The IMF is looking at ways to improve its lending policies for countries experiencing sovereign debt distress (photo: IMF)
IMF Lending
A paper recently discussed by the IMF’s Executive Board further explores how the institution’s framework for lending to countries that request “exceptional access” to IMF resources—that is, financing above the normal lending limits—can be made more flexible. This follows an earlier Board discussion in May 2013.
Under the preliminary ideas being considered, the IMF would have the flexibility to make its resources available on the basis of a broader range of debt operations than is currently the case, allowing the institution to better take into account the individual circumstances of countries’ debt situations. Under the present framework, the IMF must decide to either bail out a seriously indebted country or condition its financing on an upfront debt reduction. The reforms under discussion would preserve the IMF’s ability to provide large-scale financing without a debt restructuring when there are no significant concerns regarding the sustainability of the member’s debt situation.
The broader range of debt operations outlined in the paper would include a new option of “debt reprofiling,” in which creditors would be asked to extend maturities for a limited period, without a reduction in principal or coupon. This reprofiling option would be called for only in certain circumstances, and the operation would have to be accompanied by a credible adjustment program that would allow the country to solve its underlying debt problems.
Making the general lending framework more flexible would also diminish the need for the “systemic exemption”—which allows the safeguard on debt sustainability to be relaxed when there is a concern that debt restructuring would trigger volatility in other countries’ debt markets. The paper argues that, in any event, a simple bailout in circumstances where debt sustainability is in doubt cannot be relied upon to address contagion risks, and that more effective approaches are needed to mitigate contagion.
In the following interview, Sean Hagan, the IMF’s General Counsel and Director of the Legal Department, and Hugh Bredenkamp, Deputy Director of the IMF’s Strategy, Policy, and Review Department, discuss these preliminary ideas, which will be further discussed with public and private sector stakeholders over the next several months.
IMF Survey: What is the current lending framework for countries with sovereign debt vulnerabilities?
Hagan: In 2002, the IMF established an exceptional access policy designed to reduce moral hazard and avoid delays in the restructuring of unsustainable debt, which can adversely affect both the member country and its creditors. Under that policy, unless it can be determined that a country’s debt is sustainable with high probability, the IMF is not be able provide exceptional access in the absence of a debt restructuring that is sufficiently deep to restore debt sustainability with high probability.
This framework was modified in 2010, in the context of the Eurozone crisis. The exceptional access framework would have called for upfront debt reduction at the time, and the concern was that this could lead to severe contagion. So the IMF created a “systemic exemption” that allowed large-scale financing to go ahead without a restructuring in circumstances where there is a high risk of cross-border spillovers, even where there is considerable uncertainty regarding debt sustainability.
IMF Survey: Why are we revisiting this framework?
Bredenkamp: The experience with the current policy framework over the past few years strongly suggests that there are lower-cost ways to deal with sovereign distress, in two respects.
First, because the policy sets a high bar—we have to be confident with “high probability” that debt is sustainable—it means that in all cases where that bar is not met, the IMF has to ask for debt reduction. And that could include cases where there is a reasonable prospect that the program could succeed without the need for debt reduction—it’s just that we are not in a position to conclude that it’s a high probability of success. For countries in this middle ground between debt being clearly sustainable or clearly unsustainable, seeking an upfront, preemptive debt reduction operation—with all the costs that this entails for creditors and for the debtor country—may prove to be an unnecessarily drastic measure.
Second, the systemic exemption has recreated some of the tensions that the 2002 framework was intended to address. In particular, it can lead to situations in which Fund resources are used to pay out creditors in advance of a debt reduction operation that, later on, becomes unavoidable, as turned out to be the case in Greece. As we have said before, the delay implied that the creditor base had shrunk in the interim, and those creditors that remained had to bear a larger burden to achieve the necessary degree of debt reduction.
It is also not clear that the systemic exemption achieves the objective that it was created to achieve—to mitigate contagion. If there are significant doubts about debt sustainability, lending without measures to address the distressed country’s debt problems may not be viewed as a credible solution. That could lead to further uncertainty about the “end game,” and this uncertainty may actually provoke contagion.
IMF Survey: So what ideas are you putting forward to address these problems?
Hagan: We’re exploring changes in the framework to make it more flexible, with options that correspond in a more calibrated way to the spectrum of debt problems that countries face. Debt is not always either clearly sustainable or clearly unsustainable: there are situations where it is simply unclear. We argue that, in these situations, it makes sense not to go for an upfront debt reduction but simply to extend maturities—basically keep creditors’ exposure to the country at its current level—to give the country a chance to work its way out of its problems. This is the reprofiling option. At the same time, the IMF would negotiate a program that provides liquidity support and a plan for economic policy adjustment.
If it is used to support a credible adjustment program, reprofiling tends to be less costly to creditors than debt reduction, less disruptive to financial markets, and hence less contagious. So we also argue it reduces the need for the systemic exemption, to deal with contagion. In cases where contagion is nevertheless a concern, it is best addressed by defensive measures in the potentially affected countries—with IMF financial support, if needed. And, in extreme cases, if there is a desire to avoid any form of debt restructuring, IMF lending could be combined with support from other official creditors on terms that are sufficiently preferential to render the distressed country’s debt sustainable with high probability.
IMF Survey: How does reprofiling help a country reduce debt?
Bredenkamp: Simply maintaining creditors’ exposure does not in itself reduce debt. But we argue that it does improve the prospects of program success, partly because it conserves resources that would otherwise be used to pay out creditors during the program.
A country in debt distress would normally have large financing needs associated with paying out creditors during a program. If creditors stay in, the country doesn’t have to make those payments during the program. The country could instead use the money—or a portion of it—to finance a less constrained adjustment path. To the extent that this increases the chances of growth and a restoration of sustainability, it benefits both the sovereign and its creditors.
Some of the savings could also be used to reduce the overall size of the financing package, which could speed up the country’s return to market access, since potential private lenders would welcome the smaller overhang of senior official debt. Moreover, in the event that a reprofiling is not successful and an upfront debt reduction operation is needed, there will be a broader creditor base to work with, thereby reducing the “haircut” that creditors holding longer-term claims will need to absorb.
From the IMF’s perspective, the safeguard that we normally require in the form of high probability of debt sustainability, we would get instead by an agreement by all creditors to maintain their exposure and give the program a chance to work.
IMF Survey: When would a country exercise the reprofiling option?
Bredenkamp: The first consideration is whether the country still has market access.
If the country can still tap the markets on reasonable terms, then its financing difficulties are likely temporary and it just needs supplementary financing to get through a temporary liquidity shortage. In those cases, we would not require any kind of debt operation—we would lend on the premise that this would allow the country to work its way out of its difficulties.
If the country has lost market access, we would have to determine whether this is caused by a temporary shift in market sentiment as opposed to reasons related to the country’s fundamental economic situation. If our debt sustainability indicators suggest that the country’s debt situation is solid, meaning the high probability threshold is met, then we would lend without requiring a debt reduction operation.
If, however, the country has lost market access and we conclude there is reason to believe this is linked to debt sustainability concerns, then debt reprofiling would make sense.
In this framework, up-front debt reduction would be reserved for cases where it is clear at the outset that debt is unsustainable. The interests of both the debtor and the creditor are then best served by biting the bullet, since the costs of debt reduction will have to be borne eventually anyway, and removing the debt overhang early will be good for growth.
IMF Survey: How does the IMF determine whether a country’s debt is sustainable?
Bredenkamp: Last year we introduced a new framework for assessing debt sustainability in countries that rely on market financing, and that framework specifies, in greater detail than before, the range of debt indicators to be examined. We look not just at the debt-to-GDP ratio but also at other dimensions, such as how much debt service is coming due over the next few years in relation to the size of the economy, the currency composition of the debt, and the nature of the creditor base. We have developed various thresholds based on empirical evidence from past debt crises as to when the risk of a debt crisis is higher. We would not use this information to make decisions in a mechanistic way, but we have a better framework for making a judgment based on these indicators.
IMF Survey: To what extent would this approach rely on discretion?
Hagan: While the debt sustainability methodology developed by the IMF has become increasingly robust, as Hugh says, its application still requires considerable judgment regarding the circumstances of the particular case—that is, there will always be discretion in determining whether a member's debt situation is clearly sustainable, clearly unsustainable, or whether there is considerable uncertainty on this question.
But once the IMF has made a judgment as to where the member falls on this sustainability spectrum, the framework would be relied upon to determine whether a debt restructuring is called for and, if so, what type of restructuring is needed.
IMF Survey: How would creditor support for the plan be obtained?
Hagan: As with other types of debt restructuring supported by the IMF, a reprofiling would be market based, and the sovereign’s creditors would be requested to amend the terms of the instruments to extend maturities. This will require consultation with creditors, including an explanation of the assumptions that underpin the member’s debt sustainability analysis. Collective actions clauses, which now exist in most—but not all—bonds, would be relied upon to address collective action problems. As for official creditors, they would be expected to maintain their exposure either through an extension of maturities or provision of new financing.
Bredenkamp: The IMF also generally sets a minimum participation threshold in a debt operation of any kind, whether it’s a reprofiling or a debt reduction operation. In other words, we’d announce that the IMF would only come in with its financial support once, say, 90 percent of creditors have agreed to participate. That creates an incentive for the creditors to join because they know that if that threshold is not met and the IMF doesn’t lend, there’s a much worse outcome—the country may be forced into default, and then everybody is worse off.
IMF Survey: What are the implications of the recent US Supreme Court decision regarding Argentina for the ideas you’ve just described?
Hagan: The potential implications of the recent US Supreme Court ruling are not specific to reprofiling. Rather, and as is stated in the paper, it may exacerbate collective action problems for all forms of debt restructurings, including upfront debt reduction. The Fund is exploring market-based ways of addressing these broader implications, including through the modification of contractual provisions in future bond issuances. Progress in this area will be discussed in a forthcoming paper, to be discussed within the next several months.
IMF Survey: What are the next steps?
Hagan: This is preliminary work. Our Executive Board has agreed that the institution could pursue these ideas further in a follow-up round of work. We would expect to come back with another paper, later this year or early next year, based on further analysis and consultations with market participants and other stakeholders on the impact and feasibility of the possible reforms to the lending framework.
