In sovereign liquidity crises like Mexico in 1994/5 and several East Asian countries in 1997/8, how can the IMF avoid being manoeuvred into supplying emergency financing that puts international creditors in a no-lose situation? The answer, according to new research by Professor Marcus Miller and Lei Zhang of Warwick University, published in the latest issue of the Economic Journal, is to restrict creditors” rights in the event of such crises – that is, to impose the threat of ”bail-ins” to balance the promise of bail-outs.
The researchers note that a salient feature of both the Mexican financial crisis and the East Asian crises is that the IMF has been forced to provide bailouts, which have effectively guaranteed creditors” investment in sovereign debt. This poses a clear risk of moral hazard: if lenders know their investments are guaranteed, why should they monitor their investments? And if there is no monitoring, the quality of investment will surely deteriorate – undermining the objective of globalising the world financial system to promote investment efficiency.
The solution of imposing ”bail-ins” would involve changing the rules of the game to enable the IMF to act as a bankruptcy court as well as the lender of last resort. For example, in the latter phase of the Latin American debt crisis of the 1980s, when the IMF decided to help the debtors under the Brady Plan, it authorised a standstill of debt payments. This was followed by debt restructurings and write-downs. Threats of repeat performances would surely give creditors the incentive to avoid crises, both by increased monitoring before the event and by debt roll-overs after the event.
More than that, these researchers argue, creditors would then have the incentive to change debt contracts to allow for sharing and for majority voting, as recommended in the recent reports by the G-10 and G-22. Put differently, such ”voluntary” contractual changes – and the corresponding creation of a Bondholders Council – are unlikely to be implemented without the credible threat of a payments standstill.
There is yet another reason for deliberately changing the rules of the game: namely, the risk of something worse. In particular, if the international monetary system continues effectively to promise bailouts – thus encouraging carefree lending and callous capital flight – emerging countries may be forced to take things into their own hands. One response might be capital controls as Malaysia has imposed. Protecting debtors would prevent others following this example.
Miller and Zhang suggest that the time has come for changes in the international financial system to limit those creditor rights where their unfettered exercise threatens social efficiency. As sovereign debt becomes more like commercial debt, it is only to be expected that rules governing the international bond markets will imitate the institutional features of domestic bond markets. For example, during the Spring 1999 IMF meetings, then US Treasury Secretary Robert Rubin suggested that the official American position might be moving in this direction: ”It is said of commercial bankruptcy law that it affects far more cases than those that come to court because of the incentives it sets up for ”bargaining in the shadow of the law”. The same would surely apply in the international context.”
Whether the power to limit the rights of international creditors should be given directly to the IMF or to some other quasi-legal agency charged with renegotiating debt contracts is an interesting and important issue. These researchers propose the creation of a Basle Club – an analogy with the existing Paris and London Clubs for restructuring debt. This proposal might become reality if it won the backing of the Basle-based international Forum for Financial Stability, which has just been set up at the Bank of International Settlements to assess the vulnerability of the global financial system and to identify and oversee the actions needed to address them.
”Sovereign Liquidity Crises: A Strategic Case for a Payments Standstill” by Marcus Miller and Lei Zhang is published in the January 2000 issue of the Economic Journal. The authors are at the Centre for the Study of Globalisation and Regionalisation (CSGR) at the University of Warwick. The full report is available on the CSGR website at: www.warwick.ac.uk/fac/soc/CSGR/glob-fin.html.