International Monetary Seminar, Banque de France, Remarks by Ms. Anne O. Krueger, First Deputy Managing Director, IMF
May 13, 2003International Monetary Seminar
Banque de France
Remarks by Ms. Anne O. Krueger
First Deputy Managing Director, International Monetary Fund
May 13, 2003
1. Good afternoon Ladies and Gentlemen. Let me start by thanking the Banque de France for inviting me to speak at this seminar. I am sorry that I cannot be with you in person—and am unable to enjoy a visit to the Banque. Unfortunately, a range of prior commitments forces me to limit my participation at this distinguished gathering to a video hook-up.
2. The past year has witnessed a vigorous and constructive debate regarding the need to improve arrangements for the resolving of financial crises, and in particular the tools for restructuring sovereign debt. To be sure, this remains a controversial topic. But the debate has served to help define the issues, and to build understanding on possible ways to strengthen the international financial system. In particular, how to address the hopefully rare cases in which sovereign debtors and creditors must confront debt burdens that have become unsustainable. At times, however, the intensity of the discourse may have tended to mask the extent to which there has indeed been a convergence of views regarding the nature of the problem, and the desirability of taking actions to strengthen the system.
3. Today I would like to step back from the fray and look at the convergence of views on the diagnosis of the problem, and at some of the factors that will have to be part of the solution.
Importance of policies as crisis prevention tools
4. A first point on which there is general agreement concerns the importance of the sustained implementation of sound macroeconomic policies. And the critical importance of buttressing these with efforts to reduce vulnerabilities to crises. Strengthening tools for resolving crises and the debate about how to improve mechanisms for sovereign debt restructurings must never be allowed to detract from the critical need to persevere with reforms that could reduce the frequency, and mitigate the severity, of crises. In this regard, substantial progress has been made in recent years. In many respects, the world economy is now more resilient to shocks. Moves toward more flexible exchange rate regimes, strengthening of domestic financial systems (particularly through enhanced banking supervision), and rebuilding official reserves have contributed to making economies more robust and less vulnerable to crises. We should not forget that the crises in Asia, Russia, and Brazil of the late 1990s were typically associated with pegged exchange rates, a mix of monetary and fiscal policies that attracted short-term capital hoping to benefit from high domestic interest rates, and generally inadequate banking supervision. But we should not lose sight of the fact that there are a number of emerging market countries that have high debt burdens and continue to experience fiscal pressures.
5. Of course, through bilateral and multilateral surveillance, we are engaged in a continuous dialogue with our members, which focuses on the implementation of sound policies. But in recent years, the Fund has put enormous emphasis on prevention. Beyond working on strengthening macroeconomic policy frameworks, we have worked closely with our members to help them assess and manage vulnerabilities, strengthen surveillance over financial systems, and improve debt management. We have stressed the importance of remaining vigilant to developments in capital markets, re-orienting and re-designing policies where needed. For instance, it is important that financial supervision be kept in line with increased integration into global capital markets. Moreover, with the aim of improving the environment for private sector decision taking, we have promoted transparency, and have disseminated—and encouraged adherence to—standards and codes.
6. Of course, we must avoid complacency, and recognize that despite best efforts at prevention, crises will still occur. The 15 or so years since the resolution of the 1980s, debt crisis have witnessed large-scale capital flows to emerging market borrowers. But we are now moving into a period in which an increasing number of emerging markets have become mature borrowers—by which I mean countries that regained access to capital markets have allowed their debts to increase to levels at which future net borrowing needs be kept strictly in line with their growth in their payments capacity. This has a number of implications.
- First, although we have recently seen some resurgence in capital market activity, in the period ahead we should not expect net debt creating flows to emerging markets to return to the scale of those witnessed in the 1990s. Indeed, the recent trends in net flows to emerging market sovereigns may be comforting to the extent that it may indicate that debt markets are not repeating the bubble behavior experienced in other asset markets.
- Second, with only limited capacity to take on additional debt in the context of resolving crises, countries' room for maneuver to address building tensions may be more restricted than was the case in the past.
- Third, close attention to developments in countries' vulnerabilities, and prompt corrective action, is more important than ever.
Resolution of financial crises
7. However, in a hopefully very limited number of cases, countries may experience rising debt or other capital account pressures—including unanticipated external shocks—which may develop into full-blown crises.
- In some cases, the source of the difficulties may lie in the balance sheet of the public sector. As a result of some combination of bad policies and bad luck, a sovereign may experience acute liquidity difficulties, and in extreme cases may find that its debt burden has become unsustainable.
- We are also likely to continue to witness cases where the source of the problem may lie in financial (or nonfinancial) corporate sectors. Recent crises have demonstrated the ways in which difficulties in one set of balance sheets in an economy can rapidly propagate across to other sectors, and spillover to the external accounts.1
This suggests that the resolution of individual crises will need to be tailored to the diversity of situations that our members may confront.
8. In any event, there is typically at least a brief period between the recognition that a member has a building capital account or an acute debt problem and the outset of a full-blown crisis. But in such circumstances, time is the friend of neither country authorities nor private investors. Nevertheless, there is likely to be a window of opportunity for taking corrective actions that offer the prospect of resolving crises in a fashion that limits the scale of economic dislocation and preserves assets' economic value. The challenge confronting policy makers is to utilize the window, and thereby to avert an even worse outcome.
- In some cases, a combination of the forceful implementation of corrective policies, market based liability management operations, and official financing may allow for a rapid and orderly resolution of the crisis.
- In other cases, it may be necessary to complement the sustained implementation of corrective policies and the provision of official financing, with concerted measures to reprofile—or in some cases even reduce—debt service burdens. Here too the design of the measures to resolve a crisis will need to be carefully formulated to reflect the member's situation. In some cases, it may be necessary to restructure the debt of the sovereign. But if sovereign debt restructuring is the hammer in the international community's toolbox, we must recognize that not every crisis is a nail! Other cases may need to address some combination of the liabilities of nonsovereign debtors and capital flight.
The Fund's access policy
9. The Fund, through its role both as an advisor and as a lender, will continue to play a key role in the resolution of financial crises. And so access policy—the conditions under which the Fund is willing to extend support for a member's adjustment program, and the scale of such support—will remain an important parameter in the resolution of crises. The scale of potential financing needs has increased as a result of the increasing integration of countries into the global economy, and with it the risk of abrupt changes in market sentiment and reversal of capital flows.
10. In some cases, it may be appropriate for the Fund to provide large-scale access in support of a forceful adjustment program. This would be done with the expectation that, as policies take hold and confidence builds, this support will have a catalytic effect in facilitating a return to national and international capital markets. But it would only be appropriate for consideration to be given to large-scale access to the Fund's resources in cases where:
- The member country is experiencing exceptional balance of payments pressures on the capital account, resulting in a need for Fund financing that cannot be met within the normal limits;
- A rigorous and systematic analysis indicates that there is a high probability that debt will remain sustainable;
- The member has good prospects of regaining access to private capital markets within the time Fund resources would be outstanding, so that the Fund's financing would provide a bridge; and
- The policy program of the member country provides a reasonably strong prospect of success, including not only the member's adjustment plans, but also its institutional and political capacity to deliver that adjustment.
11. In other cases, however, these conditions may not be satisfied, and so it would not be appropriate for the Fund to provide exceptional access to its resources. Accordingly, in such cases the resolution of crises must entail some form of concerted refinancing or restructuring of the claims on sovereign and/or nonsovereign debtors.
Strengthening the arrangements for resolving sovereign debt difficulties
12. Now let me turn to efforts to strengthen arrangements for resolving sovereign debt difficulties. The debate surrounding the Sovereign Debt Restructuring Mechanism (SDRM) served as a useful platform to consider avenues for improving the debt restructuring process. While we do not now have the high level of support that would be required to make the adoption of the proposed mechanism feasible, the analytic work and broad discussion has been extremely helpful in helping to develop our thinking on where the main shortcomings lie.
13. The focus of our current efforts is on promoting the inclusion of collective action clauses (CACs) in debt contracts, and, more generally, on finding ways to improve arrangements for sovereign debt restructuring within the existing legal framework.
Process of debt restructuring
14. Let me first address ways in which the process of debt restructuring could be improved. A number of commentators have highlighted, in particular, the absence of procedural clarity regarding the conduct of debtors and creditors.
15. These concerns have contributed to calls for a voluntary Code of Good Conduct. The various proposals that have emerged—including, importantly, from the Banque de France—are constructive, and could, in our view, help provide greater predictability to the restructuring process under any legal framework.
- A Code could be made applicable to a broad set of circumstances, ranging from periods of relative tranquility to periods of acute stress, and could constitute an established set of best practices. In contrast, proposals for strengthening arrangements for debt restructuring have a more limited scope and purpose—to facilitate the resolution of financial crises.
- By its very nature, a voluntary Code, while potentially helpful, could not resolve collective action problems. This is a subject to which I shall return in a moment.
- Finally, a Code could only be effective to the extent to which it is able to attract broad support among debtors and their creditors. Accordingly, the most promising approach to developing a code that could form the basis of a consensus would be for it to be developed jointly by debtors, their creditors, and other interested parties (including the Fund). Conversely, it appears unlikely that a Code designed by the Fund would attract broad support, though we stand ready to collaborate with others in the elaboration of a code.
16. Recent adaptations in Fund policies could be complementary to a Code. Last year the Fund's Executive Board adopted a modification of the lending into arrears policy—the policies that govern the circumstances under which the Fund can provide financial support for a member's adjustment program during the period in which it has arrears to private creditors, and is attempting to reach agreement on a restructuring. This policy establishes expectations regarding the behavior of debtors that are receiving financial support from the Fund in such circumstances:
17. The debtor should engage in an early dialogue, which should continue until the restructuring is completed:
- The debtor should share relevant, non-confidential information with all creditors on a timely basis. This would include an explanation of the adjustment program and the financial circumstances that justify a restructuring, as well as a comprehensive picture of all domestic and external claims on the sovereign.
- The debtor should provide creditors with an early opportunity to give input on the design of the restructuring strategy. This could help address the specific needs of different types of investors, thereby increasing the likelihood of a high participation rate.
18. In addition, in cases in which creditors have organized a reasonably representative committee on a timely basis, there is an expectation that the member would negotiate with such a committee. Our policy suggests a number of principles that should guide the debtor's conduct during negotiations. In formulating these principles, we have drawn on the expertise of workout specialists reflected, for example, in the report by the Council on Foreign Relations (CFR), and efforts by International Federation of Insolvency Professionals (INSOL) to distill best practice for nonsovereign workouts.
Collective action difficulties
19. Let me add a few words concerning the motivation behind initiatives to promote the inclusion of CACs. An important shortcoming of the existing arrangements for the restructuring of sovereign debt relates to the failure of collective action. It complicates the process of reaching agreement on a restructuring. There is a danger that individual creditors will decline to participate in a voluntary restructuring in the hope of recovering payment on the original contractual terms, even though creditors—as a group—would be best served by agreeing to a restructuring.
- The problem of collective action is most acute prior to a default, where individual creditors may have some reasonable hope of continuing to receive payments under the terms of their original contracts.
- Following a default, the options facing creditors—particularly those who have no interest in litigation—are more limited and so the problems of collective action may be less acute. But a more formal mechanism would still make sense in such cases. It would provide greater clarity as to the predictability and transparency of the process by which agreement could be reached, while of course eliminating the possibility of at least some creditors hoping to secure better terms through litigation.
20. But we should not fall into the trap of believing that default is a good solution to collective action difficulties. Of course, there is no doubt that following default, agreement on a restructuring would eventually be reached. But default—and the associated uncertainties regarding creditor-debtor relations—tends to be associated with widespread economic dislocation. Proposals for strengthening arrangements for debt restructuring are intended to increase the likelihood that early agreement can be reached on restructuring that can restore viability. They are also intended to see that neither debtors nor their creditors must bear costs that are unduly large.
21. But I am pleased to be able to say that progress is being made! I would like to take this opportunity to applaud Mexico, Brazil, and most recently, South Africa for the inclusion of CACs in their recent bond issues governed by New York law. These are very important steps. If this leads to the establishment of a new market standard, it could go a long way toward a more orderly and efficient process for debt restructurings. The Fund's role in this area is to promote the voluntary use of CACs through its surveillance, as recently mandated by the International Monetary and Financial Committee (IMFC).
Dealing with banking system crises
22. In addition to the work on improving the sovereign debt restructuring process, there is also a need to develop further our thinking on a number of other issues arising in the context of a crisis. One is how best to assist members in addressing systemic banking crises, particularly in cases in which the system is highly-dollarized, and/or cases in which systems that are highly exposed to sovereign debt.
23. With highly dollarized banking systems, issues arise regarding the extent to which liquidity assistance can be sustained in the event of a crisis, where that assistance has to be provided in a currency that the government does not have the ability to create. The inability of a central bank to serve as a credible lender of last resort in these circumstances may end up fueling a run and leading to greater economic disruption. In this context, questions may arise as to the extent to which it would be appropriate for the official sector may need to step in with additional financing to boost the central bank's lender of last resort capacity, which in turn raises several issues regarding debt sustainability and the adequacy of macro policies.
24. As the recent cases of Argentina and Uruguay illustrate, the combination of a highly dollarized banking system and a rigid exchange rate regime can result in vulnerabilities are difficult to manage. In this context, severe liquidity losses stemming from a bank run will quickly feed into a currency crisis and eventually necessitate a sharp exchange rate adjustment. The adjustment in relative prices may in turn induce an unsustainable debt profile and severe balance sheet problems in the corporate sector. These problems will be further compounded when the banking system is largely exposed to the sovereign's unsustainable debt, and as restructuring will unavoidably amount to a further deterioration in banks' balance sheets. Thus, measures to stem the effects of debt restructuring on the banking system also need to be considered in greater depth.
25. In conclusion, let me summarize the five key areas where there appears to be broad agreement.
- First, there is no doubt about the critical role of prevention and the importance sustained implementation of appropriate macroeconomic and structural policies. The best way to ensure that countries gain the benefits of globalization while avoiding the pitfalls is through constant vigilance in economic management, including the prudential supervision of financial systems
- Second, there is a need to improve the existing arrangements for restructuring sovereign debt. The intention is not to make sovereign debt restructuring an easy option. But rather to allow debtors with unsustainable debt burdens to reach agreement on a restructuring without unnecessary dislocation and loss of asset values. Of course, nobody believes that this is the complete answer to the difficulties of resolving financial crises. The restructuring of sovereign debt is likely, as a practical matter, to need to be complemented by other measures. Including those to stabilize and restructure the domestic financial system, and perhaps resolve balance sheet difficulties in the corporate sector. It may also need to be conducted against the background of temporary resort to some combination of exchange controls and a deposit freeze. But that is a subject for another day.
- Third, a key market failure relates to collective action. This is the main pillar of both the contractual and statutory approaches to improving the arrangements for sovereign debt restructuring. Welcome progress is being made with the incorporation of collective action clauses into sovereign debt contracts. This is encouraging. Now that the first mover problem has been resolved, we must redouble our efforts to promote the widespread adoption of such clauses.
- Fourth, there is considerable merit in efforts to improve the transparency and predictability of the debt restructuring process. Here I see strong complementarities between a possible Code of Good Conduct, some of the proposals for CACs, the recent revisions to the Fund's lending into arrears policy—which establishes expectations regarding debtor's behavior vis-à-vis their creditors—and a number of key features of the SDRM proposal. But we have further to go.
- Finally, there is a need for further thinking on how to deal with the implications of a crisis for the banking system and how to reduce the effects of debt restructuring on the financial sector when it is highly exposed to sovereign debt. The experience of Argentina has served to illustrate how these elements may combine to generate massive economic and social disruptions.
Thank you very much.
1 See, for example, "A Balance Sheet Approach to Financial Crisis," by Mark Allen; Christoph Rosenberg, Christian Keller, Brad Setser; Nouriel Roubini. WP/02/210, 2002.