The Difference is in the Debt: Crisis Resolution in Latin America, Address by Anne O. Krueger, First Deputy Managing Director, IMF
November 14, 2003The Difference is in the Debt:
Crisis Resolution in Latin America
Anne O. Krueger, First Deputy Managing Director, IMF
Luncheon Address, Latin America Conference on Sector Reform
Stanford Center for International Development
Stanford, November 14, 2003
It's always a great pleasure to come back to Stanford, and I'm thoroughly enjoying catching up with so many old friends. As you can imagine Latin America is very much on my mind these days, and this conference is a welcome opportunity to reflect on some of the broader issues affecting the region and its economic performance.
With that in mind, I want to share with you today some thoughts about the outlook for Latin America but, more specifically, to raise some questions about the best way of resolving financial crises when they occur. I want to argue that there is a fundamental difference between crises where a country's underlying debt position appears sustainable over the longer-term; and those where a debt restructuring is inevitable. In the latter case, deciding on the right course of action for the Fund to take in providing help is particularly difficult.
The economic outlook
For the first time in several years, I think there is reason to be cautiously optimistic about the economic outlook for Latin America. The global economic upturn offers the region a new opportunity. The prospects for the United States economy look distinctly brighter than we had anticipated just a few months ago. Even in Europe and Japan there are signs of tentative recovery. Some Latin American countries are seeing a pick up in domestic as well as export demand.
This gives many governments a breathing space. It is a chance to put public finances on a sound footing, and to press ahead with difficult structural reforms. Of course, this is a challenge for many governments beyond Latin America. Finance ministers in many of the industrial countries were guilty of failing to confront difficult problems when they had more room for maneuver in the years of buoyant growth.
It is never easy to undertake unpopular economic reform; but it is far more difficult when the economy is stagnating, or even contracting, and unemployment is rising. Look at the experience of France and Germany, for instance. Who could have anticipated that the stability and growth pact would come back to haunt them?
But extensive reforms are still urgently needed in much of Latin America. The region's recent economic history makes it vital that the current breathing space is used profitably. The 1990s were a considerable disappointment to those who thought the region had embarked on a new path of economic reform. Instead of the upward shift in long-term growth rates for which many had cherished hopes, the last decade of the twentieth century was, for Latin America, like so many of the others: another period of erratic economic performance.
In the 1980s, most of Latin America experienced falling real GDP per capita—minus 0.6% a year on average between 1981 and 1990. The 1990s got off to a much better start. Between 1991 and 1997, growth in the region averaged 2.3% a year. Even that compares unfavorably with, for example, East Asia's 6.4% average annual growth rate. But from 1998-2002, Latin America's growth performance deteriorated sharply—indeed, real GDP fell at an average annual rate of about one quarter of a per cent a year.
The region was also affected by greater terms of trade volatility than both the industrial countries and emerging Asia, as a result of the high share in total exports of primary commodities with volatile prices.
Significantly, the reform programs undertaken brought insufficient improvement in the ability of these countries to withstand financial shocks. Although reforms took place, vulnerability (with weak economic policies) to private capital markets rose. The list of financial crises is a reminder of the inadequacy of the financial resilience that the reforms had actually delivered: between 1994 and 2003, crises erupted in Mexico, Brazil, Ecuador, Argentine, Uruguay, Paraguay and Venezuela.
I do not propose today to offer a comprehensive analysis of what went wrong. But I think it would be a grave mistake to blame what we sometimes call the "Washington consensus". The basic policy prescription is, to my mind, still the right one: prudent fiscal policies, careful debt management aimed at long-term sustainability, transparent monetary policy, institutional and judicial reform—I won't rehearse the full list. These remain essential for an economy to enjoy sustained growth and rising living standards.
They are also, of course, a prerequisite for poverty reduction and any narrowing of the inequality gap that governments want to set as a policy priority. For all kinds of reasons, poverty reduction is an explicitly desirable objective: it is one into which the Fund has put a great deal of effort, especially in recent years. But it can be easy to lose sight of the fact that by far the most effective way to reduce poverty and increase economic welfare is through economic growth. And while poverty reduction can be directly targeted, economic growth appears to be a necessary condition for continuing results.
So there should be no change of focus on policy aims, compared with the 1990s. But the lesson of that decade was, surely, that reforms must be ambitious in deed as well as rhetoric. They must be sufficiently far-reaching and ambitious; and they must be implemented in full. The best time to reform is when—as now—growth is accelerating rather than—as too often in the past—in forced response to crisis.
The importance of sound policies
A sound macroeconomic framework is, or should be, the objective of all emerging market economies, just as it is for the rich industrial countries. It is true that even the world's most prosperous economies came relatively late to an understanding of the need for stability and sustainability. Short-term fine-tuning, sometimes with a political undertones, was a familiar sight in many parts of the industrial world even as late as the 1970s.
Now, though, there is little argument about the need to set clear, transparent, long-term objectives for macroeconomic policy in all economies. A clear framework is the sine qua non for economic progress.
And it is, of course, the IMF's principal task. Our core objectives, as set out in the original articles of agreement, have been remarkably enduring: we are there to maintain international financial stability in order to promote economic growth and the expansion of trade. Stable national economies are an important ingredient of international stability and much of our work these days is intended to help governments put in place sound economic policies.
There can be no doubt that to achieve stable growth there has to be a framework in place which permits—indeed, encourages—the development of sustainable macroeconomic policies and the sustained growth of international trade. The ingredients of an appropriate macroeconomic framework might change over time. And I think it is fair to say that both the Fund and others have been forced to rethink what sustainable policies need to include.
I noted the number of financial crises in Latin America. The region was not alone in the 1990s—the Asian crisis, Russia, Turkey have all helped focus the IMF's thinking. But though the list sounds long, I think it is remarkable just how few crises there have actually been, particularly in the last few years of considerable global upheaval: and just how quickly most of them have been resolved.
That said, I think two factors have affected both the nature of the crises we face, and how we deal with them.
The first is the rapid growth of private capital flows. By the 1990s, these flows had grown so rapidly that sovereign debt to the private sector, mostly bonds, greatly exceeded that to the official sector. The headline crises of the 1990s were capital rather than current account crises.
Of course, crisis management is difficult in part because the assessments involved are always probabilistic. But I think it is nevertheless possible to argue than capital account crises usually have several distinguishing features:
They can occur very rapidly, and can require a much more immediate response than current account crises
They occur because holders of a country's debt lose confidence in its ability to service that debt. This means that, in principle, a crisis can occur even if the country's macroeconomic policies are sound, if it is believed they will not be sustained.
But when there are well-founded doubts about macroeconomic policy, these can translate into a full-blown crisis very rapidly.
Fixed exchange rates—we now know—tend to compound the problem. Doubts about the sustainability of the exchange rate peg can precipitate a crisis just as quickly as doubts about the ability to service debt. And the two factors are closely inter-related: a currency mismatch between assets and liabilities can greatly increase the debt burden when the exchange rate depreciates.
The only effective policy response in such circumstances is to restore investors' belief that a country will be able fully to meet its debt service obligations. That, though, is easier said than done.
The second factor that I think changes the way we should prevent, as well as seek to resolve, crises is the level of public debt. We are clear now that any assessment of macroeconomic sustainability must include a judgment about debt sustainability. Again, this problem is not unique to Latin America. The Fund has made public its current disquiet with worryingly high debt burdens in several emerging market economies. But fiscal indiscipline has been a chronic problem in Latin America—and one that, so far, has not been effectively tackled in many countries in the region.
In the early 1990s, budget deficits had tended to fall in many Latin American countries; this, combined with economic growth, eventually brought some decline in debt-to-GDP ratios in some countries. But as economic growth slowed in the latter part of the decade, and turned negative in some countries, deficits rose and so did debt-to-GDP ratios—all aided, of course, by the easy availability of external finance.
It has become increasingly clear that the rise in debt burdens greatly increases vulnerability to any changes that call into question debt sustainability, as creditors stop rolling over outstanding debt. As we have seen on several occasions, the debt burden can rise suddenly and sharply in the wake of a large currency depreciation. The cost of debt servicing can also rise sharply if, for example, bond spreads widen; or if banks have sharp increases in non-performing loans and require government funding to recapitalize. In that circumstance, governments must focus on fiscal and monetary tightening to restore market access.
Crisis prevention and resolution
Much of the Fund's work is aimed at preventing crises. Our aim is to help countries develop a stable macroeconomic framework. The much greater emphasis on, for example, institutional reform is matched by a much broader range of technical assistance from the Fund—as well as the other IFIs. Prevention is always better than cure, which is why we place so much emphasis on the need for fiscal discipline, and the urgency of reducing debt burdens.
Better public expenditure management, better tax collection—these are issues that matter a great deal, however banal they might seem to the casual observer. And efforts to guard against currency mismatches and hence foreign exchange rate risk—in corporates as well as in banks—are also crucial.
But there will always be crises, and working to resolve them will always be an important feature of the Fund's work. For obvious reasons, it is certainly the aspect of our work that attracts most interest from those outside the main policymaking arena.
I said at the outset that I think one can distinguish between two types of crisis—at least, for the purposes of deciding on the appropriate response.
The first type is the crisis where the debt position of the affected country appears sustainable. Such crises are not uncommon. Mexico, Brazil, Turkey—all have been involved in crises where the debt burden, though high, was judged to be sustainable by the government and most analysts. Other factors precipitated trouble: in Brazil, last year, for example, the markets became concerned about whether the new president would continue the same macroeconomic policies of the outgoing government.
I do not mean to suggest that these crises are easy to resolve. They aren't. Once lost, market confidence can be difficult to restore. That is especially true if the problems that sparked trouble aren't resolved quickly. In Brazil in 2002, market confidence only started to return when all the presidential candidates undertook to follow the same economic policies of the outgoing government—policies which the IMF had supported.
However, what the Brazilian experience in particular demonstrated was that once the cause of the crisis has been tackled, to the satisfaction of the markets, confidence can return remarkably quickly. At the height of the trouble in 2002, the risk premium on Brazilian bonds was of the order of 2400 points. At the time of my visit there last week, it was below 600 points. That is a remarkable turnaround, underpinned by the new government's continuing commitment to a sustainable economic program.
Incidentally, Brazil's experience was also an interesting illustration of the benefits that market discipline can bring. The sudden loss of market nerve served as a powerful reminder both to the political class and to ordinary Brazilian citizens of the importance of maintain sound economic policies.
But even in cases where the debt burden appears sustainable, changing circumstances can alter the picture. Lower-than-anticipated growth, exchange rate depreciation, or widening bond spreads can make an otherwise acceptable primary surplus target look insufficient.
Of course, performance that exceeds the targets—as we have recently seen in the case of both Brazil and Turkey—helps create a cushion against unexpected shocks.
Unsustainable debt burdens
Crises where the debt burden of the country is widely regarded as unsustainable present the Fund with a much more difficult challenge. Once a crisis erupts, the country concerned is likely to find itself both under pressure to change economic course, and to restructure its debt. The two go together. Debt restructuring without the adoption of a macroeconomic strategy that confronts the underlying problems will be a waste of time. And the opposite is also true: macroeconomic reform without debt restructuring will not work either.
Suppose, for instance, that the debt is truly unsustainable and that, for whatever reason, a government fails to introduce economic reforms of the kind needed to rebalance the economy. It is difficult to see how, in such circumstances, a program of Fund financial assistance could help. If the structure of the existing debt doesn't change, the total amount that a country can repay will not change. It is bound to be less than that needed to service the debt. Additional lending from the Fund will simply displace private debt [and, in practice, increase the size of the `haircut' that private creditors will, eventually, have to accept.].
In this context, I am always puzzled by occasional references to Fund assistance as a bailout for the banks. This does not square with the reality, which is that when debt burdens are truly unsustainable Fund help without the two interlinked conditions—reform and restructuring—having been met would basically mean the Fund substituting for the banks. Only if there is a high probability of the Fund being able to add value—by supporting policy changes that restore or accelerate growth and thus enhance debt-servicing capacity—is Fund support productive.
Of course, once a country has defaulted it will no longer be able to access the private capital markets until its debt has been restructured. And even quite extensive economic policy reform will not assist a restructuring if the new macroeconomic framework fails to provide a convincing plan for debt servicing.
When the debt position is sustainable, of course, it is relatively easy to design an economic program that provides for satisfactory debt servicing: it is largely a matter of calculating the appropriate primary surplus.
It is much more difficult to judge the best way forward without a clear fiscal path, since that also makes it more difficult to reach a view—let alone agreement—on the appropriate restructuring of the debt. Any given primary surplus trajectory will determine the capacity for debt servicing.
These are complicated issues that affect the country concerned, the Fund and the capital markets. At the end of the day, the Fund is seeking to help member countries resolve their problems—that must mean providing financial assistance and supporting policy changes that help move the situation forward, however uncomfortable that role might be on occasions.
There are no easy answers to these issues, and at the end of the day each case must be judged on its own merits.
But I think there are some basic principles that should guide the Fund, and member governments, in the efforts both to prevent crisis and to resolve them. And I think the experience of the past few years—in Latin America, yet, but elsewhere too—has helped bring these principles into sharper focus.
I apologize if I am beginning to sound like a record that has stuck on one groove: but there really is no getting away from the fact that a stable macroeconomic framework has to underpin everything else. Governments cannot expect to deliver economic stability and long-term prosperity for their citizens if they are not prepared to put in place sound economic policies, and do so in a transparent manner.
They must have clear—and clearly articulated—objectives, including control of the public finances, wide-ranging economic reforms along with institutional reform where necessary. Half-baked reforms will not work. Macropolicy must be supported by other effective reforms—in the labor market, the financial sector, in the judicial system and at the institutional level.
The Fund stands ready to help member countries to achieve these objectives. But if governments are reluctant to embrace the necessary reforms, our crisis prevention work will, inevitably, be limited in its effectiveness.
This is also true where governments are less transparent in their policymaking and their policy performance than is now judged desirable. Markets can price bad news, but not uncertainty. Our efforts to persuade governments of the benefits of transparent policymaking have been given a small boost by new research completed in the Fund. This shows that improving transparency lowers borrowing costs, as measured by sovereign spreads. This, of course, is entirely consistent with the argument that transparency reinforces the pressure for the development of sound economic policies.
Sound policies and transparent policymaking are just as important in crisis resolution. The Fund cannot easily help a member government that is reluctant to introduce reforms that we—and, indeed, the markets—judge essential to restore economic stability and, of course, access to the capital markets.
It all sounds so simple, doesn't it—deceptively so, I'm afraid. Achieving a balance between what is politically feasible for a government, especially one in crisis, and what makes longer-term economic sense is often extremely difficult. And, while I've spoken as if outcomes are known with certainty, in fact there is always uncertainty about the impact of policy measures, the likelihood of exogenous shocks, and other relevant variables.
But the experience of Latin America in recent decades surely highlights the dangers of going for the short-term political fix. The current global upturn provides countries in the region with a short breathing space: they urgently need to use it to help make their economies less vulnerable and more resilient.