Chapter 4: The Global Financial Crisis and the Euro-Area Crisis
The Global Financial Crisis (2007-2012)
Taking stock in the aftermath (2013-18)
Sean Hagan and Martin Mühleisen
Over the last four decades, the Fund has played a central role in preventing and resolving sovereign debt crises. The legal basis for the Fund’s work in this area stems from the Articles of Agreement, which give the Fund the mandate to promote the stability of the international monetary and financial system and to provide financing to member countries to assist them in resolving their balance of payments problems and to restoring medium term external viability. While the globalization of financial markets has delivered important benefits, it has also given rise to periodic crises arising from excessive indebtedness, with resultant hardship for individual countries and risks to the overall system.
The papers in this volume provide critical insight into the Fund’s response to this challenge over the past 40 years, identifying four different historical phases: the 1980’s Debt Crisis (Chapter 1); the Mexican Crisis and the design of policies to ensure adequate private sector involvement (often referred to as “creditor bail-in”) (Chapter 2); the Argentine Crisis and the search for a durable crisis resolution framework (Chapter 3); and finally, the Global Financial Crisis and the Eurozone crisis, and their aftermath (Chapter 4).
As is evident from the papers in this volume, the specific characteristics of the crises varied. For example, in some cases, the crisis was mainly due to the excessive debt on the balance sheet of government. In other cases, the underlying problem was the balance sheet of the banks, whose liabilities migrated to the sovereign’s balance sheet. In the 1980s, much of the debt owed to commercial banks originated in the private sector and fell into arrears due to the imposition of exchange controls, and was only subsequently assumed by the sovereign. These differences had an important impact not only on the country-specific programs but also on the design of the Fund’s overall crisis prevention and resolution framework.
Furthermore, the evolution in the Fund’s approach to preventing and resolving debt crises reflected significant changes in the international credit markets. While the 1980s debt crisis centered on the inability of members to service syndicated loans extended by commercial banks, subsequent crises involved problems arising from the newly predominant form of sovereign finance: bonded debt. Not only did the legal terms of these instruments pose new challenges, but the incentives of bondholders vis-à-vis the sovereign and amongst themselves—proved to be considerably different from those of commercial banks. The composition of official financing has also evolved, with a growing diversity of official bilateral creditors, placing increasing strain on the existing creditor coordination framework (namely, the Paris Club).
Finally, while the systemic spill-over effects of a crisis in a particular country have always been a concern, the nature of these spillovers have also varied considerably. For example, while the 1980’s debt crisis was shaped—at least at the outset—by concerns regarding the insolvency of the U.S. banking system, Fund-supported programs post-2010 had to address the systemic consequences of the incomplete financial architecture of the euro-area integration. Indeed, as the financial markets have become increasingly interconnected with the liberalization of the capital accounts of emerging economies, and as economic and financial integration of particular regions has deepened, concerns regarding the systemic implications of a crisis in a single member country have become only more acute.
Given this dynamic of constant evolution, one of the challenges for the Fund has been to learn the lessons from earlier crises, while leaving sufficient flexibility in its policies to respond to the unknown characteristics of a subsequent one – a key goal has been to avoid being the general who was “fighting the last war”.
Despite the diversity of crisis and the rapid evolution of the international financial system, the Fund has sought to adhere to a number of underlying principles. As such, while the discussions during each of the periods of this volume have their own particularities, there are common recurring themes:
First, the Fund has – to the extent possible - always sought to take into account the concerns of all relevant stakeholders. In that regard, a particularly complex issue has been the Fund’s approach to addressing private creditors. Although the Fund’s primary obligation is to assist its members in resolving their balance of payments problems, it has always recognized that addressing the interests of private creditors—to the extent possible—is necessary to achieve that objective. In some cases, creditor co-operation was essential to secure adequate financing of the Fund-supported program, as was the case during the 1980s debt crisis. In other cases, addressing creditor concerns was necessary to enable the member to regain market access in the medium term; i.e. after the expiration of the Fund supported program, but also during the period when the member would be servicing its obligations to the Fund.
However, there have been important limits to the degree to which creditor interests could be accommodated under the Fund-supported program. For example, with the introduction of the lending into arrears policy for private creditors in 1989, the Fund recognized that there may be circumstances where reducing the leverage of private creditors is a necessary means of ensuring timely Fund support for members’ adjustment programs. Moreover, over time a more general concern arose as to whether the Fund’s crisis resolution role was generating moral hazard. This concern came to the fore in the 1990s, with the discussions of private sector involvement, in the early 2000s with the Prague Framework, and resurfaced again in the post-Euro area crisis era, where it was recognized that “bailing out” private creditors in the case of Greece led to more pronounced sovereign debt difficulties later in the crisis.
Second, although the Fund has always played a central role in the restructuring of sovereign debt, it has strived to avoid micromanaging the process. It has not been easy to strike the right balance. Over time, its access policies have explicitly recognized that the Fund’s decisions on the availability of financing would often trigger the initiation of the restructuring process, given that, if a member’s debt is assessed as unsustainable in the medium term, the Fund is precluded from lending, unless steps are taken to restore sustainability. Moreover, the design of the program will normally determine the necessary balance between financing and adjustment, thereby determining the overall financing envelope that informs the overall amount of debt relief that is needed. At the same time, the Fund has tried to avoid becoming involved in the negotiating process, leaving it to creditors and debtors to determine the detailed terms of the restructuring instruments. While inter-creditor equity considerations are often critical, the Fund has also avoided taking a position on how the debtor should allocate the necessary adjustment amongst its creditors, although it has recognized that a member’s failure to address inter-creditor problems can undermine creditors’ participation in the restructuring.
Third, in the design of its policies, the Fund has sought to find the difficult balance between rules and discretion. In that context, it has relied on criteria that allow for case-by-case determination while, at the same time, constraining the exercise of discretion in a manner that ensures consistency and even-handedness. For example, over time, the assessment of the member’s capacity to repay its debt has played an increasingly explicit role in the application of the Fund’s access polices. On the one hand, this generally precludes the Fund from providing financing where debt is unsustainable, unless steps are taken to restore debt sustainability. On the other hand, a determination of debt sustainability continues to require the exercise of judgement, notwithstanding efforts by staff to establish an increasingly robust methodology. Similarly, the Fund’s lending into arrears policy to private creditors requires a determination that the debtor is making “good faith efforts”, and the Fund has provided only broad operational guidance as to how this rather subjective concept should be applied. While more detailed guidance has the benefit of giving the market clear expectations as to what the Fund will do in a particular case, the Fund has been reluctant to go as far as to provide for full automaticity out of a concern that discretion - even if constrained - is necessary to address the idiosyncrasies of individual cases.
Finally, the Fund has been forced to recognize in its approach a global order where countries are unwilling to cede sovereignty to international bodies. For example, following the Argentine crisis, the Fund proposed a statutory framework in the form of an amendment to the Articles of Agreement to establish the sovereign debt restructuring mechanism (SDRM), to address global coordination failures with respect to restructuring sovereign debt. However, it ultimately relied on the market-based contractual approach of collective action clauses, due to the unwillingness of members to cede sovereignty through the establishment of treaty obligations.
By providing insight into the considerations that underpin the Fund’s policy development in this complex area, we hope that these papers enable outside observers to gain a better understanding of the Fund’s overall mission. We also hope that they will provoke discussion. Transparency is not only an important means of ensuring legitimacy; it also provides an important mechanism for the Fund to receive feedback with respect to the soundness of its approach – and the ways in which Fund policies can be improved.