Efforts to prevent debt-rollover crises are looking at the wrong problems, says IMF working paper

By Reshmi Basu

New York, Aug. 12 - The international community's attempts to mitigate debt-rollover crises has ended up making the problem worse because it is looking at the wrong issues in highly leveraged debt structures, according to International Monetary Fund analyst Olivier Jeanne in a working paper titled "Debt Maturity and the International Financial Architecture."

The global crises of the 1990s generated a perception that global financial systems left to their own devices tend to produce "dangerous forms of finance," the researcher said in his paper, which represents his views, not the IMF's.

For instance, Mexico in 1994 and Indonesia, Korea, Malaysia, Thailand and Russia in 1997 to 1998 had to roll over large amounts of short-term external debt, making them vulnerable to debt-rollover crises

After such crises, the international community focused on reforming the international financial architecture, the after-the-event inefficiencies involved in debt defaults and restructuring.

"Thus, analysts often start from the premise that the reforms should aim at facilitating 'orderly debt workouts' either though the contractual approach or through a statutory mechanism such as an international bankruptcy court," wrote Jeanne.

In the contractual approach, countries are encouraged to make their debts easier to renegotiate using contractual features that ease the coordination among creditors. But problems of coordination failures do still arise.

Also, the ability to renegotiate is dependent on the structure of debt. For instance, syndicated bank loans are easier to renegotiate than international bonds.

Using models, the author tested several reform approaches such as a collective action clause, which involves the trade-off between a benefit (increasing the repayment conditional on a crisis) and a cost (aggravating debtor moral hazard).

Although countries gain from using a collective action clause, public policy does not play a role in mandating or encouraging the use of these provisions.

"Some countries will choose not to include them in their debt even after they have been fully informed of their benefits because it raises excessively their cost of borrowing," writes Jeanne.

In the case of statutory approaches, the underlying argument is that efficient renegotiations cannot be achieved in a "purely contractual way."

The author assesses the value of a bankruptcy regime, which gained recognition in 2002 under Anne Krueger, the IMF's first deputy managing director. The project was criticized for weakening creditors' rights.

The author finds that, "the welfare properties of a bankruptcy regime for sovereigns depend on the bargaining power of creditors."

One reason that the bankruptcy regime falters is that it grants protection to all debtors that run into a crisis, independent of their pre-crisis policies.

Of the possible reforms being discussed, establishing a bankruptcy regime with gate keeping appears to be most promising because it addresses the incompleteness of sovereign debt contracts rather than the creditors' failure to coordinate.

This kind of bankruptcy mechanism completes the sovereign debt contracts by making them renegotiable, but also makes this renegotiation contingent on pre-crisis policies.

There are obvious problems with gate keeping. For example, the bankruptcy court must determine what are good and bad policies.

The author concludes that the "international financial architects" should focus more on the underlying inefficiency of contract incompleteness and less on the symptoms such as coordination failures.

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