The Evolution of Emerging Market Capital Flows: Why We Need to Look Again at Sovereign Debt Restructuring -- Remarks by Anne Krueger, IMF First Deputy Managing Director
IMF News, January 21, 2002
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- Published: January 21, 2002
I. Introduction
- Proposed reconsideration of sovereign debt restructuring because of inadequate incentives to resolve truly unsustainable debt problems promptly and orderly.
- Plan of remarks: describe changes in sovereign debt markets; discuss implications for restructuring; outline ideas being considered.
II. The Ups and Down of Emerging Market Capital Flows — key findings and statistics
- Historical context and composition shifts:
- Stock markets: Turkey by 1866, India by 1875, Brazil by 1877.
- Widespread sovereign borrowing began in the late 18th century.
- In the late 19th / early 20th century ("first 'golden age' of financial globalization"), flows to developing countries were larger in relation to the world economy than today.
- In Australia, capital flows financed half of all domestic investment in the late 1880s.
- In 1884, banks in Sydney paid 5.5 percent to attract 12-month term deposits; New South Wales government sold bonds in London paying 4 percent.
- Disruptions and recoveries:
- Private capital flows interrupted by the First World War; resumed in the 1920s; many issuers defaulted in the Great Depression.
- Net private flows to developing countries did not resume consistently until the 1970s.
- 1970s: big rise in syndicated bank lending (especially to Latin America); led to the debt crisis of the early 1980s.
- Net private flows into emerging markets rose from $12 billion in 1988 to more than $100 billion by 1991.
- Proportion of gross inflows from bank loans fell from 70 percent in 1989 to barely 40 percent in 1994 as bonds and equity regained prominence.
- Total net private inflows peaked at $234bn in 1996; Asian and other crises then caused a sharp decline.
- Net FDI inflows have remained around $150bn a year, but were likely outweighed by portfolio outflows in the year before these remarks, possibly producing the first overall net private outflow since 1984.
- Change in stock composition:
- Proportion of outstanding public external debt owed to private creditors that takes the form of bonds rose from 13 percent in 1980 to 60 percent in 2000.
III. Implications for Sovereign Debt Restructuring — analysis and challenges
- Historical frequency and causes of default:
- According to Standard & Poor's, more than 90 countries have defaulted or rescheduled their debts over the last two centuries; several have done so many times.
- Frequent triggers include wars and commodity price shocks.
- IMF mandate and adaptation:
- IMF created for fixed exchange rates and limited capital mobility; originally focused on current account crises.
- In a world of large and volatile private capital flows, the IMF's role and tools have had to adapt.
- 1980s and bank-led restructurings:
- "Concerted lending" initially required bank rescheduling/new money for Fund support.
- Fund later prepared to lend to countries in arrears to banks; official sector provided upfront funding and exchanged bank debt for "Brady bonds" collateralized with US government securities.
- 1990s capital-account crises and Fund responses:
- Created the Supplemental Reserve Facility in 1997 to lend larger sums over short periods at higher interest rates to countries strengthening policies.
- Fund cannot and should not replace all private financing; moral hazard and limited official resources constrain fresh official bailouts of private creditors.
- Collective action and creditor coordination problems:
- Shift from syndicated bank loans to dispersed bondholders increases the "collective action problem" because bondholders are more numerous, anonymous, lack long-term debtor relationships, have stronger incentives to litigate, and are not bound by cross-default proceeds sharing.
- Growing variety of instruments and derivatives complicates restructuring.
- IMF policy adaptation:
- In 1999 the IMF extended willingness to lend into arrears to bondholders (paralleling the earlier decision on bank debt).
- Application limited in practice: not necessary in Pakistan's restructuring in 1999 or Ukraine's in 2000; Fund did lend into arrears in Ecuador in 1999.
- Holdout litigation risk highlighted when an aggressive holdout creditor effectively held Peru to ransom by persuading courts in the US and Europe to prevent Peru from servicing its Brady debt; Peru settled rather than default.
- Limitations of market-based mitigants:
- Collective action clauses (CACs) reduce holdout risk and are common in international sovereign bonds under English law, but:
- A large part of outstanding bonds lacks CACs and may not mature for many years.
- Sovereigns may exclude CACs to signal determination to repay.
- CACs bind only holders of the same bond issue and are of limited use in broad restructurings covering varied instruments.
IV. A New Approach to Sovereign Debt Restructuring — proposals and rationale
- Core objective:
- Create stronger incentives for creditors to remain involved and for debtors to start restructuring sooner, thereby avoiding chaotic capital outflows and economic declines even if the negotiating table is reached only a month earlier.
- Proposed design elements inspired by domestic bankruptcy regimes:
- Allow a country to request a limited period of legal protection from creditors while negotiating a restructuring, conditional on an obligation to negotiate in good faith and pursue corrective policies.
- Request granted only if the country's debts are judged truly unsustainable.
- Once terms are agreed by a sufficiently large majority of creditors, dissenters would be bound to accept the same terms.
- Expected benefits for creditors and the system:
- Most creditors should welcome greater predictability because creditor claims fall more sharply on the secondary market when workouts are disorderly.
- Framework would discourage expectation of unlimited official financing and thus limit moral hazard.
- Fund would not provide fresh financing to be captured by creditors; instead it would help national authorities develop sustainable policies while creditors and debtors negotiate.
- Predictable framework would help private investors discriminate between good and bad risks, potentially lowering costs for countries with strong policies and improving global financial stability.
- Legal and institutional considerations:
- Framework would need global legal force to prevent forum-shopping by litigious creditors.
- One route: treaty obligation via amendment of the IMF's Articles of Agreement—requiring approval by three-fifths of members holding 85 percent of total voting power to be binding on all members.
- Numerous issues to address before a concrete proposal: institutional arrangements, rules for triggering the stay, tools to guarantee creditor good behavior, scope of debt covered by the stay.
- Expectation that most restructurings would occur "in the shadow of the law" without formal activation of the mechanism.
V. Conclusion — summary judgment and forward look
- Despite progress in strengthening the international financial system, absence of better incentives for orderly resolution of unsustainable sovereign debts remains a serious weakness.
- Changes in size and composition of emerging market finance make reconsideration of restructuring approaches more important than ever.
- Even with a new approach, restructuring will remain economically painful and debtors will be reluctant participants; nevertheless a more orderly framework would benefit debtors, creditors, and the international community.
- IMF staff and management plan to discuss design details with the Board and other interested parties in the coming months.
Remarks by Anne Krueger, First Deputy Managing Director, International Monetary Fund — Economics Society Dinner, Melbourne, Australia, January 21, 2002.