IMF Executive Board Discusses Involving the Private Sector
in the Resolution of Financial Crises
IMF Executive Board Discusses Involving the Private Sector
in the Resolution of Financial Crises
Involving the Private Sector in the Resolution of Financial Crises — Standstills — Preliminary Considerations
Prepared by the Policy Development and Review and Legal Departments
September 5, 2000
Table of ContentsSumming Up by the Acting Chairman, Executive Board Meeting, September 5, 2000 Part I. Status Report
Resolving Balance of Payments Difficulties
A Framework for Private Sector Involvement in Crisis Resolution
General Issues Concerning Standstills
Immediate Impact of a Standstill
How do Standstills Affect Capital Flows?
The following conventions have been used in this report:
Directors stressed that prevention remains the first line of defense against a financial crisis. They noted that the adoption of consistent macroeconomic and exchange rate policies, sound debt management, and effective supervision over financial systems are all critical elements of a policy framework designed to manage and reduce vulnerabilities and the frequency and severity of crises. Directors emphasized that the primary tool available to the Fund in support of prevention is surveillance. They noted that, beyond the traditional policy areas, surveillance is now focusing on improving the environment for private sector decision–making through measures to improve the transparency of members’ policies, the development and strengthening of standards, and the assessment and reduction of members’ vulnerability to financial crises. Directors emphasized the value to borrowing countries of establishing regular procedures for a dialogue with their private creditors. They called on the staff to follow up on this matter in Article IV consultation discussions with emerging market countries, and to report back to the Board on progress in this area.
Resolving Balance of Payments Difficulties
Directors agreed that, despite the adoption of preventive measures, members may at times face serious stresses in their external accounts. In some cases, a member may be able to address these stresses through the prompt adoption of corrective measures without financial support from the official community. In other cases, a member may complement the adoption of corrective measures with an arrangement with the Fund. In yet other cases, the difficulty in financing its external accounts may become severe, and the member may face a loss of access to international capital markets, at least on terms broadly consistent with a return to external viability and sustainable growth. In such circumstances, the member needs to work with all its creditors to ensure continued financing. However, Directors noted that if this is not successful, concerted private sector involvement may be required to achieve an orderly resolution of the crisis.
Directors agreed that, under the suggested framework for involving the private sector, the Fund’s approach would need to be a flexible one, and the complex issues involved would require the exercise of considerable judgment. They called on the staff, in bringing program documentation to the Board, to be clear about the financing that is expected to come from the private sector for the member’s program. In cases where the member’s financing needs are relatively small or where, despite large financing needs, the member has good prospects of regaining market access in the near future, the combination of strong adjustment policies and Fund support should be expected to catalyze private sector involvement. In other cases, however, when an early restoration of market access on terms consistent with medium–term external sustainability is judged to be unrealistic, or where the debt burden is unsustainable, more concerted support from private creditors may be necessary, possibly including debt restructuring. Directors agreed that the assessment of a member’s prospects for regaining access to international capital markets in the near future was a critical element of the framework. They broadly agreed on the factors that would be relevant to making this judgment; these include the characteristics of the member’s economy, including the profile of debt service and debt stock, and the strength of the fiscal accounts and the financial system; previous levels of market access and market indicators; the strength of macroeconomic and structural policies; the authorities’ commitment to sustain the implementation of the reform program; the level of reserves and availability of financing; and the stage of the crisis and experience with creditor–debtor relations. Directors called on the staff to continue its work on the analytic issues involved, with a view to strengthening the ability to assess both the pace and magnitude of a resumption of market access by countries emerging from crisis.
A number of Directors favored linking a strong presumption of a requirement for concerted private sector involvement to the level of the member’s access to Fund resources. These Directors noted that a rules–based approach would give more predictability to the suggested framework for private sector involvement, while limiting the risk that large–scale financing could be used to allow the private sector to exit. Many other Directors, however, stressed that the introduction of a threshold level of access to Fund resources, above which concerted private sector involvement would be automatically required, could in some cases hinder the resumption of market access for a member with good prospects for the successful use of the catalytic approach to securing private sector involvement. They also noted that a trigger of this sort could increase the volatility of international capital markets at a time of tension. Some Directors pointed to the presumption of continued private sector involvement in financing the balance of payments of members drawing on the Supplementary Reserve Facility.
While there remain differences among Directors, I believe, nevertheless, that there has been welcome progress toward a convergence of views concerning the circumstances in which the use of Fund resources would be conditioned on action to secure private sector involvement. All Directors agreed that Fund operations should, to the extent possible, limit moral hazard, and that the availability of Fund financing is limited. Directors also agreed that reliance on the catalytic approach at high levels of access presumed substantial justification, both in terms of its likely effectiveness and of the risks of alternative approaches.
Directors acknowledged that the range of tools available to assure a reasonably orderly and timely involvement of the private sector was limited. Most Directors stressed the importance of promoting the use of existing tools, including through the introduction of collective action clauses in international sovereign bonds issued by both industrial and emerging market members, and the use of contingent lines of credit. Directors noted that, in some cases, it may be possible to reach collaborative agreements with banks and other specific creditors for the maintenance of exposure or agreements on the restructuring of international sovereign bonds. In other cases, however, it may not be possible to contain capital outflows without using additional measures, the possible negative effects of which on the country itself, and on other countries, would need to be considered.
Directors encouraged the staff to examine issues concerning the process of debt restructuring and the relative treatment of different types of debt against the background of the principle that no one category of private debt should be regarded as inherently senior relative to others in a similar position. Some Directors noted that the treatment of sovereign bonds in a restructuring compared with other types of long–term credits, including the claims of Paris Club and other official bilateral creditors, required further consideration. Directors noted that decisions adopted in this area could affect the willingness of long–term private investors to hold emerging market sovereign debt.
Directors welcomed the opportunity to have a preliminary discussion of issues associated with the possible use of standstills, and considered the staff paper to be very helpful as a first step. They noted that, as there is little empirical evidence concerning the effects of standstills, the staff’s analysis and this discussion were inevitably somewhat speculative. Directors noted that the term “standstill” covers a range of techniques for reducing net payment of debt service or net outflows of capital after a country has lost spontaneous access to international capital markets. These range from voluntary arrangements with creditors limiting net outflows of capital, to various concerted means of achieving this objective.
Directors agreed that, when creditors are reasonably homogenous and have an interest in maintaining a long–term relationship with the borrower, voluntary agreements to contain private capital outflows may be feasible. This might be the case when exposure is predominantly due to commercial banks or suppliers, particularly if these creditors are satisfied that their commercial interests would be protected through a standstill. They concluded that, since the interests of nonbank investors who hold sovereign claims tend to be less homogeneous, it may be more difficult to secure agreement on voluntary standstills when payments due on such indebtedness are significant.
Directors underscored that the approach to crisis resolution must not undermine the obligation of countries to meet their debt in full and on time. Nevertheless, they noted that, in extreme circumstances, if it is not feasible to reach agreement on a voluntary standstill, members may find it necessary, as a last resort, to impose one unilaterally. Directors noted that, while a standstill limited to payments on sovereign obligations might be sufficient to stabilize the balance of payments, there could be a risk that this action would trigger capital outflows. They recognized that if a tightening of financial policies and appropriate exchange rate flexibility were not successful in stanching such outflows, a member would need to consider whether it might be necessary to resort to the introduction of more comprehensive exchange or capital controls. More generally, Directors recognized that exchange or capital controls would need to be tailored to the specific characteristics of the individual member, with the feasibility of imposing controls rapidly depending upon the existence of an established control infrastructure. All Directors emphasized that controls were no substitute for strong adjustment policies and should be considered only in exceptional circumstances.
Some Directors thought that, in some circumstances, a standstill could serve the best interests of both the member and its creditors; even so, they stressed that, as a general rule, a standstill should be maintained for the shortest possible period. These Directors noted that a standstill may be a useful tool for halting runs and could provide a breathing space to enable a member to put in place corrective policies, and—if necessary—to negotiate a restructuring agreement that would help pave the way toward a return to medium–term viability. Some Directors noted that bond exchanges had successfully followed some recent standstills. Many Directors, however, warned that the threat of a standstill could precipitate outflows and thus be destabilizing.
Some Directors noted that the use of standstills could cause concern about debtor moral hazard. Other Directors considered, however, that a compulsory standstill would still impose such significant costs on the member, including in the form of lost output, that the argument was not compelling. Directors stressed that the rights of creditors needed to be protected in a standstill.
Directors stressed that the imposition of a standstill by one systemically important country could lead to substantial spillover effects on the external accounts of other emerging market countries. They noted, however, that the strength and duration of these effects would depend on circumstances in the international capital markets and the relative importance of the transmission mechanisms, which are likely to vary over time.
Directors agreed that the impact of the imposition of a standstill in the medium term would depend on both the nature of the standstill and the risk preferences of investors. The imposition of exchange or capital controls is likely to reduce the availability of private capital over the medium term, because of the re–evaluation by both domestic and foreign investors of the extent of default and transfer risk. However, to the extent that the corrective policies adopted by a country and the extent of its cooperation with creditors indicate that the future resort to a standstill would be less likely, this effect may dissipate over time.
Most Directors considered that the appropriate mechanism for signaling the Fund’s acceptance of a standstill imposed by a member was through a decision for the Fund to lend into arrears to private creditors. Under the established policy, the Fund can lend in such circumstances when it is essential for the success of the member’s adjustment program, and the member is making a good–faith effort to reach orderly agreement with its creditors. Some Directors favored an amendment to Article VIII Section 2(b) that would allow the Fund to provide a member with some protection against the risk of litigation through a temporary stay on creditor litigation. Other Directors did not favor such an approach, and noted that in recent cases, members’ ability to reach cooperative agreements with private creditors had not been hampered by litigation. Irrespective of the actual mechanism applied, some Directors considered that Fund support of standstills could help reduce financing costs by assuring creditors that standstills are being implemented as part of an orderly and comprehensive approach to crisis resolution. These Directors were of the view that greater clarity and predictability in this area could lead to more stable capital flows to emerging markets. Other Directors expressed a concern that Fund endorsement of standstills could increase the price and reduce the availability of private capital flows to emerging market economies.
Some Directors noted that a clear framework for the circumstances in which a standstill would be invoked could encourage capital markets to limit the build–up of vulnerabilities. On the other hand, some Directors noted that a move toward a clearer framework for imposing a standstill could provide an incentive for creditors to position themselves to be the first to exit through a shortening of maturities of their instruments. Investors may also develop complex financial structures that could frustrate the efforts to impose a standstill.
Directors noted that the complex operational issues that standstills raise warranted further consideration.
In sum, I believe that Directors agree that these staff papers and the discussion, which draw on our recent experience and build on the guidelines provided to us in the April IMFC Communiqué, represent a very useful step toward the refinement of our strategy for private sector involvement.
This discussion has also highlighted a number of areas in which further work is required. In the period ahead, our work program in this area will include:
This paper was prepared by the staff of the International Monetary Fund, for consideration by the IMF’s Executive Board in the context of its deliberations on the status of private sector involvement in the prevention and resolution of financial crises and standstills. The views expressed in the paper are those of the IMF staff and should not be attributed to Executive Directors or to their national authorities. The Board’s views on this topic, as expressed at meetings on September 1, 2000 and September 5, 2000 at which the staff’s paper was discussed, are highlighted in the summing up on the pages at the front of this report.
The paper was prepared by staff from the Policy Development and Review Department under the direction of Jack Boorman, Director, and Mark Allen, Deputy Director, and the Legal Department under the direction of François Gianviti, General Counsel. The primary contributor to part I was Matthew Fisher (Assistant Director of the Capital Account Issues Division of the Policy Development and Review Department). The primary contributors to part II were Matthew Fisher and Ross Leckow (Assistant to the General Counsel). Staff of the Capital Account Issues Division prepared several sections of the paper.
The authors are grateful to numerous colleagues in the Fund for detailed comments on drafts of this paper. The authors would also like to thank Lucia Buono, Julia Baca, and Maame Baiden for their dedicated assistance throughout the preparation of the paper.
The purpose of this section is to provide a brief status report on issues concerning progress toward an agreed approach to the involvement of the private sector in forestalling and resolving financial crises. It does not provide a detailed recapitulation of issues discussed by the Executive Board and in previous staff papers. Rather, it seeks to identify the key issues, areas of broad agreement, and areas in which a convergence of views has yet to be achieved.
One important role for the Fund is to facilitate the flow of international capital, including to emerging market and developing countries in a manner that, together with domestic savings, promotes sustainable growth and efficiency, while avoiding the emergence of major imbalances or the building up of vulnerabilities. The primary tool available to the Fund for this purpose is surveillance. Beyond traditional areas of policy advice, bilateral surveillance is now to an increasing extent focusing on improving the environment for private sector decision taking (transparency and standards), as well as the assessment and management of vulnerability to financial crises, and steps that could be taken ex ante that could help facilitate the orderly resolution of crises. At the same time, multilateral surveillance provides a vehicle for analyzing systemic risks to global financial markets.
An important issue that has recently received increased attention concerns the need for members to establish and maintain constructive dialogues with their creditors (and foreign investors more generally). Such dialogues could provide an opportunity for an exchange of information and views during relatively normal periods, and could provide a venue for engaging investors in a constructive dialogue in the context of the authorities’ efforts to address emerging pressures in the external accounts.
On occasion prevention will fail, and members will be confronted, to a greater or lesser extent, with emerging tensions in their external accounts. The globalization of capital markets has increased substantially the volume and volatility of private capital movements. As such movements respond to sometimes abrupt shifts in market sentiment, members’ increased integration in international capital markets has increased both the risk of sharp reversals in financial flows and the pace at which emerging pressures may develop into full-blown crises.1
In some cases, members may be able to address emerging balance of payments difficulties through the prompt adoption of convincing corrective measures without financial support from the official community. In other cases, members may decide to complement their adjustment efforts with an arrangement (possibly precautionary) with the Fund. This would signal the Fund’s endorsement of the authorities’ package, enhancing the credibility of their stabilization efforts, and could provide investors with added assurances regarding the potential availability of official reserves.
Relatively Severe Balance of Payments Difficulties
Members may also confront more severe balance of payments difficulties in which they have substantially lost access to international capital markets, at least on terms broadly consistent with a return to external viability and sustainable growth.2 Depending on the circumstances of individual cases, Fund support for a member’s adjustment efforts may be sought in the midst of a rush for the exit (Korea and Thailand), or after the exit of creditors has led to a depletion of official reserves and may have forced the authorities to default on certain obligations and consider controls on various domestic financial transactions (Ecuador and Pakistan).
The international community’s approach to handling crisis cases has been discussed extensively in the IMFC, the Executive Board, and other fora, including the Group of Seven (G–7). The recent Communiqué of the IMFC meeting noted that in some cases, the combination of catalytic official financing and policy adjustment should allow a country facing crisis to regain market access quickly. In other cases, however, the early restoration of market access on terms consistent with medium–term external sustainability may be judged to be unrealistic, and a broader spectrum of actions by private creditors, including comprehensive debt restructuring, may be warranted to provide for an adequately financed program and a viable medium–term payments profile.
In a previous discussion, Directors gave preliminary consideration to a
suggested framework for addressing individual country circumstances. The
suggested framework sought to build on the principles, considerations, and
tools articulated by the G–7 Finance Ministers in their report to the Köln
Economic Summit in June 1999 (Box 1.1 and Attachment I). Directors
generally agreed that the Fund’s approach to individual cases would need
to be flexible and would require considerable judgment on some complex issues.
They considered that a range of issues would have a bearing on the approach
adopted in individual cases, including the size of the financing requirements,
both during the program period and over the medium term; the prospects for a
spontaneous return to capital market access; the availability of tools for
securing appropriate private sector involvement; and the desirability of
minimizing possible spillover effects on other countries.3 There is general agreement that the Fund has the
primary responsibility to work with the member concerned in the design of
adjustment programs, and, in that context, to estimate financing requirements
and assess medium–term prospects.
Countries with Reasonable Prospects for Regaining Spontaneous Market Access
Under the suggested framework, private sector involvement could be ensured primarily through reliance on the Fund’s traditional catalytic approach if the member’s financing requirements are moderate, or if the member has good prospects for rapidly regaining market access on appropriate terms, even if the financing requirements are large.4 An issue that arises in making this operational concerns the need to assess at the start of an arrangement the prospects for regaining market access. While it is difficult to predict with confidence the evolution of market access, particularly in the midst of, or during the recovery from, crises and periods of global turbulence, a range of factors is likely to have a bearing on the prospects for spontaneous capital market access, which are summarized in Box 1.2.
Countries with Poor Prospects for Regaining Spontaneous Market Access
Also under the suggested framework, more concerted forms of private sector
involvement could be required if the financing requirement is large and the
member has poor prospects for regaining market access in the near future, or if
the member has an unsustainable medium–term debt burden. This is the approach
adopted in the cases of Korea (in the midst of a rush for the exit after an
earlier attempt based upon the catalytic approach had been unsuccessful, and
before the rapid change in market sentiment that allowed Korea to reenter
capital markets) as well as in Pakistan and Ukraine. It is also the approach
being followed in the case of Ecuador, for which policies that could form the
basis of a Fund arrangement were agreed only after substantial capital
outflows, a default on international sovereign bonds, and a restructuring of
domestic government debt and banks’ domestic liabilities. In the case of
Ecuador, the staff analysis suggests that a restoration of medium–term
viability will require the consistent implementation of appropriate policies,
complemented by debt and debt–service reduction. In the meantime, the Fund is
providing support to the authorities’ adjustment efforts, which implies
lending into private sector arrears.
This box provides a summary of factors that are likely to have a bearing on a member’s prospects for regaining or deepening access to international capital markets.
Private Sector Involvement and Access to Fund Resources
Views remain divided regarding whether or not it would be desirable to establish a presumption concerning the circumstances that would require concerted private sector involvement. Some Directors favor establishing a presumption (but not necessarily a requirement) that if access to Fund resources exceeded a specified limit (figures of 100 percent of quota for annual access and 300 percent of quota for cumulative access were mentioned), concerted means of securing private sector involvement would be required. Such a limit would also serve to limit any moral hazard that may result from the large–scale use of Fund resources. Other Directors indicated that individual cases would need to continue to be considered on their merits, within the framework of principles articulated by the G–7 Ministers of Finance. These Directors considered that moving toward a rules–based system for determining the circumstances in which concerted efforts would be used to secure private sector involvement would be counterproductive.
The choice between these two approaches involves an assessment of their costs and benefits. In brief, the primary benefits of establishing a presumption regarding particular conditions in which the Fund would require concerted private sector involvement would appear to be: (i) the apparent predictability of a rules–based framework, with the associated implications for the incentives facing markets to assess and manage risks; and (ii) limiting the risk that large–scale official financing could be used to allow the private sector to exit during programs. The principal costs of establishing a presumption regarding the particular conditions in which the Fund would require concerted private sector involvement could take two forms: first, an adverse effect on prospects for a resumption of spontaneous market access by a member in circumstances in which there may in fact be good prospects that the catalytic approach would be effective; and second, adverse effects on the efficient operation of the international capital markets more generally.5
Assessing the balance between the two general approaches involves two main issues: (i) the official community’s ability to estimate at the start of a program the likely effectiveness of the catalytic approach—and the associated prospects for a spontaneous resumption of capital market access within the program period (Box 1.2); and (ii) the availability of effective instruments for securing concerted private sector involvement, on the one hand, and their effects on the member’s ability to regain capital market access (and spillover effects more generally), on the other.
Tools for Securing Concerted Private Sector Involvement
While some success has been achieved in securing concerted private sector involvement, it has become increasingly clear that the international community does not have at its disposal the full range of tools that would be needed to assure a reasonably orderly—and timely—involvement of the private sector. In some cases, it may be possible to use concerted techniques in a fashion that prevents private investors from exiting in the midst of a crisis, but avoids serious spillover effects. For example, it may be possible to reach collaborative agreements with banks and other specific creditors for a maintenance of exposure (or a de facto voluntary standstill), or for the restructuring of international sovereign bonds. In other cases, however, the available tools may be insufficient, and it may not be possible to stanch capital outflows without substantial unwelcome side effects. By way of example, if it is not feasible to reach a voluntary agreement with commercial banks, it might be necessary to use concerted techniques that could (as mentioned in footnote 5 above) have adverse effects on banks’ willingness to maintain exposure to other countries experiencing balance of payments difficulties. More generally, in the face of a broad–based outflow of capital, it may be difficult to reach agreement with the relevant resident and nonresident investors, forcing the authorities, as a last resort, to default on sovereign obligations and/or to adopt comprehensive exchange controls (i.e., impose a unilateral standstill).6
Additional Issues Associated with Concerted Private Sector Involvement
An issue that may arise concerns the impact on the market for emerging economy debt of the relative treatment of sovereign bonds compared to other types of long‑term credits (including claims of official bilateral creditors) in the event of a need for debt and debt–service reduction. The restructurings by Pakistan and Ukraine succeeded in puncturing unsustainable expectations of some investors that international sovereign bonds were, in effect, immune from restructuring, but did not involve the status of bonds relative to other forms of medium–term credits. In particular, there is a question of whether or not debtors would ask bondholders to grant debt reduction in circumstances in which official bilateral creditors are not prepared to grant concessional debt relief. Clarity in this area could be an important factor influencing the willingness of long–term investors (such as pension funds and insurance companies) to hold this class of asset.
A related issue could arise in cases in which Paris Club creditors may be willing to consider a concessional rescheduling, but only after the debtor concerned has successfully implemented a Fund arrangement and a Paris Club (nonconcessional) flow rescheduling. This procedure, though well established, may complicate the task of reaching an appropriate agreement in the near term (i.e., during the arrangement period) with private creditors holding long–term instruments, such as bonds. Such creditors may be reluctant to grant debt reduction at an early stage before having a reasonably firm indication of the terms that would be extended by Paris Club creditors when they are prepared to consider concessional rescheduling. At the same time, there is a question of whether it would be feasible to reach agreement on a flow restructuring (for example, by restructuring coupons) with private creditors in the face of continued uncertainty regarding the eventual treatment of the underlying instruments.
Since the onset of the Mexican and Asian crises, considerable attention has been given to efforts to reduce the frequency and mitigate the severity of financial crises. Nevertheless, crises will occur. In some cases, it would seem appropriate to rely on the Fund’s traditional catalytic approach, though in other cases, this may need to be buttressed by concerted means of securing private sector involvement. In this regard, progress has been made in developing a framework for addressing individual country circumstances that builds on the principles set out in Box 1.1. Moreover, considerable experience has been gained with securing the involvement of the private sector in the resolution of individual cases. This experience has highlighted the strengths of, but also the limitations on, the tools available to the international community for securing concerted private sector involvement.
Attachment IA Framework for Private Sector Involvement in Crisis Resolution7
In addition to crisis prevention measures addressed above, we agreed that the international financial community needs to set out in advance a broad framework of principles and tools for involving the private sector in the resolution of crises. The following framework should help to promote more orderly crisis resolution and therefore should be of mutual benefit to debtors and creditors in finding cooperative solutions. It should also help to promote cooperative solutions between borrowing countries and the private sector and to shape expectations in a way that reduces the risk that investors believe they will be protected from adverse outcomes. Developing a framework that facilitates debtor/creditor cooperation should minimize the incidence and intensity of crises and also should minimize the time before debtor countries can expect to regain market access.
We agree that this framework should comprise the following key principles:
a. The approach to crisis resolution must not undermine the obligation of countries to meet their debts in full and on time. Otherwise, private investment and financial flows that are crucial for growth could be adversely affected and the risk of contagion could increase.
b. Market discipline will work only if creditors bear the consequences of the risks that they take. Private credit decisions need to be based on an assessment of the potential risk and return associated with a particular investment, not on the expectation that creditors will be protected from adverse outcomes by the official sector.
c. In a crisis, reducing net debt payments to the private sector can potentially contribute to meeting a country's immediate financing needs and reducing the amount of finance to be provided by the official sector. It can also contribute to maintaining appropriate incentives for prudent credit and investment decisions going forward. These potential gains must be balanced against the impact that such measures may have on the country's own ability to attract new private capital flows, as well as the potential impact on other countries and the system in general through contagion.
d. No one category of private creditors should be regarded as inherently privileged relative to others in a similar position. When both are material, claims of bondholders should not be viewed as senior to claims of banks.
e. The aim of crisis management wherever possible should be to achieve cooperative solutions negotiated between the debtor country and its creditors, building on effective dialogues established in advance.
The principles outlined above, and the tools we propose below, should help establish a broad framework for making judgments about the policy response appropriate to a given case. The appropriate role for private creditors, if any, and the policy approaches needed to induce private creditors to play this role will vary depending on the circumstances of the particular case. There are advantages to making clear in advance the basic considerations that will guide our actions and the specific approaches we will employ. The principles and tools we propose should help provide a degree of predictability for investors, without sacrificing the flexibility required to address each particular financial crisis effectively.
There are various circumstances in which countries might face external financing pressures. There are circumstances where we believe emphasis might best be placed on market–based, voluntary solutions to resolve the country's financial difficulties. There are also cases where more comprehensive approaches may be appropriate to provide a more sustainable future payments path. In practice, there will be a spectrum of cases between these two extremes. Where a country falls on this spectrum will help to determine the policy approach best suited to the country’s particular circumstances. Relevant considerations include the country's underlying capacity to pay and its access to markets.
In addition, the feasibility of different policy approaches will depend on the nature of outstanding debt instruments. These will influence assessments of which claims need to be addressed to resolve the country's financing difficulties, the magnitude of possible concerns about equitable treatment among various categories of creditors, and the scope for voluntary versus more coercive solutions. The nature of the relevant debt obligations can differ along many axes, including whether the debt obligations are principally private or public; foreign or local currency; short–term or long–term; payment of principal or interest; offshore or onshore; secured or unsecured; held narrowly or held by a diffuse group of creditors.
It is important to put into place incentives that would encourage a country to take strong steps at the early stages of its financial difficulties to prevent a deepening crisis.
To address a wide range of potential cases effectively, the international community needs to have a broader range of tools available to promote appropriate private sector involvement. The tools available to the international community should comprise the following:
a. Linking the provision of official support to efforts by the country to initiate discussions with its creditors to explain its policy program.
b. Linking the provision of official support to efforts by the country to seek voluntary commitments of support, as appropriate, and/or to commit to raise new funds from private markets.
c. Linking the provision of official support to the country's efforts to seek specific commitments by private creditors to maintain exposure levels.
d. Linking the provision of official support to the country's efforts to restructure or refinance outstanding obligations.
e. In cases where a country's official debt needs to be restructured in the Paris Club, the Paris Club principle of comparability of treatment applies to all categories of creditors other than the international financial institutions. The Paris Club should adopt a flexible approach to comparability, taking into account factors including the relative size and importance of different categories of claims.
f. Imposing a reserve floor that effectively ensures that the private sector makes an adequate contribution, such as through debt restructuring, alongside official resources in the resolution of crises.
g. In exceptional cases, it may not be possible for the country to avoid the accumulation of arrears. IMF lending into arrears may be appropriate if the country is seeking a cooperative solution to its payment difficulties with its creditors.
h. In exceptional cases, countries may impose capital or exchange controls as part of payments suspensions or standstills, in conjunction with IMF support for their policies and programs, to provide time for an orderly debt restructuring.
We call on the IMF to further develop and define the legal and technical questions involved in implementing the specific approaches identified in the framework agreed here. We look forward to its conclusions by the autumn Annual Meetings.
In order to guide expectations more effectively, we agree that we will seek to provide a clear and timely explanation of the policy approaches, adopted in individual cases, in relation to the principles and considerations that we have set forth above.
There is agreement in the official community concerning the need for the involvement of the private sector in the resolution of financial crises. The official community is increasingly unwilling to provide large–scale official financing to allow the private sector to exit in the midst of a crisis, largely on account of moral hazard. There is also agreement that, while in most cases it may be possible to rely on the Fund’s traditional catalytic approach to mobilizing private capital, circumstances may arise in which it would be appropriate to make Fund resources available only in the context of concerted efforts for securing private sector involvement. In some cases, it may be possible to move toward a restructuring based on moral suasion and/or the credible threat of default. In other cases, it may be difficult to reach such agreement, and members may have little choice other than to impose a standstill through some combination of a sovereign default and the imposition of exchange controls and/or controls on capital transactions. To the extent that such action gives rise to sovereign and nonsovereign arrears, the Fund would be able to continue to provide financial support under the lending into arrears policy, provided early support is considered essential for the success of the member’s adjustment program, and the member is making a good faith effort to reach an orderly settlement.8
Views differ on how to specify the circumstances in which concerted action
would be appropriate. Despite these differences in views, a number of
commentators have suggested the use of standstills as a part of the framework
for including the private sector (Box 2.1). Some have suggested a move toward a
more predictable framework for the circumstances in which a member in crisis
would resort to a standstill. Specifically, rigid limits on members' cumulative
access to Fund credit have been suggested. Under the suggested approach, a
member could call a standstill at any time. If a member has called a standstill,
resources could be made available up to some prescribed threshold within the
context of the policy on lending into arrears. Resources made available under
this policy would carry a higher rate of interest. In a recent report, the
Council on Foreign Relations has also suggested that the use of Fund resources should be strictly limited. The report notes that
a country could resort to a temporary standstill, but recommends that
additional resources could be made available for systemically significant cases
through a new contagion facility.
1/ Can the Moral Hazard Caused by IMF Bailouts be Reduced? CEPR, September 2000, forthcoming.
2/ The Economic Journal, 110 (January 2000), pp. 335–362.
This paper provides a preliminary discussion of standstills, their operational modalities, and the impact on the countries concerned. It also considers whether a move toward a more predictable framework for the use of standstills could bring a number of benefits, including strengthening incentives for better risk assessments and management by private creditors that could reduce the frequency and severity of crises, and whether in some circumstances, such a framework could help catalyze voluntary market–based solutions that could help to avoid the need for standstills to be imposed. The paper also provides a preliminary discussion of the pros and cons of standstills. It seeks to provide an evenhanded treatment of the issues in order to help stimulate discussion, but does not attempt to draw firm conclusions. There is little empirical evidence concerning the effects of the use of standstills, and so the analysis in this paper is inevitably somewhat speculative. The rest of this paper is organized as follows. Section II provides an overview of issues concerning standstills. This includes a brief sketch of operational modalities, but does not offer a comprehensive treatment of these complex issues. Section III presents a discussion of the immediate impact of a standstill on both the member concerned, and capital markets more generally. Section IV examines possible effects of standstills on the pattern of capital flows to emerging markets. Finally, Section V suggests issues for discussion.
What is a Standstill?
The term “standstill” has been used by commentators to cover a wide variety of techniques for reducing net outflows of private capital during crises.9 For the purposes of this paper, a wide definition has been adopted. Standstills cover a wide range of approaches to reducing net payment of debt service and/or withdrawal of capital after a country has lost spontaneous access to international capital markets. Under this definition, a standstill could range from a voluntary arrangement to limit net outflows of private capital to various concerted means of achieving this objective. Concerted techniques could include the application of moral suasion, prohibitions on capital movements (resulting from the imposition of exchange controls and/or controls on capital transactions), or default on government obligations. This subsection provides a brief description of the various mechanisms that could be used to engineer a standstill. Broader issues concerning the effects of the standstills are discussed in subsequent subsections. In all cases, it is assumed that a standstill would be used as a temporary measure to prevent or stop a run while comprehensive corrective policies are put in place and take hold. Standstills do not provide a long–run substitute for appropriate policies.
Voluntary agreements for the maintenance of exposure by specific creditors may provide effective means of securing the continued involvement of certain creditors during crises (Brazil). Voluntary agreements—and the associated dissemination of data on actual changes in exposure—can provide a way of resolving a collective action problem.10 Voluntary agreements would seem to provide a useful complement to the catalytic approach to maintaining private sector involvement, rather than serving as a part of a more concerted framework.
In circumstances in which it is not possible to reach a voluntary agreement, it may nevertheless be feasible to maintain the exposure of some private creditors through the application of moral suasion (Korea). As a practical matter, the only creditors potentially subject to moral suasion by regulatory agencies that are likely to have large exposure are commercial and investment banks.11 However, there are questions regarding circumstances under which regulatory authorities would be willing to apply moral suasion.12 Regulators are generally likely to be hesitant about interfering with banks’ commercial judgments. Similarly, as the role of regulators is to help ensure the financial soundness of the financial institutions under their supervision, they are likely to be reluctant to exercise regulatory forbearance—for example, through a lenient treatment of loan loss provisioning. (Clearly, increases in required loan–loss provisions in the context of a crisis would strengthen incentives for banks to reduce exposure.) It is worth noting that, even with moral suasion, it is likely that an effective agreement will require assurance that forbearance by commercial banks is not being used to allow other investors to unwind their exposure.13 Thus, it is likely that regulators would not be willing to apply moral suasion in all cases in which a run on interbank credit lines is a source of balance of payments pressures.
Standstills Imposed by Debtor Countries
In addition to standstills that depend upon action by regulators in creditor countries, there are three types of standstills that can be engineered by the authorities of crisis countries.
The first concerns a decision by a sovereign to default on specified debt–service obligations.
It is possible that a sovereign default would trigger capital flight. The first line of defense against such capital movements would involve a tightening of macroeconomic policies and exchange rate flexibility; if these are not successful in arresting outflows, consideration may need to be given to the imposition of comprehensive exchange controls.
A second means of imposing a standstill would be through the imposition of exchange controls that limit the ability of residents and nonresidents to make payments or transfers associated with specified external transactions.15 More specifically, such measures could prohibit residents from making payments in foreign and, possibly, domestic currency to nonresidents for specified transactions, and could prohibit nonresidents from transferring abroad the proceeds of specified transactions. In the case of nonsovereign obligations, exchange controls could limit the availability of foreign exchange to meet contractual obligations, as well as being used to limit the withdrawal of other types of capital (Malaysia 1998).16
A third mechanism for imposing a standstill would be through the introduction of transactions–based capital restrictions. Such measures restrict the right of residents or nonresidents to enter into underlying capital transactions; for example, a country could prohibit its residents from engaging in foreign borrowing or from purchasing specified capital assets abroad.17
Operational Considerations of Standstills
When Will a Voluntary Standstill be Feasible?
This subsection provides a brief overview of operational considerations. It is not intended to be comprehensive or to form the basis for policy advice in specific cases.
As noted above, voluntary standstill agreements may be effective in helping to resolve collective action problems, but would not be effective in persuading investors who do not wish to do so to maintain their exposure. This suggests that such agreements will only be feasible in circumstances in which creditors are reasonably homogeneous, and have an interest in maintaining a long–term business relationship with the borrower. This implies that the coverage of such agreements may be limited to credits extended by commercial banks and, possibly, trade credit extended by suppliers. In contrast, nonbank investors holding sovereign claims—including bondholders—tend to be heterogeneous and generally do not have comparable long–term business relations with borrowers, and so are less likely to be willing to participate in voluntary agreements.18 Accordingly, with the increased importance of sovereign bonds, it may become increasingly difficult to secure agreement on voluntary standstills.
In cases in which commercial banks and suppliers have substantial exposure, there are a number of factors that could have a bearing on whether or not it would be feasible to reach a tacit understanding on a payment's standstill.
Coverage of Exchange Controls and/or Controls on Capital Transactions
If it is not feasible to reach agreement on a voluntary standstill, in the context of a developing crisis, it may be necessary to consider imposing a compulsory standstill. The most straightforward type of standstill to implement would be a default on sovereign obligations. In some cases, a default limited to international sovereign obligations might be sufficient to stabilize the balance of payments; however, there could be a risk that the action would trigger capital flight, particularly in cases in which the authorities had not elaborated and implemented a comprehensive adjustment strategy. A default on domestic sovereign obligations (either through a suspension of payments, or through a unilateral restructuring) might be more likely to trigger broad–based capital outflows, particularly if the default is seen as compromising domestic banks’ ability to manage their liquidity or presaging the introduction of comprehensive exchange controls.
In the face of outflows associated with nonsovereign transactions, a standstill would require the introduction of exchange controls and/or controls on capital transactions. At one extreme, for members with already restrictive capital account regimes, a limited intensification of capital account restrictions might be sufficient to stabilize capital movements. By way of example, in 1998 Pakistan was able to stabilize capital outflows through a combination of freezing and restructuring foreign–currency deposit liabilities of commercial banks, and restricting the availability of foreign exchange (requests for foreign exchange were queued at the central bank).
While the specification of exchange controls would need to be tailored to individual cases (and a detailed discussion of these issues is beyond the scope of this paper), it would be expected that controls—whether new or existing—would need to cover the following broad categories of transactions:
The feasibility in a crisis of imposing controls that are comprehensive, yet targeted so as to allow payments for essential imports to continue, will depend upon the existence of an established infrastructure of exchange controls (as well as the authorities’ administrative capacity). In countries with such an infrastructure, it may be feasible to tighten specific regulations regarding, for example, residents’ ability to invest abroad and the amortization of external debt. (Both Malaysia and Pakistan had established exchange control systems before the recent intensification of restrictions.) Conversely, in countries without an established exchange control apparatus, it is likely to be difficult to impose exchange controls in the context of crises in ways that are able to discriminate effectively between specified capital transactions and a range of normal transactions associated with the payment for imports of goods and services. In such cases, imposing exchange controls could exacerbate the economic dislocation of the crisis by further interrupting normal commercial relationships and the availability of essential imports.
The Duration of Standstills
As a general matter, it would be desirable for standstills to be maintained for the shortest feasible period. Standstills may provide a useful tool for halting runs and providing breathing space to allow policies to be elaborated and take hold. Standstills may also help provide space for the negotiation of restructuring agreements. However, standstills provide no substitute for the sustained implementation of appropriate macroeconomic and structural adjustment policies and, if needed, agreements to restructure debt on terms consistent with a return to medium–term viability.
In many cases, it may be possible to bring standstills to an end expeditiously. For example, it may be possible to reach agreement on restructuring debts owed by a sovereign or a homogeneous group of debtors (such as commercial banks) relatively quickly. In a similar vein, standstills imposed through the imposition of exchange controls may be removed fairly quickly if resources are available to allow the backlog of requests for foreign exchange to be worked down over a relatively short period.20 In other cases in which controls imposed in the context of a standstill are more comprehensive, it is less likely that the combination of the adoption of appropriate policies and the provision of official financing could reduce sharply the pressures in the capital account as investor sentiment may have been more seriously damaged.21 In such cases, controls may need to be kept in place for a more extended period. It is worth noting, however, that exchange controls are likely to become progressively less effective over time, and so, need to be accompanied by the adoption of corrective policies, including specific measures to make the country's debt profile sustainable.
Could Standstills be Officially Sanctioned?
Consideration could be given to the official sanctioning of a standstill. This could potentially serve two possibly complementary objectives. First, the international community could make a public statement which would provide a clear signal that the standstill was considered likely to be ultimately in the best interest of the debtor and creditors, and would provide an assurance that it was being used to provide breathing space for handling a crisis, rather than being used to postpone adjustment. In order to provide a clear linkage to the adoption of appropriate stabilization and reform policies, the Fund would appear to be well placed to provide an official endorsement. (Operational modalities would require further consideration.)22
A second possible objective of an official sanction would be to provide the member with some protection against the risk of litigation. This protection would not be intended to permanently alter creditors’ rights; rather, it would be intended to provide a temporary stay on creditor litigation. Such a stay would be intended to ensure that the conduct of economic policy and progress toward an orderly and collaborative settlement with creditors is not disrupted by the effects of creditors trying to enforce legal rights. In some respects, the Fund’s Articles provide only limited protection from creditor litigation (Box 2.2).23
The private sector may have three concerns about the sanctioning of standstills by the Fund.
Article VIII, Section 2(b) states that exchange contracts which involve the currency of any member and which are contrary to the exchange control regulations of that member maintained or imposed consistently with this Agreement shall be unenforceable in the territories of any member.
In order for Article VIII, Section 2(b) to provide more effective protection
against creditor litigation (for example, by covering defaults on sovereign
obligations), an amendment of the Fund's Articles would be required.
In circumstances in which the financing needs exceed the likely available financing from official and private sources, as well as some portion of the official reserves, a member may have no choice other than to impose a standstill. Indeed, with the increase in capital mobility and the globalization of international capital markets, the potential magnitude of private capital movements dwarfs resources available from the official community. At the same time, the official community is reluctant to increase the volume of capital available for crisis resolution, primarily on account of concerns relating to moral hazard. This suggests that if agreement cannot be reached on voluntary arrangements to bring net payments to private investors to an appropriate level, it may be necessary to reach for concerted techniques, and impose a standstill.
This section first examines the extent to which the adoption of a credible framework for the use of standstills as a tool for resolving financial crises could help to catalyze voluntary, market–based agreements between the debtor and its private creditors that could avoid the need for a standstill. It then discusses the immediate impact of the use of a standstill on the member concerned, as well as possible spillover effects on other countries. As noted above, with limited empirical evidence, the analysis is inevitably somewhat speculative in character.
Could the Credible Threat of a Standstill Help Facilitate Voluntary Market–Based Solutions, thereby Avoiding the Need for a Standstill?
Would a move toward a more predictable framework for the circumstances in which a standstill would be invoked help facilitate orderly market–based solutions, thereby helping to remove the need for a standstill? This seems likely to depend on the circumstances of individual cases and, specifically, the nature of the capital outflows.
On balance, it is difficult to predict how a move toward a more predictable framework for introducing a standstill would affect the dynamics of capital flows in the development of a crisis. In some cases, it could help promote orderly, market–based solutions. In others, it might actually accelerate the development of emerging pressures in the external accounts into a full–blown crisis.
Immediate Impact on Internationally Active Domestic Banks and Corporations
If a voluntary agreement between a debtor and its creditors cannot be reached, a standstill may become unavoidable. What would be the immediate impact of such a move on both the member concerned and other emerging markets? 27
The imposition of a standstill may have a positive impact if investors accept that it would be temporary and view the corrective policies adopted as appropriate. In this context, individual corporations may be able to reach agreement with their creditors on a standstill (which may even provide limited new money to keep the corporation in operation).
However, under other circumstances, one immediate impact of the imposition or tightening of exchange and/or controls on capital transactions could be to encourage residents and nonresidents to find alternative means of taking capital out of the country concerned. This added impetus to capital flight underscores the need for exchange controls imposed in the context of crises to be comprehensive.
Controls that do not give rise to breaches of contractual obligations are unlikely to have significant effects on investor behavior, and would not provide a basis for investors to seek legal remedies (Malaysia 1998).28
If controls do give rise to breaches of contractual obligations, and provided they are expected to be temporary, it is likely that a broad range of investors would be willing to show forbearance, as they would have few commercially viable alternative courses of action. Nevertheless, corporations would likely find it harder to obtain trade credit and might need to finance critical imports without foreign credit. To some extent, however, suppliers with long‑term commercial interests may be willing to provide at least limited financing. Similarly, corporations might have to suspend the implementation of investment projects if their sources of external financing are interrupted. By the same token, foreign banks that both hold deposits placed by financial and nonfinancial corporations and have extended credits to the same corporations may decide to apply setoffs, and debit deposits for the funds required to service credits.
If exchange controls that lead to breaches of contractual obligations are allowed to persist for an extended period, it is probable that creditors would consider alternative means of securing settlement. Creditors with long–term established relationships (such as joint–venture partners, suppliers, and commercial banks) may be unlikely to resort to litigation, though they may try to use techniques such as transfer pricing to ensure that they receive payment. Other investors, however, without a long–term commercial relationship with the debtor, and with limited concerns regarding the impact on their reputations, may decide to weigh the potential costs and benefits of litigation versus a “wait and see” strategy.
A full treatment of these issues is beyond the scope of this paper. In brief, however, as a general matter, a nonsovereign debtor that has issued only domestic debt instruments, regardless of whether it has assets (including receivables) located abroad, would be protected from litigation. A breach of contractual obligations stemming from the imposition of exchange controls would generally not provide a basis for litigation in domestic courts and foreign courts would not have jurisdiction. It is worth noting that in countries without well–defined property rights and bankruptcy laws, there would be a risk that the corporate sector would have an incentive to use a standstill as an opportunity to start asset stripping, thereby jeopardizing the value of foreign creditors' claims.
In contrast, debtors that have issued international instruments and have assets located abroad could be vulnerable to litigation. Creditors could seek to recover missed payments, but could also accelerate principal so as to make the full amount of the outstanding loan payable.29 Clearly, creditors would need to weigh the potential gains from litigation (and the associated legal costs) with the potential recovery value under a "wait and see" strategy. The potential gains from litigation will vary from case–to–case, and will depend critically on the contractual provisions of the instruments in question, and the availability of assets that could be attached. Creditors’ assessment of the probable recovery value under a “wait and see” strategy is likely to be influenced by the authorities’ policy response. Countries that are seen as taking forceful measures to address crises may be able to persuade creditors that their best interests are served by exercising forbearance. In cases in which the authorities are not able to take such measures, creditors could be confronted with deterioration in the underlying value of their assets, and perhaps be more inclined to seek to protect their interests by resorting to legal remedies.
Nonsovereign debtors would generally have few defenses in foreign courts against creditor litigation in relation to a default stemming from the imposition of exchange controls. As a practical matter, a debtor might face the uncomfortable choice between paying off litigious creditors and seeking the protection of a bankruptcy court, with the associated potential loss of asset value.
During a period of sustained interruption in the ability of the private sector to perform contractual obligations, it is likely that both the sovereign and the private sector would face a comprehensive loss of access to private capital. Not only would corporations and the government be unable to attract credit to finance new investment, but it is also possible that the country would lose access to non–debt financing such as portfolio flows and possibly also inward direct investment. The experience of the 1980s suggests that countries would be unlikely to regain spontaneous access to private capital until substantial progress had been made in normalizing creditor–debtor relations.
Risk of Spillover Effects
The recent experience with financial crises has highlighted the importance of contagion effects. It is possible that the imposition of a standstill by one systemically important country would amplify contagion and have important spillover effects on the external accounts of a wide range of other emerging market countries. Such effects may be transmitted by at least three mechanisms.
The strength of spillover effects, and the relative importance of the various transmission mechanisms, are likely to vary from case–to–case, and may vary over time, for example, in line with the extent of leverage in the global financial system. At the same time, it should be recognized that in nonsystemic cases, or cases in which foreign investors have been able to unwind their positions, the spillover effect may be minimal (demonstrated by the case of Côte d'Ivoire this year). The limited experience to date with standstills points to the difficulty of making concerted projections of the likely magnitude of spillover effects in individual cases.
In recent crises, members have generally been very reluctant to impose standstills, whether through a default on sovereign obligations, or through the imposition of exchange controls or controls on capital transactions. In large part, this reflected concerns about the impact over the medium term on the availability and terms of new financing. Against this background, this section first looks at the likely impact over the medium term on the market access on a member that has previously imposed a standstill. It then discusses the extent to which a move toward a more predictable framework for standstills could strengthen incentives faced by private investors for the assessment and management of risk, and thereby help to reduce both the frequency and severity of crises. Finally, this section explores the possible impact of a move toward a predictable framework for standstills on the pattern of capital flows to emerging markets.
Medium–Term Impact on the Member Concerned
The impact on the debtor of a standstill will clearly depend upon the nature of the standstill, as well as the risk preferences of investors. Over the medium term, the imposition of exchange controls is likely to tend to reduce the availability of private capital, though the effect is difficult to quantify. Inevitably, in view of the limited experience and the changes in the structure of capital markets witnessed in recent years, the following analysis is somewhat speculative.
Unilateral restructurings of domestic government debt and/or banks’ deposit liabilities are likely to have a sustained impact on residents’ willingness to hold such assets as either stores of wealth or as precautionary balances. Similarly, concerns about future transfer risk may lead residents to hold an increased share of their portfolios of financial assets abroad. Over time, the effect is likely to dissipate, particularly if the authorities are perceived by resident and nonresident investors as taking measures that will avoid the need for further resort to standstills. It is worth noting that Russia regained access to the domestic debt market within 18 months of the August 1998 crisis, following a sharp turnaround in the fiscal and external accounts, reflecting, inter alia, oil prices, the exchange rate depreciation, and improved tax collection efforts.
The behavior of foreign investors may be influenced by two competing considerations. On the one hand, they will need to take account of revised estimates of default and transfer risk in their portfolio allocation decisions.30 On the other hand, they will look to the strength of the authorities’ policy responses, both in terms of immediate macroeconomic stabilization and in terms of structural reforms designed to reduce vulnerability to future crises. To the extent that these responses build confidence that future resort to default and/or controls will not be necessary, foreign investors may be willing to continue investing in the country concerned.
Recent months have witnessed a return of private capital to Malaysia
following the easing of the controls. Although welcome, this may provide only a
limited guide to the likely behavior of private capital following the
imposition of a standstill during a crisis. The Malaysian controls were
introduced only in September 1998 after a substantial volume of private
capital, estimated at $10.4 billion, had been withdrawn (made possible by
large holdings of official reserves) and the pace of outflows had already eased
substantially (Box 2.3) Had the controls been introduced at a
significantly earlier stage, they may have had a more pervasive effect on
investors. In such circumstances, the immediate effect of easing the controls
might have been renewed outflows, reflecting a shift in investors’
Box 2.3 Malaysia’s Experience with Capital Controls
In September 1998, Malaysia introduced capital controls on portfolio outflows and offshore ringgit activities, and pegged its exchange rate to the U.S. dollar. The controls imposed a one–year holding period on foreign portfolio investment and prohibited trading of the ringgit outside Malaysia. The controls did not directly interfere with contractual obligations (e.g., trade or debt contracts) between Malaysian residents and foreign parties or with foreign direct investment (FDI). In February 1999, the holding period for portfolio investment was replaced by a system of graduated exit levies on the repatriation of capital and profits from portfolio investment; this system was replaced in September 1999 by a flat 10 percent levy on the repatriation of profits. However, offshore trading in ringgit remains prohibited.
The capital controls were introduced after Malaysia had already suffered heavy capital outflows and as market sentiment toward Asian countries was just beginning to improve. During January 1997–September 1998, a substantial amount of capital (about $10.4 billion) left Malaysia, thereby reducing substantially the stock of portfolio capital that could be affected by the controls. Market sentiment toward Malaysia and emerging markets in general bottomed out around this time—meaning that outflows were abating. 1/
There is little evidence of large–scale circumvention of the controls, or of an emergence of a parallel or nondeliverable forward market. Incentives for circumvention were weak, as ex–post undervaluation of the ringgit and improved prospects for domestic and regional recovery encouraged investors to keep their funds in Malaysia. In addition, the institutional framework for the imposition of capital controls was already in place (temporary controls on portfolio inflows had been introduced in 1993‑94); this allowed the central bank and commercial banks to monitor and enforce controls in a stringent and effective manner. Furthermore, most loopholes were closed through a tightening of regulations on exchange and capital controls as well as relevant company law and offshore trading regulations.
Despite the easing of capital controls during 1999, net portfolio outflows were not substantial. Because as a substantial amount of capital had already left Malaysia by the time capital controls were introduced, far less portfolio investment was held “captive” by the controls than if they had been introduced earlier. Thus it may still be the case that portfolio flows to Malaysia were actually lower than they would have been in the absence of controls. The effect of controls may also have been obscured by generally improving investor sentiment towards emerging markets. The regional recovery started to gain momentum in the second half of 1999, which, combined with progress in restructuring Malaysia’s banks and corporate, evidently boosted investors sentiment toward Malaysia. Investors’ confidence was further lifted by the upgrading of Malaysia by various rating agencies and by Morgan Stanley’s announcement that Malaysia would be reinstated in its investment index from June 2000 onwards.
Capital controls may have contributed to a decline in FDI, as investors faced higher country risk—as measured by the sovereign bond spread, rising administrative costs associated with approval and verification requirements, and a perceived unpredictable investment policy regime. After having fallen considerably in 1998, Malaysia’s net FDI remained constant in 1999 (see Table below). However, applications for new FDI fell by 26 percent in 1999. In contrast, net FDI to South Korea bounced back strongly in 1999 after contracting significantly in the previous year. Due in part to slower progress in economic and financial restructuring, net FDI flows to the Philippines and to Thailand, which had expanded in 1998, contracted again in 1999. Due to the fact that many factors influence both inward and outward FDI flows, it may be too early to draw definitive conclusions regarding the effect of capital controls on FDI.
Could Standstills Strengthen Incentives for Prevention?
Would a move toward a more predictable framework for the circumstances in which a standstill would be invoked strengthen incentives for capital markets to avoid building vulnerabilities? The following points have a bearing on this issue.
The recognition that the resolution of a financial crisis may entail a standstill is likely to be reflected in the private sector's assessment and management of risk. This may prove to be beneficial in terms of providing strong incentives for the private sector to better monitor and limit borrowers’ vulnerability.
The predictability of a standstill—and thus presumably the incentives for prevention—will depend critically on preannounced conditions under which a standstill would be imposed. It has been suggested that such a rule could be framed in terms of limitations on Fund financing. Notably, the Fund is only one source of official crisis financing (albeit the dominant one) and therefore investors will be concerned about funding from all official sources (including other international financial institutions, the Paris Club, and bilateral creditors). Thus, from the perspective of strengthening incentives for prevention, it would be important that any framework that envisaged a move toward a predictable standstill mechanism would provide a credible and comprehensive cap on financing from all official sources. A market perception that in the case of large, systemically important emerging markets additional resources might be forthcoming from official sources could undermine the incentives for prevention in such cases.
Even if the limits on financing from official sources are expected to be binding in all cases, there may nevertheless be instances in which the effect on incentives might be limited. It is worth recalling, for example, that before the onset of the Asian crisis, Indonesia, Korea, and Thailand were generally perceived by financial markets as having graduated from using Fund resources. Over time, it is likely that other members will be seen as having graduated from the possibility of needing to use Fund resources. In such cases, changes in the policies concerning the use of Fund credit would presumably have only limited bearing on market behavior. It may also be recalled that before the financial crisis triggered by the sharp devaluation of the Thai baht in 1997, data on the buildup of short–term interbank liabilities were widely available. Market sentiment at the time was that the level of short–term debt—while high by historical standards—was sustainable by an Asian Tiger economy.31 Accordingly, there is a question of whether an announced Fund policy concerning standstills would have had an impact on market behavior in that case.
Impact of Standstills on Capital Flows to Emerging Markets
It is difficult to assess the impact of moving toward a more predictable framework for imposing standstills on the overall volume of capital flows to emerging markets. It is likely, however, that a signal that the official community is less willing to provide large–scale financing packages than was the case in the past would reduce the availability of private capital to emerging markets. To the extent that the effect of large–scale official financing had been to create moral hazard, a move toward limits on official financing could improve the efficiency of the global allocation of capital. To the extent that the effect of large–scale official financing packages had been to address market failures (such as herd behavior stemming from asymmetric information), a move toward limits on official financing could reduce the efficiency of the global allocation of capital.
There is also a question of whether the threat of a standstill could have an impact on the composition of capital flows. Three points are worth noting.
First, a move toward a more predictable framework for introducing a standstill would provide clear incentives for creditors to position themselves to be able to be the first out of the exit, through a shortening of maturities. Second, a move toward such a framework would provide strong incentives for the private sector to develop complex financial structures, which would be intended to frustrate efforts to impose standstills. In particular, it would increase the attractiveness of financing secured with a lien on export receivables, or other assets. Although attractive from the perspective of individual creditors, the prevalence of such financing would reduce the authorities’ room for maneuver in the face of future financing difficulties, and would increase the likelihood of arrears to unsecured creditors—including the Fund.
Third, in the absence of mechanisms to provide long–term investors with an assurance that short–term exposure—and the associated risk of a standstill—will not be allowed to build, what impact might a predictable standstill mechanism have on the flow of long–term capital? The answer may depend upon the type of long–term capital. On the one hand, investors with long–term commercial interests (such as inward direct investment) may accept the risk of short–term inconvenience associated with temporary standstills to the extent that they are seen as an effective tool for resolving crises in a fashion that helps to protect asset values. On the other hand, investors who hold long–term marketable securities (such as bonds), which may be subject to renegotiation in the context of a standstill, are likely to be concerned by the process by which their claims are restructured.
For claims on nonsovereign borrowers, this is likely to focus attention on the relevant legal framework, and applicable insolvency laws. This, in turn, is likely to strengthen incentives for members to establish legal mechanisms that are perceived as being transparent, efficient, predictable, and reasonably equitable.
In the case of sovereign obligations, the absence of an international bankruptcy mechanism provides debtors with considerable discretion as to how creditor–debtor relations would be handled in a crisis. At the same time, the Fund has a key role under the lending into arrears policy for defining the circumstances under which it would be willing to provide financial support for a member’s adjustment efforts pending the resolution of arrears to private creditors.
A number of managers of dedicated emerging market investment funds have expressed reservations about the process for renegotiating bonds used in the case of Pakistan and Ukraine and, more recently, Ecuador. In particular, they have expressed concerns about the ability of debtors in default to retain the initiative regarding a restructuring, and their ability to present investors with a "take it or leave it" exchange offer. These managers have indicated that the absence of a transparent and equitable process for renegotiating bonds issued by countries in crisis is likely to have adverse effects on the supply of savings channeled to this type of investment.32 Fund managers have also expressed concerns regarding the relative treatment of sovereign bonds and other types of long–term credits (including the claims of official bilateral creditors) in the event of a need for debt and debt–service reduction. Specifically, they have expressed a concern that they would be asked to provide debt and debt–service reduction at a time when Paris Club creditors are not prepared to grant concessional debt relief.33 This de facto subordination of their claims could reduce the attractiveness of emerging market debt as an asset class, thereby curtailing private capital flows to emerging markets.
There is general agreement that in the context of the resolution of financial crises, circumstances may arise in which it would be appropriate for a member to use a standstill. The potential magnitude of private capital flows, and limitations on the availability of official financing suggest that in extreme circumstances, even with the implementation of strong macroeconomic and structural policies, members may have few alternatives. In some cases, it may be possible to reach a voluntary agreement, while in others, it may be necessary to resort to some combination of the imposition of exchange controls or controls on capital transactions, and a sovereign default. This paper has attempted to lay out the costs and benefits of standstills, though it is recognized that the analysis is somewhat speculative in character. It has examined the possible role of a credible threat of a standstill in catalyzing a voluntary, market–based solution, as well as the risk of triggering a rush for the exit. The paper has discussed the likely immediate impact of a standstill on the member concerned and spillover effects to other emerging markets. It has also offered a preliminary discussion of the effects of a move toward a more predictable framework for the introduction of standstills on the stability of the international monetary system. Specifically, the paper has analyzed the extent to which such a move could provide incentives for prevention, on the one hand, and lead to a shortening of maturities as investors position themselves to be first out of the exit, on the other. The analysis suggests that the effects in specific cases will depend upon the circumstances of the member concerned (such as the composition of external liabilities), the member's systemic importance, and the general state of capital markets, which are likely to vary over time.
1 It should also be noted, however, that the high degree of capital mobility may help engender faster and stronger recovery from crises than previously thought likely, as seen in the cases of Brazil, Korea, and, to a lesser extent, Thailand.
2 Particularly in periods of stress in the external accounts, estimates of financing requirements (and thus of the severity of the balance of payments difficulties) are likely to be subject to wide margins of uncertainty, reflecting the difficulty of predicting short–term capital movements.
3 Summing Up by the Acting Chairman Involving the Private Sector in Resolving Financial Crises—Experience and Principles, EBM/00/31 (3/22/00), BUFF/00/42 (4/27/00).
4 This is the approach that has been adopted, with varying degrees of success, for Brazil, Thailand, and Russia. In the case of Brazil, the program, approved in December 1998, was continued after Brazil reached a voluntary agreement in early 1999 with foreign commercial banks for the maintenance of exposure to interbank and other trade–related credit lines.
5 By way of example, concerted rollovers of interbank credit lines in one case may lead banks to cut lines early in the face of emerging difficulties in other cases so as to escape from any future concerted rollover arrangements. Indeed, if the presumption of concerted private sector involvement were established, there would be a danger that in the face of emerging difficulties, the initiation of policy discussions with the Fund could trigger a rush for the exit.
6 To the extent that such controls limit the ability of highly–leveraged investors to unwind their investments, it is possible that the need for liquidity to meet margin calls would again force the liquidation of investments in other markets, thereby giving rise to contagion across a number of emerging market (as occurred in August 1998 in the aftermath of the Russian crisis).
7 Extract from the Report of G–7 Finance Ministers to the Köln Economic Summit; Cologne, Germany, 18–20 June, 1999 (www.library.utoronto.ca/g7/finance/fm061999.htm).
8 The Fund’s policy on lending into arrears allows it to provide financial support for members with arrears to private creditors as a result of government default, as well as arrears of nonsovereign borrowers stemming from the imposition of exchange controls.
9 In other contexts, a distinction has been made between standstills and moratoria. The term “standstill” has been used to describe an agreement (whether formal or informal) between a debtor and one or more of its creditors providing for a suspension of debt–service payments, while the term “moratorium” has been used to describe unilateral action (and as default or exchange restrictions) taken without the agreement of creditors.
10 In Brazil, Indonesia, and Korea, Fund staff helped country authorities establish and operate high–frequency debt monitoring systems that facilitated the implementation of the agreements.
11 At the onset of a crisis, international bonds that are traded in secondary markets may tend to be acquired by hedge funds and other financial institutions that specialize in high–yield, high‑risk investments. Such investors tend to be heterogeneous and are generally not subject to moral suasion by regulatory authorities. In all cases, however, it would be useful to have detailed knowledge of the composition of external debt, and, to the extent possible, the holders of the debt.
12 Some banks, often those most prone to leave at the first sign of trouble, may be less susceptible to moral suasion. The task of persuading banks that intend to continue doing business with a country facing a financial crisis may be easier once the former group has exited, as happened in Korea.
13 In the case of Korea, this assurance was provided by the restrictive capital account regime, which placed tight limitations on all private capital movements other than those intermediated through domestic banks.
14 In October 1999, the Ecuadoran government announced a unilateral rollover of all principal maturing on domestic bonds maturing in the period October 1999 to December 2000 into seven–year bonds at below market interest rates.
15 It is worth noting that a default on sovereign obligations payable abroad is a proprietary act of governments, and not the result of the imposition of exchange controls.
16 The exchange controls introduced by Malaysia in September 1998 forbade foreign portfolio investors from withdrawing funds invested in the country for at least one year. Transfers abroad became subject to official approval, and exports and imports of ringgit bank notes were restricted. International lending and borrowing in ringgit were prohibited.
17 Beyond imposing restrictions on underlying capital transactions, a country could also decide to freeze specified types of bank deposits held by residents (Ecuador 1999 and Pakistan 1998). Ecuador froze virtually all U.S. dollar–denominated accounts and about half of sucre accounts in Ecuadoran banks in March 1989. Pakistan imposed restrictions in May 1998, including a suspension of withdrawals from foreign–currency deposits (FDCs).
18 In the case of Ukraine, in 1999, in the context of ongoing negotiations, bondholders agreed to a temporary standstill.
19 The voluntary agreement reached by Brazil and commercial banks to roll over interbank and credit lines in March 1999 was made possible by the adoption of macroeconomic policies that ensured to a great extent that the rollover would not be used to finance a generalized rush for the exit.
20 In the case of Pakistan, in January 1999, the Fund completed the review under the Extended Fund Facility (EFF) and approved the second annual arrangement under the Poverty Reduction and Growth Facility (PRGF) arrangement. The program provided for the elimination of arrears associated with requests for foreign exchange for debt–service transactions queued in the central bank to be eliminated over a period of six months. Pakistan maintains controls on foreign currency deposits of commercial banks.
21 There are a number of possible situations in which the desire of resident and nonresident investors to move capital abroad may not be responsive to the adoption of corrective policies and the provision of official financing. These include shifts in portfolio preferences as a result of (i) the move from a pegged to a more flexible exchange rate regime and (ii) changes in the perceived level of political uncertainty.
22 Such modalities would need to ensure that any official sanctioning was effected in a way that did not raise problems of tortious interference with contractual relations between debtors and creditors.
23 See Box 2.1.
24 In a similar vein, the 1982 agreement between Mexico and its commercial bank creditors to roll over principal pending a restructuring was reached against the backdrop of a credible threat of default (and the application of moral suasion).
25 An earlier paper noted that a proposal by Buiter and Sibert for a contractually–based approach to imposing a standstill, the UDROP (Universal Debt Rollover with Penalty), gave rise to a concern that creditors would rush for the exit before UDROP was activated, thereby accelerating the pace at which a crisis would develop. Buiter & Sibert, "UDROP: A Small Contribution to the New Financial Architecture," CEPR Discussion Paper No. 2138 (May 1999).
26 It should be recalled that the sharp reduction in Brazil’s access to interbank credit lines in October–November 1998 reflected, in part, a concern that a concerted rollover operation (similar to the arrangement with Korea) would be an element of the financing package for the Fund arrangement. By the same token, it may be recalled that the agreement to stabilize interbank exposure to Korea was struck—with the assistance of moral suasion—when it was generally recognized that reserves were almost exhausted and that, absent an agreement, a default was inevitable.
27 The immediate effects of a sovereign default have been extensively discussed in previous papers. Experience with Ecuador, however, suggests that the risks of creditor litigation may not be as great as some had feared.
28 In the case of Malaysia, capital controls were selective and did not extend to payments for current international transactions or to foreign direct investment, since these would have affected controls and obligations. Although the short–term effects of Malaysia's controls on investor sentiment have yet to be fully understood (Box 2.3), they do not appear to have had any significant long–term effect on investor behavior.
29 The right to accelerate a claim is a typical feature of international loans and bonds, and is specified in the original contract. An acceleration of a bond typically requires the support of investors holding 25 percent of principal of the issue in question, though the threshold varies among instruments.
30 Money managers who are obligated to redeem the claims of end investors on demand (e.g., managers of open–ended mutual funds) may be reluctant to accept significant transfer risk.
31 This argument is analogous to that concerning the valuation of the U.S. stock market. It is generally recognized that equities are expensive by historical standards. The question debated in the financial press is whether these valuations are justified by the “new economy,” rather than whether or not the authorities would intervene to bail out investors in the event of a sharp stock market correction.
32 In recent informal contacts, a group of fund managers have noted that players who believe themselves to have been hard done by, tend to leave the field after extracting whatever near–term justice they can. Players who lose, but believe in the game, tend to return to the field.
33 It is worth noting that, in some recent cases, bonds have enjoyed a de facto seniority over the claims of Paris Club creditors with regard to liquidity risk; Ecuador, Nigeria, and Pakistan in the period of 1999–2000 continued to service bonds while accumulating arrears to Paris Club creditors. In the case of Nigeria, the bonds in question were restructured debt from the 1980s debt crisis; comparable Paris Club claims were not subject to a comprehensive restructuring and have been in arrears for an extended period. In the case of Ukraine, however, in 1998–99, claims of bondholders were restructured while the claims of Paris Club creditors continued to be serviced in full.