Private sector involvement (PSI) has been an integral part of all crisis resolution efforts, and it is not new. At the time of the resolution of the Latin American debt crisis of the 1980s, for example, the official community had many of the same objectives it has today: limiting the size of official packages, reducing moral hazard in the private sector’s lending decisions, and restoring the external viability of the country in crisis. Some academics (e.g., Dooley, 1994) see the lending preceding the debt crisis of the 1980s as raising charges of moral hazard.
By the late 1980s, however, the improved financial positions of major international banks (as measured by their developing country loan exposures relative to their capital) and the continuing poor economic performance of many emerging markets led to the adoption of the Brady plan, which involved substantial writedowns (measured in net present value terms) of developing country syndicated loans. Indeed, the losses experienced by banks on medium-term syndicated lending to developing countries in the 1980s are regarded as a key factor in the decision of banks to shift away from syndicated lending to sovereigns toward shorter-term interbank lending in the 1990s. Large official financing packages in the 1990s, starting with Mexico (1994–95) and then in Asia (1997), were also seen by many observers as increasing the private sector’s expectation of being rescued should it be confronted by an imminent credit event. This sentiment likely peaked in the run-up to the Russian default in August 1998 because Russia was widely viewed as “too big or too nuclear to fail” and would therefore receive the support of the official community no matter what.
Others have seen the crises of the 1980s and 1990s as arising out of a much more complex set of macroeconomic and financial factors and have argued that there needs to be a more nuanced view of the extent and potential sources of moral hazard. It has also been argued that moral hazard in the international financial system can potentially arise from a number of sources, including the official safety net that underpins all banking systems and the lending activities of international financial institutions (IFIs).
The official safety net underpinning the banking system is typically designed to ensure the overall stability of the domestic financial system and to protect the domestic payments system. It is widely recognized that the knowledge that a bank is “too big to fail” can lessen the incentives to impose both market and managerial discipline. Domestic bank bail-outs costing the sovereign the equivalent of 10–20 percent of GDP have not been uncommon, and they clearly have an impact on the expectations for future bail-outs by the domestic banks as well as the expectations of international banks providing financing to domestic banks.
While the moral hazard effects of the official safety net underpinning national banking systems are a constant feature of the global financial system, the potential moral hazard effects of lending by IFIs will be influenced by both the scale and the timing of such lending. As noted above, market participants regard such lending as having had its most significant effect on creditors’ expectations during the run-up to the Russian default in August 1998. Nonetheless, there remains considerable disagreement between those who see lending by IFIs as having a “first-order” effect in creating moral hazard and those who view such lending as having a much smaller and episodic effect (Lane and Phillips, 2000). Whatever the conclusion on the likely significance of moral hazard arising from official international support to countries facing external financing difficulties, the fact is that the scale of such support is limited. When there is a meaningful risk that a country may be insolvent and therefore incapable of timely repayment of emergency official assistance, the official community typically refrains from providing such assistance except on the condition that other claims against the country be rescheduled and written down to an extent that ensures that emergency official assistance can be repaid. These are situations where, like it or not, the creditors of a country’s debtors (its sovereign, its banking system, or its private sector) will unavoidably be “involved” in the resolution of the country’s financial difficulties. More broadly, when a country faces a huge outflow of capital that threatens to swamp that country’s own resources plus any plausible level of emergency assistance from the official community, and when efforts to resolve the crisis through policy adjustments, limited official assistance, and a spontaneous restoration of confidence fail, the creditors of that country will also face “involvement” in the resolution of that country’s financial difficulties on terms and conditions not contemplated in their credit instruments. In these situations, private sector involvement in crisis resolution is, and always has been, a fact of life.
In designing and implementing policies on private sector involvement, the official sector has—and is perceived in private markets to have—several, not necessarily consistent, objectives. One is burden sharing. Because of concerns about moral hazard and for other reasons, the official community wants to keep its emergency support limited. It also wants to ensure that private creditors play—and are seen to play—an appropriate role in resolving crises. When losses need to be absorbed—especially in situations of insolvency—the official sector wants to ensure that private creditors do not escape by imposing losses they should bear onto others. A second broad objective is limiting the damage done by the crisis, both to the country primarily involved and to the world economy more generally. Sometimes, especially in cases of insolvency, this may again mean that creditors should absorb losses (also part of burden sharing). It also means, especially in cases of illiquidity, seeking to restore external viability and market access as rapidly as possible following the resolution of a crisis—something that may not be facilitated by efforts to impose substantial losses on creditors. The third broad objective of the official community is to preserve integrity and reasonable efficiency in the functioning of international credit markets. This means that debtors should not be allowed to escape from servicing their obligations when they have the capacity to do so. It also means that creditors who undertake risks should expect to see those risks sometimes materialize into actual losses.
These policies also interact dynamically, as the private sector reacts to the policies of the official sector for future financing flows and the official sector, in turn, adapts its policies. Debt restructurings are repeated games, and while addressing the current crisis the official sector is already affecting the conditions of the next debt crisis. This phenomenon is clearly apparent in the evolution of international credit arrangements over the past two decades. Medium-term loans from large syndicates of commercial banks to developing country sovereigns and public sector entities were a dominant form of international capital flows before the debt crisis of the 1980s. An important part of the mechanism that the official sector used to deal with that crisis involved the concerted rollover and subsequent restructuring and write-down (in present value terms) of syndicated bank loans. Bonded debts of affected sovereigns generally escaped restructuring on the grounds that the amounts were small and that these instruments (held by widely diversified creditors) were difficult to restructure. The market adapted. Medium-term syndicated bank loans to developing country sovereigns largely disappeared in the 1990s. Banks shifted to interbank loans of much shorter maturity. International borrowing by sovereigns predominantly took the form of bonded debts. The shifts in the form of international credit flows posed new challenges in efforts to resolve the financial crises of the 1990s. Lenders to emerging markets were either thousands of individual bondholders whose actions were difficult to concert or banks with short-term facilities that could easily “cut and run” in a crisis. Mechanisms for private sector involvement in the crises of the 1990s have adapted to these new realities.
The fact that the private sector will adapt, taking losses or gains on existing debt while changing the level or structure of its future lending, to the official sectors’ policies and practices with respect to private sector involvement is not necessarily negative. For example, although unwelcome to potential debtors, policies that raise the cost and diminish the availability of international credits to some emerging market borrowers may be desirable if they reflect a more appropriate pricing of risks and serve properly as a deterrent to imprudent borrowing, that is, reduce debtor moral hazard. Policies that encourage longer-term securitized borrowing (which is presumably limited by available collateral) may contribute to the avoidance of more efficient resolution of crises because such loans are hard to restructure. Longer-term loans are likely to be less dangerous in a potential crisis than an equivalent volume of short-term loans, and creditors who believe they have secure collateral should be less prone to panic than those that do not. On the other hand, a country that has already encumbered most of its liquid assets and a good deal of its future export earnings may find itself in a very difficult situation in the event of a financial crisis.
The point is that in considering various policies and practices with respect to private sector involvement, it is critical to be aware of how the private sector is likely to adapt to these policies and practices and to the difficulties or opportunities that these reactions will generate. The analysis in this paper is based on some fairly simple observations and assumptions of the behavior of creditors and debtors in the international capital markets. It takes as given that debtor moral hazard is a key concern for a creditor’s lending decision, and the analysis presented here tries to fill a gap in earlier papers’ focus solely on creditor moral hazard.
Section I of this paper presents a framework that examines how a sovereign debtor and a private sector creditor value debt and therefore how they are likely to be affected when key variables change, such as the cost of default and the recovery value, as they may have done in the context of the recent official sector crisis resolution initiatives. Two forms of impact are discussed: first how future lending will be affected as the debtor and creditor adjust to a new equilibrium, and second how already existing debt will be affected in their price. Section II discusses how this framework can be used to analyze how private creditors will adapt to recent official community initiatives with regard to debt payment suspensions. Section III addresses how the private sector is likely to adapt to the recent string of successful bond exchanges. It is argued that the conclusion that bonds will be as easy to restructure in the future as they have been recently is premature, because it does not take into account the fact that private sector creditors will adjust their expectations and lending instruments going forward. Section IV ends the paper with some broad conclusions and raises the question whether the private sector is already adapting to the recent official sector crisis resolution initiatives.
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Both authors belong to the Global Markets Division of the IMF’s International Capital Markets Department. The authors would like to express their thanks to Torbjörn Becker, Bankim Chadha, Olivier Jeanne, Andrew Haldane, Arend Kapteyn, Maziar Minovi, and an anonymous referee for helpful comments and suggestions.
See Nystedt (2001) for a more elaborate model involving two types of creditors extending credit through two different instruments: loans with a low cost of default and bonds with a high cost of default. A clear implication of the model is that if the cost of default is suddenly reduced for bonds, the borrower will shift to borrow relatively more through loans in the new equilibrium.
This assumes that in a bad-luck default rp – λ – RV ≥ 0 and hence RV = rp – λ, which may be equal to zero if λ is large enough and the outcome bad enough.
Other authors have suggested that the IMF, or some other multilateral institution, could play the role of an outside monitor that could distinguish between bad-luck defaults and strategic defaults. The IMF could signal what type of default had occurred by lending-into-arrears and thereby, at least partly, offset the cost of default for the debtor, in that state of the world, and lead to a higher recovery value for the creditor ex post, leading to a lower coupon ex ante.
For example, in return for its forbearance, a creditor will either receive ancillary business if it is a bank or have its claim’s obligor status be upgraded to that of the sovereign rather than that of a corporate (see, for example, the description of the Korean crisis experience in IMF 2000b).
As several authors have pointed out, for example Eichengreen (1999) and Petas and Rahman (1999), defaults on international bonds have been frequent, historically speaking, especially in the 1930s. In 1999, Ecuador was the first sovereign to default on both eurobonds and Brady bonds.
See Rappoport (2000) and Rappoport and Xu (2000) for a much more detailed discussion on the sensitivity of emerging market and U.S. high-yield bonds to default probability, recovery value, and other assumptions.
This can be determined by looking at the differential between the price of the new exchange bond when issued (basically forward contracts on the new bond) and the price of the old to-be-exchanged bond. A small differential implies that investors believe the exchange will succeed. When-issued markets existed in all four bond exchanges.
The clauses commonly referred to as CACs are as follows: a majority action clause (allowing a qualified majority of bondholders to bind a minority); a sharing clause (stating that any funds received through, for example, litigation by one bondholder have to be shared with the other bondholders based on their share of the outstanding bond); and a collective representation clause (allowing a trustee, for example, to represent bondholders, facilitating majority actions). CACs can facilitate creditor-debtor negotiations because they reduce both the threshold needed for achieving a restructuring agreement (the majority action clause) and the potential threat of litigation from “holdout” creditors (reducing their incentive to litigate through the sharing clause). Bonds issued under English law typically include CACs. These clauses are not regularly contained in bonds issued under New York law.
Empirical work, however, suggests that collective action clauses tend to reduce the cost of borrowing for some borrowers. See, for example, Eichengreen and Mody (2000), and for a more critical assessment Becker, Richards, and Thaicharoen (2000).
The use of exit consents is a strategy that, similar to CACs, can be employed to provide the stick in a bond exchange and induce bondholders to participate in the exchange by changing key nonpayment terms and thereby reducing the value of the old bond after the exchange has been completed. The main advantage of exit consents is that they can be used in bonds that otherwise would require unanimity to change any of their payment terms, and they can thereby replicate some of the features of CACs. Exit consents in a sovereign New York law bond were first used in Ecuador. See Buchheit and Gulati (2000) for an insightful discussion.
Rating agencies assign future flow securitizations substantially higher ratings (up to four notches in some cases; see Standard & Poor’s, 1999) as the political and transfer risk of these types of debt is mitigated by their structure. In emerging markets, major examples of issuers using future flow securitizations are PdVSA and PEMEX (Venezuela’s and Mexico’s oil companies).