Abstract
The Fund's Lending Framework and Sovereign Debt-Further Considerations
I. Background
1. As a follow up to the June 2014 Board discussion of the staff paper The Fund’s Lending Framework and Sovereign Debt—Preliminary Considerations, this paper provides specific proposals for the modification of the exceptional access framework. The June 2014 Board paper (henceforth the “2014 paper”) focused on the relationship between the Fund’s lending framework and sovereign debt vulnerabilities and provided possible avenues for reform. It identified key limitations of the Fund’s 2002 exceptional access framework: namely, the exceptional access policy embodied rigidities that contributed to the introduction of a systemic exemption in May 2010, a modification that does not provide a coherent solution to the rigidity in the underlying framework. As endorsed by the Executive Board in May 2013, the 2014 paper focused on a market-based approach to resolve sovereign debt crises. This approach continues to inform the Fund’s current work program.
2. The preliminary proposals in the 2014 paper sought to provide more flexibility in the general framework and reduce costs to the member, its creditors, and the overall system. In particular, in cases where market access has been lost and debt is assessed to be sustainable but not with high probability, exceptional access would be conditional on a more limited form of debt restructuring (“reprofiling”) that maintains the exposure of creditors during the program but does not require that the test of “high probability” of debt sustainability be met.1 The paper also proposed to eliminate the systemic exemption in light of both the flexibility being introduced in the framework and concerns that the exemption compromises the distressed member’s prospects for returning to external viability and hence does not actually achieve its objective of mitigating international systemic spillovers. The exemption also aggravates moral hazard.
3. Most Executive Directors supported increasing the flexibility in the general framework but expressed a range of views on removing the systemic exemption. Most Directors agreed with staff analysis on the underlying rigidity in the 2002 exceptional access framework and saw merit in broadening the range of available policy responses, including through the ability to rely on a debt operation (reprofiling) that will not necessarily restore debt sustainability with high probability. Many Directors favored removing the systemic exemption. Some others preferred to retain it as, in their view, it was a pragmatic way to safeguard financial stability and its abolition might create the perception of a lack of evenhandedness. These Directors called on staff to consult further with relevant stakeholders on possible approaches to managing contagion before making concrete proposals regarding the systemic exemption. Directors also asked staff to clarify a number of design and implementation issues related to reprofiling in the follow-up staff paper.
4. This paper addresses the issues raised in the June 2014 Board discussion. The paper (a) presents specific proposals regarding the objectives and design of the new flexibility that would be added to the exceptional access framework with respect to debt sustainability; (b) discusses how risks of financial cross-border spillovers associated with debt restructuring would be addressed in the absence of the systemic exemption; and (c) provides further analysis on a number of design and implementation issues. This paper does not include proposed decisions. If warranted by Directors’ input, a final paper would be prepared that would present proposed decisions. The final paper would also discuss the implications, if any, of the proposed changes for the other exceptional access criteria.
II. Increasing Flexibility in the Exceptional Access Framework
5. The criteria that guide the use of exceptional access were first established in 2002 to strengthen the policy for lending above normal limits. As discussed in the 2014 paper, these criteria impose more stringent conditions for Fund lending than those that are applied in the context of normal access and are designed to take into account the additional risks that arise for the Fund as a result of significant financial exposure to the member. Prior to the introduction of the 2002 framework, the Fund was able to grant exceptional access on the basis of an “exceptional circumstances” clause that did not include any substantive criteria. The 2002 criteria were introduced out of a concern that the Fund had been excessively permissive in providing financing in circumstances where there were concerns regarding the sustainability of a member’s external debt situation.2
6. A critical criterion in the existing exceptional access framework is the requirement that “a rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term.” This criterion was designed to address concerns that Fund lending under the exceptional circumstances clause was delaying restructurings that, because of underlying sustainability problems, had become inevitable. As discussed in the 2014 paper, such delays create costs to the sovereign debtor, its creditors and the system more generally. At the same time, the June 2014 paper pointed out that the 2002 framework created costs of its own, by requiring a definitive—and potentially disruptive—debt restructuring even in circumstances where the assessment of debt sustainability is not clear cut at the outset. These costs could be reduced if the existing criterion were modified to provide some additional flexibility—allowing more graduated responses, tailored to the severity of the initial debt situation. The design and implications of this flexibility are outlined below.
A. The Existing Text
7. The existing text of the relevant exceptional access criterion that addresses debt sustainability reads as follows:
“A rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term. However, in instances where there are significant uncertainties that make it difficult to state categorically that there is a high probability that the debt is sustainable over this period, exceptional access would be justified if there is a high risk of international systemic spillovers. Debt sustainability for these purposes will be evaluated on a forward-looking basis and may take into account, inter alia, the intended restructuring of debt to restore sustainability. This criterion applies only to public (domestic and external) debt. However, the analysis of such public debt sustainability will incorporate any potential contingent liabilities of the government, including those potentially arising from private external indebtedness.”
8. Although the above-quoted “high probability” criterion establishes a single standard, it effectively creates two categories. Members falling under the first category are those whose debt is judged to be sustainable with high probability in the absence of any debt restructuring, that is, on the basis of the adjustment and financing considered feasible under the program. Members falling into the second category are those where high probability could only be achieved through a debt restructuring. More specifically:
If a member fell into the first category, the Fund would be in a position to provide financing in accordance with its catalytic function; namely, although the member might have lost market access, the Fund was confident that the underlying debt dynamics were sound, the loss of market access was temporary, and that, accordingly, it would be appropriate for the program to allow for the payment of outstanding obligations as they fall due.
If, on the other hand, a member fell into the latter category, the type of debt restructuring needed would have to be sufficiently definitive to re-establish debt sustainability with high probability.3 Under the 2002 Framework, a member’s debt can be considered sustainable with high probability even though it needs to be restructured because, as is made explicit in the above text, the debt sustainability evaluation is made on a forward-looking basis and may take into account the intended restructuring that will restore sustainability.
9. The systemic exemption created in 2010 effectively established a third category of members. Under the 2010 decision, the 2002 framework was modified to permit exceptional access in cases where there are “significant uncertainties that make it difficult to state categorically that there is a high probability that the debt is sustainable in the medium term” and where there is “a high risk of international systemic spillovers.” It is important to emphasize that this category is limited to those cases of “significant uncertainties.” If a judgment is reached that the member’s debt is clearly unsustainable (i.e., where there is relatively little uncertainty on this question), the Fund would be precluded from providing financing without steps being taken to address the situation.
10. The above text recognizes that a debt restructuring may not be the only means of restoring debt sustainability with high probability. Specifically, the use of the term “inter alia” in the third sentence takes into account the possibility that this standard could be met, for instance, through the provision of financing from sources other than the Fund if the terms of that financing were sufficiently favorable to address the underlying sustainability concerns.
B. The Proposed Text
11. Taking into account the above analysis and the considerations set forth in the 2014 paper regarding the benefits of introducing greater flexibility, the revised text of the relevant sustainability criterion could be formulated as follows:
“A rigorous and systematic analysis indicates that there is high probability that the member’s public debt is sustainable in the medium term. Where the member’s debt is assessed to be unsustainable ex ante, exceptional access will only be made available where the financing being provided from sources other than the Fund restores debt sustainability with a high probability. Where the member’s debt is considered sustainable but not with a high probability, exceptional access would be justified if financing provided from sources other than the Fund, although it may not restore sustainability with high probability, improves debt sustainability and sufficiently enhances the safeguards for Fund resources. For purposes of this criterion, financing provided from sources other than the Fund may include, inter alia, financing obtained through any intended debt restructuring. This criterion applies only to public (domestic and external) debt. However, the analysis of such public debt sustainability will incorporate any potential contingent liabilities of the government, including those potentially arising from private external indebtedness.”
12. Under the revised text, the first sentence would cover those cases where debt is considered sustainable with high probability in the absence of any debt restructuring. These cases would include those where, although a member may have lost market access, the Fund is confident that this loss is temporary and that underlying debt dynamics are sound. As discussed in the 2014 paper, in these circumstances, the approach that is least costly to all stakeholders is for the Fund to provide financing in support of a strong adjustment program that envisages payments being made to creditors in accordance with their original terms. Accordingly, for this category of members, no change is proposed.
13. The second sentence would explicitly cover those cases where debt is assessed to be clearly unsustainable. Again, relative to the existing framework, no substantive change is being proposed for this category. Exceptional access would be provided in such circumstances only where action is taken that is sufficiently definitive to restore debt sustainability with high probability.4 The new text makes explicit that such action could involve up-front debt restructuring, but also recognizes—consistent with the existing text—an alternative remedy whereby financing is obtained from sources other than the Fund that is on terms sufficiently favorable to achieve the same objective: “For purposes of this criterion, financing provided from sources other than the Fund may include, inter alia, financing obtained through any intended debt restructuring.”5
14. The third sentence would introduce the key substantive modification to the existing exceptional access framework (Figure 1). It would cover those cases where, although the member’s debt is considered to be sustainable, this determination cannot be made with high probability, that is, there is a considerable uncertainty on this question.6 These are cases that are not covered by the first two sentences. Unlike the systemic exemption introduced in 2010, however, this category would cover all members where there is uncertainty—irrespective of whether or not there is a high risk of international systemic spillovers. In terms of the treatment of these cases, exceptional access would only be made available “if the financing provided from sources other than the Fund, although it may not restore sustainability with high probability, improves debt sustainability and sufficiently enhances the safeguards for Fund resources.”
Comparison of Current and Proposed Frameworks for Exceptional Access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Comparison of Current and Proposed Frameworks for Exceptional Access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Comparison of Current and Proposed Frameworks for Exceptional Access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
15. The fact that, in these uncertain cases, external financing does not have to be sufficient to restore debt sustainability with high probability is designed to introduce greater flexibility into the exceptional access framework established in 2002. As discussed in detail in the 2014 paper, where there is uncertainty as to whether a member’s debt is sustainable or unsustainable, requiring a debt restructuring that is sufficiently definitive to restore debt sustainability with high probability may impose unnecessary costs on the member, its creditors, and the system given the fact that the debt reduction involved in these types of restructuring can have a disruptive effect.
16. Under the proposed modification, a less definitive debt restructuring would be acceptable provided that it satisfies two inter-related requirements: (a) it improves debt sustainability and (b) it sufficiently enhances the safeguards for Fund resources. A restructuring that involves a “reprofiling” of debt obligations (i.e., a relatively short extension of maturities that would normally not involve a reduction of principal or interest) would typically be sufficient to meet these criteria for the following reasons:
First, while a reprofiling would not reduce the nominal level of debt and may not restore debt sustainability with high probability, it would generally improve debt sustainability prospects. For a sovereign that is liquidity-constrained, reprofiling would tend to ease the burden of a given stock of debt by smoothing repayments, or shifting them to a period where capacity to pay is expected to be greater. Moreover, relative to a program that envisages maturing obligations being paid in full with official resources, a reprofiling would positively affect sustainability by facilitating a restoration of market access: creditors are more likely to re-engage if a larger portion of the debt stock consists of private claims (as would be the case following a reprofiling), since it reduces the risk that they would be subordinated to official sector claims in the event of a subsequent debt restructuring.7 In addition, a reprofiling may enhance the prospects of securing sustainability, since the financing it provides would facilitate a less constraining adjustment path, where appropriate. Finally, the fact that creditors are contributing to the resolution of the crisis through a reprofiling may help the member catalyze domestic support for the implementation of the program.
Second, a reprofiling enhances the safeguards for Fund resources by effectively providing a form of insurance against the possibility that, ultimately, a more definitive debt restructuring may be needed. In the event that downside risks materialize and a subsequent and deeper restructuring is needed, the key benefit of a reprofiling—relative to a bailout—is that there would be a larger pool of non-senior creditor exposures that can absorb the burden of such an operation. Indeed, from the perspective of the member’s capacity to repay the Fund, it is this feature that enables the Fund to accept a lower degree of certainty with regard to debt sustainability. For these purposes, it would be important that a reprofiling broadly maintains the exposure of non-Fund creditors over the course of the program.8 The insurance provided by the reprofiling would also be beneficial to private creditors holding longer maturities: relative to a bail-out where a significant portion of the private claims may be substituted by senior official claims, the burden of a subsequent restructuring will fall on a broader group of creditors, thereby reducing the amount that each creditor will need to contribute.
Third, the financing provided by the reprofiling should enhance safeguards for Fund resources since it will normally reduce the level of access that will be needed. As noted above, there may be cases where the additional financing provided by the reprofiling will be used to ease an adjustment path that would otherwise be excessively constrained. In many—if not most—cases, however, a primary benefit of this financing is that it will reduce the level of access that will be needed.
17. Consistent with the flexibility in the current criterion, it is possible that external financing in uncertain cases will not always involve a debt restructuring. The proposed formulation is designed to take into account two different possibilities that may arise in uncertain cases. First, there may be circumstances where, notwithstanding concerns regarding debt sustainability, the member continues to have market access. In this case, private creditors would continue to contribute to the financing of the program without the need for a debt operation.9 Second, where market access has been lost, there may be situations where the repayment profile of the member’s debt is such that, even in the absence of a debt restructuring, sufficient private or non-Fund official sector exposure is maintained during the period of the program to mitigate the type of risks being addressed. Moreover, in some circumstances, official bilateral creditors may prefer to make their contribution in the form of new financing commitments.
18. As discussed at length in the 2014 paper, the above approach is based on an assessment that, in circumstances of uncertainty, a reprofiling is less costly than a deep debt operation aimed at restoring debt sustainability with high probability. This assessment takes into account the Fund’s own experience with reprofilings in the past (the case of Uruguay, 2003, being a notable example) as well as extensive consultation with market participants. Although a debt reprofiling is a form of debt restructuring that will likely result in a credit rating downgrade to selective default, a sovereign is likely to return to capital markets more quickly following a reprofiling than after an operation that results in debt reduction (see the past experience reviewed in the 2014 paper). Since reprofilings, by design, will have a smaller impact on the net present value of creditors’ claims, they will be less disruptive both for the financial institutions of the member that hold these claims and for the foreign holders of such claims. At the same time, it will be important to ensure that reprofilings are not relied upon in circumstances where a more definitive debt restructuring is needed. Where it has become clear that a member’s debt is, in fact, unsustainable, it is in the interest of all stakeholders—the debtor, creditors, the system and the Fund—for there to be a debt restructuring that is sufficiently definitive to resolve the underlying problem; that is, one that restores debt sustainability with high probability.10
19. The precise modalities of the restructuring will be determined by the sovereign debtor, in consultation with its creditors. While the Fund’s assessment of where the member falls on the sustainability continuum would determine how much debt relief is needed, the way in which this debt relief is delivered may vary. Where there are uncertainties regarding the member’s sustainability and, accordingly, a less intrusive debt restructuring is needed, the design of the restructuring may vary depending on the circumstances of the member. For example, while a reprofiling would generally imply a relatively short extension of maturities, its actual length may vary depending on the structure of the member’s debt. Conversely, for members that need significant debt relief (because it is relatively clear that the debt is unsustainable), the restructuring would normally involve an explicit write-down of principal. There may be circumstances, however, where, as part of a menu of options, creditors are offered instruments that involve reschedulings of sufficiently long duration that they effectively deliver the same amount of debt relief as upfront debt reduction—and far more debt relief than provided by the type of reprofiling envisaged in circumstances of uncertainty. As discussed in the next section, the scope of debt to be covered would also take into account the impact of any operation on financial stability.
20. Under the proposed approach, the systemic exemption would be eliminated. As discussed in the following section (Section III), staff is of the view that such an exemption does not achieve the objective of limiting contagion and risks increasing costs for the sovereign debtor and its creditors. Nevertheless, in very rare cases (”tail” events) it is recognized that the official sector may wish to avoid any form of debt restructuring because of contagion concerns. In these tail events, it is proposed that, as an alternative to the systemic exemption, Fund support would be made conditional upon financing from official bilateral sources that meets the criteria under the revised general framework discussed above. This proposal is outlined in Section III.C.
21. It is important to highlight that, in staff’s view; the proposals to (i) increase the flexibility of the general framework, and (ii) remove the systemic exemption should be seen as a “package.” Consistent with the views expressed by a number of Directors during the 2014 discussions, increasing the flexibility of the general framework, while at the same time retaining the systemic exemption, would create a framework that is excessively permissive.
III. Addressing Spillover Effects from Debt Restructuring
22. While the Fund’s lending policy must be designed to address the problems of the distressed member, in a world of interconnected financial systems it should also take into account the impact on other members. At the same time, Fund policy cannot have the effect of hampering a country’s efforts to return to financial viability in order to mitigate spillover concerns. This is the central problem with the systemic exemption: by not conditioning exceptional access on a debt operation that would otherwise be warranted, it leaves the distressed member laboring under a debt burden that will likely impede its economic recovery and delay the return to market access. An alternative approach to address spillover concerns is therefore needed. This section begins by describing the nature of the spillover effects that can arise in a sovereign debt crisis, including from debt restructuring. To the extent that such effects are an essential part of the adjustment to a new equilibrium, they should be accommodated. At the same time, policy interventions may be called for to manage the adjustment process, avoid overshooting, and preserve macroeconomic stability. Section B discusses the wide range of tools that can be used for this purpose. Such measures are likely to be sufficient to maintain stability and allow a debt restructuring to proceed in all but the most extreme cases of systemic risk. In the rare event where policymakers conclude that the potential fallout from a restructuring of private claims would be unmanageable, section C describes an alternative approach in which debt sustainability is instead restored through the provision of bilateral official sector support on sufficiently favorable terms.
A. Understanding the Nature and Types of Spillovers
23. Situations of sovereign debt distress have the potential, in general, to trigger financial spillover effects both domestically and across borders. Experience shows that such effects build up progressively as confidence in the sustainability of the sovereign’s debt deteriorates. As a crisis point approaches, market behavior is increasingly influenced by expectations about how policymakers will act to resolve the crisis, including the possibility that debt may need to be restructured. Once a plan for addressing the crisis is announced and associated actions taken, further market shifts and spillovers may occur, in particular if the policy decisions differ from priced-in expectations. If, at that stage, the risks to debt sustainability are perceived to have been credibly addressed, market volatility and spillover risks then typically subside as the uncertainties diminish.
24. The possible spillovers from a debt restructuring operation have to be considered in this broader context. In particular:
The channels through which debt restructuring may trigger spillover effects are at work throughout an episode of sovereign debt distress, whether or not the episode culminates in a restructuring: these channels are discussed further below.
The nature, intensity, and timing of the spillover effects associated with a restructuring decision will depend on the extent to which the decision is anticipated by markets, which in turn will depend in part on the clarity of the policy framework governing such decisions; market uncertainty regarding the policy framework will tend to aggravate volatility and spillovers before and after the decision is announced.
A decision to restructure debt that is widely anticipated and viewed as credibly resolving the crisis country’s debt vulnerabilities is more likely to settle than to disrupt financial markets; conversely, a decision not to restructure debt may lead to market pressures and spillovers if the alternative policy approach is not viewed as adequate to restore debt sustainability, leaving markets concerned about default risk on remaining maturities (see Section C).
25. Spillover channels are numerous and complex. Broadly speaking, they can be grouped under four broad headings:11
Financial channels. In this category, spillovers operate through banks or other financial intermediaries abroad. They can result from direct exposure to the sovereign—through these institutions’ holdings of the affected debt, the provision of protection through credit default swaps (CDS) on that debt, or where the debt is used as collateral—or from indirect exposure. An example of the latter would be where financial institutions in the crisis country are funded in international markets; to the extent that the local institutions are impaired by a sovereign debt operation, the losses inflicted on foreign funding institutions may cause those foreign funding institutions to reduce the supply of credit in other countries. Such spillovers may be especially severe if the debt shock (and, possibly, related currency depreciation) leaves domestic banks undercapitalized, or triggers deposit runs.
Risk aversion and confidence channels. When a sovereign debt crisis hits, or when a restructuring is launched, it is often unclear where the exposures lie, how severe the fall-out will be, and who else might be affected. This and other informational asymmetries could lead to more generalized “risk off” behavior in which investors sell assets across countries and retrench to safe havens. Investors may also be prompted to re-evaluate countries that have similar economic characteristics or are perceived to share common vulnerabilities with the crisis country (the “wake-up call” phenomenon), probing for vulnerabilities that they may not have been aware of—or concerned about—during calmer market conditions. Less discriminating investors may decide to re-price the entire asset class to which the crisis country belongs, with the result that even countries with solid fundamentals are adversely affected.
Portfolio reallocation channels. Significant losses on exposure to a particular sovereign may force exposed institutional investors to liquidate assets in other countries to meet margin calls or cash requirements, or to rebalance their portfolios (in some cases, as required by their mandates). The trade strategies employed by institutional investors also often attempt to exploit assumed correlations among different assets or asset classes (“cross-market hedging”). Again, this can mean that sudden losses on holdings of one sovereign’s debt precipitate a broader sell-off of other assets. More broadly, as investors seek to rebalance their portfolios, secondary market trading may result in debt instruments migrating from investors who hold relatively high-rated sovereign claims toward investors who have a greater tolerance for risk. This is likely to be associated with a shift in the pattern of yields, and possibly market volatility as the rebalancing plays out.
Policy channels. A country engaged in restructuring its debt may have to take other complementary policy measures that, in turn, create cross-border spillovers. To shore up impaired domestic banks, for example, the authorities may need to extend guarantees on bank liabilities, at least temporarily, and this may put pressure on other countries that have close banking relationships with the crisis country (e.g., in a currency union) to follow suit. Alternatively, the response (or lack of response) of policymakers, including at supra-national levels, can generate uncertainty that, in turn, can trigger panic-selling in other markets. For instance, the Deauville declaration (in the aftermath of the May 2010 Greece bail-out) that proposed that private creditors share the burden in future defaults sent Irish spreads soaring as investors interpreted it as signaling a change in the “rules of the game.” However, the subsequent decision not to bail in the creditors of Irish banks generated more speculation about the same “rules of the game.”
26. Not all cross-border spillovers induced by an actual or expected debt restructuring are unhealthy. Indeed, to the extent that the ensuing adjustments in capital flows, prices, and balance sheets reflect a proper repricing of risk—in line with economic fundamentals—they are beneficial and should be allowed to play out. At the same time, efficiency considerations suggest a role for policy intervention, depending on the circumstances, to moderate the pace of adjustment, avoid overshooting, and resist those adjustments not related to fundamentals (e.g., fluctuations driven by herd behavior or imperfect information), to the extent that these can be distinguished. The next section discusses the forms that such policy action might take.
B. Managing Spillovers and Stability Risks
27. Experience from past crises suggests a wide range of measures that policymakers can deploy in the face of sovereign debt distress to maintain stability and minimize costs, while allowing the necessary adjustments to run their course. Some of these measures are systemic in nature and are best put in place preemptively. Some are steps that can be taken by the crisis country, with a view to ensuring that its own adjustment process (including the design of any debt operation) is as orderly as possible—thereby avoiding unnecessary spillovers to others. Some can be taken by those countries that are (or may be) affected by spillovers in order to safeguard the stability of their economies.
Systemic measures
28. The policy frameworks that guide decisions on debt restructuring, and the resolution of financial distress more broadly, should be articulated as clearly as possible ex ante. As noted in the previous section, when debt sustainability concerns arise, investor uncertainty regarding the circumstances under which a restructuring of debt will be called for will tend to aggravate market volatility and spillovers. Such uncertainty cannot be eliminated, but it can be mitigated. The Fund has an important role in this regard, since its lending decisions often determine whether and when a country in distress decides to restructure its debt. The adoption of the exceptional access policy in 2002 was an important step forward in clarifying the criteria governing Fund lending decisions. While the policy needs to retain room for case-by-case judgments, the further reforms now being proposed would help make the current framework more transparent, as will ongoing efforts to improve and disseminate the tools the Fund uses to inform judgments on debt sustainability. In a similar vein, since in many cases sovereign debt restructuring operations have to be accompanied by measures to recapitalize banks, market responses are likely to be more orderly if policies regarding the bail-in of bank creditors are specified clearly in advance. Major reforms in the US and Europe since the global financial crisis have made the “rules of the game” significantly clearer in this area, and should help mitigate volatility in future stress episodes.
29. Financial safety nets at the global and regional level also have a crucial role to play in managing spillovers. In recognition of this fact, important steps have been taken in the wake of the global financial crisis, on several fronts. The Fund’s resources have been scaled up substantially and its facilities overhauled to provide an expanded range of actual and precautionary support to members facing cross-border spillover risks. In the eurozone—among the segments of the global economy most prone to systemic financial spillovers, given its large size and highly interconnected markets—the establishment of the European Stability Mechanism (ESM), together with the demonstrated commitment of the European Central Bank (ECB) to provide large-scale liquidity support when needed, have created credible firewalls to help member states preserve financial stability and manage spillovers in times of severe stress. The development of other regional financial arrangements (RFAs) and networks of bilateral swap lines—notably in Asia and Latin America, and most recently by Brazil, Russia, India, China and South Africa (BRICS)—has likewise intensified since the crisis, and there is scope to strengthen these safety net mechanisms further to guard against future adverse spillovers.12
Measures in the crisis country
30. In a situation of sovereign debt distress, prompt action by the country to address its debt problems will limit their severity and the resulting fallout, not only for its own economy but also internationally. Policy adjustment should begin early, if necessary with financial support from the Fund and other partners—preferably well before concerns about debt sustainability trigger a loss of market access. In situations where adjustment alone is considered unlikely to ensure debt sustainability, taking steps to restructure debt sooner rather than later will result in lower costs and more limited market disruption at home and abroad.13
31. If and when a decision is made to restructure the sovereign’s debt, there are ways to design the operation that can mitigate its impact on domestic financial stability and hence limit broader spillover risks. First, if action is taken early, it is more likely that the operation can take the more limited form of a reprofiling, rather than a significant up-front debt reduction. For the reasons discussed extensively in the 2014 paper, and recapped above, reprofilings tend to be less disruptive and hence any spillover effects will be more muted. Second, past experience has shown that the debtor and its creditors can exercise considerable discretion over the scope of debt to be treated and can establish backstops, with a view to avoiding undue financial disruption. Indeed, in general, it makes sense to apply cost-benefit principles to these decisions. On the one hand, a broad coverage of debt instruments has benefits in terms of the associated improvements in debt sustainability and the likely willingness of creditors to participate (haircuts, if needed, will tend to be smaller, and inter-creditor equity problems will be less severe). On the other hand, various potential costs need to be set against these benefits. This could lead to the conclusion that, on a case-by-case basis, some categories of debt should be excluded from a particular debt operation or that explicit protection for some classes of debt holder needs to be adopted.14 For example:
Short-term debt instruments (by original maturity). These are not only difficult to capture in practice but they also often play an essential role in the functioning of interbank markets, and hence in maintaining financial stability. They have generally been excluded from past restructurings, with a few exceptions.15
Trade credits, guarantees, and complex instruments of limited size. These types of obligation tend to be either hard to restructure or yield benefits that are too modest to justify the disruption involved.
Domestic currency-denominated debt. In a typical adjustment program, the real value of these instruments may be reduced through currency devaluation or ongoing inflation and hence may not warrant the same treatment as foreign exchange denominated debt. They also tend to be held disproportionately by domestic financial institutions, implying a limited net contribution to the country’s financing needs in a crisis context and possible adverse financial stability effects.16
32. Ultimately, the design of a particular debt operation, including its scope, will depend very much on country circumstances and prevailing market conditions. There is no standard blueprint. On the contrary: where there are significant stability and spillover concerns, the parties involved have considerable leeway to tailor the scope of debt restructuring operations, taking these concerns into account case-by-case, and to deploy supporting measures as necessary to limit any adverse effects. Cyprus and Jamaica are two recent examples of reprofilings where careful choices around the scope of debt, informed by country and market conditions, preserved financial stability.
Measures in countries affected by spillovers
33. Any economy that is integrated into international capital markets has to be prepared to manage externally induced volatility from time to time. As should be apparent from the preceding discussion of spillover channels, the types of shock a country may face as a result of a foreign sovereign debt crisis or restructuring are not qualitatively different from others it has to contend with as international capital ebbs and flows, asset prices fluctuate, and the cost of credit rises and falls. Possible policy responses to preserve macroeconomic and financial stability would include central bank liquidity support, foreign exchange market intervention, steps to ensure domestic financial institutions remain adequately capitalized, and (when stresses are severe) temporary use of regulatory forbearance and of capital flow management measures.
34. If necessary, countries facing actual or potential large-scale spillovers can also draw on various sources of cross-border financial support. Such recourse has been a common feature of past systemically significant crises—from the Mexican and Asian crises of the 1990s to the recent global financial crisis. As described above, the main components of the global financial safety net (bilateral swap lines, RFAs, and Fund facilities) have been progressively strengthened.
C. Addressing ‘Tail’ Events
35. Despite the abundance of possible containment measures, there may be cases where any type of restructuring (even a reprofiling) is considered too costly. In particular, in a rare tail-risk event, policymakers may conclude that contagion and financial stability risks are so severe that defensive measures would be inadequate—or would take time to put in place—and a restructuring of private claims must be avoided. In this context, some have argued that the existence of the systemic exemption acts as an implicit guarantee and, by doing so, creates some constructive ambiguity about how “other” cases in similar circumstances to the crisis country could be treated. The exemption, by facilitating a bail-out of the crisis country, may be perceived as reducing the likelihood of debt treatment in “other” similar cases. This dynamic may offer a channel through which contagion can be mitigated, to the extent that the markets’ fears regarding “other” countries’ vulnerabilities are misplaced. However, staff’s view is that even in such cases, the systemic exemption and the ensuing bail-out do not constitute an appropriate solution.
36. The principal problem with the systemic exemption is that it impairs the program country’s prospects for success. When a distressed member faces significant debt vulnerabilities—notwithstanding the adjustment efforts it is committed to making under a Fund-supported program—it is in the member’s interest to address those vulnerabilities sooner rather than later in an appropriately calibrated way. If the systemic exemption is invoked, and a debt reprofiling that would otherwise be called for under the reformed exceptional access policy is ruled out, the various benefits from that reprofiling (as described above) are foregone and the prospects for a successful outcome to the member’s program are correspondingly diminished. Specifically, in the absence of the financing provided by the reprofiling, significantly more official sector resources would be required to accommodate a less stringent adjustment path. Moreover, the effective replacement of private claims with public debt will result in greater subordination of remaining (and future) private creditors, thereby further hampering the member’s re-access to capital markets. While it is appropriate for the Fund to take due account of spillover effects from policies it supports, it should not do so in a way that imposes an undue burden on a distressed member.
37. Second, it is far from clear that the systemic exemption can be relied upon to mitigate contagion. As discussed above, staff’s analysis suggests that contagion in a sovereign debt crisis is driven primarily by market concerns regarding the crisis country’s underlying vulnerabilities, and uncertainties about how those vulnerabilities will ultimately be addressed. Lending in the context of a systemic exemption will not address these concerns or uncertainties. A close examination of the 2010–12 euro area crisis, which could certainly be seen as a tail event, illustrates this point (Figure 2). When the Greek situation came to a head in early 2010, neither the institutional arrangements in the euro area, nor expectations in global financial markets were ready for a sovereign debt restructuring in a currency union of closely-linked advanced economies. In this context, the systemic exemption and associated bailout bought time to build the necessary firewalls. But the effectiveness of the bailout in mitigating contagion was impaired, as concerns lingered about Greece’s solvency.17 In particular, the bailout was not seen as averting the likelihood of a subsequent debt restructuring, in the context of broader market concerns about the euro zone’s policy framework and the prospects of the euro itself. It was only after European institutions, most notably the ECB, made commitments in mid-2012 that were perceived as constituting credible firewalls that sovereigns and bank spreads began to abate throughout the euro zone. By this stage, euro area policymakers had also come to accept that the terms of the financing provided by official creditors would need to be improved to bolster Greece’s debt sustainability. Below (¶39 et seq.), we set out an alternative approach that could have addressed concerns about debt sustainability even without a debt operation.
Sovereign CDS Spreads in Italy, Spain, Ireland, Portugal, and Greece (2010–12)
(basis points)
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sovereign CDS Spreads in Italy, Spain, Ireland, Portugal, and Greece (2010–12)
(basis points)
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sovereign CDS Spreads in Italy, Spain, Ireland, Portugal, and Greece (2010–12)
(basis points)
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
38. Third, the systemic exemption aggravates moral hazard in the international financial system and may exacerbate market uncertainty in periods of sovereign stress. The lessons policymakers have drawn from the crisis with regard to taxpayer-funded bail-outs of banks, and the subsequent shift to frameworks that prescribe creditor bail-in, apply also to Fund lending in a sovereign context.18 Specifically, the perception of insurance against downside risk fueled by implicit bail-out guarantees can encourage excessive debt accumulation, as creditors’ decisions become disconnected from underlying fundamentals.19 The retention of the exemption could be seen as the perpetuation of such a guarantee on sovereign debt, and lead to an ex-ante under-pricing of sovereign risk. Ex-post, that is, in periods of sovereign stress, the exemption has the potential to distort market prices (and thus, to contribute to uncertainty) as market participants may bet on whether the exemption will be activated, rather than focusing on underlying sustainability.
39. As suggested in the 2014 paper, in an extreme tail-risk event where rescheduling of private claims is considered too hazardous, Fund support could be warranted if accompanied by assurances from other official creditors of support on terms sufficiently favorable to address sustainability concerns. This approach would be more effective than invoking the systemic exemption because it would address the source of the member’s vulnerabilities. It would not avoid the moral hazard problem, but this concern is allayed by the expectation that this approach would be called upon only very rarely.
40. The Fund has extensive experience with catalyzing supplementary support from other official sources. Box 1 looks at a sample of arrangements with exceptional access—from the 1990s to the global financial crisis—where the official sector provided large-scale financing as part of, or as a backstop to, Fund-supported programs. The review shows that official creditors have often committed a large share of past rescue packages, with some stakeholders moving rapidly to provide support. There are also precedents for tailoring the terms of such support in light of the financial situation of the borrower, including the euro area programs and Jordan (2012).
Earlier Crisis Episodes with Official Sector Financing
This box reviews Fund experience with official financing in earlier crisis episodes. The analysis shows that the Fund has a wide range of experience catalyzing official support, particularly in cases where there was a potential for significant cross-border spillovers. Official creditors have often contributed a large share of rescue packages, with one large member at times moving swiftly to provide support.
This box examines exceptional access Fund programs with official financing between 1994 and 2012. The analysis focuses on cases where non-multilateral creditors provided sufficient financing to form a firewall or backstop to the crisis (i.e., the share of non-multilateral financing exceeded one-third of total financing needs). These include Mexico (1995), Thailand (1997), Indonesia (1997), Korea (1997), and Brazil (1998) as well as programs launched since the global financial crisis: Iceland (2008), Latvia (2008), Greece (2010, 2012), Ireland (2010), Portugal (2011), and Jordan (2012). These countries were selected due to the importance of financing from non-international financial institutions (IFI) in the program packages. In addition, they are regionally diverse, including countries from Asia, Latin America, Europe, and the Middle East, and were supported by a range of official bilateral creditors (US, EU, G7, and the Gulf Cooperation Council). They also include both systemic and nonsystemic countries.
A number of common themes emerge from the analysis:
The official sector contribution in the earlier crisis episodes was as large as in the euro area crisis countries. The Fund’s share of the financing package ranged from ¼ to ½ at the time of the program requests.
In Korea, some of the financing was contingent, and was provided as a second line of defense. So while the ex-ante Fund share was small, the de facto share was significantly larger, as these contingent bilateral lines were not activated. In contrast, in the 1998 Brazil program bilateral financing was provided as a first line of defense.
A key factor that separates Mexico and Thailand from subsequent cases was the presence of a large member willing to move rapidly to mobilize financing. The Clinton administration’s efforts to mobilize resources for Mexico were initiated long before the approval of the Stand-By Arrangement (SBA). Similarly, in Thailand, although this was not a sovereign debt crisis, the Japanese moved to assemble a package. In subsequent cases, with financing fatigue setting in and growing concerns about bail-outs, there was no equivalent champion to lead the fundraising efforts, and broader coalitions had to be assembled.
In the earlier crisis programs, the terms of the financing package were tied to creditor funding costs.
The U.S. loan in the Mexican crisis was provided on terms equal to US funding costs (91-day treasury bills), that is, much lower than Mexico’s market rates at the time. With the resolution of the crisis, the Mexican authorities repaid the loans three years ahead of schedule.
In Thailand, the bilateral loans were provided as six-month swaps, disbursed in conjunction with Fund disbursements.
Information on the terms of other official financing packages is unavailable but they were likely also tied to funding rates (e.g., LIBOR).
In Iceland, the bulk of the financing was provided at a spread of about 300 bps over mid-swaps.
Lending in euro-area programs, especially Greece, was provided at low interest rates (creditor funding cost plus small margin, as above), and maturities were subsequently extended by up to 30–40 years, with long grace periods (e.g., 10 years in Greece).
In non-euro-area programs, concessionality took on different forms. In Jordan, for example, the GCC provided grants and the U.S. provided large Eurobond guarantees.
Crisis Episodes with Official Sector Financing1
(billions of US$)
All amounts are as foreseen at the time of the IMF arrangement request and may differ from actual disbursements.
Billions of Euros.
Financing provided by banking consortium.
Financing earmarked for payments in relation to the foreign branch deposits of the Icelandic banks.
Crisis Episodes with Official Sector Financing1
(billions of US$)
| Program | Total | IMF | IFIs | Bilateral and EU | Other | IMF share | Non-IFI share | |
|---|---|---|---|---|---|---|---|---|
| Earlier crisis episode | ||||||||
| Mexico SBA (Mar 1995) | 51.8 | 17.8 | 31.0 | 3.0 3/ | 34.4 | 65.6 | ||
| Thailand SBA (Aug 1997) | 16.0 | 4.0 | 3.0 | 9.0 | 25.0 | 56.3 | ||
| Indonesia SBA(Nov 1997) | 33.0 | 10.0 | 8.0 | 15.0 | 30.3 | 45.5 | ||
| Korea SBA (Dec 1997) | 55.0 | 21.0 | 14.0 | 20.0 | 38.2 | 36.4 | ||
| Brazil SBA (Nov 1998) | 42.0 | 18.0 | 9.0 | 15.0 | 42.9 | 35.7 | ||
| Recent crisis episodes | ||||||||
| Iceland SBA (Nov 2008) | 10.2 | 2.0 | - | 8.2 4/ | 19.6 | 80.4 | ||
| Latvia SBA (Dec 2008) 2/ | 7.5 | 1.7 | 0.5 | 5.3 | 22.7 | 70.7 | ||
| Greece SBA (May 2010) 2/ | 110.0 | 30.0 | 80.0 | 27.3 | 72.7 | |||
| Ireland EFF (Dec 2010) 2/ | 67.5 | 22.5 | 45.0 | 33.3 | 66.7 | |||
| Portugal EFF (May 2011)2/ | 78.0 | 26.0 | 52.0 | 33.3 | 66.7 | |||
| Greece EFF (Mar 2012) 2/ | 172.7 | 28.0 | 144.7 | 16.2 | 83.8 | |||
| Jordan SBA (Aug 2012) | 4.2 | 2.0 | 0.4 | 1.8 | 47.6 | 42.9 | ||
All amounts are as foreseen at the time of the IMF arrangement request and may differ from actual disbursements.
Billions of Euros.
Financing provided by banking consortium.
Financing earmarked for payments in relation to the foreign branch deposits of the Icelandic banks.
Crisis Episodes with Official Sector Financing1
(billions of US$)
| Program | Total | IMF | IFIs | Bilateral and EU | Other | IMF share | Non-IFI share | |
|---|---|---|---|---|---|---|---|---|
| Earlier crisis episode | ||||||||
| Mexico SBA (Mar 1995) | 51.8 | 17.8 | 31.0 | 3.0 3/ | 34.4 | 65.6 | ||
| Thailand SBA (Aug 1997) | 16.0 | 4.0 | 3.0 | 9.0 | 25.0 | 56.3 | ||
| Indonesia SBA(Nov 1997) | 33.0 | 10.0 | 8.0 | 15.0 | 30.3 | 45.5 | ||
| Korea SBA (Dec 1997) | 55.0 | 21.0 | 14.0 | 20.0 | 38.2 | 36.4 | ||
| Brazil SBA (Nov 1998) | 42.0 | 18.0 | 9.0 | 15.0 | 42.9 | 35.7 | ||
| Recent crisis episodes | ||||||||
| Iceland SBA (Nov 2008) | 10.2 | 2.0 | - | 8.2 4/ | 19.6 | 80.4 | ||
| Latvia SBA (Dec 2008) 2/ | 7.5 | 1.7 | 0.5 | 5.3 | 22.7 | 70.7 | ||
| Greece SBA (May 2010) 2/ | 110.0 | 30.0 | 80.0 | 27.3 | 72.7 | |||
| Ireland EFF (Dec 2010) 2/ | 67.5 | 22.5 | 45.0 | 33.3 | 66.7 | |||
| Portugal EFF (May 2011)2/ | 78.0 | 26.0 | 52.0 | 33.3 | 66.7 | |||
| Greece EFF (Mar 2012) 2/ | 172.7 | 28.0 | 144.7 | 16.2 | 83.8 | |||
| Jordan SBA (Aug 2012) | 4.2 | 2.0 | 0.4 | 1.8 | 47.6 | 42.9 | ||
All amounts are as foreseen at the time of the IMF arrangement request and may differ from actual disbursements.
Billions of Euros.
Financing provided by banking consortium.
Financing earmarked for payments in relation to the foreign branch deposits of the Icelandic banks.
41. This approach would fit within the proposed general framework described in Section II, thereby avoiding the need for any exemption. Specifically:
First, in circumstances of uncertainty, a restructuring could be avoided if other official bilateral creditors were willing to provide or maintain financing during the period of the program on terms that “improve debt sustainability and sufficiently enhance the safeguards for Fund resources”: namely, official creditors would need to provide assurances that they would be willing to change the terms of their claims in the event that the Fund assesses that the outlook for debt sustainability has deteriorated and a subsequent restructuring is needed. This commitment would provide the type of ”insurance” that would normally be provided through a reprofiling of private claims. If, however, official creditors are unwilling to provide such assurances, the terms of the financing would need to be sufficiently generous, upfront, to restore debt sustainability with high probability.
Second, in circumstances where debt is clearly unsustainable, the terms of the financing provided by other bilateral creditors would need to be sufficiently favorable to restore debt sustainability with high probability. This could take the form of loans with long tenors and concessional rates, grants, or other instruments.
42. It should be emphasized that the tail event approach described above could be implemented with considerable flexibility and with sufficient speed. First, where debt is unsustainable, the provision of financing on “favorable terms” need not necessarily require the creditor to lend below its own cost of funds: the key is that the terms are better than the debtor could get elsewhere, including from the Fund—how much better will depend on the severity of the member’s debt problems. Second, it would not be necessary to hold up Fund support until there is complete clarity regarding the nature or the terms of the financing. In circumstances of uncertainty, creditors would provide assurances that they would be prepared to modify the terms of their loans in the future in the event a more definitive debt restructuring is needed. Where debt is clearly unsustainable, the Fund could rely on a credible political commitment from official creditors that they will do whatever it takes to provide financing on terms that are sufficiently favorable to restore sustainability with high probability. Third, the form of the eventual financing package could vary. Possibilities include concessional rescheduling of existing claims, new money on favorable terms, or guarantees that allow the member to borrow cheaply from other lenders.
43. This approach would not involve the Fund “stepping back” from the central role it plays in crisis resolution. On the contrary, this approach would enable the Fund to step forward with financial assistance with a degree of confidence that the program will actually work. To the extent that the financing provided by official creditors, when coupled with the adjustment program, addresses underlying sustainability concerns, Fund support will enable the member to effectively address its underlying balance of payments problems, and will contribute durably to global financial stability. Moreover, the Fund would continue to play its traditional role in coordinating the provision of bilateral official financing in support of a member’s adjustment program.
44. Staff has engaged in informal outreach with market participants on the perceived costs and benefits of the elimination of the systemic exemption. A number of market participants emphasized the subordination problems that arise with a reliance on the systemic exemption: if, in the end, the exemption is relied upon to defer a restructuring that is very likely to take place, the replacement of private claims with more senior official claims adversely affects those private creditors who are not able to exit because of the maturity structure of their claims. These participants also took the view that, as a general matter, concerns regarding contagion are overstated and, in those rare cases where it is an issue, it will not be addressed unless and until there is a credible financing and adjustment package in place. Finally, they noted that the exemption undermines the predictability of the Fund’s lending framework since it introduces a variable that is unrelated to sustainability and is subject to potential abuse; for example, it could be invoked for geopolitical rather than systemic reasons. Some market participants, however, observed that, even if the systemic exemption is removed, the Executive Board can, by a majority of votes, re-introduce an escape clause, if it deems it necessary. It was noted that while the possibility of such an option being exercised in extremis may weaken market discipline to some degree, it is likely to be less damaging from that perspective than retaining an exemption as a standard part of the framework.
IV. Implementation Issues
This section addresses a number of practical issues relevant to the application of the modified exceptional access policy, if it were adopted.
A. Assessing Market Access
45. As noted in the 2014 paper, reprofiling would only be appropriate in cases where a member has already lost market access, and where debt is considered sustainable though not with high probability. In those cases, the inability to borrow would suggest that markets have significant doubts about the country’s ability to meet its debt obligations. Conversely, if market access is preserved, the Fund would be willing to lend without a debt operation so long as debt is deemed sustainable even if the “high probability” threshold is not met.20
46. The assessment of market access would therefore play an important part in the revised policy.21 This assessment would need to determine whether a member has the ”ability to tap international capital on a sustained basis through the contracting of loans and/or issuance of securities across a range of maturities, regardless of the currency denomination of the instruments, and at reasonable interest rates.“22 As is currently the case, this would require the exercise of judgment on a case-by-case basis.
47. This judgment, however, would need to be guided by an analysis of indicators that have performed well in signaling market access loss in previous cases. The 2014 paper summarized the types of indicators that could be used to assess whether market access has been lost or its loss is imminent. Further staff work since the 2014 paper shows that a number of indicators have been particularly useful in signaling loss of market access (see Box 2 and Annex III) including, among others, spreads, credit ratings, nonresident holdings of debt, and changes in maturity and currency composition of sovereign debt and/or borrowing. Staff would assess whether these indicators have deteriorated significantly and the extent to which they signal high risk relative to historical norms. While ex-post testing of the signaling power of the indicators was limited by data availability, in future cases, other market indicators could also be considered, including CDS spreads, country risk premia, market positioning, option-implied volatility and skewness, and the shape of the yield curve.
Assessing Market Access Loss
This box reviews past cases of market access loss.1 The analysis suggests several indicators were useful in signaling market access loss. Spreads and credit ratings had particularly high signaling power in the period leading up to market access loss. In real time, staff would also have access to additional data to make an assessment of access to markets. Such historical analysis is subject to caveats, the most important one being that market access is a forward-looking concept. Hence, judgments cannot be based mechanically on the indicators analyzed in this note, however robust their historical empirical properties are.
Market access was judged to have been lost in a number of recent Fund-supported programs that involved debt restructuring, as well as in all recent euro area programs that invoked the systemic exemption. An analysis of the staff reports supporting the arrangement / review requests shows that the following indicators, amongst others, were cited to signal loss of market access: widening spreads, rating downgrades, lack of investors’ interest in government bonds, cancelations of planned bond issuances, and at times the falling participation of foreign investors in domestic markets.
Analytical work was undertaken to examine the behavior of various indicators prior to loss of market access (LMA). The empirical exercise was conducted on a sample of 45 frontier, emerging and advanced markets between 1990 and 2013 using the signaling approach and a risk zone classification approach. Following the May 2013 Board paper, market access is defined as ‘the ability to tap international capital on a sustained basis through the contracting of loans and/or issuance of securities across a range of maturities, regardless of the currency denomination of the instruments, and at reasonable interest rates’. Following the literature, the analysis assumes market access is lost when sovereigns default or stop issuing bonds controlling for financing needs and previous pattern of issuance. Out of 45 countries in the sample, 31 had lost market access at least once over the observation period, out of which 14 lost market access more than once.
The results suggest that spreads, credit ratings, nonresident holdings of debt, and changes in maturity and currency composition of sovereign debt and/or borrowing have performed well in signaling LMA (Figures). Spreads start to rise faster 10 months prior to LMA for the median country in the sample—with the steepest increase occurring 2 months prior. Credit ratings show evidence of a decline starting around 6 months prior to LMA, with the decline becoming abruptly steeper after the initial LMA. Nonresident debt holdings also decline prior to LMA. And finally, the share and maturity of local currency debt also falls prior to LMA as sovereigns found it difficult to place longer term local currency instruments even in the domestic market. While the focus in this analysis was on these four key indicators of market access due to data availability constraints, a broader range of indicators could be considered in future cases. Results from the broader sample were also road-tested on selected case studies of Argentina, Mexico, Brazil, Portugal, and Greece, and proved encouraging.
Selected countries. Sovereign bond spreads 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Bloomberg and Fund staff calculations.1/ Sample includes 21 emerging and advanced economies.Selected countries. Sovereign bond spreads 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Bloomberg and Fund staff calculations.1/ Sample includes 21 emerging and advanced economies.Selected countries. Sovereign bond spreads 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Bloomberg and Fund staff calculations.1/ Sample includes 21 emerging and advanced economies.
Selected countries. Credit ratings 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Rating agencies and Fund staff calculations.1/ It covers 22 emerging and advanced economies. It refers to the average of S&P, Moody’s and Fitch.Selected countries. Credit ratings 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Rating agencies and Fund staff calculations.1/ It covers 22 emerging and advanced economies. It refers to the average of S&P, Moody’s and Fitch.Selected countries. Credit ratings 1/
in basis points, t=0 time of loss of market access
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Rating agencies and Fund staff calculations.1/ It covers 22 emerging and advanced economies. It refers to the average of S&P, Moody’s and Fitch.
Selected Countries. Nonresident participation
in percent of total General Government debt
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Arslanalp, Serkan and Tsuda, Takahiro, 2012, “Tracking Global Demand for Advanced Economy Sovereign Debt,” IMF Working Papers 12/184, (Washington DC: International Monetary Fund); Arslanalp, Serkan and Tsuda, Takahiro, 2014, “Tracking Global Demand for Emerging Market Sovereign Debt,” IMF Working Papers 14/39, (Washington DC: International Monetary Fund); and Fund staff calculations.Selected Countries. Nonresident participation
in percent of total General Government debt
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Arslanalp, Serkan and Tsuda, Takahiro, 2012, “Tracking Global Demand for Advanced Economy Sovereign Debt,” IMF Working Papers 12/184, (Washington DC: International Monetary Fund); Arslanalp, Serkan and Tsuda, Takahiro, 2014, “Tracking Global Demand for Emerging Market Sovereign Debt,” IMF Working Papers 14/39, (Washington DC: International Monetary Fund); and Fund staff calculations.Selected Countries. Nonresident participation
in percent of total General Government debt
Citation: Policy Papers 2015, 048; 10.5089/9781498344739.007.A001
Sources: Arslanalp, Serkan and Tsuda, Takahiro, 2012, “Tracking Global Demand for Advanced Economy Sovereign Debt,” IMF Working Papers 12/184, (Washington DC: International Monetary Fund); Arslanalp, Serkan and Tsuda, Takahiro, 2014, “Tracking Global Demand for Emerging Market Sovereign Debt,” IMF Working Papers 14/39, (Washington DC: International Monetary Fund); and Fund staff calculations.The behavior of the identified market access indicators in previous cases of LMA could helpfully guide staff judgment in future cases. The results of the empirical work suggest that a number of the market access indicators performed well in signaling past episodes of LMA. However, it is important to emphasize that they can only inform but not substitute for staff’s judgment. Depending on the type of country, some indicators may be more relevant than others. While this analysis focused on testing the signaling power of the four key indicators due to data availability constraints, a broader range of indicators could be considered in future cases, such as CDS spreads, country risk premia, market positioning, option-implied volatility and skewness, and the shape of the yield curve.
1This box summarizes the analysis in Annex III “Assessing Loss of Market Access.”B. Securing Creditor Participation
48. Although recent experience indicates that the contractual market-based approach has worked reasonably well in securing creditor participation, there is a broader concern that hold-out problems may become more severe in future restructurings. Most international sovereign bonds now incorporate collective action clauses (CACs), which allow the key financial terms of a bond to be modified upon receipt of support of a qualified majority of bondholders holding a requisite percentage (typically 75 percent) of the outstanding principal of a given series. Although the contractual approach has worked reasonably well, recent developments—in particular the Argentine litigation in the US courts—have underscored the importance of strengthening the existing framework; the Executive Board recently endorsed key features of strengthened CACs and modified pari passu clauses.23 While the recent adoption of these enhanced clauses is encouraging, it also needs to be recognized that these reforms do not resolve the problems arising from the substantial stock of existing debt carrying weaker legal provisions.
49. As suggested in the 2014 paper, consideration could be given as to whether the Fund should play a more active role in providing additional incentives for creditors to participate in a reprofiling. In the late 1980s and 1990s, the Fund had policies that allowed its resources to be used to collateralize interest payments, thereby providing security to creditors and inducing them to participate in a debt exchange. In the current low-interest environment, it is doubtful that the provision of such enhancements would make a material difference to the incentives for creditors to participate in a debt operation. Moreover, given the increasing complexity of sovereigns’ interactions with private capital markets, it may be difficult to provide such incentives without triggering negative pledge clauses in other agreements.
50. Nevertheless, there may be limited circumstances in which the provision of incentives might be helpful from the perspective of securing adequate creditor participation. For example, ensuring that all creditors have received the cash payment of accrued interest up to a common point may help resolve inter-creditor equity issues in cases where creditors are asked to provide substantial debt reduction. Similarly, in a reprofiling operation, it may be helpful to provide incentives for investors holding claims with relatively short residual maturities to participate, as these are likely to be least willing to extend their maturities. While the design of such incentives would depend on the specific circumstances of the case and consultation with market participants, it could include understandings that, in the event a definitive debt restructuring were subsequently required, the Fund and the sovereign would exclude a limited portion of the principal of shorter-maturity claims that had voluntarily participated in the initial reprofiling operation. Such incentives could be structured so as to provide creditors with incentives to participate in both the reprofiling and a possible, more definitive, subsequent restructuring, if such a restructuring is ultimately needed.
C. Conditionality on the Implementation of a Restructuring
51. As noted in the 2014 paper, the implementation of a reprofiling operation would not delay provision of Fund support. The policies guiding program design and the setting of conditionality for debt reprofiling are not different from those guiding deeper restructurings. The legal framework is the same and conditionality would be guided by the same general guidelines that currently apply in restructuring cases. In particular, the policies should retain the flexibility to handle different members’ circumstances, subject to some general guiding principles.
52. As with all restructurings, Fund policy should seek to ensure an orderly debt operation, taking into account several considerations:
In principle, a restructuring should be undertaken in a timely manner once a judgment has been made that it is needed. Prompt implementation has the advantage of (i) reducing the financial risk to the Fund; (ii) strengthening incentives for creditors’ participation and minimizing the risk of a bail-out of private creditors; (iii) easing the program financing requirement and the required adjustment, hence enhancing the prospects for program success; and (iv) reducing uncertainty for creditors and investors. The completion of any needed debt reprofiling before approval of a Fund arrangement should therefore always be considered, if feasible.24
However, as in past cases, there may be circumstances under which more flexibility is warranted. Time can be of the essence in a debt crisis, and the member’s maturity profile may be such that delaying the first disbursement until a reprofiling is put in place would cause a disorderly default. In such cases, it may be advisable for the completion of debt restructuring (including a reprofiling) to be contemplated by the time of the completion of, say, the first review. There may also be other country-specific circumstances warranting a more extended time line for the reprofiling, including situations where complementary measures need to be put in place to preserve financial sector stability.
53. While high creditor participation in a debt restructuring—whether such participation is secured before or during a program—should be a central objective of the program, existing policy provides the Fund with sufficient flexibility to enable it to continue to provide support even in the absence of such participation. In the event that there is inadequate creditor participation, and taking into account the financial parameters underpinning the program, it is unlikely that the debtor will have sufficient resources to continue servicing its unrestructured debt obligations as they fall due. In the event that this results in the member incurring arrears to private creditors, the Fund’s lending into arrears policy enables the Fund to continue to provide support, provided that the member is “making a good faith effort to reach a collaborative agreement with its creditors.” Indeed, the existence of the lending into arrears policy provides private creditors with an important incentive to participate in the restructuring. Specifically, in considering whether to participate, creditors would need to be aware that, if they held out, there would be a serious risk of default (since the member would not have the resources to repay on the original terms) and that, in this event, the Fund would be in a position to continue to provide support provided that the conditions of the lending into arrears policy are satisfied. As agreed in 2013, the Fund’s work program envisages a review of the lending into arrears policy, including the operational implications of the “good faith” criterion. It is envisaged that this discussion will take place after the Board concludes its deliberations on possible modifications of the exceptional access framework.
54. The Fund’s flexible application of conditionality on debt restructuring, confirmed by a review of past cases, would continue.25 Completion of a debt operation has not always been a pre-requisite for the Fund to begin disbursing. For example, under appropriate circumstances, flexibility was exercised in pre-default cases when there were urgent financing needs that could not be postponed until the completion of the reprofiling. In such cases, conditionality has been set on intermediate steps towards the completion of the debt operation.
V. Next Steps and Issues for Discussion
55. This paper elaborates on the June 2014 proposals to introduce greater flexibility in the general exceptional access framework and remove the systemic exemption. It provides an analysis of the nature and channels of spillovers in a sovereign debt crisis, and describes how spillovers could be better managed in the absence of the systemic exemption. For extreme cases where any restructuring of private claims is considered too risky (“tail events”), the paper presents a better approach in which Fund lending would be complemented with official bilateral support on appropriate terms and thereby address underlying concerns about debt sustainability. Staff views these proposals as essential for the Fund to fulfill its mandate and responsibilities for its members and the system in a manner that also safeguards Fund resources.
56. If the Board supports the proposals in this paper, staff intends to complete the work stream on the Fund’s exceptional access framework by fall 2015. Thus, staff will circulate a paper with proposed decisions in fall 2015 for Board consideration. In addition to proposing changes to the second exceptional access criterion, as discussed above, this paper would also discuss possible complementary modifications to the third exceptional access criterion on market access, as foreshadowed in the June 2014 paper.
57. Staff will also commence work on the remaining two items on the sovereign debt-related work program endorsed by the Board in May 2013. Following the October 2014 Board paper on strengthening the contractual framework for sovereign debt, and the anticipated completion of work on the lending framework, staff will commence analysis of the two remaining sovereign debt issues on the Board-endorsed work program.26 The first relates to clarifying the framework for official sector involvement in light of the growing role and changing composition of bilateral official lending. The second is a review of the Fund’s Lending-Into-Arrears policy in light of the recent experience and increased complexity of the creditor base. Staff expects to bring papers addressing these issues to the Board in late-2015/early 2016.
58. At this stage, Directors may wish to share their views on the following:
Do Directors agree that the proposed changes to the second criterion of the Fund’s exceptional access policy (¶11) strike the right balance between flexibility and preserving adequate safeguards?
Do Directors support staff’s view that spillovers can only be effectively managed if the underlying source of market concerns—including about debt sustainability—are addressed, and complementary defensive measures put in place (¶22–34)?
Do Directors agree that the systemic exemption is not a coherent solution to addressing contagion concerns, does not address debt sustainability concerns, and should be eliminated (¶35–38)?
Do Directors agree that, in rare “tail event” situations, where any restructuring of private claims is considered too risky, a more effective approach to resolving the crisis would combine Fund lending with official bilateral support on appropriate terms as described in ¶39–43?
Do Directors agree with the timing of the remaining work program on sovereign debt restructuring issues?
Where debt is considered unsustainable, a definitive debt restructuring, rather than a reprofiling (which is a less definitive form), would be appropriate.
For a discussion of how the Fund’s framework for exceptional access has evolved, see Annex I in The Fund’s Lending Framework and Sovereign Debt—Annexes, IMF Policy Paper, June, 2014.
In this latter category of cases, the Fund could provide regular (instead of exceptional) access if public debt was considered sustainable though not with high probability.
In rare cases where debt is assessed to be clearly unsustainable but the member, notwithstanding, continues to have market access, a restructuring would still be required. Market access under such circumstances is unlikely to be durable and may, in fact, reflect market expectations of a bailout.
In so far as a debt restructuring (debt reduction or reprofiling) reduces the refinancing needs of the member, it constitutes new financing.
Henceforth, circumstances where debt is considered sustainable but not with high probability are referred to as cases of “uncertainty” or “uncertain cases” with regard to debt sustainability.
This subordination risk would be mitigated insofar as official sector financing is provided on very long maturities.
This would generally apply to both private and bilateral official creditors. As ¶17 notes, official bilateral exposure can be maintained by providing new financing rather than a reprofiling. If the bilateral official creditors provide financing through a reprofiling, it can be undertaken in the Paris Club context or, in the context of non Paris Club claims or creditors, the Fund would approach the group of creditors directly.
Subsequently, if market access was lost and the sovereign did not meet the high probability criterion, a debt operation would be required.
Accordingly, and in line with most Directors’ views during the discussion on the 2014 paper, repeat reprofilings would generally be considered inappropriate, as this would indicate deeper solvency issues, which would not be solved through further maturity extensions.
This categorization draws on Annex I, “Channels of International Financial Contagion,” which reviews how spillovers have played out in past crisis episodes and summarizes the findings from the academic literature on this topic.
See Analytics of Systemic Crises and the Role of Global Financial Safety Nets, IMF Policy Paper, May 31, 2011; and Review of the Flexible Credit Line, the Precautionary and Liquidity Line, and the Rapid Financing Instrument, IMF Policy Paper, January 27, 2014.
See Sovereign Debt Restructuring—Recent Developments and Implications for the Fund’s Legal and Policy Framework, IMF Policy Paper, April 26, 2013.
See Annex II “Analytical Note on the Scope of Sovereign Debt for Reprofiling” for a detailed discussion.
Russia (1998); Ukraine (1998); and Côte d’Ivoire (2011).
In a sample of 16 debt restructurings since 1998 (excluding currency union cases), only five included domestic currency debt.
This is consistent with the media and market commentary at the time, where the prevailing assessment was that the Fund-supported program in Greece was unlikely to avert the need for an eventual restructuring of Greece’s sovereign debt.
The financial crisis exposed significant weaknesses in the architecture of the financial system—not least the perception by creditors that some too-big-to-fail banks could not be resolved without causing significant economic disruption. The realization that this feature of the system had to change led to an ambitious program of reform, including the adoption of bail-in rules for banks in the aftermath of the crisis. Leaders pledged to “develop resolution tools and frameworks for the effective resolution of financial groups to help mitigate the disruption of financial institution failures and reduce moral hazard in the future.” (G20 Leader’s Statement, September 2009).
See “Revisiting Sovereign Bankruptcy,” Committee on International Economic Policy and Reform (CEIPR), Brookings Institution, October 2013.
In cases where debt is assessed to be sustainable with high probability but the member has lost market access, a reprofiling would not be required for Fund lending as such loss is likely to temporary when the underlying solvency is considered secure.
As described above, in those cases where market access has been temporarily lost (including because contagion has hit an “innocent bystander” with sound fundamentals) but debt is considered sustainable with high probability, the Fund would play its catalytic role and lend without requiring any debt restructuring, as under the existing framework.
See Sovereign Debt Restructuring—Recent Developments and Implications for the Fund’s Legal and Policy Framework, IMF, April 26, 2013.
See Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring, IMF Policy Paper, October, 2014.
The decision to restructure sovereign debt lies solely with the member. Hence, a requirement to restructure debt can only be established after an announcement by the authorities of their intention to do so.
See Annex IV “Reprofiling and Program Conditionality.”
See Public Information Notice (PIN) No. 13/61 on the Executive Board discussion of the May 2013 paper.
