Dealing with Systemic Sovereign Debt Crises: Fiscal Consolidation, Bail-ins or Official Transfers?

IMF Working Papers, October 16, 2015

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The paper presents a tractable model to understand how international financial institutions (IFIs) should deal with the sovereign debt crisis of a systemic country, in which case private creditors' bail-ins entail international spillovers.
Besides lending to the country up to its borrowing capacity, IFIs face the difficult issue of how to address the remaining financing needs with a combination of fiscal consolidation, bail-ins and possibly official transfers.
To maximize social welfare, IFIs should differentiate the policy mix depending on the strength of spillovers.
Stronger spillovers call for smaller bail-ins and greater fiscal consolidation.
To avoid requiring excessive fiscal consolidation, IFIs should provide highly systemic countries with official transfers.
To limit the moral hazard consequences of transfers, it is important that IFIs operate under a predetermined crisis-resolution framework that ensures commitment.

The model highlights international spillovers from private creditors' bail-ins when the sovereign in crisis is systemic.
IFIs can lend up to the borrowing capacity of the country; remaining financing needs must be met through a mix of:
- fiscal consolidation,
- bail-ins,
- official transfers.
Optimal policy mixes vary with the strength of spillovers:
- Stronger spillovers → smaller bail-ins and greater fiscal consolidation.
Official transfers can reduce the required degree of fiscal consolidation for highly systemic countries.
Commitment via a predetermined crisis-resolution framework is crucial to limit moral hazard from transfers.

Differentiate the IFI policy mix according to the strength of international spillovers associated with a systemic sovereign crisis.
Use smaller bail-ins and larger fiscal consolidation when spillovers are stronger.
Provide official transfers to highly systemic countries to avoid excessive fiscal consolidation.
Ensure transfers are provided within a predetermined crisis-resolution framework to ensure commitment and limit moral hazard.