Nowadays, as IMF Managing Director Horst Köhler noted in opening the conference, the line between interesting research and important day-to-day operational work is blurring, as it should be. As former U.S. President John F. Kennedy once said, “Too often we enjoy the comfort of opinion without the discomfort of thought.” Köhler suggested that the IMF needs the “discomfort of thought” to arrive at fresh and balanced views that are useful for policy discussion.
In that spirit, a number of papers focused on the IMF’s stepped-up efforts to figure out an orderly way for countries in financial distress to restructure their debts. Two approaches are being studied simultaneously: a statutory approach—a possible new international legal regime in which debt restructuring is mandated—and a purely market-based approach in which debt contracts are encouraged to include renegotiation-friendly clauses.
Insights from corporate bankruptcies
A presentation by Princeton University Professor Patrick Bolton looked at what sovereign debt restructuring efforts could learn from corporate bankruptcy practices. After comparing bankruptcy regimes across a number of countries, he concluded that the U.S. regime is perhaps the most relevant for the international system. Interestingly, despite its acceptance today, the U.S. regime was very controversial in the nineteenth century. At least seven attempts were made to introduce some sort of bankruptcy code between 1789 and 1898, each attempt prompted by a major economic crisis. Laws were passed in 1800, 1841, and 1898, but the first three were repealed within a few years of their enactment. Perhaps there is a lesson here for the quest for an international bankruptcy procedure, Bolton suggested. With patience, a system with merit may eventually earn acceptance, even respect.
Bolton also presented some arguments in favor of a statutory approach. A market-based approach, he said, might lead to debt that is excessively difficult to restructure for several reasons, some of which have been developed in the corporate finance literature. For example, creditors may insist on high restructuring costs mainly as a way of guaranteeing that their loans take priority over those of other lenders. Another problem is that the administrations that build up debt are typically no longer around when the time comes to repay, and thus, they may not fully internalize the future costs of financial distress.
But there is a limit to the similarities between corporate and sovereign debt restructuring, Bolton cautioned. In particular, creditors’ ability to collect collateral is more limited in the international context. Thus, debtors have a natural edge in international negotiation. To encourage acceptance by creditors, Bolton noted, U.S. history offers examples of “exemptions” or state provisions for opting out. These helped reduce resistance to a federal system. Bolton also believes that “jurisdiction shopping,” whereby debtors choose a court in which to file for bankruptcy, is a useful feature of the U.S. system that may be worth replicating in the international setting.
In discussing Bolton’s paper, Harvard University Professor Jeffrey Frankel concurred that the U.S. bankruptcy regime is a relevant benchmark for the international context. “The United States often tries to persuade multilateral forums to extend the approach that it follows at the domestic level to the international level, out of a conviction that its way represents either free market virtue, or lazy ignorance of competing standards, or a conscious desire to give its firms a leg up,” Frankel noted. But this time, he said, using the U.S. bankruptcy code as a model for an international statutory approach for sovereign debt restructuring has real merit. Ironically, Frankel pointed out, the U.S. government was slow to come around to this idea, and the U.S. investment community remains opposed, at least for the moment.
Columbia University Professor Jeffrey Sachs, an early proponent of an international bankruptcy court, suggested that Chapter 11 of the U.S. bankruptcy code is not the only chapter relevant to this discussion. In his view, Chapter 9 and maybe Chapters 7 and 13 are also relevant. These offer a “fresh start” to debtors, particularly municipal governments, so that they don’t have to be forever burdened with a large debt. The current international system, Sachs argued, does not offer enough of a fresh start to sovereign governments that have accumulated a mountain of debt. This debt, he added, undermines the well-being of people, particularly the poor. He suggested that a new international system should give more explicit recognition to the concept of a fresh start.
Weighing collective action clauses
Adding collective action clauses to bond contracts has been billed as an important component of a market-based approach to the sovereign debt restructuring problem. A collective action clause stipulates that a qualifying majority of creditors can decide on the terms for restructuring payment with the debtor and makes this decision legally binding on the rest of the bondholders. The objective, which is similar to the statutory approach that Bolton discussed, is to minimize the risk that a minority of creditors could unnecessarily prolong the negotiation process to the detriment of the collective interests of the creditors, as well as of the interests of the debtors.
Because collective action clauses do not necessarily grant an automatic stay on debt repayment and do not necessarily allow new borrowing by the debtor to have seniority over existing debt, such clauses are much less ambitious than the statutory approach to sovereign debt restructuring. Nonetheless, some researchers and debtor countries have expressed concern that both collective action clauses and the statutory approach might increase the cost of borrowing. Their reasoning is that anything that could make it easier for debtors to renegotiate their debts could potentially make creditors more reluctant to lend. But an argument could also be made that a collective action clause (or a statutory framework) that helps creditors and debtors reach an efficient outcome faster might enhance investors’ willingness to lend.
Of course, the argument could be sustained forever in the abstract or it could be grounded in data, as IMF economist Torbjorn Becker sought to do in his paper. He compared the yields of bonds with a collective action clause—issued under London law—with the yields on bonds without such a clause. (Interestingly, the research paper on which Becker based his presentation could be considered a collective action: two of the coauthors hail from the other side of the globe—Australian central bank economist Anthony Richards and Thai central bank economist Yunyong Thaicharoen.)
After dissecting the data in a number of ways, the authors found no evidence that the use of a collective action clause has increased debtors’ borrowing costs. In theory, debtors with a relatively high risk of default might be the most likely group to face higher borrowing costs because creditors would be most concerned about this group of debtors. Indeed, this finding is reported in earlier research. Becker, Richards, and Thaicharoen, however, did not find support for this notion in the data. They found, paradoxically, that borrowing costs for high-risk debtors actually declined with the inclusion of a collective action cause.
Michael Mussa, former Economic Counsellor and Director of the IMF’s Research Department and now a Senior Fellow at the Institute for International Economics, agreed that the collective action clause has not raised the borrowing cost. And this is quite consistent with what he knows about market participants. Investors simply do not consider collective action clauses an important feature in pricing bonds and often confess to blissful ignorance of the subject. Mussa reminded his audience of Rudiger Dornbusch’s quip that all empirical work should pass the “pigs do not fly” test. Any empirical finding that collective action clauses have a significant impact on bond prices is, he said, a pig that flies.
Why “sudden stops” in flows?
Another hot topic was the volatility of capital flows. Around the time of the Latin America debt crisis in the 1980s, the Turkish crisis of 1993-94, and the Asian crisis of 1997-98, for example, capital flows to the affected countries dried up or reversed sharply just before, or during the early phase of, the crisis. Guillermo Calvo, Chief Economist at the Inter-American Development Bank and professor at the University of Maryland, dubbed this phenomenon “sudden stops.” In the conference’s annual Mundell-Fleming lecture, he pondered the causes of sudden stops and how developing country governments could mitigate their negative impact. Calvo offered a new theory. Like wind and rain in a storm, a sudden stop of capital flows, a halt in growth, and a balance of payments crisis often occur simultaneously. He argued that fiscal policy holds the key to why these three phenomena can occur together, particularly in emerging market economies. Because government expenditure must be financed partly by output taxes that tend, in turn, to discourage production, multiple outcomes are possible. In the favorable scenario, output is high and there is less need to collect taxes, which helps maintain high output growth. In the unfavorable scenario, a low rate of output growth leads to a high rate of tax that must yield a given amount of revenue. But the high tax rate discourages economic growth and could lead to a growth crisis. At the onset of the crisis, capital inflows stop suddenly.
Calvo’s theory is simple and elegant and gives rise to many interesting insights. According to his model, currency crises, as a direct consequence of sudden stops, may be a sideshow of the dysfunctional domestic policies and financial vulnerabilities that can trigger and amplify these crises. Thus, rather than deal with currency crises on the surface, governmental authorities, the IMF, and other international institutions should concentrate on improving fiscal policies and financial institutions. Policymakers should also be prepared with appropriate emergency drills. There is a message the IMF and other international institutions can take from Calvo: they should try to coordinate a high-growth, low-tax scenario for developing economies facing the threat of a sudden stop in capital flows. The coordinating efforts should include possible burden sharing by the lending community (under the label of a “private sector bail-in”).
Sudden stops in international capital flows can cause dramatic ups and downs in developing countries’ income and consumption. But capital flows, by allowing these countries to borrow in bad times and repay in good times, can also help stabilize consumption. In the final analysis, then, does international financial integration reduce or raise consumption volatility? Three IMF economists—Ayhan Kose, Eswar Prasad, and Marco Terrone—centered their presentation on this question.
Photo credits: Denio Zara, Padraic Hughes, Pedro Màrquez, and Michael Spilotro for the IMF; Rodrigo Arangua for AFP, page 377; Yuri Cortez for AFP, page 378; and U. S. National Archives, pages 382-84.
They found that output volatility declined in the 1990s relative to the three previous decades but that consumption volatility relative to income volatility actually increased, on average, in the most financially integrated developing countries.
When they looked at what financial integration brought to developing countries, they found a “threshold effect.” Up to a certain point, more financial integration appears to be associated with more consumption volatility. But beyond this threshold, consumption volatility starts to decline as integration increases. This effect suggests an interesting way to view the consequence of financial globalization. In his discussion of the paper, MIT economist Roberto Rigobon termed the results interesting but maintained that more research would be needed to check their robustness before firm policy conclusions could be drawn.
Another research paper, by IMF economists Paul Cashin, Luis Céspedes, and Ratna Sahay, investigated the real exchange rate movements of countries that are highly dependent on a small number of commodities, such as cocoa, cotton, or copper. They found that changes in commodity prices for 22 out of 58 such countries largely explained the movements in the real exchange rate. Their study highlights the importance of stabilizing commodity prices for these economies.
No one at the conference said that volatility of capital flows or debt crises would disappear any time soon, but many papers suggested directions that developing countries and the IMF could take to better manage these phenomena. If the conference demonstrated the “discomfort of thought,” then the discomfort was lively as well as informative. And the search for a deeper understanding of capital flows and global governance goes on—to be continued at next year’s Annual Research Conference.
Also at the conference . . .
“IS-LM-BP in the Pampas,” Andrés Velasco (Harvard University), Luis Céspedes (IMF), and Roberto Chang (Rutgers University)
“Banking, External Flows, and Crises,” Raghu Rajan and Douglas Diamond (University of Chicago)
“Bubbles and Capital Flows,” Jaume Ventura (CREI-UPF and MIT)
“Securities Transaction Taxes and Financial Markets,” Karl Habermeier and Andrei Kirilenko (IMF)
“Global Financial Integration,” Philip Lane (Trinity College, Dublin) and Gian Maria Milesi-Ferretti (IMF)
All of the conference papers are available on the IMF’s website (www.imf.org/external/pubs/ft/staffp/2002/0000/arc.htm)