The Difference is in the Debt: Crisis Resolution in Latin America, Address by Anne O. Krueger, First Deputy Managing Director, IMF

IMF News, November 14, 2003

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Published: November 14, 2003

Introduction and purpose

Luncheon Address, Latin America Conference on Sector Reform, Stanford Center for International Development, Stanford, November 14, 2003.
Purpose: reflect on the outlook for Latin America and raise questions about the best way of resolving financial crises; distinguish crises where debt appears sustainable from those requiring debt restructuring.

Economic outlook for Latin America

Global context:
- Global economic upturn offers a new opportunity for the region.
- Prospects for the United States economy look distinctly brighter than anticipated a few months earlier; signs of tentative recovery in Europe and Japan.
Recent regional performance and volatility:
- 1981–1990: most of Latin America experienced falling real GDP per capita—minus 0.6% a year on average between 1981 and 1990.
- 1991–1997: growth in the region averaged 2.3% a year.
- East Asia benchmark: 6.4% average annual growth rate (1991–1997).
- 1998–2002: real GDP fell at an average annual rate of about one quarter of a per cent a year.
- Region affected by greater terms of trade volatility due to high share of primary commodities in exports.
Implication:
- Current breathing space should be used to put public finances on a sound footing and press ahead with difficult structural reforms.
- Reforms must be ambitious in deed as well as rhetoric, implemented in full, and timed when growth is accelerating.

Importance of sound macroeconomic frameworks

Core policy prescriptions affirmed as still appropriate:
- Prudent fiscal policies.
- Careful debt management aimed at long-term sustainability.
- Transparent monetary policy.
- Institutional and judicial reform.
Macroeconomic stability is necessary for sustained growth, expansion of trade, poverty reduction, and narrowing inequality.
IMF role: help governments put in place sound economic policies to maintain international financial stability and promote growth and trade.

Financial crises: changing nature and implications

Two factors changing crisis prevention and resolution:

1. Rapid growth of private capital flows in the 1990s:

Sovereign debt to the private sector (mostly bonds) greatly exceeded that to the official sector.
Headline crises of the 1990s were capital rather than current account crises.
Characteristics of capital account crises:
They can occur very rapidly and require immediate response.
They occur because holders of a country's debt lose confidence in its ability to service debt—even if macroeconomic policies are sound but believed unsustainable.
Fixed exchange rates compound the problem; currency mismatch between assets and liabilities can greatly increase debt burden upon depreciation.
Effective response must restore investors’ belief that a country can meet debt service obligations.

2. Level of public debt:

Any assessment of macroeconomic sustainability must include a judgment about debt sustainability.
Fiscal indiscipline has been a chronic problem in Latin America.
Early 1990s: budget deficits tended to fall in many countries, combined with growth, led to some decline in debt-to-GDP ratios.
Latter part of the decade: slower growth, negative growth in some countries, rising deficits, and higher debt-to-GDP ratios aided by easy external finance.
Debt burdens increase vulnerability when creditors stop rolling over outstanding debt; depreciation or widening bond spreads can sharply raise cost of debt servicing.
Banks’ non-performing loans requiring government recapitalization can force fiscal and monetary tightening.

Historical incidence:
- Between 1994 and 2003, crises erupted in: Mexico, Brazil, Ecuador, Argentine, Uruguay, Paraguay and Venezuela.
- Despite many episodes, relatively few crises overall and many resolved relatively quickly.

Crisis prevention and resolution: policy tools and distinctions

Prevention focus:
- Emphasis on stable macroeconomic framework, institutional reform, technical assistance.
- Urgency of fiscal discipline and reducing debt burdens.
- Better public expenditure management and better tax collection.
- Guarding against currency mismatches and foreign exchange risk in corporates and banks.
Two types of crisis for policy response:

1. Debt appears sustainable:

Examples: Mexico, Brazil, Turkey faced crises where debt burden, though high, was judged sustainable.
Market concerns often driven by political uncertainty about policy continuity.
Resolution hinges on convincing markets that the macroeconomic program will be sustained.
Case study—Brazil 2002:
Risk premium on Brazilian bonds at the height of trouble in 2002 was of the order of 2400 points; at the time of the author’s visit the risk premium was below 600 points.
Confidence returned when presidential candidates committed to continuing the outgoing government’s economic policies supported by the IMF.
Outperformance versus targets (e.g., Brazil and Turkey) creates cushions against shocks.

2. Debt widely regarded as unsustainable:

Presents a far more difficult challenge for the Fund.
Debt restructuring is likely inevitable and must go hand-in-hand with macroeconomic reform.
Debt restructuring without a credible macroeconomic strategy is wasteful; macroeconomic reform without restructuring will not work.
If debt is truly unsustainable and the government fails to reform, Fund financial assistance alone cannot resolve the problem—additional Fund lending can displace private debt and increase the eventual private creditor "haircut".
Fund assistance is productive only if there is a high probability the Fund can add value by supporting policy changes that restore or accelerate growth and enhance debt-servicing capacity.
After default, market access is cut off until debt is restructured; restructuring requires a convincing plan for debt servicing embedded in the new macroeconomic framework.
Any given primary surplus trajectory determines capacity for debt servicing; absence of clear fiscal path complicates restructuring decisions.

Policy recommendations and principles

Core principles guiding Fund and member governments:
- Maintain a stable macroeconomic framework as the foundation of crisis prevention and resolution.
- Commit to sound economic policies in a transparent manner with clear, articulated objectives, including control of public finances.
- Implement wide-ranging, fully implemented reforms: labor market, financial sector, judicial system, and institutional reforms.
- Prioritize fiscal discipline and debt reduction to lower vulnerability to shocks.
- Combine debt restructuring with credible macroeconomic reform when debt is unsustainable; do not substitute Fund lending for private creditor losses without policy change.
- Improve transparency in policymaking and performance; Fund research shows improving transparency lowers borrowing costs as measured by sovereign spreads.
- Use current global upturn as a breathing space to make economies less vulnerable and more resilient.

Concluding judgments

No one-size-fits-all answers; each case judged on its merits amid uncertainty about policy impacts and exogenous shocks.
Emphasis on avoiding short-term political fixes; use periods of improving global conditions to implement enduring reforms.
The Fund stands ready to help member countries that embrace necessary reforms; prevention efforts are limited where governments are reluctant or opaque.

Source: The Difference is in the Debt: Crisis Resolution in Latin America, Address by Anne O. Krueger, First Deputy Managing Director, IMF, November 14, 2003.