play a crucial part in an export-led recovery. In the market’s assessment, it was therefore important for the authorities to ensure that throughout the crisis these banks were not discouraged from supporting the future recovery, by not coercing them to maintain their exposure at the time. In the context of the strengthened IMF program in March 1999, creditor banks participated in a truly voluntary rollover. However, by that time the creditor banks that had wished to exit had already cut their credit lines and rollover rates were basically all the way back to 100 percent as the Brazilian recovery looked increasingly likely to take hold.

Extent of Private Sector Involvement

For the three recent major rollover experiences, the record with regards to their success in securing private sector involvement and restoring external viability is seen by market participants as being mixed.

Rollovers in a Portfolio of Exposures

Even if international banks agreed to the rollover of their exposures, some reduced their exposure toward Brazil and did so by shorting Brazilian bonds, such as the C-bond, which at the time was the most liquid bond in the emerging market universe. These transactions highlight one feature of using rollovers as an instrument for PSI and not only for crisis resolution. In countries with a relatively open capital account, international banks that find themselves in a situation where they have to keep exposure higher than they optimally want can often see to it that their overall exposure is reduced. For example, the bank can either short the sovereign’s external debt or, if relevant, it can reduce its local lending operations if the exposure maintenance agreement only covers cross-border interbank exposure. Of course, the former would still maintain the overall foreign currency debt exposure of the private sector vis-à-vis the country.²⁰ However, hedging of the bank’s credit exposure increases pressure in the secondary markets where the hedging takes place, potentially exacerbating overall pressures against the country.

Implications of Rollovers

The recent rollover experiences raise two questions in addition to whether they contribute to PSI or not. First, will international banks as a rational response cut lines sooner in anticipation of a forced rollover and bring forward the expected crisis? Second, what will be the likely impact on the levels and maturities of interbank debt for the other emerging market countries?

Comprehensive Versus Limited Approach

When a sovereign is unable to fully service its external bonded debt, regardless whether this is due to a liquidity or solvency crisis, the authorities will have to decide whether to offer a comprehensive restructuring package or to limit the restructuring to the bonds themselves or some other form of foreign currency debt.²²

As most eurobonds and Brady bonds have cross-default clauses or cross-acceleration clauses in their covenants, it may be impossible for a sovereign debtor to pick and choose which bondholders are repaid and which ones are not. This has led to the argument that a sovereign debtor should be at least comprehensive within the whole external sovereign bond community as an asset class, since it would rarely be able to default on debt service on a short maturity eurobond while continuing to service a longer-term eurobond, or vice versa, without the bondholders taking actions.²³ Therefore, a cross-default clause ensures a certain amount of “pragmatic equality” between bondholders.

Experience from Ecuador also indicated that holders of Brady bonds would have little sympathy for the rumored preferential treatment of eurobonds and the dollar-denominated domestically issued debt. Market participants also argued at the time that the perceived decision by the Ecuadoran authorities to treat eurobonds as de facto senior reflected the wish to make eurobonds more attractive to Brady bondholders by offering a relatively more senior instrument to them in a future bond exchange. However, a creditor group at the time (the Ecuador Creditors Advisory Group Inc., ECAG) stated that “we would view a decision to make payments on the eurobonds at present as an unfair distribution of assets among creditors and, as such, strong evidence of bad faith” and the “Eurobonds do not enjoy any contractual provisions of seniority to any of the Brady bonds. Nor, conversely, do the Brady bonds’ governing documents provide for their subordination to the Eurobonds.” (See Dow Jones 1999.) A subsequent restructuring of short-term dollar-denominated domestic bonds was considered as relatively advantageous, provoking the dissatisfaction of external private creditors who still question the “fairness” of the domestic bond exchange. The restructuring of domestic debt is likely to remain an outstanding issue in any bond exchange involving Ecuador’s external bonds.

Ecuador’s experience suggests that any future debt restructuring proposal for a sovereign in debt-servicing difficulty is expected by markets to be comprehensive enough in scope to cover at least the total of the foreign currency—denominated debt of a sovereign. Preferential treatment of domestic debt is likely to be interpreted by external private creditors as if the authorities were acting in bad faith. External creditors may welcome the reverse action, but it may be politically impossible for the sovereign to offer domestic debt holders a worse deal than external creditors.

Markets, however, debate the issue of whether a restructuring of external bonded debt needs to be comprehensive across other foreign currency—denominated instruments as well. In discussing interbank rollovers above, the answer depended on what the underlying objective of the restructuring is. If the underlying repayment pressures stem from large upcoming amortizations of bonded debt, it may be possible to limit the restructuring offered to these specific bonds. However, the situation will be complicated by the fact that a restructuring of bonds typically needs to be comprehensive across the asset class, and it is likely that bondholders will call for the restructuring of other forms of long-term debt for equality of treatment reasons. Furthermore, Paris Club comparability of treatment rules may indeed insist on comparability of treatment of all forms of private sector sovereign debt, resulting in a comprehensive restructuring.

Factors Affecting the Restructuring Terms of Bonds

Haircut or Sweetener

In evaluating bond exchanges various investor groups will have different reaction functions. Mark-to-market investors, having borne the full brunt of the fall in the secondary market price of the to-be-exchanged bonds, tend generally to compare the NPV value of the exchange offered (at some discount rate) to the current market price of the to-be-exchanged bonds. In the simplest case, if the NPV of the exchange bond is higher, taking into account the likelihood of the exchange succeeding and the haircut in terms of a potential debt write-off, then the holder of the to-be-exchanged bond has an incentive to tender his bonds in the exchange. This is the way most fund managers would rationally respond. For commercial banks a similar response function is less likely, but a reasonable approximation. The response function of retail investors is much more uncertain as their tender decision may be based less on an NPV comparison than on whether or not they have to participate in a debt write-off.

As Table 5.2 shows, all the recent successful bond exchanges have involved some form of substantial sweetener, in Russia coupled with the upgrade in the obligor, to encourage bondholders to participate in the exchange. The sweetener has in many cases also reduced the incentive for at least mark-to-market bondholders to litigate as capturing the sweetener provided an immediate gain while the outcome from litigation and value recovered is much more uncertain and time-consuming.

Table 5.2.

Estimated Haircuts for Different Emerging Market Bond Restructurings

Source: IMF staff calculations. Notes: Positive haircuts implies a gain for the creditor, while a negative number is a true haircut. N.a. means not available.

¹Ask price, includes accrued interest in the price as most bonds were in default except for Pakistan where the accrued interest is estimated.

²If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is 0.7 percent.

³If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is about 5 percent.

Table 5.2.

Estimated Haircuts for Different Emerging Market Bond Restructurings

					Haircut
	Date of Listing	Opening Price	Price One Week Before Announcement1	Price One Week After Announcement2	Face value write-off	Relative to listing price	Relative to market value
					(In percent)
Pakistan
6 percent USD 2002 Eurobond	Feb. 97	100.0	58.3	60.4	0.0	-39.6	3.52
Ukraine
16 percent DEM 2001 Eurobond	Feb. 98	100.0	55.5	67.0	0.0	-33.0	20.73
Russia
Prins	Dec. 97	57.8	18.5	24.4	-37.5	-57.7	32.1
Ians	Dec. 97	67.2	21.1	25.0	-33.0	-62.7	18.8
Ecuador
Brady Par Bond	Feb. 95	27.4	n.a.	n.a.	n.a.	n.a.	n.a.
Brady Discount Bond	Feb. 95	47.0	n.a.	n.a.	n.a.	n.a.	n.a.
Brady PDI Bond	Feb. 95	27.0	n.a.	n.a.	n.a.	n.a.	n.a.
Nigeria
P-Notes	Jan. 88	n.a.	n.a	n.a.	n.a.	n.a.	n.a.
Brady Par Bond	Jan. 92	38.5	n.a	n.a.	n.a.	n.a.	n.a.

Source: IMF staff calculations. Notes: Positive haircuts implies a gain for the creditor, while a negative number is a true haircut. N.a. means not available.

¹Ask price, includes accrued interest in the price as most bonds were in default except for Pakistan where the accrued interest is estimated.

²If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is 0.7 percent.

³If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is about 5 percent.

View Table

Table 5.2.

Estimated Haircuts for Different Emerging Market Bond Restructurings

					Haircut
	Date of Listing	Opening Price	Price One Week Before Announcement1	Price One Week After Announcement2	Face value write-off	Relative to listing price	Relative to market value
					(In percent)
Pakistan
6 percent USD 2002 Eurobond	Feb. 97	100.0	58.3	60.4	0.0	-39.6	3.52
Ukraine
16 percent DEM 2001 Eurobond	Feb. 98	100.0	55.5	67.0	0.0	-33.0	20.73
Russia
Prins	Dec. 97	57.8	18.5	24.4	-37.5	-57.7	32.1
Ians	Dec. 97	67.2	21.1	25.0	-33.0	-62.7	18.8
Ecuador
Brady Par Bond	Feb. 95	27.4	n.a.	n.a.	n.a.	n.a.	n.a.
Brady Discount Bond	Feb. 95	47.0	n.a.	n.a.	n.a.	n.a.	n.a.
Brady PDI Bond	Feb. 95	27.0	n.a.	n.a.	n.a.	n.a.	n.a.
Nigeria
P-Notes	Jan. 88	n.a.	n.a	n.a.	n.a.	n.a.	n.a.
Brady Par Bond	Jan. 92	38.5	n.a	n.a.	n.a.	n.a.	n.a.

Source: IMF staff calculations. Notes: Positive haircuts implies a gain for the creditor, while a negative number is a true haircut. N.a. means not available.

¹Ask price, includes accrued interest in the price as most bonds were in default except for Pakistan where the accrued interest is estimated.

²If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is 0.7 percent.

³If the change in unaccrued bond prices is studied, that is, the up-front cash sweetener is ignored, the positive haircut is about 5 percent.

Paris Club Comparability of Treatment and Private Sector Involvement

Historically, international commercial banks have had extensive experience with the Paris Club and the application of the “comparability of treatment” principle to their private sector claims. However, it was not crucial for holders of international bonds to stay as closely informed of Paris Club actions, and, indeed, secondary market prices of bonds usually reacted positively after the announcements of Paris Club and London Club deals. The Paris Club agreement to restructure Pakistan’s external debt in January 1999 is considered by market participants as a watershed in the evolution of the international financial architecture as Pakistan constitutes the first case in which a sovereign was expected to ensure comparable treatment from its bondholders as well.²⁵ The decision damaged the implicit halo around sovereign bonds, and the “sacrosanct” nature of bonds was further undermined by Ecuador’s default in September 1999, initially on its Brady bonds, but subsequently on its eurobonds as well. As bonds constitute the majority of new financing raised by sovereigns with access to the international capital market, market participants have had to reevaluate the likelihood of a country defaulting on its external bonded debt and their likely recovery value. Rather quickly, market participants and sovereign rating agencies have judged countries with a large share of Paris Club debt relative to total external debt to be more likely to be subject to PSI pressures from the official community (see Standard & Poor’s, 1999a). As such, market participants now consider it important to look at the sovereign’s debt-service track record with the Paris Club, as the terms the Paris Club was seen offering depended on this track record. The latter consideration had previously been mostly ignored among investors buying eurobonds. For example, Ecuador managed to issue $500 million in eurobonds in 1996, while it was already running arrears on its Paris Club debt. Furthermore, Nigeria, following Ecuador’s default, is seen by markets as next in line for the official community’s PSI initiative considering its estimated $22 billion in accumulated arrears to the Paris Club. The workings of the Paris Club, an institution that had not previously figured prominently in bond investors’ portfolio allocation decisions, has now become a key consideration.

Paris Club creditors have always been seen as assigning importance to the principle that all creditors bear a fair burden of the financial support for a debtor country facing difficulties, and that debt-service savings granted by the Paris Club not be diverted to the benefit of other creditors (see Box 5.5). To this end, Paris Club agreements contain a clause under which the debtor agrees to seek terms that are at least comparable to those obtained in the Paris Club rescheduling from other creditors, excluding multilateral institutions.

Typically, Paris Club creditors have not been viewed by market participants as concerned with the precise form debt restructuring takes, but rather the effective relief it provides.

Experiences with London Club²⁶ restructurings, which mostly have involved bank loans, provide some indication of how market participants view the way the Paris Club assesses comparability of treatment. With regards to London Club restructurings, a case-by-case approach has been followed where there has been no use of the consolidation period for private sector loans (see Standard & Poors, 1999a). However, with regards to bond exchanges the Paris Club has not specified in detail how it assesses comparable treatment. The Pakistani exchange was therefore viewed by market participants as a first opportunity to gauge what determined whether an exchange was adequately comparable for the Paris Club. For example, it was observed that there seemed to be some flexibility in the Paris Club’s application of the treatment, as the maturity extension for the Paris Club was longer than that provided by the private sector through the new exchange bonds. This flexibility was appreciated by most market observers, but uncertainty remains. Generally, some market participants have noted the following four factors as being of relevance to the Paris Club when it determines whether a bond exchange is comparable or not.

• Maturity extension and the use of grace periods. If the interest rate that the Paris Club charges on its loans is the same as that charged by the private sector, a restructuring deal by the private sector could be seen as roughly “similar” if the private sector also gives the same maturity extension and grace period. However, interest rates are not the same, since the private sector charges a higher market rate and the Paris Club creditors usually have a lower interest rate on their loans.

• Relative changes in NPV of the claims restructured. A second consideration to assess comparability of treatment could be to look at the relative changes in NPV before and after the restructuring for the Paris Club and the private sector. This may be difficult to assess²⁷ as official creditors generally lend at submarket interest rates. The restructuring efforts that are undertaken by the two creditor types can, however, be compared if a common new market discount rate is used.

• Duration. Another way in which a Paris Club deal can be compared with a deal reached with bondholders is to look at the absolute or relative change in duration for a similar maturity extension. Duration provides a measure of average time to maturity of the credit weighted by its cash flow and, as such, it is another measure of the restructuring/ rescheduling effort made by creditors. Duration calculations depend critically on the maturity date and amortization profile of the obligation. Since Paris Club claims generally have much longer average maturities than private claims, it is relatively easier for private creditors to achieve a larger percentage change in duration.

• Cross-default clauses. Another reason why comparable treatment is seen by market participants as requiring fairly flexible interpretation is that cross-default clauses on bonded debt will lead to a much larger share of the bondholders’ claims being affected by a comparability extension than the eligible official debt, which falls due during the consolidation period.

Still, concerns have been expressed about the lack of a clear definition, or transparent rules of the game, on how the Paris Club assesses comparability of treatment in cases such as Pakistan, and potentially in the future. Market participants argue that this lack of clarity introduces additional uncertainty to the international investor’s lending decision, further elevating the cost of financing for borrowing countries. However, many in the official community have argued that higher borrowing costs for sovereigns, limiting the access of some sovereigns to the capital market, may not be inappropriate. The increase in cost would simply reflect the removal of an implicit subsidy given to bondholders (and thereby debtors) when they were not subject to comparability. However, it is recognized by the official sector that at some point that additional cost, and any additional uncertainty or lack of transparency, could be excessive and create distortions in debt flows in its own right.

While market participants claim to have always incorporated the impact of a probable Paris Club restructuring on a country’s debt service profile well in advance of the actual Paris Club decision, the market has now to adapt and evaluate the impact and probability of the extension of comparability of treatment to international bonds. Recent price actions in the secondary market for Nigerian Brady bonds (see Box 5.6), and even for Russian MinFins, indicate that the market is adjusting. It has been pointed out by several recent market reports that a Paris Club deal or sometimes an increased probability of an IMF-supported program can in some instances lead to a negative secondary market reaction as the bond’s price adjusts due to the increased likelihood of being restructured. The reduction in price, therefore, reflects instrument-specific restructuring concerns rather than an evaluation of the attractiveness of the reform program as such.