Incentives for Avoiding Delayed Sovereign Defaults

Keyword: 
Financial crisis
Topic: 
Macroeconomics - Economic growth - Monetary Policy

In a previous post, I argued that the international financial architecture needs a structured mechanism for dealing with sovereign defaults. The same post suggested that the main problem with the status quo is that countries tend to sub-optimally delay necessary defaults, leading to substantial loss of value for debtors and creditors alike. This post sketches a mechanism for mitigating the delayed default problem (for more details, see Panizza, 2013).

Opponents and supporters of a structured mechanism for dealing with sovereign insolvency agree on the fact that this is a difficult endeavor. I will abstract from most practical and political hurdles (for detailed proposals, see Bolton and Skeel, 2004, Kaiser, 2010, Paulus, 2012, and Raffer, 1990) and concentrate on the issue of delayed defaults.

In the literature, there is a discussion on who should have the right to open the insolvency procedure: The debtor country? Creditors? The Court? I do not think that this is a fruitful way to approach the delayed defaults problem. Delayed defaults can only be avoided by designing a system that provides incentives for avoiding unnecessary procrastination. I focus on the incentive structure of the international lender of last resort (ILOLR). After all, procrastination would be almost impossible without external financial support.

In the typical sovereign debt crisis, countries that have problems rolling over their existing debts apply for ILOLR support (usually the IMF, sometimes complemented by other multilateral and bilateral lenders). In most cases, things go well and, thanks to some financing and some adjustment, the country regains market access (for instance, Brazil in 1999 and Turkey in 2001). Sometimes, however, the situation keeps getting worse, and, after several renegotiations of the original program, the ILOLR stops providing funds and the country stops servicing its debt.1

This system generates perverse incentives for both the ILOLR and policymakers in the crisis country. As the parties can continuously renegotiate the program, they can postpone difficult decisions by gambling for redemption and inefficiently delaying the moment of reckoning.

Rules for avoiding procrastination

We can use the fact that defaults are normally preceded by a request for ILOLR support to establish a transparent procedure for triggering the restructuring process. One possibility is to follow the suggestion of Cordella and Levy Yeyati (2006) and Weder and Zettelmeyer (2010) and establish ex-ante criteria for accessing ILOLR support. In the discussion of Cordella and Levy Yeyati (2006) ex-ante criteria can be country-specific. In the example of Weder and Zettelmeyer (2010), instead, European countries that meet the Maastricht criteria can always draw multilateral support without any type of conditionality; countries that are above the Maastricht thresholds, but below higher thresholds, can draw support with some form of conditionality; and countries that are above these upper thresholds do not have access to multilateral support. If these countries lose market access, they will be forced to immediately restructure their obligations.2 While this procedure has the advantage of being transparent and automatic, it does not allow for the fact that different countries can sustain different levels of debt and deficit.

An alternative system that maintains the automaticity of the proposals by Cordella and Levy Yeyati (2006) and Weder and Zettelmeyer (2010) but allows for country and period heterogeneity could work as follows. Countries that approach the ILOLR for support are immediately subjected to debt, fiscal, and external sustainability analyses. Countries that are deemed to face a solvency problem will not receive any support and will be de facto forced to restructure their debts. If the situation appears to be sustainable, or if the country is deemed to be able to achieve sustainability in the medium term, the country will receive the necessary support. Support will come with the announcement of country-specific criteria and thresholds. If these thresholds are breached, support will be immediately and unconditionally withdrawn, and the country will be de facto forced into default (unless markets have suddenly become optimistic).

This proposal is different from standard conditionality for at least two reasons. First, while standard conditionality tends to include a large number of indicators, the approach proposed here would include a small number of easily verifiable indicators. Second, and more important, in ILOLR programs there is usually a sequential bargaining game. The ILOLR starts by setting tough conditions which are then renegotiated if the crisis country overshoots the original targets. In my proposal, there is full commitment. If a country overshoots the pre-established thresholds, the ILOLR is forced to withdraw support.

If support is withdrawn and debt restructuring becomes necessary, the insolvency mechanism will start its work by verifying claims, allowing for interim financing, and imposing an immediate cessation of payments and stay on enforcement. Next, the mechanism will determine seniority among commercial creditors by following the guidelines of Bolton and Skeel (2004).

What about the seniority of the ILOLR? Should the ILOLR be made whole as in the status quo, or should the ILOLR also get a haircut? More on this below.

Incentives

In the current system, the ILOLR cannot credibly commit to stop providing financing if the crisis country does not fulfill the program's conditions. As a consequence, the ILOLR will start with tough (and perhaps unrealistic) conditions and then renegotiate along the way.

Inability to renegotiate imposes discipline on the crisis country and forces the ILOLR to carefully consider its initial decision. If the ILOLR sets conditions that are too tight, the program will fail and the ILOLR will stop providing support. If the ILOLR sets conditions that are too lax (i.e., laxer than what is required to achieve sustainability), the program will also fail because the country will not regain market access.

The system described above is very rigid and does not accommodate for unforeseen events, such as natural disasters or large external shocks. However, if these unforeseen events were to make a country's debt unsustainable, debt restructuring would still be the only viable solution. Nevertheless, let us assume that an external shock that does not affect solvency leads to a breach of one of the program's thresholds (meaning that the threshold was too tight). In this case, the ILOLR would be forced to stop providing financing and possibly push a solvent country towards default. This concern could be allayed by endowing the ILOLR with escape clauses that kick-in in case of truly exceptional events (promoting the use of insurance and contingent instruments would be an even better solution).

A possible objection to my proposal is that strict exit rules will make the ILOLR too lax, and actually amplify incentives to gamble for redemption. This problem can be addressed with an even more radical proposal: let the ILOLR participate in the haircut. The position of the ILOLR in the seniority structure is essential for creating the right set of incentives. Rather than following the usual practice of making the ILOLR fully senior with respect to other creditors, it would be possible to build a system in which seniority depends on the difference between the market rate and the lending rate of the ILOLR (Box 1 in Panizza, 2013, provides an example).

Another possible problem is that a risk-averse ILOLR will always stand on the sidelines and never provide financing. I do not think that this will happen. Institutions have strong incentives towards self-preservation. It is lending that justifies the existence of the ILOLR, an ILOLR that does not lend will soon become irrelevant.

What about the Quis custodiet ipsos custodes problem? Automatic exit cum haircut may push the ILOLR to join forces with the crisis country in producing false statistics showing that failed programs remain on track. I do not think that this is a serious problem because statistics can always be verified ex-post and the systematic production of false statistics would seriously damage the ILOLR’s reputation.

Catalytic effects and competition

It is possible to envision a system in which the seniority structure described above applies to any private or official lender that, during crisis periods, is willing to lend at the same terms as the ILOLR. ILOLR lending would thus have a true catalytic effect and mobilize sums that are much larger than those available to the ILOLR. One could even imagine a system of many ILOLRs, with the traditional ILOLR working together (or in competition) with new ILOLRs funded by emerging economies. While it remains to be seen if, in the presence of incentive problems, ILOLR competition is optimal, the threat of competition would provide strong incentives for addressing imbalances in the governance of the main multilateral financial institutions.


Note: A version of this piece was first published in VOX EU

1. Alternatively, the ILOLR may continue to provide support, if and only if, the sovereign restructures some of its debt with commercial creditors (this was the case of Greece in 2012).

2. Without some entity able to impose seniority, countries may be able to postpone the moment of reckoning by diluting their existing obligations. However, this ability of diluting existing debt will not last long. In any case, the ability to dilute is yet another reason why the ILOLR should be paired with a debt restructuring mechanism capable of imposing seniority.

3. The criteria and thresholds can be very lax for countries with minimal insolvency risk (this is equivalent to lending without any type of conditionality), and tighter for countries that have greater risk of insolvency. Some countries may even pre-qualify for support, as under the IMF Flexible Credit Line (FCL) facility
 


References

Bolton, Patrick and David Skeel (2004) “Inside the Black Box: How Should a Sovereign Bankruptcy Framework Be Structured?” Emory Law Journal, Vol. 53: 763-822.

Cordella, Tito and Eduardo Levy Yeyati (2006) "A (New) Country Insurance Facility," International Finance, vol. 9(1): 1468-2362.

Kaiser, Jürgen (2010) “Resolving Sovereign Debt Crises: Towards a Fair and Transparent International Insolvency Framework,” Friedrich Ebert Stiftung Study, September

Panizza, Ugo (2013) "Do We Need a Mechanism for Solving Sovereign Debt Crises? A Rule-Based Discussion," IHEID Working Papers 03-2013, The Graduate Institute, Geneva.

Paulus, Christoph (2012) “A Resolvency Proceeding for Default Sovereigns,” International Insolvency Law Review, vol. 3: 1-20.

Raffer, Kunibert (1990) "Applying chapter 9 insolvency to international debts: An economically efficient solution with a human face," World Development, vol. 18(2): 301-311.

 

 

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