IMF support to debt standstill?

by Chakravarthi Raghavan

Geneva, 2 Apr 2001 - - The International Monetary Fund appears to be veering around to the view that a debt standstill and temporary capital controls may be an option to involve the private sector in the management of financial crises brought on a country by a sudden withdrawal of funds - private investments and loans - as has happened in East and South-East Asia, Russia, Brazil, now Turkey, and others so to say waiting in the line.

The IMF thinking is an issues brief by the IMF staff, posted on the IMF web site on 26 March, titled ‘Resolving and Preventing Financial Crises: The Role of the Private Sector” UNCTAD which originally flagged the issue in 1986, in the context of debt crisis (official debts) of those times, and the analogy of Ch.  11 of the US Bankruptcy code, came back to the question in 1998, in the aftermath of the Asian crisis.

The IMF, World Bank, and the leading industrial countries (whose banks and investors are the creditors) came out very critical of the suggestions.

And at that time when Malaysia, acting independently, and departing from the usual IMF solutions in all such cases - deflation, devaluation, raising domestic interest rates, etc - imposed temporary capital and exchange controls to cope with the outflows, there was strong criticism.

But when it became clear that the Malaysian move was working, and the country had in fact been able to bring down its interest rates and get the economy moving again, the IMF relaxed the conditionalities for Thailand, and subsequently professed to see some merit and usefulness in the Malaysia approach, though qualifying it with the view that even without it there would have been recovery.

The issue of capital controls and debt standstill has now resurfaced in the context of the international financial architecture issues (that had been put on the shelves, once the Asian crisis ceased to be a threat to the majors) in relation to the UN conference on financing for development. UNCTAD’s forthcoming Trade and Development Report is expected to address this issue again.

The IMF staff paper has now come out in support of a standstill - though wanting to ensure that such a debt standstill and controls would need IMF sanctions, despite the conflict of interests involved since the IMF in most of the cases of the crises is itself a creditor.

The motivation though is not reforming the international financial architecture, but awareness that with new bosses in the White House and US treasury, IMF rescue packages put together in the past are more difficult - whether for Turkey now (despite the initial package promised) or for Argentina and others - where either there is already a crises or waiting to happen, with increasing frequencies and ever increasing amounts.

The paper notes that in recent years one of the most spectacular manifestations of globalization has been the rapid expansion of international private capital flows - investments and loans from one country to another - and while these flows have brought significant economic benefits, they have also exposed countries to periodic crises of confidence when capital inflows are suddenly reversed.

These crises, the IMF concedes, can impose substantial economic and social costs. The international financial institutions (IFIs) and their member-governments, the IMF paper says, face a twofold challenge of preventing the crisis where possible and help resolving them where necessary.

The IMF paper discusses the need to involve the private sector in the crisis resolution - due to the limited official resources, the moral hazard involved in the IMF and other financial institutions coming in to provide foreign country to a country in the event of an investor panic, and recent experience with private sector involvement and the problems of ‘free riders’.

On private sector involvement in resolving a crisis, the staff paper discusses the experiences of collective action and problems in relation to the crises in Mexico, Bulgaria and the Baltics, the Brazil and Korean examples, the Ukranian problem (in the wake of Russian default in 1998), the experience of Pakistan in 2000 in restructuring its external debts including deposits held by Pakistani institutions and bonds, the 1999 problems in Ecuador, and Peru’s more recent experience in having had to settle with one party who otherwise threatened to push Peru into a costly default.

In looking at the future, “where do we go from here?”, the staff paper notes the argument of private creditors that official efforts to involve them in crisis resolution would do more harm than good, and points out that in practice this had not happened. Despite the burden-sharing and restructuring of bonds, gross flows of private financing in emerging markets have been recovering, albeit unsteadily, since post-crisis trough of end 1998. “Many private sector participants now seem to accept the need to encourage or, in extreme cases, demand their involvement. The principal complaint now is there are now clear ‘rules of the game’ explaining when and how private sector involvement will be required.”

Discussing various proposals for such involvement, the IMF paper refers to the US Ch.11 bankruptcy proceedings, and notes that there is no such international code and none is likely to be created any time soon, and that moral support by the IMF for a standstill would not be enough, since the country would get no legal protection from creditors. Such a protection could be provided by amending the IMF Articles, Art.VIII.2.b, which already empowers the IMF to sanction capital controls. But the amendments would be needed to make clear that the IMF’s jurisdiction extended to controls imposed in support of a standstill.

However, notes the staff paper, opinion among IMF shareholders are sharply divided and the practical experience to a change of this sort are considerable.

Financial crises, the staff paper says, will never be abolished entirely, but it would be a counsel of despair to argue they cannot be made less frequent through crisis prevention measures. But crisis prevention measures are not infallible.  “So it is important to take steps to make crises easier to manage when they do break out, so that the social and economic costs are minimized. There is now a widespread recognition that involving private creditors to crisis resolution can play an important role in that process. But the international community is still wrestling with a number of key questions. Among the most important - how can the process of private sector involvement be made more efficient and less painful?  And can we articulate the ‘rules of the game’ more clearly without sacrificing the benefits of a flexible approach?”

But the discussion of the proposal itself appears to suggest that the IMF is now increasingly aware and worried that the change of masters in Washington makes it more difficult for the IMF to intervene in financial crises. Turkey is already in trouble - with considerable reluctance by a Republican administration, despite its return to the cold war logic and the key role of Turkey in this, to be able to raise the kind of finance (in support of the IMF package).

The staff paper suggests that a debt standstill may be inevitable way of managing future financial crises, ut tries to ensure that the IMF keeps control of such a process.

The idea of a debt standstill was first raised by the UN Conference on Trade and Development, in the context of government debts, in 1986 - drawing an analogy to the Ch.11 bankruptcy law in the US, enabling a private business debtor to seek court intervention for a moratorium and restructuring of its debt, while continuing to keep operating.

UNCTAD came back to the subject in its 1998 Trade and Development Report, in the context of the Asian financial crisis and ways to deal with such crises in the future, and suggested a debt standstill. It presented arguments against any IMF role of sanctioning, given that its leading members, and the IMF itself, are creditors thus creating a conflict of interest, and advocated instead an independent panel.

UNCTAD said in such cases of massive attacks on the currency of a debtor country, by such sudden withdrawals of funds, four lines of defence were open to the debtor: (1) domestic policies, particularly monetary and interest rate policy, to restore market confidence and halt the run; (2) hedging by keeping sufficient foreign reserves and credit lines; (3) use of an international lender-of-last-resort facility to obtain the liquidity needed; and (4) a unilateral debt standstill and exchange restrictions, and initiation of negotiations for an orderly debt work.

Discussing the first three, UNCTAD had found problems (including the lack of an international lender-of-last- resort, and having the kind of resources that the central bank of a country has (including printing money and creating credit) and the size of international funds that would be needed, UNCTAD came out in favour of a debt standstill. It did not however favour such a standstill to be sanctioned by the IMF, through a broad interpretation of Art VIII(2)(b) of the IMF articles - noting several objections against giving the Fund so much power, including on grounds of the conflict of interest.

UNCTAD then said: “It has been argued that the Executive Board of the IMF is not a neutral body which could be expected to act as an independent arbiter, because countries affected by its decisions are also among its shareholders. Moreover, since the Fund itself is a creditor and a source of new money, and acts as the authority imposing conditionality on the borrowing countries, there can be conflicts of interest vis-a-vis both debtors and creditors.” UNCTAD then advocated declaration of a standstill by a country, and its approach to and an assessment of its merits by an independent panel, and need to combine these with debtor-in-possession financing. –SUNS4868

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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