Dealing with Sovereign Debt—The IMF Perspective
IMF Blog, February 23, 2017
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- Authors: Sean Hagan, Maurice Obstfeld, Poul M Thomsen
- Published: February 23, 2017
Debt in the economy — role and context
- Debt enables investment by firms and households, but can become problematic when investments fail or incomes fall.
- Over the past forty years, sovereign over indebtedness has been at the root of many balance-of-payments crises among IMF member countries.
- Sovereign debts (debts owed or guaranteed by the national government) cannot be restructured by courts or handled by receivership; this is a principal area where the IMF plays a role.
- The IMF ideally plays a “catalytic” role: a strong belt-tightening and structural reform program, coupled with IMF financial support, is designed to catalyze a return to market access so the government can service its debt on original terms.
When debt becomes unsustainable
- “Unsustainable” is defined as scheduled debt service exceeding the capacity of the member to service it, even with strong adjustment and significant IMF support.
- In such cases, further belt tightening is not feasible politically or economically.
- Debt sustainability assessments must be grounded in realistic—rather than heroic—assumptions about future growth, recognizing recoveries often take longer than expected.
- The IMF’s legal framework precludes providing financial support unless the program includes specific measures—normally including a debt restructuring—that credibly address the debt sustainability problem within the medium term.
- Rationale for the requirement:
- Without such steps, IMF support would not be addressing the member’s underlying balance of payments problems, as required under the IMF’s Articles of Agreement.
- Failing to address unsustainable debt creates uncertainty that can sap political support for reforms and deter new investment, impeding recovery.
- Unless a program provides a path to regain market access over the medium term, the IMF cannot conclude the program meaningfully addresses underlying problems.
- Special consideration for currency union members:
- Assessing viability in terms of a country's ability to re-access markets remains relevant in a currency union.
- Unless specific rules provide for fiscal transfers between sovereign members, a country that must depend on other union members’ support over an extended period is not resolving its balance of payments problems sustainably.
The IMF’s framework for assessing debt sustainability
- The IMF uses two main methodologies:
- Methodology 1: Ask if, by the end of the IMF program and with debt serviced on the original terms, debt ratios to GDP will be sufficiently low or on a clear enough downward path to restore lender confidence and allow market access.
- Methodology 2: Especially relevant when debt has long maturity and very low interest rates—ask whether the country’s annual financing needs (gross payments of interest and principal plus primary fiscal balance) can reasonably be met by markets going forward.
- Key methodological points:
- Projections must realistically specify levels of primary surpluses that improve debt sustainability without disrupting the economy to the point of revenue loss and fiscal target abandonment.
- Judgment relies on the country’s circumstances and the IMF’s experience with other members in distress.
- The framework requires accounting for risks to both program implementation and economic forecasts.
- Examples:
- Ukraine: Creditors agreed to significant haircuts to reduce debt to a sustainable level as suggested by the debt-to-GDP framework.
- Greece: The framework focusing on annual financing need was more appropriate because euro area partners provided debt relief through very significant extension of maturities and reduction in interest rates, rather than upfront haircuts.
- The IMF’s debt sustainability analysis remains the responsibility of the IMF and cannot be delegated; it is guided by the framework for Public Debt Sustainability and Analysis in Market-Access Countries and The Fund's Lending Framework and Sovereign Debt—Further Considerations.
Providing debt relief — modalities and credibility
- When debt is unsustainable, debt relief can be delivered through various mechanisms depending on creditor type:
- Private creditors: Restructuring is normally implemented at the outset of the program or as a condition for the program’s first review.
- Official bilateral creditors: Approaches may vary.
- Under the Paris Club: Specific debt relief commitments are made by each official bilateral creditor at the outset (in the form of the Agreed Minute) and implemented through modification of individual loan agreements.
- Some official creditors may prefer to make actual delivery of debt relief conditional on full program implementation—warranted where there are concerns about a member’s adjustment track record—but the commitment to provide necessary relief must be made at the beginning and be sufficiently credible.
- Credibility requirements:
- Commitments must be sufficiently specific; excessively vague commitments raise market uncertainty and undermine program chances of success.
- Debt relief can be contingent on the debtor meeting specific policy targets, but such targets need to be realistic to keep the debt strategy credible.
- Sovereign decision and negotiation dynamics:
- The decision to seek debt relief remains that of the member country.
- Negotiations take place between the member and its creditors; the IMF typically explains the basis for its debt sustainability assessment.
- Wherever possible, the IMF encourages restructuring unsustainable debt without a default, which can be particularly disruptive.
Conclusions and policy implications
- When sovereign debts are unsustainable, and unless grant financing is available:
- Some degree of debt relief, coupled with a strong but credible adjustment program, is the only means to make the best of a bad situation.
- Pretending unpayable debts can be repaid undermines adjustment efforts and ultimately makes all parties lose more than if the reality were promptly faced.
Source: Dealing with Sovereign Debt—The IMF Perspective, Sean Hagan, Maurice Obstfeld, Poul M. Thomsen, February 23, 2017.
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