Given that the International Monetary Fund has backed more than $300 billion in bailouts since the Mexican peso crisis of 1995, it has become obvious that the world needs a new way of handling debt crises. The IMF has been at the center of a crisis-generating system in which investors and emerging-country governments engage in less cautious behavior on the expectation that they will be “rescued” if anything goes wrong.
IMF head, Horst Kohler, identifies such moral hazard as one reason to reduce reliance on bailouts. The inability of massive IMF aid to prevent the collapse of the Argentine and other economies provides further impetus for reform. But if investors won’t automatically be rescued in times of financial turmoil, how will they resolve disputes with sovereign countries in an orderly manner?
The IMF’s answer is to create bankruptcy procedures on the international level that are similar to those that exist on the domestic level. The Fund is proposing to turn itself into a sort of bankruptcy court for countries, a fundamental change in its mission.
Yet the bankruptcy approach proposed by the fund is fraught with problems. The changes called for require the IMF’s charter to be amended, a procedure that would take years to complete if accepted by its members. The Fund would play a central role in determining what countries would qualify for default and why, including countries holding IMF debt.
IMF financing would still be used during debt negotiations. In practice, that would encourage creditors to prolong the workout process in an effort to extract more IMF financing; debtors could also use the IMF money to game the system and delay needed reforms. The result of putting the Fund at the center of debt renegotiations would likely be unpredictability, financial volatility and higher borrowing costs to emerging markets across the board regardless of whether some countries merit such an outcome or not.
Better approaches involve direct negotiations between creditors and debtors without the IMF’s cumbersome, third party interventions. For example, Undersecretary of the Treasury for International Affairs John Taylor has proposed that creditors begin relying on clauses that would allow a majority of creditors to negotiate in the name of all creditors in the event of a default, thus eliminating the need for unanimous consent among thousands of creditors.
Carnegie Mellon University economists Adam Lerrick and Allan Meltzer point out that all of the protections offered by a formal bankruptcy court can be incorporated into new debt issues. Lerrick and Meltzer also show how market mechanisms already exist to renegotiate outstanding debt in a short period of time without the aid of the IMF. Well-established capital market tools can be used to voluntarily convert old debt into new debt with majority action clauses and to change the terms of the old debt. Those tools, and Argentina’s experience with a well-organized creditors’ committee formed before the country defaulted, undermine the argument that coordination among creditors would be too difficult to achieve absent an IMF-backed bankruptcy procedure.
One of the reasons to allow creditors and borrowers to engage in direct debt renegotiations is to increase accountability on both sides. Lenders would take a hit for poor investment decisions and debtors would be forced to shape up to get access to new money. That level of accountability should also include the IMF.
But while the Fund urges the private sector to take losses as part of its sovereign bankruptcy scheme, it exempts itself from such an outcome. In the Fund’s view, countries should always pay the agency back in full, no matter how poor were its previous loans.
The troubling idea of a bankruptcy court judging cases where it has its own money at stake — and holding itself to a different standard — is being tested in Argentina today. Bankrupt Buenos Aires owes $10.7 billion to the IMF, coming due this year and next. The country claims it will not pay back the IMF unless it receives a new IMF package, which the Fund rightly claims Argentina does not merit. But the Fund’s tendency to use new loans to pay back old loans is well known. If the IMF lends to Argentina out of self-interest, it will distort any debt workout and undermine its own integrity. If the Fund does not lend, it will encourage more accountability on all sides — and prove its own irrelevance at resolving debt problems.