Theme: The involvement of the private sector in external crises is now under review. Proposals by the IMF to facilitate an orderly resolution of these crises are critically reviewed in this analysis. Notably, particular consideration of foreign direct investment (FDI) has been absent from the current debate.
Summary: Events in Asia and Latin America during the 1990s and the early years of this decade have given rise to a debate over the frequency and intensity of external crises stemming from the process of globalisation. Crisis countries complain of the unfair and inefficient distribution of costs. The presumption is that creditors, in general, come out largely unaffected. At the same time, creditors argue that uncertainties surrounding economic policies and the enforcement of property rights account for observed high lending costs and that proposals for a new financial international architecture may result in a significant reduction in the amount of funds available to emerging market economies. The International Monetary Fund is now exploring the possibilities of a new Sovereign Debt Restructuring Mechanism (SDRM) that might include both collective action clauses (CAC) in bond contracts and a statutory approach to debt restructuring. However, neither measure is likely to exert a meaningful impact on the frequency and intensity of such crises. Furthermore, FDI remains nearly completely absent from such discussions.
Analysis: Capital flows (including equity, FDI and debt flows) to emerging market economies have declined to about one third of their peak levels registered during the boom years of the mid-1990s This is not good news for developing economies, which, almost by definition, lack sufficient domestic savings and need to borrow abroad to finance investment priorities consistent with rapid and sustainable mid-term growth. This is an obvious -but often neglected- reality. Furthermore, investment needs in excess of domestic savings are a hard fact, regardless of the need to follow adequate pro-market policies capable of attracting inflows of foreign investment, since emerging markets compete among themselves for a portion of a scarce pool of resources -a pool which is shrinking in the current context, given the predominant risk-averse mood of the markets-. Only a few countries are lucky enough to finance their development through tourism receipts and emigrant remittances (Spain, Greece and occasionally El Salvador are a few examples, but even these countries have not avoided recurrent external crises). So, countries need to borrow internationally and, in doing so, run at least some risk of future default.
This is important to understand because there are a number of proposals floating around that essentially aim at reducing the absolute level of capital flows. The idea that financial globalization is the root of all evils and that, therefore, countries would do well to isolate themselves from financial markets either through a non-convertible currency (the case of China) or through severe capital controls (the case of Malaysia) is but an extreme view of the former notion. Proponents of such policies, of course, tend to ignore the fact that China is the world largest recipient of foreign direct investment and that Malaysia exports well over 30% of its GDP. For better or for worse, this is not the case of most emerging economies. Nevertheless, many prominent economists (notoriously Stiglitz) have made themselves immensely popular (after having failed dramatically as policy makers) with the notion of reducing the exposure of developing economies to the vagaries of financial markets. While this is an interesting concept, its application is certainly not a free lunch.
The simplest approach would imply taxing capital flows. This idea has recently received much attention in the form of the so-called Tobin tax (or Tobin-like taxes) on international financial transactions. However, even in the unlikely, and undesirable, event that such a tax is established, the problem arises as to who would collect it? The parent country, or the host country, of the financial institutions moving the money? Or would it be an international institution like the UN, which could then use the proceeds to finance social programs or even its own operations? Or all of them? Well-intentioned proponents of such a tax should remember the collecting voracity of tax authorities worldwide and the international trend towards reducing, not increasing, the taxation of capital. Moreover, should a Tobin-like tax become a reality, how do we avoid the problem of the free rider that is so pervasive in tax and financial matters? A country may decide not to impose the tax, despite international pressure to do so, as a way to increase its attractiveness to foreign capital; a process not so different from the observed resistance to establish a withholding tax on interest payments in certain countries within the EU.
The potential problems with such a proposal are so varied that even the most sophisticated proponents of limiting the vulnerability of emerging market economies now argue instead for the need to focus on changing the composition of capital flows through the use of the tax system to encourage equity and long-term debt flows to the detriment of short-term speculative flows. There are, nevertheless, a number of definitional problems involved with such an approach, some of which have been presented by Carmen Reinhart in her work at the IMF. But even if we were to ignore them, the fact remains that such a system would require well-functioning tax and monetary authorities at once sufficiently honest, competent and independent to avoid being captured or manipulated by special interests. Yet, such effective bureaucracies are rare luxuries that very few developing countries currently enjoy. Even Chile -the standard reference in this regard- found it necessary to increase systematically the range of flows subject to administrative control in a fruitless effort to curb evasion. Yet in the end, it was forced to lift all capital controls once foreign capital ceased to be abundant. So, the evidence suggests that capital controls may be, under appropriate exceptional circumstances, at best partially useful in limiting temporarily excessive bursts of confidence in a country, like a euphoria bubble, but are of limited significance in avoiding external crises, unless we are willing to forego potential growth. Moreover, the imposition of controls brings significant enforcement costs and cannot be instituted overnight to offset a sudden wave of country popularity.
Once we accept the need for capital flows, then we must admit that countries need to learn how to live with the threat of external crises, just as domestic financial markets have learned to live with the reality of recurring banking crises. On the other hand, both international and domestic indebtedness must be kept at sustainable levels. The attention of policy makers around the world has, therefore, rightly turned to domestic financial markets in the search for the particular institutional characteristics, which explain the behaviour and success of the most efficient of these markets. It is obvious, of course, that sound fiscal and monetary policies help, just as domestically, banks in stable economies and these are less prone to excessive risk and therefore more resilient to crises. Policy autonomy in economic matters will remain a fundamental feature of the international system, while international financial institutions (IFIs) in charge of preventing and dealing with crises will continue playing the dual role of economic advisors and catalytic creditors. The link between both functions -so-called conditionality- will also remain characteristic of the international financial environment. Public money will keep flowing to economies in need in exchange for adequate policies. Furthermore, the academic discussion over what constitutes adequate policies will not only continue but will probably intensify as capital becomes less abundant. Simply put, the temptation to link available money to political conditionality will not go away.
What constitutes adequate economic policies lies beyond the scope of this analysis. Nevertheless, one should make a cautionary observation on the current existence of 'academic bubbles' -that is to say, intellectual or policy fads-. We are currently witnessing one such a conceptual bubble: that of the desirability and superiority of flexible exchange rates. There are no magic solutions, and policies need to be consistent. 'Fear of floating' remains no less a reality in emerging economies than the fear of recession. Too often both have come hand in hand. But returning to the issue of conditionality, this is the core of the difference between international and domestic crises. In domestic banking crises, conditionality restricts itself to ensuring repayment, but, if things become nasty, it can always be enforced through the judicial system. In institutional international lending, conditionality extends over a broad -often too broad- list of issues only indirectly related over the medium term with the country's ability to repay. Moreover, in the event of default, it cannot be imposed.
Creditor countries -and Spain is a recent newcomer to this elite group of countries- have always tried to use IFIs to promote their economic and political agenda in the developing world. This is logical, for they finance the bulk of the work of these institutions. It is also a positive phenomenon because such agendas tend, in general, to promote the type of policies that have worked well in facilitating economic growth and social cohesion in those countries. Yet, it also means that these institutions live in constant imperfect equilibrium, one that is exasperated by the fiscal difficulties experienced by some of the large industrial economies. Taxpayers in industrial economies seem to be unwilling to finance anymore large bailouts like the one that helped deal with the Mexican crisis in 1995. This at least has been the message that has emerged from the review of recent practices conducted by the IMF at the insistence of the G-7. This review concluded by underlining two major problems with the established policy approach towards emerging market balance of payments crises. Even if a policy of massive financial aid could succeed, as it did in Mexico and Korea, it could easily begin to strain the IMF's own financial resources at a time when fiscal consolidation has become a political reality for creditor countries -even before unilateralism in international relations became a distinctive worrisome feature-. Moreover, contrary to all economic evidence, it has been extensively argued that a policy of large bailouts would result in careless future lending -the so-called moral hazard problem-. For better or for worse, this claim defines the existing political environment, and the limited proposals put forward to build a new international financial architecture have to be understood within this political context.
Financial markets have gone through major transformations in the 1990s and, as a consequence, balance of payments crises are no longer simply banking crises but rather major financial market events. Banking finance accounts for a limited and declining fraction of capital flows to emerging markets, particularly in Latin America and Central and Eastern Europe. Bond finance has become prevalent, enlarging the opportunities for governments but complicating the infrastructure of dealing with events of non-payment when they arise. It is no longer possible to resolve matters by negotiating in a closed room between the defaulting government and a select number of institutions grouped under a steering committee, as was the case during the debt crisis of the 1980s. Today, there are literally millions of households involved in emerging markets finance, many of them totally unaware of their exposure. And even if the number of active financial houses is limited, the individual bondholder retains the legal right of challenging any agreement. On the other hand, domestic financial markets have also been liberalized. Therefore, under the guidance of the Washington consensus, many economies have opened up their banking markets to foreign owners, thus creating truly international banking institutions that play a major role in the local retail market -and not only as corporate or investment banks-. Today, the players involved in any external crisis are, therefore, many and varied, as are their interests and strategies. Likewise, the domestic consequences of a disorderly default on the local credit and payment system (witness Argentina) are also varied and complex.
The IMF's proposal for a Sovereign Debt Restructuring Mechanism (SDRM) focuses mainly on one of these players -bondholders- and offers some common sense solutions to a typical game theory problem. If the participants are many and their interests varied and often contradictory, the outcome is likely to be messy and unduly costly not only for the debtor country, but also for at least some of the creditors. A group of the latter may in fact hold the country at ransom by refusing any negotiated settlement in the hope of creating a large enough problem that becomes systemic and forces a large bailout from international institutions. Despite all the talk about moral hazard, we have witnessed again and again (Russia, Turkey and possibly Brazil in the future) that if a country is large enough so that the potential default threatens the stability of the international financial system -or even simply of some large global banks- public money will come to the rescue. Systemic risk is always a possibility, and bailouts always remain a close call when dealing with the likelihood of sovereign defaults. Currently, no member of the G-7 has enough confidence in the empirical evidence on moral hazard so as to risk the disruption of the international financial system.
One of the changes likely to be introduced to foster an orderly restructuring of bond debt is the generalization of collective action clauses (CACs) in bond contracts. The clause already exists in contracts negotiated in London, although not in New York, where the majority of emerging markets finance takes place. This mechanism simply allows for a majority of bondholders to force a negotiated solution on the remaining reluctant minority (which in a way are expropriated of their legal right to call for termination of contracts). Despite claims from some market players that CACs would lead to increased borrowing costs, existing evidence suggests otherwise. In fact, the recent examples of Pakistan and Ecuador would indicate that the actual resolution of cases of financial distress is largely independent of the strict contractual terms involved. Nevertheless, the widespread use of CACs may be a welcome development, albeit an ultimately insignificant one. If only because it might refocus the attention of policymakers and market players where it is currently needed.
Anne Krueger, Deputy Managing Director of the IMF, has argued extensively for adding a last resort debt reduction option to the menu of accepted mechanisms to deal with balance of payments crises. This is nothing new, and one could argue that it was already used intelligently in the form of the Brady bonds invented in the 1980s. The current notion stems from the original work of Jeffrey Sachs (then at Harvard and now at Columbia) suggesting an extension of US corporate default law and practice (the well known chapter XI mechanism) to international debt crises. The idea is appealing, if ultimately unworkable, although some positive developments may come from its careful consideration. In summary, such a proposal amounts to a country at the verge of bankruptcy having the option to declare a standstill on debt payments and to put itself under the protection of an international institution. Yet, while it might sound logical and appealing, the devil remains in the details. Who would ultimately retain the right to declare such a standstill: the debtor country itself or its creditors? If the debtor country were to possess right unilaterally, we would indeed face a serious moral hazard problem that would not only increase borrowing costs but also significantly reduce the amount of debt financing flows available to emerging markets. The Institute of International Finance, a lobby for the largest private financial institutions, has emphasized this point. In this case, the resolution of current instances of financial distress would certainly not be any easier. Imagine any of the populist governments recently elected in Latin American having such statutory power. On the other hand, the possibility that creditors would be empowered with such authority flies in the face of the notion of national sovereignty, and indeed runs contrary to the notion of sovereign debtors.
The current SDRM proposal therefore amounts to the creation of an international institution, which would become a sovereign bankruptcy forum (or more likely to the granting of such authority to an existing international financial institution). The most obvious candidate would be the IMF, although the Bank of International Settlements in Basle (BIS) could also be considered as an alternative. Nevertheless, it is not likely to happen. Does anybody seriously consider it likely that the IMF, the evil of all evils, would formally be empowered by the United Nations, or by its member countries, with the authority to declare a country in bankruptcy and thereby obliged to suspend external payments? Does anybody seriously consider it possible that current politicians in countries in distress (just pick your favourite) would abide by such a ruling and commit themselves to implementing whatever policies the Fund may decree? This is precisely the essence of a bankruptcy procedure: the debtor seeks protection in exchange for surrendering decision-making power. Furthermore, there is also the not so minor issue that the rule of law and the authority of the sovereign state in question would be obliged to enforce the procedure on domestic agents.
Efforts to reform the international financial architecture focus on increasing private sector involvement in crisis prevention and resolution. In the area of crisis prevention, the presumption is that improved regulation, supervision and enforcement of the domestic financial sector, and superior sequencing of financial and capital account liberalization will achieve that goal. Efforts in the area of crisis resolution focus on the SDRM, because these events of financial distress have a large impact on international financial markets. But the role of foreign direct investment in domestic banking systems has increased dramatically over the last ten years, particularly in the case of Spanish banks in Latin America. Their involvement as private sector agents in these crises has received very little attention from the international financial community. This is probably because Spain has only just been invited to the creditor table and lacks the experience and authority to carry forward its own agenda. However, the outcome in cases like Argentina and Brazil will probably determine the future of this type of foreign direct investment for a long time to come. This is a far more promising field of investigation than all the current debates on the SDRM -at least beyond New York-.
Conclusions: International default events are very complicated processes that lack a final authority. They can only be resolved through moral suasion and a careful consideration of all interests involved. The traditional approach needs to be modified to take into consideration recent changes in the composition of debt flows and amended to include the complexities of bond finance. Moreover, the opening of domestic banking systems to foreign institutions has also created a new player: foreign retail banks. Their interest cannot be ignored if foreign direct investment is to be preserved.
Most of the current work in framing a new international financial architecture evolves around the notion of private sector involvement as a way to rebalance the perceived unfairness in the distributions of costs among debtors and creditors. In an effort to do so, the International Monetary Fund is actively pursuing a new Sovereign Debt Restructuring Mechanism. However, in the absence of an international central bank, a lender of last resort that can also close the lending institution, and of a bankruptcy forum that can supersede the management of the debtor country while granting it a temporary stay, the SDRM would merely restrict itself to a code of conduct, a list of good practices that countries would be well advised to follow if they wish to resume prompt access to international capital markets. In a world where multilateralism is in receding gear, the creation of any such new international institutions is highly unlikely.
In any case, every so often instances will occur in which a country, or its government, decides to cut itself off from the international economy. No SDRM would ever prevent this, nor it would help to make it more unlikely. Just as crises prevention can never be so effective so as to prevent all such events, crises management can never hope to eliminate forever any disorderly defaults. In as much as an accepted procedure is known in advance and applied systematically, however, it may become priced into available financial instruments. This would constitute a welcome development. Nevertheless, we are still a long way off from such a scenario and, indeed, one could argue that a certain degree of greyness, of negotiating latitude, is an inherent characteristic of the resolution of debt problems -that is, unless we wish to make international financing so prohibitively expensive as to reduce capital flows to a trickle-. Strengthening domestic financial systems and public finances is a much more promising avenue for international attention than a possible SDRM. Fostering foreign direct investment in banking through non-discrimination between local or external creditors in crises management should also be a matter of concern.
Fernando Fernández Méndez de Andés
is currently Rector and Professor of Economics at the Universidad Europea de Madrid. He formerly served as Senior Economist at the IMF and Chief Economist at Santander Central Hispano