## _spn0908 - Executive Summary

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---

### Main shocks and overall assessment
- Two concurrent shocks to Emerging Market Economies (EMEs):
  - A “sudden stop” of capital inflows driven by global deleveraging.
  - A collapse in export demand associated with the global slump.
- Heterogeneous initial conditions:
  - Some EMEs had homegrown vulnerabilities—unsustainable credit booms, fiscal policies, and large debt overhangs.
  - The majority were “innocent bystanders.”
- Policy objective:
  - Solve debt overhangs and bring about recovery across both groups of countries.

### Role of official financing and IMF instruments
- Greater official financing expands “policy space” for supportive macroeconomic policies and can help meet fiscal outlays (e.g., bank recapitalization costs).
- IMF readiness and toolkit changes:
  - Doubling of access limits.
  - Introduction of the Flexible Credit Line (FCL) with no preset cap on access.
  - Modifications to phasing of Stand-By Arrangements (SBAs) to allow more front-loaded disbursements.
- Complementary support:
  - Bilateral support, central bank swap lines, and regional multilateral support can complement IFI resources.
- Limitation:
  - Official resources can boost investor confidence but are unlikely to fully substitute for private external financing given the scale of global deleveraging.

### Debt overhangs, insolvencies, and workout frameworks
- Large debt overhangs—especially unhedged foreign exchange–denominated debt—can prolong recessions and constrain macro policy.
- Critical need for legal/institutional frameworks to facilitate rapid debt workouts and reduce inefficiencies in bankruptcy and restructuring.
- Restructuring approaches:
  - Ex post: recapitalizing banks after losses.
  - Proactive: converting foreign currency mortgages to domestic currency with possible bank compensation (perhaps with a haircut).
- Trade-offs:
  - Restructuring can enable monetary easing and shorten downturns, reducing cumulative fiscal costs.
  - Large short-term fiscal outlays for bank solvency restoration may limit room for conventional fiscal expansion.
- Precedents:
  - Korea’s 1998 private bank debt exchange: 96 percent investor participation and no investor “haircut.”
  - Uruguay’s 2003 debt exchange: 89 percent participation of internationally issued bonds and a haircut of 13 percent (considered a default).

### Monetary policy guidance
- Basic thrust: monetary easing is appropriate in most EMEs given global deflationary pressures and widening interest differentials with advanced countries.
- Trade-off to weigh: growth benefits of looser policy versus negative balance-sheet impacts from exchange rate depreciation on unhedged liabilities.
- Policy tools and considerations:
  - Lower policy interest rates, foreign exchange intervention, and, where appropriate, quantitative measures.
  - Use of foreign exchange reserves to prevent excessive depreciation or to substitute for foreign credit lines to banks to preserve domestic lending.
  - For inflation-targeters: greater scope to absorb depreciations without compromising credibility; for pegged regimes: scope depends on whether the peg is retained.
- Decision factors for allowing depreciation:
  - Initial overvaluation, exchange rate regime, balance sheet exposures, regional contagion, and systemic implications.

### Fiscal policy guidance
- Use expansionary fiscal policy depending on available “fiscal space” — the scope to finance a deficit without undue crowding out, sharp funding cost increases, or undermining debt sustainability.
- In countries with large debt overhangs, fiscal space may be needed for resolution and financial sector recapitalization, reducing room for conventional fiscal stimulus.
- Fiscal measures can include conventional stimulus and less conventional measures such as credit guarantees on domestic borrowing.
- Fiscal credibility matters: a credible exit strategy that places government finances on a sustainable long-term footing will help contain financing costs of short-term stimulus and strengthen investor confidence.

### Initial conditions and external financing constraint
- Varied initial conditions across EMEs: improved policies and reserves in many, but significant variation in policy space, flow imbalances, and stock vulnerabilities.
- Net private capital flows projection:
  - Inflow of US$600 billion in 2007.
  - Outflow of US$180 billion in 2009.
- Policy options facing lost external financing:
  - Exchange rate depreciation: reasonable on average but risks adverse balance-sheet effects with unhedged foreign currency liabilities.
  - Raising interest rates: traditional response but likely less effective here because outflows reflect creditors’ deleveraging rather than loss of confidence.
  - Official financing: one of the few avenues to ease external constraints (see IMF instruments).
  - Controls on capital outflows: generally less appropriate; may at best freeze credit lines and almost surely collapse fresh inflows. In full-blown crises, standstills or voluntary creditor agreements may be considered; as a last resort, capital transaction regulation is possible but risky.

### Practical measures to limit insolvencies and preserve credit intermediation
- Four elements for an effective approach:
  - Provision of domestic currency liquidity to prevent illiquidity from becoming insolvency; may require quantitative central bank measures if banks are reluctant to lend.
  - Provision of foreign exchange liquidity to banks (e.g., central bank FX loans or reserve use) where rapid depreciation and nonrenewal of foreign credit lines threaten solvency—recognizing risks if depreciation persists.
  - Strengthening institutional and legal frameworks to facilitate creditor coordination, Pareto-improving write-downs, and efficient out-of-court mechanisms where judicial insolvency systems are overwhelmed.
  - Careful regulatory forbearance when appropriate (e.g., when depreciation is judged to be overshooting and expected to reverse), while mindful of longer-term implications for bank solvency and public finances.

### Box 1 — Debt Workouts and Insolvency Proceedings (key findings and reforms)
- Bankruptcy efficiency evidence (Djankov and others (2008) hotel case):
  - Only 36 percent of sampled countries achieved the efficient outcome of maintaining the firm as a going concern.
  - Firm continues operating (average dummy):
    - Advanced Economies: 0.73
    - Emerging Market Economies — All: 0.21
    - Emerging Market Economies — Asia: 0.29
    - Emerging Market Economies — Europe: 0.24
    - Emerging Market Economies — Latin America & Caribbean: 0.24
    - Emerging Market Economies — Africa/Middle East/Central Asia: 0.00
  - Efficiency (present value of terminal value after bankruptcy costs; 100 = current value as going concern):
    - Advanced Economies: 77.6
    - Emerging Market Economies — All: 41.8
    - Emerging Market Economies — Asia: 46.2
    - Emerging Market Economies — Europe: 45.0
    - Emerging Market Economies — Latin America & Caribbean: 35.0
    - Emerging Market Economies — Africa/Middle East/Central Asia: 41.9
- Risks from the global crisis:
  - Sharp rise in bankruptcies will likely overwhelm judicial systems, worsening delays and value destruction.
  - Clogged courts and lower reputational costs can encourage “gambling for resurrection.”
  - Falling collateral values can reduce other firms’ creditworthiness.
- Legal and procedural reforms recommended:
  - Allow fresh capital to take priority over other creditors where needed.
  - Use out-of-court restructuring guided by "London rules" and enable "prepacked" bankruptcies enforceable on holdouts.
  - Consider temporary, more radical measures in severe crises (e.g., "Super-Chapter 11" elements), recognizing implementation complexity.
- Government and banking-sector interventions:
  - Proactive government support to avoid mounting bank losses and depositor confidence loss.
  - Recapitalization principles:
    - Existing shareholders bear first losses.
    - Salvage banks with viable business models only.
    - Cross-border recapitalization raises coordination and burden-sharing issues.
  - Asset management companies (AMCs) can help maximize recovery by avoiding fire sales.
  - Conversion of selected foreign currency assets to local currency (with borrower and creditor consent) can redistribute risk to the government and limit foreclosures; precedents include Bulgaria, Korea, Mexico, Poland, Uruguay, Indonesia, and Nicaragua.
  - Warning: wholesale forced pesification risks bank runs, capital flight, and lengthy legal challenges.

### Box 2 — Government Financial Support for Debt Restructuring (mechanisms, trade-offs)
- Context:
  - Dollarized financial sectors facing sharp devaluation may require government intervention if provisioning and recapitalization by banks prove insufficient.
  - Interventions entail significant fiscal costs and redistributive implications.
- Recapitalization:
  - Mechanism: fiscal resources deployed to recapitalize banks after devaluation affects balance sheets; owners absorb the first tranche of losses.
  - Advantages: potentially low cost if owners take large hit; possible later recoveries.
  - Risks: high foreign ownership complicates recapitalization; continuing defaults can sap confidence.
  - Country examples: Romania, Hungary.
- Temporary subsidy of loan repayments:
  - Mechanism: government temporarily reduces debt service in foreign currency terms and compensates banks if devaluation is expected to be temporary.
  - Risk: government exposure can escalate if devaluation persists; may precipitate deposit runs.
- Currency conversion of bank assets:
  - Mechanism: government swaps foreign currency–denominated government paper for troubled assets and converts them to local currency loans (with consent).
  - Objective: reallocate foreign currency risk, avoid defaults/foreclosures, and reduce uncertainty.
  - Constraints: potentially prohibitively expensive; requires sufficient government resources.
- Heterodox/combined approaches:
  - Countries may mix measures (e.g., Hungary: loan maturity extensions, temporary easing, conversion options, and temporary state guarantees for mortgage payments of the unemployed).
- Policy considerations:
  - Fiscal cost and sustainability, redistribution and equity, and implementation constraints (foreign bank ownership, limited fiscal space, potential moral hazard, capital flight, deposit runs).

### Box 3 — Evidence on Effectiveness and Procyclicality of Fiscal Policy in EMEs
- Empirical findings on fiscal effectiveness:
  - Fiscal policy tends to have smaller and more transient stimulative effects in EMEs than in advanced economies (Spilimbergo and others, 2009).
  - IMF (2008): medium-term impact of discretionary fiscal expansion on output in EMEs is negative; immediate impact positive but small.
  - Ilzetzki and Vegh (2008): larger output response at one-quarter horizon in EMEs, but much smaller at longer horizons than in advanced economies.
  - Ghosh and Rahman (2008): small and generally negative multipliers in both advanced and emerging economies, particularly when public debt is high.
  - Freedman and others (2009): immediate positive effect in Asian EMEs similar to advanced economies (dependent on monetary response), but more pronounced negative medium-term effect.
  - Ortiz and others (2009): in 22 “Systemic Sudden Stops,” countries with tighter fiscal policy experienced sharper contractions.
  - Clements, Flores, and Leigh (2009): stabilizing role of fiscal policy depends critically on financing conditions.
  - Mendoza and Ostry (2008), Celasun, Debrun, and Ostry (2006): constraints on expansionary fiscal policy in EMEs given shock nature and debt sustainability concerns.
- Evidence on procyclicality:
  - Fiscal policy has tended to be less countercyclical in EMEs, especially those with a fixed exchange rate.
  - Regression framework summary and reported coefficients (as presented):
    - Output gap -18.92 -2.86***
    - Pegged regimes*output gap 30.69 2.63***
    - Intermediate regimes*output gap -10.21 -1.38
    - Number of observations, R2 3000.63
    - Output gap -7.86 -1.10
    - Pegged regimes*output gap 30.89 a2.76***
    - Intermediate regimes*output gap 11.62 1.35
    - Number of observations, R2 1740.50
    - Note: a The combined coefficient on the output gap (including regime interaction) is positive and significant at the 10 percent level; this indicates procyclical fiscal policy.
- Using available fiscal space:
  - Automatic stabilizers:
    - More timely and better targeted; authorities should allow them to operate fully, potentially overriding fiscal rules where needed.
    - Automatic stabilizers tend to be relatively small in EMEs.
  - Discretionary measures:
    - Target spending or tax cuts to protect the poor and vulnerable.
    - Income tax cuts are likely less effective because of narrow tax bases; payroll and consumption tax cuts could be more effective for the poor.
    - Explicitly temporary consumption tax reductions may incentivize bringing forward consumption.
    - Increasing government capital expenditure can have larger impacts on potential growth if “shovel-ready” projects exist; caveat: higher import content implies leakage.
    - Recurrent expenditure increases are risky due to difficulty of reversal and debt sustainability implications.
  - Government guarantees:
    - Can be effective to maintain private demand when credit supply is the main channel; design must mitigate adverse selection, moral hazard, and contingent liability risks.

### Box 4 — Credit Guarantee Schemes: Principles and Design Issues (summary)
- Use case:
  - Useful when supply of bank credit contracts and other policy options are constrained.
- Principal design issues:
  - Adverse selection: limit guarantees to new lending and verifiable borrower quality.
  - Moral hazard: partial guarantees to reduce risk-taking incentives.
  - Additionality: ensure guarantees encourage new lending rather than merely reclassifying existing loans.
  - Bank bailouts and conditionality: link guarantees to recapitalization and lending targets, mindful of governance risks.
  - Fiscal sustainability: guarantees are contingent liabilities requiring transparent monitoring.
- Design recommendations:
  - Limit guarantees to new lending and verifiable borrower quality where possible.
  - Use partial guarantees to mitigate moral hazard.
  - Combine guarantees with recapitalization and conditionality where appropriate.
  - Ensure transparency about contingent liabilities and monitor fiscal exposure carefully.

### Conclusions and overall policy message
- EMEs face two shocks: a “sudden stop” of capital inflows from global deleveraging and a collapse in export demand from the global slump; deleveraging especially harms countries with foreign currency credit booms and large debt overhangs.
- Measures to ameliorate debt overhang and support recovery include:
  - Bankruptcy and debt restructuring reforms and mechanisms.
  - Monetary and exchange rate policies supportive of demand while managing balance-sheet risks.
  - Fiscal policy options that respect limited fiscal space in many EMEs, including use of automatic stabilizers, targeted discretionary measures, and carefully designed guarantees.
- Crucial requirement:
  - A credible exit strategy is essential so policies can be sufficiently bold to restore confidence and stem the slide in activity in the short run without jeopardizing long-term sustainability or policy credibility.

*Source: EXECUTIVE SUMMARY of _spn0908 (IMF).*

### Executive Summary ......................................................................................................

### _spn0908 - Executive Summary

### Document structure and major sections
- Executive Summary ...................................................................................................................2
- I. Introduction and Overview.................................................................................................3
- II. Initial Conditions and the External Financing Constraint ...................................................6
- III. Insolvencies, Debt Overhangs, and Workouts ....................................................................9
- IV. Macroeconomic Policies....................................................................................................14
  - A. Monetary Policy......................................................................................................14
  - B. Fiscal Policy ............................................................................................................19
- V. Conclusions .......................................................................................................................25
- References................................................................................................................................26

### Figures
- Figure 1. Shock to Emerging Market Economies .........................................................................4
- Figure 2. Emerging Market Economies: Initial Conditions ..........................................................7
- Figure 3. Policy Interest Rates in Emerging Market Economies ................................................18

### Boxes
- Box 1. Debt Workouts and Insolvency Proceedings   .............................................................11
- Box 2. Government Financial Support for Debt Restructuring...............................................13
- Box 3. Evidence on Effectiveness and Procyclicality of Fiscal Policy in EMEs ....................22
- Box 4. Credit Guarantee Schemes: Principles and Design Issues ...........................................24

### Front-matter acknowledgements and disclaimers
- "We would like to thank Olivier Blanchard, Guillermo Calvo, Simeon Djankov, and numerous colleagues at the IMF for their useful comments."
- "The views expressed in this paper, however, are those of the authors and do not necessarily reflect the views of the IMF, its Executive Board, or management."
- Footnote markers present: 1, 2

*Source: _spn0908 - Executive Summary (IMF PDF)_*

### EXECUTIVE SUMMARY

### _spn0908 - EXECUTIVE SUMMARY

### Main shocks and overall assessment
- EMEs face two concurrent shocks: a “sudden stop” of capital inflows driven by global deleveraging, and a collapse in export demand associated with the global slump.
- Some EMEs entered the crisis with homegrown vulnerabilities—unsustainable credit booms, fiscal policies, and large debt overhangs—while the majority were “innocent bystanders.”
- Policy objective: solve debt overhangs and bring about recovery across both groups of countries.

### Role of official financing and IMF instruments
- Greater official financing expands the “policy space” for EMEs to pursue supportive macroeconomic policies and can help meet fiscal outlays (such as bank recapitalization costs) associated with resolving debt overhangs.
- The IMF stands ready to provide support through new and existing instruments, and to act in concert with other international financial institutions.
- Recent IMF toolkit changes: doubling of access limits and introduction of the Flexible Credit Line (FCL) with no preset cap on access; modifications to phasing of Stand-By Arrangements (SBAs) to allow more front-loaded disbursements.
- Bilateral support and central bank swap lines, and regional multilateral support, can complement IFI resources.
- Official resources can boost investor confidence but are unlikely to fully substitute for private external financing given the scale of global deleveraging.

### Debt overhangs, insolvencies, and workout frameworks
- Large debt overhangs—especially unhedged foreign exchange–denominated debt—can prolong recessions and constrain macro policy.
- A critical element is ensuring an adequate legal/institutional framework to facilitate rapid debt workouts and reduce inefficiencies in bankruptcy and restructuring processes.
- Debt restructuring approaches:
  - Ex post: recapitalizing banks after they suffer losses.
  - More proactive: e.g., converting foreign currency mortgages to domestic currency and compensating banks (perhaps with a haircut).
- Potential trade-offs:
  - Restructuring can provide scope for monetary easing by mitigating balance-sheet effects of depreciation and can shorten downturn duration, reducing cumulative fiscal costs of restoring the financial sector.
  - However, large short-term fiscal outlays to restore bank solvency may limit room for conventional fiscal expansion.
- Examples and precedents:
  - Korea’s 1998 private bank debt exchange had investor participation of 96 percent and involved no investor “haircut” (Kim and Byeon, 2002).
  - Uruguay’s 2003 debt exchange achieved high participation (including 89 percent of internationally issued bonds) and a haircut of 13 percent (Sturzenegger and Zettelmeyer, 2009), though it was considered a default.

### Monetary policy guidance
- Basic thrust: monetary easing is appropriate in most EMEs given global deflationary pressures and widening interest differentials with advanced countries.
- Central banks should weigh the trade-off between growth-enhancing effects of looser policy and the negative impact of exchange rate depreciation on unhedged balance sheets.
- Policy tools and considerations:
  - Lower policy interest rates, foreign exchange intervention, and, in some cases, quantitative measures.
  - Use of foreign exchange reserves to prevent excessive depreciation or, in some cases, to substitute for foreign credit lines to banks, allowing maintenance of domestic lending.
  - For inflation-targeters, greater scope to absorb depreciations without compromising credibility; for countries with pegs, scope depends on whether the peg is retained.
- Allowing exchange rate depreciation depends on factors including initial overvaluation, exchange rate regime, balance sheet exposures, regional contagion, and systemic implications.

### Fiscal policy guidance
- Deploy expansionary fiscal policy depending on available “fiscal space”—the scope to finance a deficit without undue crowding out, sharp increases in funding costs, or undermining debt sustainability.
- In countries with large debt overhangs, part of fiscal space will be needed for resolution and financial sector recapitalization, reducing room for conventional fiscal stimulus.
- Fiscal measures can include conventional stimulus and less conventional measures such as credit guarantees on domestic borrowing.
- Fiscal credibility matters: a credible exit strategy that places government finances on a sustainable long-term footing will help contain financing costs of short-term stimulus and strengthen investor confidence.

### Initial conditions and external financing constraint
- EMEs entered the slump with varied initial conditions: improved policies and reserves in many, but significant variation in policy space, flow imbalances, and stock vulnerabilities.
- Net private capital flows to emerging market (and developing) countries are projected to decline from an inflow of US$600 billion in 2007 to an outflow of US$180 billion in 2009, implying a severe credit crunch.
- Policy options in the face of lost external financing:
  - Exchange rate depreciation: reasonable on average, but risks adverse balance-sheet effects with unhedged foreign currency liabilities; peg-versus-float trade-offs apply.
  - Raising interest rates: traditional response in capital account crises, but likely less effective here because outflows reflect creditors’ deleveraging needs rather than loss of confidence in EME currencies.
  - Official financing: one of the few available avenues to ease external constraints (see IMF instruments above).
  - Controls on capital outflows: generally less appropriate in a global deleveraging context; may at best freeze credit lines and almost surely collapse fresh inflows. In full-blown crises, standstills or voluntary creditor agreements may be considered; as a last resort, regulation of capital transactions is possible but carries significant risks and long-term costs.

### Practical measures to limit insolvencies and preserve credit intermediation
- Four elements for an effective approach to rising insolvencies:
  - Provision of domestic currency liquidity to prevent illiquidity from becoming insolvency; may require quantitative central bank measures if banks are reluctant to lend.
  - Provision of foreign exchange liquidity to banks (e.g., via central bank FX loans or reserve use) where rapid depreciation and nonrenewal of foreign credit lines threaten solvency—recognizing risks if depreciation persists.
  - Strengthening institutional and legal frameworks to facilitate creditor coordination, Pareto-improving write-downs, and efficient out-of-court mechanisms where judicial insolvency systems may be overwhelmed.
  - Careful regulatory forbearance when appropriate (e.g., when depreciation is judged to be overshooting and expected to reverse), while being mindful of the longer-term implications for bank solvency and public finances.

*Italic line: Source: EXECUTIVE SUMMARY of _spn0908 (IMF).*

### Box 1. Debt Workouts and Insolvency Proceedings

### Box 1. Debt Workouts and Insolvency Proceedings

### Evidence on bankruptcy efficiency
- Djankov and others (2008) conducted a survey among insolvency practitioners from 88 countries to analyze debt enforcement against an identical hotel about to default (there is only one large secured creditor).
- In the case study the firm is worth more if preserved as a going concern than if it is sold piecemeal.
- Only 36 percent of the countries in their sample achieved the efficient outcome of maintaining the firm as a going concern.
- Efficiency of the bankruptcy process is strongly correlated with per capita income and legal origins.
- Efficiency of Bankruptcy in Advanced Countries and Emerging Markets (based on Djankov and others (2008)):
  - Firm continues operating (average of a dummy that equals 1 if firm continues operating throughout the bankruptcy process and upon its completion):
    - Advanced Economies: 0.73
    - Emerging Market Economies — All: 0.21
    - Emerging Market Economies — Asia: 0.29
    - Emerging Market Economies — Europe: 0.24
    - Emerging Market Economies — Latin America & Caribbean: 0.24
    - Emerging Market Economies — Africa/Middle East/Central Asia: 0.00
  - Efficiency (defined as the present value of the terminal value of the firm after bankruptcy costs, with 100 being the current value of the firm as a going concern):
    - Advanced Economies: 77.6
    - Emerging Market Economies — All: 41.8
    - Emerging Market Economies — Asia: 46.2
    - Emerging Market Economies — Europe: 45.0
    - Emerging Market Economies — Latin America & Caribbean: 35.0
    - Emerging Market Economies — Africa/Middle East/Central Asia: 41.9

### Risks from the global crisis for insolvency systems
- The global crisis will lead to a sharp rise in bankruptcies across the world.
- Most judicial systems are not equipped to handle a spike in bankruptcy cases, raising concerns about further exacerbation of delays and value destruction in bankruptcy proceedings.
- Inefficiencies likely to worsen in this downturn:
  - A wave of defaults can overwhelm judicial systems, exacerbating value-destroying delays (particularly if firms cannot continue normal operations during bankruptcy).
  - Clogged courts and lower reputation costs of defaults can encourage excessive risk taking by distressed firms ("gambling for resurrection").
  - Widespread defaults put downward pressure on collateral (e.g., price of used machinery or real estate), reducing creditworthiness of other firms.
- Important caveat: substantial improvements in bankruptcy processes to prevent inefficient destruction of value should not be biased against creditors, so as not to hinder long-term financial development.

### Legal and procedural reforms to improve outcomes
- Reform bankruptcy codes to allow fresh capital to take priority over other creditors in countries where that is not the case, because without financing firms may not be able to continue operations.
- Use out-of-court restructuring guided by the so-called "London rules" (guidelines for out-of-court restructuring used in the Mexican crisis and expanded during the East Asian crisis).
- Enhance out-of-court restructuring effectiveness by enabling "prepacked" bankruptcies in insolvency law, whereby an agreement reached among a majority of creditors can be enforced on remaining creditors.
- Consider more radical, temporary measures in severe crises:
  - "Super-Chapter 11" (Stiglitz (2002)) proposed elements:
    - Strong presumption that current managers remain in charge (bankruptcy caused by external shock, not mismanagement).
    - Debt-to-equity conversion.
    - Heavier burden on creditors seeking delays, with creditors required to demonstrate that the management proposal was "grossly inequitable."
    - Specification of a wide set of default/guideline provisions to facilitate speedy resolution.
  - Implementation requires high sophistication in bankruptcy law and practice.
- Given the expected prolonged nature of the current crisis, other novel debt-restructuring mechanisms may need consideration.

### Government and banking-sector interventions for debt restructuring and bank recapitalization
- Government support can be proactive to avoid mounting bank losses and loss of depositor confidence:
  - Rather than letting losses accumulate on bank balance sheets, proactive government action can lessen risk of systemic crisis and speed recovery of the normal credit process.
- Principles for recapitalization where additional shareholder capital is not available:
  - Ensure existing shareholders bear the first burden.
  - Salvage only banks with viable business models.
  - Recapitalization of domestic subsidiaries of foreign parent banks raises coordination and burden-sharing issues between parents and host and home country governments; regional, cross-border cooperation is key.
- Asset management companies (AMCs) have often been useful in past crises to cleanse bank balance sheets while maximizing recovery values by holding assets to maturity (or at least avoiding fire sales).
- More proactive approaches could include conversion, with consent of borrowers and creditors, of selected foreign currency banking system assets into local currency, with part of the losses absorbed by the government:
  - Although the country would still face exchange rate risk, redistributing some risk to the government could prevent costly defaults and spillover effects.
  - Basic mechanism: government negotiates with banks to swap their foreign currency loan portfolio for government paper (restructuring bonds) denominated in foreign currency.
  - In past crises, foreign exchange–denominated restructuring bonds were used in Bulgaria (1994, 1997, 1999), Korea (1998), Mexico (1995–96), Poland (1991), and Uruguay (1982–84).
  - Foreign currency–indexed restructuring bonds were used in Indonesia (1998–2000) and Nicaragua (2000–01).
  - Because banks would otherwise face a wave of costly foreclosures, they would presumably be willing to absorb some cost of marking down the foreign currency value of their assets; their loss would be delineated and limited up front, with banks accepting a haircut and the government absorbing the rest of the loss.
- Warning: wholesale conversion of bank foreign currency assets and liabilities into local currency ("pesification") would not be appropriate because it would likely prompt bank runs and capital flight and further destabilize the exchange rate; forced pesification could be subject to lengthy and complex legal challenges.

*Source: Box 1, "Debt Workouts and Insolvency Proceedings" (from the provided IMF content unit).*

### Box 2. Government Financial Support for Debt Restructuring

### Box 2. Government Financial Support for Debt Restructuring

### Context and framing
- Some EMEs face an actual or potential sharp devaluation in the context of a dollarized financial sector.
- First best response: banks provision proactively, obtain additional capital, and restructure.
- Scale of potential losses may require government intervention, contingent on sufficient fiscal space.
- Governments should bear in mind that interventions are likely to incur significant fiscal costs and have redistributive and equity implications that could affect public support for other crisis measures.

### Recapitalization
- Mechanism:
  - Government waits for devaluation to affect banks’ balance sheets (via household/corporate defaults on foreign currency loans).
  - Fiscal resources deployed to recapitalize banks where shareholders cannot provide additional capital.
  - Banks’ owners absorb the first tranche of losses.
- Advantages:
  - May be relatively low cost because existing owners take a large hit.
  - Government might recover some recapitalization costs later.
- Risks and drawbacks:
  - High foreign ownership of banks may complicate recapitalization (owners might “walk away”, reducing credit availability).
  - Households and corporations may be left with liabilities they cannot pay, causing continuing defaults that weaken bank balance sheets and sap confidence.
- Country examples:
  - Romania: sought support for recapitalization from parent banks within an IMF-supported program to avoid complications from high foreign ownership.
  - Hungary: enacted a bank support law with provisions for capital enhancement by either voluntary or mandatory means.

### Temporary subsidy of loan repayments
- Mechanism:
  - If exchange rate overshooting is expected (much of devaluation temporary), government negotiates with banks to temporarily reduce debt service in foreign currency terms and makes up the difference.
- Objective:
  - Limit the wave of defaults and protect bank balance sheets.
- Risks:
  - If devaluation persists, government exposure could quickly escalate.
  - Continued uncertainty may sap confidence in banks, further depreciate the currency, and precipitate deposit runs, potentially necessitating a full banking sector bailout.

### Currency conversion of bank assets
- Mechanism:
  - Government absorbs a significant fraction of foreign currency loss up front by swapping foreign currency–denominated government paper for troubled assets and converting those assets to local currency–denominated loans (with borrower and lender consent).
  - Government could later sell converted loans (not wanting to be a permanent bank owner), potentially at reduced loss if exchange rate recovers.
- Objective:
  - Reallocate foreign currency risk and losses to those able to bear them, avoid costly defaults and foreclosures, and reduce drawn-out uncertainty that could further depreciate the exchange rate.
- Advantages:
  - Avoids defaults/foreclosures and prolonged uncertainty compared with devaluing and recapitalizing banks afterwards (though some recapitalization may still be required).
- Constraints:
  - Might be prohibitively expensive for most governments.
  - Requires sufficient government resources.

### Heterodox and combined approaches
- Reality:
  - Countries may find it best to adopt heterodox approaches combining elements of different schemes.
- Example—Hungary:
  - Agreement with banks to facilitate loan restructuring through options including loan maturity extensions, temporary easing of repayments, and conversion of foreign exchange loans into domestic currency.
  - Introduced legislation to provide temporary state guarantees for mortgage payments of the unemployed.

### Policy considerations and trade-offs
- Fiscal cost and sustainability:
  - All interventions likely to incur significant fiscal costs.
  - Governments must weigh redistributive and equity implications which affect public support.
- Redistribution and equity:
  - Interventions may shift burdens across creditors, borrowers, and taxpayers; these implications can influence political feasibility and support for other crisis mitigation measures.
- Implementation constraints:
  - High foreign bank ownership, limited fiscal space, and potential for persistent devaluation constrain options and magnify risks of moral hazard, capital flight, and deposit runs.

*Source: Box 2. Government Financial Support for Debt Restructuring*

### Box 3. Evidence on Effectiveness and Procyclicality of Fiscal Policy in EMEs

### Box 3. Evidence on Effectiveness and Procyclicality of Fiscal Policy in EMEs

### Empirical evidence on effectiveness of fiscal policy in EMEs
- Empirical evidence supports the view that fiscal policy tends to have smaller and more transient stimulative effects in EMEs than in advanced economies (Spilimbergo and others, 2009).
- Key empirical findings cited:
  - IMF (2008) — based on dynamic panel estimation — finds that the medium-term impact of a discretionary fiscal expansion on output in EMEs is negative (compared to a small positive effect in advanced economies), although in both cases the immediate impact is positive but small.
  - Ilzetzki and Vegh (2008) — using a quarterly panel VAR — find that the output response to higher government spending is larger in EMEs at the one-quarter horizon, but at longer horizons the effect in EMEs is much smaller than in advanced economies.
  - Ghosh and Rahman (2008) find small and generally negative (i.e., non-Keynesian) multipliers in both advanced and emerging market economies, particularly when public debt is high.
  - Freedman and others (2009) — simulated macro model — find an immediate positive effect in Asian EMEs of a similar magnitude to that for advanced economies (dependent on the monetary policy response assumption). However, there is a negative effect in the medium term that is more pronounced than in advanced economies.
  - Ortiz and others (2009) — sample of 22 episodes of “Systemic Sudden Stops” — find that countries with tighter fiscal policy experienced sharper contractions than those with a looser stance (partly reflecting better fundamentals in countries that could “afford” a looser fiscal stance).
  - Clements, Flores, and Leigh (2009) (GIMF for Colombia) find that the stabilizing role of fiscal policy depends critically on financing conditions.
  - Mendoza and Ostry (2008) and Celasun, Debrun, and Ostry (2006) discuss constraints on expansionary fiscal policy in EMEs given the nature of shocks and debt sustainability concerns.

### Evidence on procyclicality of fiscal policy in EMEs
- There is evidence that policy has tended to be less countercyclical in EMEs, particularly those with a fixed exchange rate, where there is evidence for procyclical fiscal policy.
- Regression framework (description provided):
  - Regression of fiscal stance on output gap (with regime interactions) and other control variables (inflation, public debt ratio, government expenditure ratio, and domestic interest rate; coefficients not reported).
  - Fiscal stance defined as cyclically neutral general government balance minus actual balance; increase in fiscal stance represents a fiscal expansion.
  - Output gap defined as logarithm of actual output relative to potential.
  - A positive coefficient on the output gap implies a procyclical policy. A negative coefficient on the output gap indicates countercyclical fiscal policy under floating regimes (the omitted regime category).
  - A coefficient of 1 implies a .01 percentage point fiscal loosening in response to a 1 percent increase in the output gap.
- Reported coefficients and statistics (as presented in table):
  - Output gap-18.92-2.86***
  - Pegged regimes*output gap30.692.63***
  - Intermediate regimes*output gap-10.21-1.38
  - Number of observations, R2 3000.63
  - Output gap-7.86-1.10
  - Pegged regimes*output gap30.89 a2.76***
  - Intermediate regimes*output gap11.621.35
  - Number of observations, R2 1740.50
  - Note: a The combined coefficient on the output gap (including regime interaction) is positive and significant at the 10 percent level; this indicates procyclical fiscal policy.

### Using available fiscal space
- Automatic stabilizers
  - Automatic stabilizers are more timely, better targeted (for example, recipients of unemployment benefits are more likely to spend than save), and more credibly reversed than discretionary changes in policy.
  - Authorities should allow automatic stabilizers to operate fully; this might involve overriding some existing fiscal rules (for instance, providing central government funding to local governments whose programs are hindered by balanced budget rules or constrained by financing difficulties).
  - Automatic stabilizers tend to be relatively small in EMEs (reflecting a smaller public sector, less extensive social transfers, and less progressive income taxes), so discretionary policy response—where feasible—will likely be necessary.
  - Footnote: Commodity-exporting countries that derive a large portion of government revenue from royalties related to natural resource extraction that are paid by foreign corporations will tend to experience a significant decline in revenues as a result of the fall in global demand for commodities. This should not be thought of as an automatic stabilizer, however, because the reduced tax liability is experienced by external rather than domestic taxpayers.

- Discretionary measures
  - Discretionary increases in spending or tax cuts should be targeted to achieve maximum impact and to protect the poor and other vulnerable groups, who have a high marginal propensity to consume.
  - Income tax cuts are likely to be less effective in EMEs because the tax base tends to be narrow; cuts to payroll and consumption taxes could have a greater impact on the poor and thus be more effective.
  - Explicitly temporary reductions in consumption tax rates may be more effective in the short run by providing incentives to bring forward consumption to the current period.
  - Large consumption tax cuts targeted on big-ticket items may be more effective than small cuts on a wide range of goods, although this strategy may be more distortionary and pose greater risk of producer capture.
  - Increasing government capital expenditure may be easier in the short term if “shovel-ready” projects exist and public sector capacity can rapidly scale up the capital budget. Given likely prolonged downturns and larger infrastructural needs in EMEs, the impact on potential growth could be larger than in advanced economies.
  - Caveat: import content of investment expenditure—and hence leakage of stimulus—is probably higher in EMEs.
  - Because all government spending is spent, whereas some tax cuts are saved, expenditure measures ought to have a greater impact on aggregate demand. However, increases to recurrent expenditure are risky because they are hard to reverse and could have negative implications for debt sustainability.

- Government guarantees
  - Government guarantees on (domestic) bank lending could be an effective means of maintaining existing levels of private sector demand under certain circumstances (see Box 4).
  - Guarantees might be preferable to tax cuts or expenditure increases where domestic credit is a key driver of economic activity, especially because functioning credit markets may be a precondition for the success of conventional fiscal policy interventions.
  - If the government would not expect to be “on the hook” for the full amount guaranteed (only a fraction likely to default), then each dollar allocated to the guarantee scheme would have a multiplicative impact. But contingent liabilities could balloon if conditions deteriorate, perhaps undermining the government’s ability to undertake other fiscal measures.
  - To reduce risks and protect the government’s balance sheet, guarantees could be provided only for high-quality assets and jointly with government support for recapitalization; transparency about the full extent of contingent liabilities is recommended.

### Box 4 — Credit Guarantee Schemes: Principles and Design Issues (summary)
- Use case: Government guarantees of bank lending could be useful when other policy options are constrained and when the shock to demand has come mainly through a sharp reduction in the supply of bank credit due to higher perceived credit risk.
- Principal design issues:
  - Adverse selection: banks may offload worst existing loans. Limiting guarantees to new lending and to sectors where borrower quality can be easily verified (e.g., fully collateralized loans) helps reduce this risk.
  - Moral hazard: banks may take on riskier loans with guarantees. Offering partial guarantees can reduce this, but may be insufficient to encourage new lending.
  - Additionality: banks may not make additional loans but merely reduce risk exposure. Fungibility of money makes this hard to overcome, though reduced risk exposure should allow balance sheet expansion to some extent.
  - Bank bailouts and conditionality: linking lending targets to recapitalization can encourage lending but raises risks of political interference, inefficient directed lending, or corruption, especially with weak governance.
  - Fiscal sustainability: credit guarantees are contingent liabilities; exposure needs careful monitoring because a deterioration in external conditions could radically increase government exposure.
- Design recommendations:
  - Limit guarantees to new lending and verifiable borrower quality where possible.
  - Consider partial guarantees to mitigate moral hazard.
  - Combine guarantees with recapitalization and lending conditionality when appropriate, with attention to governance risks.
  - Ensure transparency about contingent liabilities and monitor fiscal exposure carefully.

### Conclusions (from the box)
- Emerging market economies face two shocks: a “sudden stop” of capital inflows from global deleveraging and a collapse in export demand from the global slump. Deleveraging has particularly negative effects for countries with foreign currency credit booms and large debt overhangs.
- The note outlines measures to ameliorate debt overhang and macroeconomic policies to bring about recovery, including bankruptcy and debt restructuring, monetary and exchange rate policies, and fiscal policy options that respect the limited fiscal space EMEs often face.
- A crucial conclusion: putting in place a credible exit strategy is essential so policies can be sufficiently bold to restore confidence and stem the slide in activity in the short run without jeopardizing long-term sustainability or policy credibility.

*Source: Box 3. Evidence on Effectiveness and Procyclicality of Fiscal Policy in EMEs (from the supplied content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2009/_spn0908.pdf_