In my previous Vox column (Panizza 2013a), I argued that the international financial architecture needs a structured mechanism for dealing with sovereign defaults. 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. Opponents and supporters of a structured mechanism for dealing with sovereign insolvency agree on the fact that this is a difficult endeavour. 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 this column, I sketch a mechanism for mitigating the delayed default problem (for more details, see Panizza 2013b).
The insolvency procedure?
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. 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 international lender of last resort 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 international lender of last resort stops providing funds and the country stops servicing its debt1.
This system generates perverse incentives for both the international lender of last resort 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 international lender of last resort support to establish a transparent procedure for triggering the restructuring process. One possibility is to follow Weder and Zettelmeyer (2010) and establish ex ante criteria for accessing international lender of last resort support. In their example (targeted to the European case), 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 obligations2. 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 approach
An alternative system that maintains the automaticity of Weder and Zettelmeyer's (2010) proposal, but allows for country heterogeneity could work as follows. Countries that approach the international lender of last resort 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 thresholds3. 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 international lender of last resort programmes there is usually a sequential bargaining game. The international lender of last resort 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 international lender of last resort 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 international lender of last resort? Should the international lender of last resort be made whole as in the status quo, or should the international lender of last resort also get a haircut?
In the current system, the international lender of last resort cannot credibly commit to stop providing financing if the crisis country does not fulfill the program's conditions. As a consequence, the international lender of last resort 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 international lender of last resort to carefully consider its initial decision. If the international lender of last resort sets conditions that are too tight, the programme will fail and the international lender of last resort will stop providing support. If the international lender of last resort sets conditions that are too lax (i.e. laxer than what is required to achieve sustainability), the programme 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 programme's thresholds (meaning that the threshold was too tight). In this case, the international lender of last resort would be forced to stop providing financing and possibly push a solvent country towards default. This concern could be allayed by endowing the international lender of last resort with escape clauses that kick in in the 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 international lender of last resort too lax, and actually amplify incentives to gamble for redemption. This problem can be addressed with an even more radical proposal: let the international lender of last resort participate in the haircut. The position of the international lender of last resort in the seniority structure is essential for creating the right set of incentives. Rather than following the usual practice of making the international lender of last resort 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 international lender of last resort (Box 1 in Panizza 2013b provides an example).
Another possible problem is that a risk-averse international lender of last resort 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 international lender of last resort. An international lender of last resort that does not lend will soon become irrelevant.
What about the quis custodiet ipsos custodes problem (that is, “who will guard the guards themselves”)? Automatic exit cum haircut may push the international lender of last resort to join forces with the crisis country in producing false statistics showing that failed programmes 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 international lender of last resort’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 international lender of last resort. International lender of last resort lending would thus have a true catalytic effect and mobilise sums that are much larger than those available to the international lender of last resort. One could even imagine a system of many international lenders of last resort, with the traditional international lender of last resort working together (or in competition) with new international lenders of last resort funded by emerging economies. While it remains to be seen if, in the presence of incentive problems, international lender of last resort competition is optimal, the threat of competition would provide strong incentives for addressing imbalances in the governance of the main multilateral financial institutions.
Bolton, P and D Skeel (2004), “Inside the Black Box: How Should a Sovereign Bankruptcy Framework Be Structured?”, Emory Law Journal 53: 763-822.
Kaiser, J (2010), “Resolving Sovereign Debt Crises: Towards a Fair and Transparent International Insolvency Framework”, Friedrich Ebert Stiftung Study, September.
Panniza, U (2013b), "Sovereign default and the rules of engineering", VoxEU.org.
Panizza, U (2013b), "Do We Need a Mechanism for Solving Sovereign Debt Crises? A Rule-Based Discussion", IHEID Working Papers 03-2013, The Graduate Institute, Geneva.
Paulus, C (2012), “A Resolvency Proceeding for Default Sovereigns”, International Insolvency Law Review 3: 1-20.
Raffer, K (1990), "Applying chapter 9 insolvency to international debts: An economically efficient solution with a human face", World Development 18(2): 301-311.
Weder di Mauro, B and J Zettelmeyer (2010), “European debt restructuring mechanism as a tool for crisis prevention”, VoxEU.org.
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.