The authors are members of the Office of the Executive Director for Italy, Greece, Portugal, Malta, San Marino, and Albania at the International Monetary Fund. Biagio Bossone is also associated with the Banca d’ltalia. The authors wish to thank Ms. A. Krueger for providing them with extensive comments and suggestions. They are grateful to their Executive Director, P. C. Padoan, for advising them throughout the preparation of this work, and thank T. Cordelia, R. Filosa, E. Frydl, C. Giannini, A. Sdralevich, J. Zettelmeyer, and the reviewers from the IMF’s Policy Development and Review Department for their views. The opinions expressed in the text are the authors’ only and do not necessarily reflect those of the institutions, officials, and individuals named above.
See A. Krueger, International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring, speech delivered at the National Economists’ Club Annual Members’ Dinner, American Enterprise Institute, Washington D.C., November 26, 2001.
We see the difference between voluntary and involuntary PSI arising from the coercive element of the NPV reduction of assets, not from the existence of a haircut itself. Creditors can accept a haircut (i.e. a reduction in the NPV) in the context of cooperative negotiations with the debtor. PSI becomes involuntary as soon as the debtor imposes a haircut on the basis of its sovereign powers, or of a standstill mechanism sanctioned by a third party. While a haircut of this latter kind usually involves the creditors’ declaration of technical default, creditors generally abstain from taking this formal step in the context of a cooperative solution.
This principle was endorsed by the International Monetary and Financial Committee at its meeting in Prague in September 2000, and was established out of consideration that official financing is limited, that debtors and lenders must bear full responsibility for their decisions to borrow and lend, and that contracts must be honored to the fullest extent possible.
From a formal point of view, a legal default can be avoided in two cases. First, and as often happens even now, the parties to the debt contract may agree not to declare a legal default to avoid consequences such as cut-off from certain kinds of official financing and triggering cross-default clauses. Second, the international community could agree that the legal component of the SDRM framework inhibits a declaration of default in the standstill phase.
The expectation—or the assumption—of losing out from resorting to the SDRM standstill is a crucial aspect of the mechanism. See below.
The parallel with bank runs should of course be qualified. A bank run involves many (or all) depositors simultaneously demanding their assets. Foreign creditors, by contrast, would only in extreme situations be in the position of trying to liquidate their assets all together. A more typical situation would involve the decision to renew credit lines or bond holdings. Here a “run” would be reflected in a rapid deterioration of roll-over ratios. However, in a country with a very open capital account, a full-fledged run can take place if holders of domestic currency-denominated deposits panic and try to convert deposits in foreign-currency denominated assets.
Although creditors generally recover less from a default than from a cooperative solution, not all creditors lose out necessarily from a default. Vulture funds, indeed, aim to gain from disorderly debt restructuring.
This broad definition of the cost of sovereign default provides a rationale for undertaking public action aimed at reducing the social welfare costs associated with it.
A high expected cost of default, also, lowers the equilibrium debt coupon and therefore increases the probability of debt repayment. See G. Lipworth and J. Nystedt, 2001, “Crisis Resolution and Private Sector Adaptation”, IMF Staff Papers, Vol. 47, Special Issue (Washington DC: International Monetary Fund): 188-214.
For simplicity we avoid considering the role of the default costs for other countries and the international community.
Assuming for simplicity that this offer can be measured, for example, in terms of net present value reduction of the debt instruments.
The sovereign could still improve on the creditors’ terms, but would have to do it out of its own resources, say, by tightening the adjustment (super-adjustment). This possibility would have to be permissible, since it would be part of the sovereign-creditor relationship and would not involve bailing out the private sector with public money.
The existence of creditor moral hazard could be contested by pointing out that if debt is unsustainable (which is the only situation when the original SDRM is envisaged to apply), creditors anticipate a haircut, and cannot expect to gain more in the SDRM phase if official financing is bounded. This argument however rests on the possibility of clearly distinguishing solvency from liquidity crises – and it was argued earlier in this paper that this is often not the case. By consequence, creditors do not have perfect information on the needed haircut.
Mohan Kumar and Marcus Miller make a similar (though somewhat weaker) point in “Bail outs, Bail ins and Contracts: Strategic Aspects of the New Architecture”, in G. Underhill and X. Zhang (eds.), Global Financial Crisis: What is to be done? (Cambridge, Mass: Cambridge University Press, 2002, forthcoming), where they suggest that the IMF’s intervention should be subject to strategic ambiguity for the prospect of bail-out to be marred by the risk of an all-out default. Taking into account the practical difficulty for the IMF to embark credibly on strategic ambiguous behavior, our recommendation goes as far as suggesting the imposition of a strong rule on access limits before the SDRM is activated.
These issues are similar to those raised by the activation review of the IMF’s Contingent Credit Line Facility.