The IMF's Harmful Debt Restructuring Proposal
The International Monetary Fund (IMF) executive board will soon decide how far to go in imposing costs on creditors when a country requests large scale IMF assistance. Early indications based on current staff proposals are that its decision will weaken the international financial architecture and the structure of global capital markets. The current IMF staff proposals (presented in 2013 and revised in 2014 ) risk aggravating the weaknesses and instability of the global financial system (see the comments on the 2013 proposal and the discussion of the 2014 version at this Peterson Institute event).
The 2014 version of the IMF staff proposal includes two major initiatives. The first would eliminate the so-called systemic exception—whereby the IMF can create an exception on systemic grounds and provide an exceptional access loan (that is, a loan that is a bigger multiple of the country's quota than standard IMF procedures allow) to a country even if it is not able to determine that its debt will be sustainable with high probability (Truman 2015a and Truman 2015b discuss this aspect in detail). The second initiative would assign countries to three groups: those whose debt is sustainable with high probability, those whose debt is sustainable but not with high probability, and those whose debt is unsustainable. For countries in the second and third grouping, an exceptional access IMF program would be conditional on (voluntary) agreement by creditors to restructure their loans, commonly known as private sector involvement (PSI). In the second grouping an extension of maturities (i.e., reprofiling) would be expected as part of the program. In the third grouping, a more extensive restructuring would be called for as part of the program, including principal reductions.
Several problems make this proposal ill-advised. The systemic exception is an important element of the IMF's mandate to ensure the stability of the global financial system. Despite the popular backlash against bailouts of the most recent crisis, the system should still come first. Because it is impossible to forecast what may become systemic in the future, depriving the IMF of a systemic exception is irresponsible. The IMF's objective should be to minimize the GDP cost of a crisis for the system as a whole, not to minimize the use of its resources or maximize the contribution of the private sector. Regardless of moral hazard concerns over the precedent set by bailouts, the systemic exception or its de facto equivalent is an option with positive value and should be maintained as a necessary tool in a crisis.
Grouping countries on the basis of a debt sustainability assessment is even more problematic. Because IMF quotas have shrunk with respect to the scale of global capital markets, most IMF programs associated with capital market crises will likely require exceptional access and thus be subject to the grouping.
The proposal will inevitably be perceived and likely implemented as a rigid rule based on the probability of debt sustainability. But there is no commonly accepted definition of debt sustainability. Countries that issue in their own currency can always print enough money to pay their debts. Accordingly, debt sustainability for them is a function of willingness to pay, not capacity to pay. Any definition based on a ratio of sovereign debt to GDP is thus arbitrary. In recent IMF programs, the target for debt sustainability has been set at 120 percent of GDP for Greece, 110 percent for Cyprus, and 70 percent for Ukraine. Defining that threshold imprecisely only creates additional uncertainty. It would be akin to a central bank targeting a measure of inflation that cannot be computed.
In addition, with two of the three country groups requiring a debt restructuring operation that would trigger a credit event and default, there is high risk of creating a damaging and destabilizing anchoring effect. Market participants would permanently associate an increasing probability of requesting IMF assistance with an increasing probability of debt restructuring. A "monkey in the mirror" effect would ensue, with markets pricing default odds based on which grouping a country may be put into rather than on the sustainability of fundamentals. In the process, the IMF would lose a valuable source of information and cross-check. Furthermore, this new policy would delay the country's request for a program while unduly escalating its funding costs for the country as investors flee first and ask questions later. Not surprisingly, Moody's declared this policy credit negative.1
The market turmoil and contagion in the euro area spurred by the Deauville Declaration,2 at which President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany vowed irresponsibly that financial assistance to countries would be made conditional on private sector loses, should have offered a cautionary tale. The Declaration was made to establish a perhaps laudable principle, but it led to a run on the debt of several periphery countries on the fear of program-led restructuring. One would think that creating an association between an IMF program request and likely debt restructuring should be avoided at all costs. The sudden stop3 and the skyrocketing interest rates that the Deauville Declaration engineered in periphery countries contributed to the deep recession that Europe is still struggling to overcome. Moreover, the fact that European Stability Mechanism (ESM) programs require an IMF program implies that this vicious circle could become entrenched. Given the high levels of debt and the large size of euro area countries, any future ESM program would fall, a priori, in the second or third group, risking another vicious cycle of default fears and contagion.
Rigid rules often backfire. Had the latest proposals been in place in 2010, Ireland and Portugal would have been forced to reprofile their debt at the start of their programs, dealing a blow to the global economy. In hindsight, it would have been a serious mistake. Ireland and Portugal have successfully adjusted their economies and returned to markets while respecting the integrity of their contracts. Debt restructurings should only happen as a last resort.
The current case of Ukraine is also telling. An IMF program has been in place there for more than a year. Despite the high uncertainty arising from Ukraine's economic difficulties, not to mention a Russian military intervention, the program was first funded with no private sector participation. The objective was to show full support for Ukraine and avoid impeding its struggle to survive. Now the IMF, following a new agreement in March, envisages a full debt restructuring, under the argument that a decisive debt reduction will restore confidence. In doing so, the IMF is ignoring the proposed new policy of requiring a reprofiling—an extension of maturities only—when uncertainty is high. The lesson here is that each case and each situation is different, and flexibility is paramount. Like it or not, politics often dictate the target debt-to-GDP ratio. The associated amount of private sector involvement is typically just the residual after taking into account the pledged contributions of the official sector.
The IMF's latest policy proposals are principally a reaction to the controversies surrounding the delays and dithering over debt relief in the Greek program. But, as a matter of principle, it is wrong to base a policy change on regrets over a single case. Any policy change must pass the "first do no harm" test. This policy proposal doesn't pass it.
1. "IMF Sovereign Debt Restructuring Proposals Are Credit Negative" (Moody's Sector Comment, June 2014).
2. The Deauville Declaration was issued on October 18, 2010, by Angela Merkel and Nicolas Sarkozy to the effect that lenders in the sovereign debt market might face losses in future bailouts.
3. A situation where capital flows into a country suddenly stop and become fast outflows.