Reforming the International Monetary and Financial System

Comments: More Private Sector Involvement and Less Official Financing

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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J. de Beaufort Wijnholds

Barry Eichengreen is well placed to introduce this session, having not only extensively studied the international monetary and financial scene as an academic, but also having recently spent a fruitful year at the IMF’s Research Department. His 1999 monograph on the international financial architecture (Eichengreen, 1999) reminded me of Fritz Machlup’s lucid survey of reform plans in the 1960s (Machlup, 1964), which helped me a great deal when I was a student grappling to understand the intricacies of the system. I will have something to say later on about Eichengreen’s proposals, many of which I agree with, but some of which I find less convincing.

The case for greater involvement of the private sector is essentially a case for lesser involvement of the official sector. The question concerning private sector involvement can in fact be turned around to ask why there should be any official involvement in resolving international financial crises. A laissezfaire economist could well question the need for any financing by the IMF at all, arguing that debtors and creditors will, on their own, come to a solution of some kind. This is, of course, a truism, and only those of us who believe uncritically in the absolute “magic of the market” will consider such an outcome desirable under all or most circumstances. There have been too many instances of market failure that have convinced the majority of economists and policymakers that we cannot leave it entirely to the market to resolve matters when financial crises strike. The risks of destructive outcomes and serious collateral damage are simply too great. An important part of the IMF’s raison d’etre rests on the recognition of this fact. Financing by the IMF helps countries to gain time to adjust their economic policies in a way that avoids a resort not only to welfare-destroying measures such as trade and payments restrictions or an excessively abrupt reduction of domestic demand, but also to an overshooting of exchange rates. Of course adjustment is required of the borrowing country so that it will return to a viable external position and service its debt on time.

The search for an optimal balance between financing and adjustment is generally where the real difference of informed opinion occurs. A recent variant of this debate is the concept of contagion. On one side, some emerging market countries may think that problems caused by poor policies in other countries cause capital outflows from their countries because market participants do not always differentiate sufficiently between borrowing countries. They believe that to the extent they are affected by such contagion, official external financing should be readily available to them, preferably with little or no conditionality, to offset the private sector outflows they are experiencing. On the other side, some believe that pure contagion is a very rare phenomenon and that markets do not pull back from countries in an entirely arbitrary fashion when the general outlook darkens. Within this line of thinking, countries may well conduct sound monetary and fiscal policies, but perhaps try to sustain an overvalued exchange rate, or are slow in tackling serious problems in their banking sector. No doubt markets can exaggerate such concerns during times of nervousness, but I tend to believe that cases of pure contagion are hard to find.

Recent Experience

Recent official financing packages (to which the IMF has contributed quite substantially) have been large, in view of the perceived systemic impact of the crisis they were meant to address. This has raised concerns about moral hazard, but also about the equity of providing official funds—often equated with taxpayer money, but this is largely inaccurate—some of which have been used to pay off private sector creditors. Such bailouts are often viewed as unnecessary support to bankers who are at least partially to blame for the financial problems. Indeed, if one takes the view that for every foolish borrower there is a foolish lender, the notion that the private sector should bear part of the burden of resolving international financial crises has significant appeal and logic to it. Attempts by the private sector to explain that they have suffered heavy losses in the Asian crisis are not all that convincing (Institute of International Finance, 1999), especially as concerns the international banks and bondholders. Hence, the insistence on private sector involvement and burden sharing, which has become stronger as more crises followed the Asian troubles.

Involvement of the private sector in crisis resolution is not new. During the Latin American debt crisis of the 1980s, the IMF coordinated creditors (bankers were herded into a room and pressed to do their share) and orchestrated the financing package. The IMF required a “critical mass” of private sector support before it was willing to disburse its own money. Bankers were generally willing to do so and to put up new money as the alternative—writing down their loans—seemed an even bleaker prospect. While this worked well in the initial stage of that crisis, a degree of erosion set in and the banks gained more control over the situation. At that point, the IMF changed its policies to allow for lending into arrears in certain cases. As the world returned to calmer waters these matters receded into the background.

The debate on the role of the private sector was reopened at the time of the 1994–95 Mexican crisis. The lack of private sector involvement and the full and timely repayment of holders of tesobonos generated strong criticism. Several suggestions were advanced to combat the moral hazard and to arrive at more acceptable solutions. For a while proposals to establish an international bankruptcy court or procedure were quite popular. Eichengreen is right, however, that most of these schemes are not realistic proposals. Better procedures for an orderly workout of international debt problems do remain necessary, however. Another proposal concerned the desirability of changing the clauses in bond contracts (Group of Ten, 1996), so as to involve bondholders and not only banks in debt workouts. While this proposal gathered considerable support, there was no real follow-up. I will come back to this question later.

The large rescue package for Korea in late 1997 was a reaction to a liquidity crisis that threatened to get out of hand because the private sector was initially left out of the resolution. When during the fall of that year some of us had the temerity to raise the idea of applying moral suasion to the banks, the answer from key players was “that is not the way we do business anymore.” Fortunately, as the crisis threatened to have severely damaging consequences, such as a moratorium by Korea, there was a change of heart and the acute phase of the crisis was over quickly. Foreign banks came to an agreement with their Korean debtors to roll over and, subsequently, reschedule loans. Unlike equity holders and some other investors, the banks did not suffer losses from this operation. In fact they could charge higher interest rates on the newly rescheduled loans, albeit on longer maturities. On the IMF’s Executive Board the European Directors were particularly uncomfortable with this experience where large amounts of IMF money had been disbursed before the private sector was finally nudged to do its part. The Directors insisted on language in the IMF’s newly created Supplemental Reserve Facility to ensure adequate private sector involvement.

In the case of Russia, investors had gone their merry way and purchased high-yielding Treasury paper or Eurobonds in view of the bailout expectations based on earlier experience and the belief that this was a “too-big-to-fail” country. That investors were shocked when Russia announced a moratorium in August 1998 was somewhat disingenuous. Whereas the aftermath of the Russian crisis provided a quite rocky episode for world financial markets, there was one important outcome—it struck a blow against moral hazard. Other than that, Russia’s response to its financial predicament was, unfortunately, a textbook case of how not to deal with the private sector, i.e. unilaterally. Better results were obtained in some other, albeit much smaller cases—Ukraine is a good example—where real, though difficult, negotiations took place between the borrowing country and its private sector creditors.

During the latest major crisis, involving Brazil, private sector involvement was, again, a very sensitive issue. Brazil, highly dependent on private sector external financing—it borrowed an average $50 billion annually in international capital markets prior to the crisis—was reluctant to put any pressure on foreign banks, let alone bondholders, for fear of hurting relations with its creditors and, in the process, seeing its market access reduced. Banks were to be approached to voluntarily sustain rollovers of their credits. The rollover assumptions in the original program with the IMF proved to be overly optimistic. Mercifully, the widely anticipated devaluation of the Brazilian real came soon, allowing a renegotiation of the program with the IMF and, this time around, reaching a solid agreement with the banks on maintaining interbank and trade credit lines.

I have gone into this recent history in some depth because it illustrates that as developments unfolded a degree of progress was made in involving the private sector on a case-by-case basis. This case law approach may achieve a new milestone if Pakistan succeeds in reaching a satisfactory solution with regard to its Eurobond debt, which the Paris Club official creditors have, for the first time, singled out for “comparability of treatment.”

Crisis Prevention

Eichengreen has helped the debate along by ruling out those proposals that are inherently unsound or that are unrealistic from a practical perspective. Among these are the Tobin tax (for which calls unhelpfully resurface every time there is a crisis) and, in my view, the more recent universal debt-rollover option with penalty (UDROP) proposal (Buiter and Sibert, 1999). Buiter describes this interesting idea as a small contribution, which I think should remain small, because I doubt that it is feasible. The universal and mandatory character of the UDROP proposal makes it a nonstarter in my view. To have the IMF refuse loans to countries without rollover clauses, and to make foreign debt contracts without such clauses unenforceable at the national level, requires a level of consensus that is hard to imagine. The whole scheme is quite interventionist and goes against an approach in which debtors and creditors reach compromises with the encouragement of official institutions, but without coercion.

Crisis prevention is, of course, essential and a number of actions have been undertaken by the IMF to strengthen such prevention. These include greater transparency, the development of standards, and Contingent Credit Lines (CCL) (see IMF, 1999). The CCL was approved by the Executive Board in late April 1999, after considerable debate that led to a tightening of its eligibility criteria, but skeptics such as myself remain to be convinced of its preventive qualities. In view of the rather strict eligibility criteria, which have elicited criticism from prospective candidates, the risks of moral hazard effects on potential borrowers seem to be limited. One eligibility criterion in particular is directed at reducing moral hazard, namely the requirement that countries qualifying for a CCL must have arrangements such as private sector contingent credit lines in place or must demonstrate that they are making credible efforts to come to such arrangements. My preference is for a CCL to match private contingency lines in size and, at the same time, allow for pari passu drawdowns.

Eichengreen is a staunch supporter of a Chilean-style tax to discourage short-term capital inflows and thereby limit the scope of a possible crisis. While agreeing that such measures can be useful as a temporary expedient, we should not expect too much from them. So far only one country has followed the Chilean route, namely Croatia, but more may follow if and when capital flows to emerging markets grow rapidly again. Keeping in mind the Latin American experience (described in Edwards, 1999) and the earlier experience with this kind of tax in Europe in the early 1970s (the best known case is the German Bardepot), I would emphasize its limited effectiveness over time.

Perhaps the best preventive action is to avoid official financing to countries with overvalued exchange rates. It is encouraging to see that the U.S. Treasury Department recently seems to have changed its views and is no longer willing to “… provide exceptional large-scale official finance to countries intervening heavily to defend an exchange rate peg…” (Rubin, 1999). Finally, it is urgent to adjust the Basel rules concerning capital adequacy, where the weights have provided perverse incentives, such as lending to OECD governments regardless of their economic state of health. This unwarranted bias toward short-term interbank lending to any country with an OECD seal quickly became apparent when Mexico and Korea underwent a financial crisis soon after joining the OECD.

Crisis Resolution

Turning now to crisis resolution, matters become more complicated. Many plans have been formulated, but very few can actually meet the dual test of theoretical soundness and practical feasibility. I will briefly comment on a few proposals that meet both criteria and are otherwise worth implementing.

It is clearly becoming untenable to restrict private sector involvement to one class of creditors only, namely the banks. High officials have questioned the rationale of seniority for Eurobonds. With the increase in securitization the only argument against excluding bondholders from being involved in debt restructuring is that it is difficult to achieve. The difficulties with having holders of existing bond debt share the burden of rescheduling are obvious. Experiments are being conducted in a few cases where either the bondholders are relatively easily identifiable or where British-type bonds are involved. Eichengreen describes the cases of Ukraine and Pakistan in considerable detail. These are interesting text cases, but the real test will come (if it ever comes) when attempts are made to involve bonds in rescheduling for much larger borrowers, such as Latin American countries.

A more forward-looking approach is the inclusion of collective-action clauses in bond contracts. Industrial countries should show the way. Also active encouragement of such practices by the IMF with regard to emerging market countries is called for. This cannot, however, be done by offering lower interest rates to countries that include collective-action clauses in their new bond issues, as Eichengreen has suggested. The IMF’s Articles of Agreement do not allow for a differentiation of interest rates within its lending facilities based on differences in policies or, for instance, stages of development. It could, however, be taken into account when determining the size of the IMF’s support to such countries, or whether they should qualify for a CCL.

A greater use of private contingent credit lines is certainly desirable although a problem with additionality cannot be ruled out. To the extent that such lines will help deter crises, they constitute a preventive element; to the extent they are used, they constitute part of crisis resolution. The banks should consider this to be in their enlightened self-interest where countries following sound policies are concerned. The experience of Canada is worth looking at in this respect. Canada maintains relatively low international reserves while relying on private credit lines for additional foreign exchange in times of undue pressure on its exchange rate. Emerging market countries may, however, find it more difficult to secure such lines and could opt to build up large international reserves instead, which will tend to be more costly. Feldstein, for instance, has recently estimated that for Mexico to double its reserves, the additional annual cost could be nearly one-half of 1 percent of GDP (Feldstein, 1999). Note that a premium will be charged by the banks providing credit lines for contingencies. Comments to the effect that private sector involvement should not add to the cost of borrowing by emerging market economies are not realistic and at odds with such premia, which simply constitute sound banking practice. What should be avoided is an excessive increase in such costs.

It is also desirable for the Fund to play a more active role in involving the private sector and to act as what Eichengreen calls a facilitator or coordinator of debt-restructuring negotiations. There is a range of possibilities between having the IMF herd banks into a room and telling them not to reduce their exposure (the De Larosière approach described by Dornbusch earlier) or having the IMF simply monitor the rollover agreement between the banks and the debtor country, as in the case of Korea. The IMF already went a small step further in the case of Brazil by assisting with the authorities’ roadshow. In situations where voluntary agreements are hard to reach because of unwillingness on the creditor side, the IMF could either exert pressure via the national supervisors of the banks involved or directly with the creditors. It can also lend into arrears in cases where more time is needed to come to a solution and where the debtor is making good faith efforts to reach agreement with its creditors.

In extreme situations, a temporary standstill should be possible. It is not desirable to spell this out in any detail since, as in the case of lender-of-last-resort activities, constructive ambiguity is the best practice here too.

This brings me to my final point. In general, a case-by-case approach to the resolution of financial crises needs to be followed, with the private sector involved, not in a standard way, but according to the circumstances. I would love to see more rules, but have not yet seen any convincing examples of this. And rather than aiming as in the past for huge official financing packages, the Fund should play an active role in involving the private sector—if need be, with the support of the national authorities whose banks are hurting from large exposures to the country in question. It is also worth emphasizing that while I believe the IMF cannot be an international lender of last resort (de Beaufort Wijnholds, 1999), I am at least equally convinced that the World Bank should cease providing balance of payments support as part of official financing packages. The World Bank has increasingly strayed from its original mandate, encroaching on the core business of the IMF and engaging in other forms of sibling rivalry. (I am also critical of the IMF’s involvement in areas where the World Bank clearly has a comparative advantage.) It may be time for the World Bank’s shareholders to consider privatizing a sizable part of its activities, as, for instance, Sachs suggests (see Sachs, 1998). This would also constitute an important form of involvement of the private sector.


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