OMG! SOS! SDRM! ... LOL ... (wherein we uncover the Sovereign Debt Restructuring Conspiracy)
You may have read about those radical plans by the International Monetary Fund (IMF) to force governments to default on their debts as a condition of IMF support. Debates over the place of sovereign debt restructuring in a financial crisis are getting more muddled and acrimonious, in no small part because no one wants to face the underlying governance challenge: political pressure to lend public money to contain the crisis, even if it means paying private creditors in full and adding to a sky-high pile of sovereign debt. As this year of public debt drama draws to a close, it is useful to separate fact from fiction before considering the way forward.
The IMF said publicly last spring that it would revisit its sovereign debt restructuring policies, prompted by its recent experiences in Greece and Argentina. The prevailing narrative holds that in Greece, the IMF came under political pressure from its biggest shareholders (member states) to finance a hopelessly over-indebted government, initially without demanding sacrifice from private creditors. IMF and European Union money paid off private claims on the Greek government. The result was a bigger Greek debt stock dominated by public creditors, and impaired IMF credibility. The Fund came off as captured by Europe, which was looking out for its banks, which had foolishly invested in risky Greek debt. Meanwhile, U.S. federal court rulings against Argentina and a copycat lawsuit against Grenada had convinced the official sector that holdout creditors were resurgent, threatening to disrupt future sovereign workouts.
Partly responding to criticism of its Greek programs, the IMF has already revamped the way in which it evaluates distressed countries’ debt burdens, and has begun to release more information about its analysis to the public. In this way, Fund staff may better insulate itself from political pressure to fudge sustainability assessments and avoid debt restructuring. More ambitiously, the Fund is reviewing its lending policies to address burden-sharing with private creditors. Responding to holdout litigation, IMF staff suggests debt contract reform to neutralize holdouts, focusing on clauses that let all of a sovereign’s private bondholders hold a single aggregated vote to restructure the debt (Paragraph 42 of the IMF paper). A supermajority could then impose new terms on everyone.
As some sovereign debt heads (me included) have observed, lending reform is by far the most controversial idea under discussion. According to the April IMF paper, “a presumption could be established that some form of a creditor bail-in measure would be implemented as a condition for Fund lending where, although no clear-cut determination has been made that the debt is unsustainable, the member has lost market access and prospects for regaining market access are uncertain.” (Paragraph 32) “Bail-in” could take the form of maturity extension, locking in private creditors pending further analysis and developments. Although IMF funding would be conditioned on bail-in, the transaction would somehow be “voluntary.” (Who thought we would yearn for the old double-speak “quasi-voluntary,” which at least had a ring of truth to it?)
Last month, an influential expert group endorsed the idea of pre-emptive maturity extension, which helped re-start the press flurry.
Apparently some see the new policy thinking at the IMF as an attempt to revive its sovereign bankruptcy proposal circa 2001, or the Sovereign Debt Restructuring Mechanism (SDRM). SDRM was a comprehensive procedure for restructuring foreign sovereign debt owed to private creditors. As designed, it would have been largely mandatory once invoked by the debtor with IMF blessing. It would have included rules for debt verification, creditor classification and majority voting to bind holdouts, dispute resolution, priority financing, protection from lawsuits, and various other bells and whistles usually associated with domestic corporate bankruptcy.
Establishing SDRM required amending the IMF Articles of Agreement (an international treaty)—a high political hurdle that likely doomed it from the start. SDRM died for lack of U.S. and emerging market support in 2003.
Apart from its general affinity for debt restructuring, the “bail-in” idea in the IMF’s April paper has nothing in common with the SDRM. In fact, bail-in is the exact opposite of SDRM: it offers no institutional innovation, but presumes a specific restructuring outcome (maturity extension) under some circumstances (uncertain debt sustainability and loss of market access). Like all presumptions, the bail-in presumption would be rebuttable—not mandatory.
The bail-in idea is much closer to the narrower but more successful efforts of the late 1990s to extend Paris Club comparability to bonds, and to allow IMF lending into arrears on sovereign bonds. The Paris Club policy demanded that countries seek “comparable” debt restructuring from private bondholders as a condition of official bilateral debt relief. Letting the IMF lend to countries in default on private bonds as well as loans gave debtors a new source of leverage against their creditors: they could threaten to stop paying unless the creditors agreed to restructure. These policies launched the era of sovereign bond restructuring, which has gone rather smoothly notwithstanding dire predictions from the private sector.
The policies worked as intended because IMF shareholders stood ready to condition public money on private creditor concessions. Neither statutory nor contractual reforms were necessary to make debt restructuring happen—simply a commitment by the IMF and its member governments. A similar commitment is embedded in the IMF’s policy on exceptional access to its resources, which required assurances that the country’s debt is sustainable with “high probability.” Yet this commitment has come across as selective, limited to smaller economies or ones of little systemic significance—a fact recognized in the 2011 exception for “international systemic spillovers,” invoked in Greece. The Greek experience has left the impression that in large economies, the official sector stands ready to replace private creditors for the sake of systemic stability (or, perhaps, their own banks) and geopolitical considerations.
This is a real dilemma, but not one that can be solved by turning the bail-in dial to include more countries whose debt sustainability is in doubt. After all, Greece’s was not really in doubt for quite some time before it restructured. On the other hand, Portugal’s—heck, even Italy’s—debt sustainability may be in doubt today. Moreover, maturity extension is no guarantee of fair burden sharing: when U.S. banks kept rolling over loans to Latin American sovereigns in the 1980s instead of writing them down, not everyone thought the countries were solvent—but the banks were under-capitalized, under-provisioned, and simply could not afford to write off the debt for much of what became “the lost decade.”
Most debt sustainability judgments come with a big dose of uncertainty, but absolute fog is rare. Restructuring decisions do not come of technical certainty; they are influenced by distribution politics.
IMF staff analysis seems to hinge on the idea that “restructuring” is hard, but maturity extension is easy, and therefore less likely to face political and market resistance. But maturity extension is not easy. For example, where the creditors are domestic banks, it could lead to deposit runs, and force the stressed sovereign to recapitalize the banking system. Put differently, maturity extension does not just freeze everything while analysts ponder the numbers—it changes facts on the ground.
Paradoxically, while the IMF paper purports to counter a false choice—bailout or debt reduction—it does so by setting up another false choice. There is no magic midpoint between sustainability and insolvency, just as there is no magic midpoint between bailouts and deep debt restructuring. In a world where investors buy distressed sovereign debt at a discount with an eye to a quick and rich exit, there is simply a continuum of debt circumstances and a continuum of restructuring terms, some softer than others. Especially when there is uncertainty, an attempt to pre-commit to a random point on either continuum is likely to backfire. Any pre-commitment policy will be riddled with exceptions, sure to be invoked at the first opportunity (Portugal? Ukraine?), discrediting all involved—doubly so when the private creditors are under-capitalized banks.
If a strict bail-in presumption were to be adopted, euro zone countries would likely escape it: they would be deemed to have “market access” courtesy of the European Central Bank. In theory, the same could be said when Argentina places bonds with Venezuela or Ukraine with Russia. The net result might be to encourage more official co-financing, not private bail-in.
In sum, IMF staff has identified a real governance problem: when an insolvent country loses market access, fear of financial contagion and political backlash push officials to lend, even if it means replacing private money with taxpayer money. Apart from the new, improved approach to debt sustainability, the IMF has not proposed a solution to this problem yet. If, as reported, key countries have lost their taste for burden-sharing, the IMF policy review will become a focal point for airing disagreements between Fund staff and its shareholders—not a unified message of market discipline.
Absent political consensus, the IMF and its members should leverage existing policies that give it the ability to refuse exceptional help for countries with too much debt—perhaps exempting debt contracts with embedded restructuring features. Presenting a unified front in support of existing policies, while maintaining constructive ambiguity about any particular future case, may work better market discipline than a feckless promise of maturity extension.
I have no doubt whatsoever that many of the people who supported SDRM in the early 2000s remain convinced that it was the right solution to sovereign debt problems, that it would have helped prevent holdout litigation, and that it should be resurrected—and maybe they are right. All this is utterly beside the point, since today there is even less political support for such elaborate institutional change in the IMF board than there was in 2003. Diehard SDRM fans know it. For better or worse, the IMF will not host a sovereign bankruptcy regime any time soon. On the other hand, those who purport to fight bail-in as a neo-SDRM conspiracy are guilty of distraction. We are virtually certain to see a sovereign debt crisis and a sovereign bond restructuring in the next few years—likely more than one. We might as well start thinking how the IMF and its members can do it better next time.
A version of this post first appeared on the Peterson Institute for International Economics Real Time Economic Issues Watch.