Abstract

Important lessons have been learned from recent experience in applying the Prague Framework—a strategy aimed at fostering the constructive engagement of the private sector creditors in crisis resolution. First, tools that complement the traditional catalytic approach are limited in their effectiveness in a crisis. In particular, market-based tools can be costly, moral suasion poses a dilemma for bank regulators, while more concerted solutions involving regulatory actions remain largely untested. Second, debt restructuring in a crisis can be difficult, and requires careful planning by the debtor to minimize collective action problems and disruption to the proper functioning of the economy. The debtor should seek a restructuring as soon as it is recognized to be unavoidable, initiate an early dialogue with its creditors, and take measures to protect the banking system from the worst effects of the restructuring. Third, maintaining a country’s access to trade credits should remain a top priority. In light of the experience gained, the official community is initiating efforts to further refine the Prague Framework. Efforts have focused mostly on finding more effective means to deal with unsustainable sovereign debts, since these cases are more challenging and costly to the economy.

Important lessons have been learned from recent experience in applying the Prague Framework—a strategy aimed at fostering the constructive engagement of the private sector creditors in crisis resolution. First, tools that complement the traditional catalytic approach are limited in their effectiveness in a crisis. In particular, market-based tools can be costly, moral suasion poses a dilemma for bank regulators, while more concerted solutions involving regulatory actions remain largely untested. Second, debt restructuring in a crisis can be difficult, and requires careful planning by the debtor to minimize collective action problems and disruption to the proper functioning of the economy. The debtor should seek a restructuring as soon as it is recognized to be unavoidable, initiate an early dialogue with its creditors, and take measures to protect the banking system from the worst effects of the restructuring. Third, maintaining a country’s access to trade credits should remain a top priority. In light of the experience gained, the official community is initiating efforts to further refine the Prague Framework. Efforts have focused mostly on finding more effective means to deal with unsustainable sovereign debts, since these cases are more challenging and costly to the economy.

The constructive engagement of the private sector in responding to financial crises is an important component in the debate on the reform of the architecture of the international financial system. The concept of constructive engagement is not new—it was a feature of the Brady Plan to deal with the Latin American debt crisis in the 1980s—but it has gained prominence in the past few years. In September 2000, the IMF’s International Monetary and Financial Committee (IMFC) endorsed an operational framework for encouraging the participation of the private sector in crisis prevention and resolution, more commonly known as the Prague Framework.2

The basic principles underpinning the Prague Framework are simple. Official or public financing is limited, debtors and creditors must bear the risks for their decisions to borrow and lend, and contracts must be honored to the fullest extent possible. The approach to be taken in individual cases would depend on an assessment by the IMF of a member’s underlying payment capacity and its prospects of regaining market access. Under the catalytic approach, countries confronting emerging balance of payments difficulties can address these difficulties through the adoption of corrective measures, possibly supported by official financing. Such official financing would signal the official community’s endorsement of the country authorities’ economic program, thus enhancing the credibility of the authorities’ stabilization measures. The combination of policy adjustment and official financing alone should allow a country to regain market access quickly. Most countries facing emerging tensions with their external accounts should fall under this category.

However, countries may on occasions confront more severe balance of payments difficulties, and the catalytic approach is judged to be inadequate to enable the country to regain spontaneous market access. In these circumstances, the constructive engagement of the private sector may be necessary to provide the required financing. While the Prague Framework relies as much as possible on market-oriented and voluntary solutions, in extreme circumstances actions could include a comprehensive debt restructuring. This section focuses on general conclusions and lessons for applying the Prague Framework in cases where a country’s balance of payments difficulties have led to a loss of market access. This is an area where the problems are the most challenging and where advice is most helpful.

For ease of exposition, the assessment can be broadly divided into two categories. The first category involves cases where official financing and policy adjustment need to be combined with encouragement to creditors to reach voluntary arrangements to overcome the collective action problem—that is, the problem that the collective interests of the creditors would be best served by full participation rather than by each creditor acting alone in its own self-interest. The second category involves the extreme case where the early restoration of full market access on terms consistent with medium-term external sustainability is judged to be unrealistic, and a comprehensive restructuring of debt may be warranted to provide a sustainable medium-term debt profile. In both cases, additional measures might be needed to stabilize the flow of trade credits in order to minimize the disruption to the basic functioning of the economy.

The section begins with an assessment of the tools used to complement the catalytic approach, starting with an assessment of instruments that are market based before considering more concerted means involving the use of regulatory actions. Some suggestions on ways to maintain trade credits during a crisis are also considered here. Next, we look at the extreme case where sovereign debt is clearly unsustainable and a debt restructuring is warranted. The analysis draws on recent experience to detail a step-by-step road map to debt restructuring. This is followed by some observations on the IMF’s latest proposals on collective action clauses (CACs) and the Sovereign Debt Restructuring Mechanism (SDRM). The last section offers some concluding remarks.

Complementing the Catalytic Approach

The Prague Framework provides for a spectrum of possible approaches, ranging from the catalytic to more concerted approaches, for involving the private sector in crisis resolution. In cases where the catalytic approach is not sufficient to lead to a swift change in confidence and restoration of market access, a broader set of instruments is needed. This can be achieved through the use of instruments that rely on voluntary and market-based means or regulatory requirements. At the same time, additional measures may be needed to secure the supply of trade credits.

The voluntary approach is intended to provide breathing space for resolving financing difficulties.3 By encouraging a voluntary and cooperative solution that does not interfere with normal creditor-debtor relations, it seeks to avoid damaging prospects for regaining market access once the immediate crisis is resolved. This approach is most likely to be successful when a country faces a liquidity crisis that is expected to be temporary and the country is not generally considered by the markets to face solvency issues. Alternatively, and in a more concerted way, regulatory measures can be imposed to lower interest rates or reduce rollover risk when financing cannot be raised on a strictly voluntary basis.

The most commonly used instruments are indicated below, and their main properties are described in Table 8.1.4 The first three instruments are typically regarded as falling under the voluntary approach, while the last is an example of the regulatory approach:

  • Market-based debt exchanges or debt buybacks;

  • Commercial bank rollover agreements;

  • Private contingent credit lines;

  • Investment requirements.

Table 8.1.

Use of Voluntary and Intermediate Tools in Crisis Prevention and Resolution

article image
article image
Source: IMF (1999); IMF (2002b); and IMF staff reports.

The usefulness of each instrument needs to be assessed on a case-by-case basis. Although some may be helpful in individual cases by bringing immediate cash flow relief, their use may raise new concerns about the ability of sovereigns to take on additional contingent claims, as well as moral hazard risk. Recent innovations in financial markets have also compromised the effectiveness of some of these tools by allowing investors to hedge their exposure through offsetting derivative positions.

Market-based debt exchanges are operations designed to lengthen the average maturity of government debt, thus reducing immediate rollover risk. Although they provide immediate cash flow relief, they can be expensive at times of crises, especially if a high yield is necessary to mitigate collective action problems and induce investors to participate in the exchange. For example, the Argentine mega-swap in 2001, which involved exchanging $30 billion of government bonds for new bonds of longer maturity, was conducted at spreads of around 1,000 basis points and thereby locked in very high interest rates for a protracted period. Ultimately, the debt exchange eased immediate rollover risk, but it added to concerns about solvency and did not prevent the eventual default.

Commercial bank rollover agreements are informal requests by the monetary authorities to foreign commercial banks to maintain exposure at a specified level. They are intended to resolve collective action difficulties among foreign banks. In each case, a high-frequency debt-monitoring system is set up to monitor foreign banks’ compliance with the agreement. To encourage the participation of foreign banks, the rollover agreements have often been facilitated by sovereign guarantees. In some cases, the rollover agreements have been enforced by exerting pressure or moral suasion on foreign banks to provide the required amount of funding.

Rollover agreements have a number of limitations. Their coverage is mostly limited to interbank transactions and to banks’ proprietary account. As a result, it is unlikely that foreign banks would increase their own exposure to fully offset any withdrawal of clients’ money. A more important concern, however, has been the difficulty in enforcing the agreements. Although moral suasion was used to good effect in Korea during the Asian crisis, the decision to apply moral suasion was taken against the background of a hemorrhaging of official reserves and the prospect of the crisis becoming systemic. Under more normal circumstances, supervisory authorities do not believe that they should interfere in the commercial decisions of the banks under their supervision. Moral suasion was not applied in enforcing the agreements in Indonesia, Brazil, or Turkey.

Equally, it is difficult to obtain a rollover agreement when market confidence in the authorities’ adjustment program is weak or if there is no demand for new loans because of reduced economic activity. In Turkey, aggregate exposure of foreign commercial banks was maintained during the good phases of the program implementation, but declined sharply when market confidence in the authorities’ policy implementation weakened. The decline in interbank lines in Turkey did not result from lower supply alone. Much of the outflow reflected syndicated loans that matured and were not fully rolled over as the recession and the currency depreciation reduced borrowing banks’ appetite for new loans. Without resolute policy implementation, it is difficult for the official sector to insist that the foreign banks roll over their lines.

Private contingent credit lines are a form of insurance policy arranged in normal market conditions to mobilize financial resources from private creditors in times of market turbulence. The increasing sophistication of financial markets, however, has limited the effectiveness of private contingent lines. The increase in exposure through the contingent lines could induce banks to hedge the exposure by dynamic hedging or taking short positions in internationally traded securities. In addition, participating banks’ resistance to the drawdown of private contingent credit lines can delay the supply of much needed financing. Although the conditions for activating the credit lines may be clearly defined, and are strictly adhered to, creditor banks involved in the arrangement may argue against the drawing and make the process of activation more difficult, as occurred in Mexico in 1999.

An investment requirement can be imposed on domestic banks, requiring them to hold government debt instruments over and above those needed for normal prudential and liquidity considerations in order to increase demand for government securities and reduce rollover risk. This is largely an untested approach. The success of the approach is likely to depend on whether markets view the introduction of an investment requirement as a constructive action to reduce the government’s rollover risk or as a destabilizing signal that might foreshadow further draconian actions. A positive market reaction could lead to a reduction in market interest rates and greater appetite for domestic debt, while a negative reaction could have an adverse effect on confidence, and thereby lead to an increase in interest rates and even a drawdown of deposits. A favorable market reaction to an investment requirement appears most likely in circumstances in which the requirement is introduced as part of a wider package of macroeconomic and structural policies that are seen as providing credible prospects for a resolution of the underlying debt problem.

Notwithstanding their potential usefulness, there is a real concern that investments in sovereign instruments made as a result of regulatory action may result in increased exposure to sovereign credit risk, and to maturity mismatches and interest rate risk, thereby potentially shifting the vulnerability from the sovereign to the financial system. This was a concern raised with regard to the regulatory action requiring pension funds in Argentina to increase their holdings of government securities.

In complementing the catalytic approach, additional measures may be needed to secure the supply of trade credits— in particular, import-related trade credits. Maintaining, to the extent possible, a country’s access to trade credits is an important priority in a financial crisis so that the extent of economic dislocation can be limited. In this respect, domestic banks are crucial, both in terms of their willingness to take on the risk associated with import financing, as well as the perception of their creditworthiness by foreign commercial banks and export credit agencies (ECAs). ECAs potentially also have a role to play. Although they have not been effective historically in supporting trade-related credit during a crisis, there is scope for these agencies, possibly under the aegis of the IMF, to assume a more active role.

The country authorities can take a number of steps to ensure that disruption of import-related trade credit will be minimized. As a first step, the authorities could avoid the accumulation of arrears as a result of transfer risk. Debt service on trade credits should be given priority in the allocation of foreign exchange. This may include ensuring that there are no restrictions on the availability and transfer of foreign exchange associated with payments for bona fide import-related trade credit; offering a transfer risk guarantee to payments associated with all bona fide import-related trade credits for raw materials, spare parts, and consumer goods, although the sovereign should avoid offering commercial risk and political risk guarantees; and requiring public buyers to settle any arrears to Paris Club creditors promptly.

As a second step, the authorities’ commitment to find an orderly and market-friendly resolution to the crisis could be expressed in approaching foreign banks. This could include a program of bilateral contacts that would provide an opportunity for the authorities to engage in a constructive dialogue regarding the most feasible approaches to maintaining credit lines. One possible approach—as used in the 1980s—is to set up a revolving trade credit facility where creditors, who could not replace maturing trade-related transactions within a specified time period, would be asked to deposit an amount equivalent to their trade-related exposure with the central bank. When new trade transactions are extended in excess of maturing transactions, such deposits would be reduced. More recently, the International Finance Corporation (IFC) considered setting up a syndicated loan facility to provide pre-export and import financing. Both the IFC and international banks would participate in the facility, with the loans extended to onshore trusts and managed by local subsidiaries of participating banks. The IFC’s role as lender of record could help to reduce transfer risk and provide a useful bridging role while confidence in the local banking system was being restored.

Alternatively, the country authorities could set aside reserves to meet the demand of exporters to finance their preshipment operations. This approach was adopted by Brazil in August 2002, involving reserves of about $2 billion. The central bank auctions foreign exchange contracts in lots of about $50–$100 million to large banks, which in turn extend foreign exchange credit to exporters. When the contract expires, the banks return the foreign currency borrowed plus interest.

As a third step, the country authorities could approach official ECAs and the relevant creditor governments to seek continued cover for short-term credit while, if applicable, avoiding a Paris Club restructuring. The contacts could be made by the authorities or by the IMF through the Group of Ten Countries (G-10) and other relevant avenues. The official community could explore the capacity of ECAs to provide an emergency trade credit insurance facility or reinsurance to private insurers willing to extend insurance cover to trade finance.

Debt Restructuring

When countries face severe budget financing problems, and the fiscal adjustment needed to continue servicing their debt is unrealistic, sovereign debt restructuring may be warranted to reach an orderly workout agreement with private creditors. Since the late 1990s, at least five countries have restructured their debts.5 Russia and Ecuador restructured their debt with the private sector after a default, and Ukraine and Pakistan restructured their debts in the shadow of a default (Table 8.2). In some of these countries the IMF applied its lending-into-arrears policy (see Box 8.1).

Table 8.2.

Recent Cases of Debt Restructuring

article image
article image
Source: IMF (2001b); IMF (2002b).

The four countries were able to obtain broad acceptance of restructurings that provided immediate cash flow relief. Nevertheless, the negotiations were protracted, and the final agreement was obtained after significant delays. The countries lost access to international capital markets for a sustained period. To the extent the banking system held a large share of the restructured assets, the quality of banks’ balance sheets deteriorated, and the banks became more vulnerable to large-scale deposit withdrawals. The ensuing uncertainty added to the economic problems associated with the initial financial crises (IMF, 2002a). That said, economic growth turned positive quickly after the debt restructuring in all four cases. Russia and Ecuador, in particular, benefited to an important extent from an increase in international oil prices and a return of domestic confidence.

More recently, in light of the large amount of bond issues involved and highly dispersed creditor base, Argentina is facing a difficult task in restructuring approximately $100 billion of domestic and external debt owed to private creditors. The Argentine authorities announced in late October 2001 their intention to restructure their debt via a two-phase approach involving a voluntary exchange. The first phase, aimed at domestic resident investors, was carried out in December 2001 and involved the exchange of about $41 billion in sovereign debt and a further $9 billion in provincial debt. The second phase, aimed at all bondholders who did not participate in Phase 1, was expected to be carried out within a few months following the Phase 1 restructuring. However, political and economic disruption mounted in the intervening period, and a moratorium on debt not included in the Phase 1 exchange was announced at the end of December 2001. Since then, there has been little progress in the second phase of the restructuring.

In what follows, the process of debt restructuring is spelled out in some detail. The purpose is not to review the experience of debt restructuring in each country case—this has been done elsewhere (IMF, 2001b)—but to demonstrate the complex set of issues that need to be considered in undertaking a re-structuring. While there is a lengthy and diverse range of decisions to be considered, and not all elements under discussion are relevant to all cases, the cases illustrate important policy lessons in the means available to deal with sovereign debt crises.

The IMF’s Policy of Lending into Sovereign Arrears

The policy requires that the member pursues appropriate adjustment policies and is making a “good faith” effort to reach a collaborative agreement with its creditors (see IMF, 2002c). The policy is flexible with regard to the form of the collaborative dialogue. It can take place within an informal structure or through a formal representative committee, depending on the complexity of the individual case and judgments about the timely organization of a sufficiently representative committee. Although the policy expects a member to initiate a dialogue with its private creditors prior to the approval of an IMF arrangement, in cases where this is not possible the dialogue is expected to continue after the approval of an IMF program, but before the launch of a restructuring proposal.

The IMF’s assessment of a member’s good-faith effort is guided by the following general principles. First, the debtor should engage in an early dialogue with its creditors, which should continue until the restructuring is complete. In cases where a representative committee of creditors has been established, a collective framework for negotiations could be established. In assessing whether a committee is sufficiently representative, the IMF would give consideration to factors such as the proportion of principal held by creditors that have signaled their support for the committee, as well as the coverage of major types of creditors represented in the committee.

Second, the member should share relevant, nonconfidential information with all creditors or a steering committee on a timely basis. Confidential information could be provided to committee members, but they would need to commit to take steps to preserve confidentiality. Such information could include:

  • An explanation of the economic problems and financial circumstances that justify a restructuring;

  • A briefing on the new adjustment program and the intended benefits of any restructuring, including any new financial assistance from the official sector (the restructuring must be perceived as providing the basis of a credible exit from crisis); and

  • The provision of a comprehensive picture of all domestic and external claims, including official claims, and the broad process by which a restructuring would restore medium-term viability.

Third, IMF policy on lending into arrears would expect creditors represented on a committee to agree to a standstill on litigation during the negotiating process.

Objectives of Debt Restructuring

A debt restructuring aims to achieve three main objectives. First, the terms of the restructuring agreement should provide both immediate cash flow relief and a repayment profile that helps to facilitate the country’s return to medium-term viability. To reduce debt to a sustainable level may imply a substantial reduction in the debt and debt-service burden.

Second, the core of the domestic banking system must be preserved with a view to limiting the scale of economic dislocation. Banks’ balance sheets will come under pressure as the value of their portfolio of government securities is reduced, and provisioning requirements have to be met. Additional stress on banks’ balance sheets could also occur as a result of losses from an increase in short-term interest rates and a sharp depreciation in the exchange rate, which typically accompany a period of financial turbulence. Banks may face a maturity mismatch as depositors shorten the maturity of their claims on the bank or as the restructured assets themselves have longer maturity. To the extent that the domestic banking system is a significant creditor to the sovereign, measures would have to be contemplated to ease the pressures on banks’ balance sheets during the restructuring.

Third, the restructuring would aim to help facilitate as early as possible a return to both domestic and international capital markets. The orderly and timely restructuring of unsustainable sovereign debts, while protecting asset values and creditors’ rights, would restore fiscal solvency and confidence in the ability of the economy to recover on a sustainable basis. Country experience suggests that, in addition to the adoption of credible corrective policies, clarity about how a country will meet its gross financing requirements and sustain debt-service payments is a key determinant to the restoration of market access (IMF, 2001a).

While the objectives of a debt restructuring are straightforward, arriving at a judgment about the sustainability of a country’s debt is much more complicated. In principle, debt can almost always be serviced through additional taxation to generate the resources needed to service that debt. But at some point, the policies to generate the additional tax revenue to cover debt payments will become socially and economically unacceptable. Since country authorities are usually reluctant to restructure early, it is often the markets that force this reality upon them. In many cases, domestic and foreign investors react to adverse economic or political developments by dumping sovereign assets en masse in order to reduce their exposure, and spreads on government debt rise precipitously. Eventually, the debt-service burden exceeds a threshold of what can be sustained, and the process of sovereign debt restructuring commences.

Notwithstanding the general reluctance of countries to restructure early, when a country faces an unsustainable debt position, the sooner it restructures its debt, the lower the costs are likely to be. By avoiding default, a preemptive debt restructuring might avoid a breach of the contractual terms of the debt and allow the debtor to initiate early dialogue with its creditors concerning the possible terms of restructuring in a more orderly fashion. Although some disruption to the economy is likely to be unavoidable, the reduction in uncertainty about the process and terms of the restructuring may limit the damage to the domestic financial system and foster a quicker return of market confidence. The cooperative process and fair treatment of creditors may allow a crisis country to regain market access more quickly once macroeconomic and financial viability are restored.

Road Map to Debt Restructuring

Once a decision has been made to restructure, the authorities need to announce their intentions clearly and make good-faith efforts to reach collaborative agreement with their creditors. The dialogue with creditors would establish the terms and mechanics of the restructuring, including the coverage of the debt to be restructured, the new instruments to be offered, and the post-restructuring debt profile. Experience shows that the authorities would also need to consider measures to protect the banking system if domestic banks hold a large portfolio of the restructured assets. In extreme cases, the authorities may also need to consider the possibility of imposing capital controls and deposit freezes to stem capital flight.

Announcement Strategy

A public announcement would be made that the government’s debt was not sustainable and needed to be restructured. At a minimum, the announcement would need to achieve the following objectives:

  • Assure investors that the authorities are willing and committed to working closely with private creditors to come up with a solution that is fair, but within the constraints of the macroeconomic adjustment.

  • Be made publicly to avoid accusations of providing privileged information and inadvertently triggering a panic in financial markets. To limit a knee-jerk reaction to the announcement and allow the markets to digest the news, the announcement could be made while the markets are closed, or a short suspension of financial markets could be declared.

  • State the intention to continue to service principal or interest, or both, until the restructuring is in place, if this is feasible.

  • Declare any restrictions on deposits or capital controls and lay the foundation for an exit strategy. To the extent possible, the announcement should provide any “bad news” up front.

Establishing a Collaborative Agreement

Following the announcement, the authorities should seek an early dialogue with their creditors to negotiate a mutually acceptable solution. The IMF’s policy of lending into sovereign arrears to private creditors under its good faith clause has special relevance in this regard (Box 8.1).6

The debtor should provide creditors with an early opportunity to give input on the design of the restructuring strategy. This could help address the specific needs of different types of investors, thereby increasing the likelihood of a high participation rate. Three elements that could be usefully discussed are the coverage of debt, the new instruments to be offered, and possible standstills on litigations during the restructuring process.

Coverage of Debt

Recent experience on debt restructuring indicates that an approach that helps to make the debtor’s strategy transparent and to resolve issues concerning intercreditor equity is more likely to produce a satisfactory debt-service profile. In addition, the approach should ensure that a sufficient amount of debt is restructured in order to improve the chances of reaching agreement on terms that are consistent with a return to medium-term viability. The discussion could also address specific arrangements to protect normal trade credit.

New Instruments

New instruments to be issued in exchange for old debts must by necessity constrain future interest payments to the availability of fiscal resources and avoid short-term humps in the maturity profile. To help ensure that the new instruments would be as liquid as possible, and thereby attractive to investors, the debt should be consolidated into a small number of new, relatively large instruments. The debtor could discuss with its creditors a menu of options, including the following choices:

  • Bonds that preserve principal, but are low coupon. These may be preferred by retail investors wanting to preserve the nominal value.

  • Bonds with coupons closer to the norm for emerging markets, but with lower principal. These may be preferred by institutional investors who have already marked-to-market their losses.

  • Bonds that allow investors to participate in the gains if the domestic economy recovers strongly— such as bonds indexed to GDP or containing rights to shares in (convertible bonds) enterprises that might be privatized. Experience with the inclusion of such provisions in Brady bonds suggests that the inclusion of these terms may impose some cost on the debtor, but the debtor obtains few benefits in terms of the scale of debt and debt-service reduction in exchange, because investors have put little value on such value-recovery clauses. Nevertheless, in light of the substantial potential benefits, the feasibility of this approach should be examined on a case-by-case basis.

  • Bonds with clauses that provide for the reinstatement of principal in the event of a subsequent default during a defined period. The Ecuador restructuring included such a provision.

Legal Issues

The debtor should move expeditiously toward a restructuring that is perceived as being equitable in order to diminish the risk that creditors will use litigation as a tool to gain the debtor’s attention. In any event, the debtor would need to consult with its legal counsel in advance of the announcement of a debt restructuring. The terms of external debt restructuring need to be considered according to the governing law of the bonds. Most bonds issued under English Law contain CACs, which permit creditors holding a qualified majority of principal to modify the payment terms of their instrument in a way that would be binding on all holders of the issue. For bonds issued under a governing law that does not have the benefit of majority action, such as New York Law, exchanges will be needed. As a result, there might be potential difficulty with creditors who might decide not to participate in the exchange offer, in the hope of being able to obtain subsequently settlement on more favorable terms. In the case of Ecuador’s exchange offer, exit consents were used to restructure international bonds governed by New York Law.7

Protecting the Banking System

It will be important that in the process of the debt restructuring, the impact on domestic banks’ balance sheets is cushioned as much as possible. The degree to which banks will be able to absorb the direct effects of a reduction in the value of their government securities holdings by running down their capital will clearly depend on the size of these holdings relative to the size of the banks’ capital base, the extent of the debt reduction, and the banks’ ability to raise additional capital. In the midst of a crisis, there is bound to be confusion about the condition of banks’ balance sheets and the ability of the sovereign to make payments under deposit guarantees. Depositors are likely to be concerned by the possibility of moves to force them to accept haircuts on their deposits in order to help recapitalize the banks, and by the possibility that the banking system does not have sufficient liquidity to withstand deposit withdrawals, raising the risk of capital flight. All these factors contributed to severe difficulties in the banking systems in Russia and Ecuador and, to a lesser extent, Ukraine and Pakistan. In Argentina, given that government debt made up 20 percent of bank assets at the end of 2001, the restructuring of government debt and the subsequent pesoization disrupted banking operations and resulted in significant losses to banks.

Therefore, consideration should be given to formulating measures to limit the erosion of confidence and prevent a deposit run once the announcement of a restructuring has been made. These issues are considered in detail in Section V, but in general might include:

  • Accompanying the announcement of the restructuring with a package of measures to deal with undercapitalized or insolvent banks.

  • Formulating a restructuring offer that responds to the needs of the domestic banks. Banks may prefer restructuring options that allow the coupon to be preserved, but the principal reduced if they have already marked-to-market their losses. In any case, following a restructuring, banks would need to have adequate liquidity, and so consideration may need to be given to providing emergency repo financing by the central bank to manage the maturity mismatch associated with an extension of maturities on the restructured instruments, and to leave the banks without excessive exposure to market risks.

Capital Controls and Deposit Freeze

In extreme cases where it is not possible to arrest a bank run through policy efforts to restore confidence, it may be necessary to introduce some form of capital controls or deposit freeze. Most of the countries that restructured their debts since the late 1990s took this course of action. Argentina declared extensive capital controls and a deposit freeze corralito at the end of 2001; Pakistan imposed a deposit freeze on all foreign currency deposits; Russia employed a combination of capital and exchange controls and a freeze on deposits in a few large and insolvent banks; and Ecuador imposed a freeze on most demand and savings deposits for six months, and on all time deposits for one year, although this action preceded the default itself by a few months.

The use of administrative controls will inevitably cause significant disruption to the efficient operation of the economy in general and the banking system in particular. The experience of the corralito in Argentina has demonstrated the potential disruption to the economy, as well as the difficulty in establishing an effective deposit freeze at a time of economic, political, and social turbulence. Moreover, it is likely that controls would become progressively less effective over time as the private sector develops techniques for circumvention. It would be important, therefore, to formulate an exit strategy as quickly as possible to minimize the infringement on the efficient operations of a market economy. The exit strategy would need to establish a time line for the phasing out of the administrative controls while ensuring that the banking system and the fiscal accounts would be restored to good order.

The choice between the imposition of exchange controls and a comprehensive deposit freeze would need to be decided in the light of the characteristics of the economy, including whether the country has the infrastructure to operate exchange controls, and its openness. If a country has the infrastructure for the application of exchange controls or if the capital account of an economy is relatively closed, it may be feasible to resort to the use of controls while limiting major economic dislocation. However, as economies have become more sophisticated, with a myriad of financial and trade links with other countries, it has become increasingly difficult to apply exchange controls effectively.

What Next?

So far, the experience with the Prague Framework has been mixed. Although there have been a few notable successes, for the most part it has proven difficult to resolve collective action problems under both the voluntary and concerted approaches. As is evident from the discussion so far, more will need to be done to further refine the Prague Framework. The official community has initiated this endeavor. Most of the efforts have been focused on finding better ways of dealing with unsustainable sovereign debts, since these cases have tended to be more challenging and costly to the economy. As a first step in this direction, the IMF is considering two broad classes of proposals. One is to promote the wider use of CACs among member countries, and the other is to introduce the SDRM, a statutory framework to provide for a broader debt restructuring (Krueger, 2002).

Collective Action Clauses

CACs apply to individual bond issues and permit creditors holding a qualified majority of principal to modify the payment terms of their instrument in a manner that would be binding on all holders of the issue. The clause would facilitate restructuring by limiting the ability of a minority to hold out from a restructuring agreement, and then litigate for full payment. Collective action provisions can be used to restructure a bond before, as well as after, a default.

Sovereign Debt Restructuring Mechanism

The SDRM proposal goes further than CACs and could be a useful complement. The SDRM would be a mechanism that allows for a restructuring to be activated in a timely manner, enables creditors and debtors to negotiate a restructuring, and binds all creditors to a restructuring agreement that has been accepted by a qualified majority of creditors. As with a domestic insolvency law, it would aggregate claims for voting purposes and could apply to all claims. An independent and centralized dispute resolution forum would be established to verify claims, insure the integrity of the voting process, and adjudicate disputes that might arise. This would limit disruption and dislocation to the economy that have been seen in recent cases and would help to preserve substantial value both for the creditors and for the debtor. Although a number of issues still need to be ironed out, the mechanism could operate under the following principles:

  • Provide incentives for an early and collaborative engagement between the debtor and its creditors, and establish a procedure that enables the restructuring process to be completed within a reasonable time frame.

  • Limit any interference with creditor rights to those measures that are needed to resolve the most important collective action problems. Seniority among claims would be respected.

  • Establish procedures that enable creditors to have adequate access to information regarding the debtor’s general situation, including its overall debt situation and its program for economic recovery.

  • Activate only with the consent of the sovereign, and only when the sovereign had formed a judgment about debt sustainability and the capacity of the SDRM to restructure its debt rapidly and in a manner that limits economic dislocation.

  • Operate under the establishment of an independent and centralized dispute resolution process. Resolving disputes that arise from diverse claims in a fair and expeditious manner is critical to the success of a restructuring exercise.

  • Limit the formal role of the IMF under the SDRM. Although the SDRM would be established through an amendment of the IMF’s Articles of Agreement, the SDRM should not give the existing organs of the IMF any significant new legal powers.

  • To the extent possible, the SDRM should avoid displacing existing statutory frameworks that are otherwise available to restructure claims.

To move the debate on the SDRM forward, the G-10 countries have asked the IMF to prepare specific proposals for the design of the SDRM in the run-up to the 2003 Spring Meetings of the IMF and the World Bank. In parallel with the SDRM discussions, the official community has also called for further efforts to better formulate and encourage the use of CACs.

Concluding Remarks

The Prague Framework has been used in a number of countries to engage the private sector in the prevention and resolution of financial crises. The experience gained from these cases has been invaluable in helping the official and private sector community define a strategy of constructive engagement. But, equally, it has brought to the fore the limitations of voluntary and more concerted forms of involving the private sector in complementing the catalytic approach, and the complex and often unpredictable process of debt restructuring. Better incentives are needed to “bail in” the private sector in a voluntary fashion and to resolve collective action problems so that unsustainable sovereign debts can be restructured in an orderly and timely manner. There are four principal conclusions.

First, the diversity of the emerging market investor base, as well as the increasing sophistication of financial markets, has limited the effectiveness of tools that could complement the catalytic approach.

  • The voluntary approach provides breathing space for countries with temporary liquidity problems to take corrective actions, but so far its application has been rather limited, and because it is purely voluntary it can be costly.

  • Moral suasion has been used effectively in some cases to enforce voluntary arrangements, but bank regulators have been increasingly less enthusiastic about exerting such pressure, for they see a conflict between their regulatory role and their pressuring the banks to maintain portfolio positions against the banks’ own best judgment.

  • More concerted solutions involving regulatory actions are largely untested and authorities are reluctant to rely on them, given concerns that the action could prompt speculation that more draconian measures are on the way. In other words, these actions could trigger the very event that the authorities would wish to avoid.

Second, when the degree of fiscal adjustment needed to allow continued debt servicing is not politically or economically feasible, debt restructuring becomes unavoidable to reduce the debt to a sustainable level to restore medium-term external viability. However, such restructuring is a process that is fraught with uncertainties. Debt restructuring can be lengthy and involved, and it requires careful planning by the debtor to minimize collective action problems and disruptions to the proper functioning of the economy. The risk of a disorderly workout and an outcome that is uncertain too often delays a necessary restructuring until the last possible moment, draining the country of its reserves and increasing the eventual cost of restoring sustainability.

Nevertheless, there are general principles to guide a debt restructuring that would help to reduce collective action problems and lessen the pain of economic dislocation. The debtor should seek a restructuring as soon as it is recognized to be unavoidable and initiate an early dialogue with its creditors in order to give creditors an early opportunity to provide input on the terms of the restructuring. As part of this process, the debtor should share relevant information on a timely basis about the nature of the economic crisis and the proposed adjustment policies. The debtor should take measures to protect the banking system to the extent possible. In extreme cases, where it is not possible to arrest a bank run through policy adjustment, some form of capital controls, including controls on withdrawals from the banking system, may have to be considered.

Third, regardless whether voluntary or more concerted approaches are adopted, maintaining a country’s access to trade credits remains a top priority.

Fourth, the IMF is in the process of strengthening its Prague Framework to improve its applicability and effectiveness. In line with these efforts, the Fund is considering two broad classes of proposals to provide better incentives to encourage the orderly and timely restructuring of unsustainable sovereign debts. The first proposal involves the introduction of CACs (collective action clauses), which are already accepted practice in some markets, more universally in sovereign debt contracts. The second proposal involves the creation of a statutory framework—the SDRM (Sovereign Debt Restructuring Mechanism)—under which broader debt restructuring might occur.

Since this section was written in the middle of 2002, a vigorous debate has been conducted about the need for, and design of, the SDRM. This debate has helped to define the issues, to contribute to design modifications for the SDRM, and to build understanding on possible ways to strengthen the capacity of the international financial system to address cases in which a sovereign’s debt burden has become unsustainable. Fresh impetus has also been provided to efforts to promote the adoption of CACs in sovereign bonds, as well as proposals for a voluntary Code of Good Conduct to which debtors and their creditors would subscribe. Of special note, in February 2003 Mexico became the first major emerging market issuer to place publicly in international capital markets a new bond issue—governed by New York law—that included CACs. As regards prospects for the adoption of the SDRM, it is clear, at the time this publication goes to press, that there does not appear to be the requisite support among the IMF membership to establish the SDRM through an amendment to the IMF’s Articles of Agreement. A range of issues of relevance to any crisis resolution framework remains and warrants continued work (see IMF, “IMF Board Discusses Economic Policy Issues Arising in the Context of a Sovereign Debt Restructuring,” Public Information Notice 03/42, April 2, 2003; available on the Internet at http://www.imf.org/external/np/sec/ pn/2003/pn0342.htm).

References

  • Fischer, Stanley, 2002, “Financial Crises and Reform of the International Financial System,NBER Working Paper 9297 (Cambridge, Massachusetts: National Bureau of Economic Research, October).

    • Search Google Scholar
    • Export Citation
  • Krueger, Anne O., “Sovereign Debt Restructuring Mechanism: One Year Later,” speech presented at the Banco de Mexico’s Conference on “Macroeconomic Stability, Financial Markets and Economic Development,” November 2002; available on the Internet at http://www.imf.org/external/np/speeches/2002/111202.htm.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 1999, “Involving the Private Sector in Forestalling and Resolving Financial Crises” (Washington, March 17); available on the Internet at http:///www.imf.org/external/pubx/ft/series/03/index.thm.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2001a, “Assessing the Determinants and Prospects for the Pace of Market Access by Countries Emerging from Crises” (Washington, September 6); available on the Internet at http://www.imf.org/external/np/pdr/ma/2001/eng/ma_fin.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2001b, “Involving the Private Sector in the Resolution of Financial Crises—Restructuring International Sovereign Bonds” (Washington, January 11); available on the Internet at http://www.imf.org/external/pubs/ft/series/03/index.htm.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2002a, “Sovereign Debt Restructurings and the Domestic Economy: Experience in Four Recent Cases” (Washington, February 21); available on the Internet at http://www.imf.org/external/np/pdr/sdrm/2002/022102.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2002b, “Informal Seminar on Involving the Private Sector in the Resolution of Financial Crises,” Public Information Notice 02/38 (Washington, April l); available on the Internet at http://www.imf.org/external/np/sec/pn/2002/pn0238.htm.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2002c, “Fund Policy on Lending into Arrears to Private Creditors—Further Consideration of the Good Faith Criterion” (Washington, July 31); available on the Internet at http://www.imf.org/external/pubs/ft/privcred/073002.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2002d, “Communiqué of the International Monetary and Financial Committee of the Board of Governors of the International Monetary Fund,” paragraphs 21–22, “Involving the Private Sector” (Washington, September 24); available on the Internet at http://www.imf.org/external/np/cm/2000/092400.htm.

    • Search Google Scholar
    • Export Citation
1

Matthew Fisher also contributed to this section.

3

Voluntary tools, such as debt exchanges, are also used in normal circumstances (or in circumstances where there are only mild balance of payments difficulties) to lengthen maturity and achieve a smooth debt-redemption profile. For a more detailed look into cases involving market access, see IMF (2001a).

4

This is by no means an exhaustive list but is indicative of the tools that countries in crisis have most frequently adopted.

5

Moldova has recently completed the restructuring of its sovereign debts, but it is not covered in this chapter. The IMF assisted Moldova under its lending-into-arrears policy.

6

The recent clarification of the good faith criteria in the IMF’s lending-into-arrears policy is aimed at improving the process for restructuring sovereign debts (IMF, 2002c).

7

Exit consents are designed to make the bond less attractive through modification of such nonpayment provisions, thereby reducing the leverage of the holdout creditors that cannot otherwise be bound because of the absence of a CAC. So far, Ecuador is the only sovereign to have used exit consents. There are indications, however, that the use in a future case could be subject to legal challenge. Specifically, depending on the type of amendment utilized, the scheme could be legally challenged on the grounds that it constitutes, in effect, an amendment of payment terms.