| Adam Lerrick | ||||||
You are the finance minister of a major industrial power. Faraway Xanadu is threatened with default. Financial contagion will spread around the globe. The dragons are waiting to devour the spoils. What do you want to do? You launch the thermo-nuclear bail-out package.
Congratulations! You survive, Mr Minister…but your taxpayers are dead.
If crises were a non-repeat game in the global gambling halls, then an expedient donation to prevent major defaults would not only be the wisest but the lowest-cost solution.
Concessions made and intelligence gained could not influence future bouts.
But if rescue missions encourage governments to become profligate, domestic entrepreneurs to overextend, foreign investment to be ill-considered, and speculation to be excessive, all with the expectation that errors will be erased by a G7 guarantee, there is a massive cost down the road. Crises will become a 10-times multiple of what has been endured. As bail-out funds travel from public coffers into private-sector pockets, the game will repeat – always with more venues, more players and more capital at stake. And why not? We have socialized the risk and privatized the return.
Raising the ante
In 1995, when Mexico became a candidate for intensive financial care, the US Treasury led an intervention effort to gather some $50 billion for an emergency transfusion of credit. Interdependence with the US economy, along with the tequila effect that threatened reverberations in all of Latin America were cited as good and sufficient reasons.
Spokesmen swore that this was a one-time event and afterwards, in 1996, the G10 stood up, hand on heart, to promise they would act to “discourage expectations that large-scale official financing packages will be available to meet debt service obligations to the private sector”.
There followed in swift succession: in 1997, Thailand for $17 billion, Indonesia for $34 billion and Korea for $57 billion; in 1998, Russia for $16 billion and Brazil for $42 billion; and now Turkey for $10 billion and Argentina for $20 billion. The total to date is more than $246 billion in debt and risk that has been shifted from the balance sheets of private creditors to official ledgers. That averages a hefty 10% of recipient GDP and more than 50% of exports.
Loss has largely bypassed the private sector that, with the exception of Russia, has not written off a single dollar on sovereign lending to large emerging nations. Government obligations have been paid in full when due, while in Korea and Indonesia responsibility was further extended to $33 billion in claims on quasi-insolvent commercial banks. After the international financial institutions have moved in and shored up the credit of faltering economies, private sector willingness to lend, on terms the market sets after the bail-out, is simply an arm’s-length decision. This cannot be confounded with the bona fide participation that implies a cooperative sharing of cost and risk.
Bluffing won’t work
The conundrum that finance ministries and central banks seem unable to solve is how to forestall a full-blown crisis in a large developing economy without giving its creditors a free ride. When the sky is falling and every passing moment is a constraint, there is no leverage for those even more desperate than borrower or lender to prevent any and all default. The map of contagion, fictional or real, has expanded with each episode, moving from close neighbours to trading regions and now, with Turkey, to the view that default in any emerging nation shakes investor confidence in all. Time is on the side of lenders, who have already pocketed high pre-crisis returns and are stonewalling appeals to absorb their fair share of post-crisis losses.
The old ways from the good old days cannot prevail in a new financial arena which is complex, arm’s-length and impervious to official pressure. Moral suasion, the bludgeon of choice in the 1980s, is an anachronism. Then, big commercial banks sat down at crisis time with central bankers who were also their regulators and, in this mutual hostage exchange, restructured existing debt and provisioned new funding.
No longer are national treasuries or big banks the key players in the global economy. In 1999, the private sector provided five times the resources flowing from official reservoirs. Contrast that with a decade earlier when private funds measured only 75% of official lending. In 1980, bank loans to emerging governments were a towering 10 times bonds outstanding; by 1999, bonds dominated, at 1.6 times bank loans.
In the vast capital markets that have displaced the intimate club of the 1980s, claims and risk are continuously transferred.
No search can ferret out the original profit-taker and no dialogue can coerce a diverse multitude of unregulated and self-interested investors. Yet political outcry in the industrialized world continues to demand that those who garner high returns must bear the costs of the high risk implied and be compelled to contribute to emergency solutions.
The paradox is that the private sector was already bailed in, until we elected to bail them out.
Change the incentives to change the game
The IMF is in a box and the way out it has chosen is long on illusion and short on reality. Consider the recent financial legerdemain in the case of Argentina, where the Fund is touting private sector participation for half of the $40 billion emergency package. In truth, it is nothing more than a $100 million gift from the Argentine people to speculative investors through the option to exchange old assets for more attractive instruments that carry a 1% to 1.5% premium above prevailing market values.
| Bailouts: a history ($bn) | |||||
| IMF | Other Multilateral | Bilateral | Total | ||
| 1995 | Mexico | $18 | $10 | $22 | $50 |
| 1997 | Thailand | 4 | 3 | 10 | 17 |
| Indonesia | 10 | 8 | 16 | 34 | |
| Korea | 21 | 14 | 22 | 57 | |
| 1998 | Russia | 11 | 4 | 1 | 16 |
| Brazil | 18 | 9 | 15 | 42 | |
| 2000 | Turkey | 10 | 0 | 0 | 10 |
| Argentina | 14 | 5 | 1 | 20 | |
| Total | $106 | $53 | $87 | $246 | |
| Sources: IMF, Institute of International Finance, World Bank | |||||
| Cost of private-sector contingent financing: by country* | |||
| Commercial bank stand-by | Credit derivatives | ||
| Life of facility/option | 3 yr. | 1 yr. | 3 yr. |
| Term of financing upon exercise | Up to 3 yr. | 1 yr. | 1 yr. |
| Argentina | |||
| Interest rate | Libor + 3% | Libor + 7% | |
| Annual commitment fee/option premium | 2.50% | 3.00% | 2.20% |
| Brazil | |||
| Interest rate | Libor + 2.50% | Libor + 7% | |
| Annual commitment fee/option premium | 2.00% | 3.00% | 2.15% |
| Mexico | |||
| Interest rate | Libor + 0.875% | Libor + 7% | |
| Annual commitment fee/option premium | 0.50% | 1.75% | 1.25% |
| China | |||
| Interest rate | Libor + 0.50% | Libor + 7% | |
| Annual commitment fee/option premium | 0.35% | 1.50% | 1.00% |
| Korea | |||
| Interest rate | Libor + 0.70% | Libor + 7% | |
| Annual commitment fee/option premium | 0.50% | 1.50% | 1.00% |
| *Pre-Argentina bailout. | |||
| Sources: Credit Suisse First Boston, International Finance Corporation | |||
There are $7 billion worth of these exchanges; $5 billion of standard new bonds, of which $3 billion are stuffed into captive domestic pension funds at below market rates; $2.5 billion in old short-term notes rolled over three times in one year, a manouevre that will not really bring $7.5 billion of new funds to the table. It does add up to $20 billion but the participation is fictional. Investors took no losses, assumed no risk and proffered not a single dollar of new funding on anything but arm’s-length terms.
Six years should have made the supranationals smarter. They are stumbling into the same pitfalls, giving credence to the same good intentions, tolerating the same broken promises of reform and encouraging the same investor indiscretions. Every move that has been made has acted to create more crises.
Experience dictates that, as Allan Meltzer of Carnegie Mellon University instructs: “We must move from a system of exhortation to one of positive incentives”.
A roster of new rules will change the game:
? The world view of crisis must alter and with it the vocabulary. As developing countries, with their violent political and economic swings, enter the global financial community, the undisciplined capital flows that follow magnify the risk. After eight bail-outs in just six years, we are not helpless before unforeseeable seismic events but confronted with an expected and recurring pattern of disturbance. The only unknowns are when and where.
? Only the credible prospect of default can enforce change in countries, write-downs in creditor holdings and caution in capitalists.
? The resolution of pre-crisis debt and the provision of new financing, always tightly bound together in the old model, must be divorced and addressed by different segments of the financial markets that offer different skills. The flow of emergency resources should not be obstructed by the renegotiation of old claims.
? New funds needed for liquidity must be sequestered to forestall diversion into the payment of past obligations.
? Systemic economies, whose default might entrain widespread disruption, can be identified by the collective opinion of the marketplace and should be vigorously supported. For the IMF, as lender of last resort, true responsibility is to the system not to individual borrowers. Today, perhaps five economies in the emerging world would qualify: Argentina, Brazil, China, Korea and Mexico. As other nations gain importance, the list will grow. For this critical universe, the IMF should establish a market-based frame work for emergency funding, persuade participation and subsidize the cost of stability as a global public good.
? In a domestic context, large banks are accorded preferential treatment as too big to fail. In the emotional climate of international opinion, current Fund policy that discriminates between the needs of large and small nations is not tenable. Whether it makes economic sense or not, all must be afforded the same opportunities.
? Reservoirs of emergency funding, on terms negotiated before the event, must be created to anticipate and diffuse the time pressure of past crisis modes. Here, the capital markets can make a legitimate contribution and play what may become the leading role.
A new strategy: securitized contingent financing
The stand-by credit line to provide emergency liquidity is ubiquitous in the marketplace.
But, it can be transformed to become tradeable, securitized, subsidized by the IMF and protected by the Fund’s endorsement of borrower policies. By this means, the IMF can enlist the private sector to assume the risk of threatened economies in advance and compensate the markets to provide an automatic first line of defence against fluctuations that might destroy investor confidence in the development sector or entrain contagion. The Fund retains its traditional role of lender of last resort.
|
View graph. |
||||||
Liquidity is the objective when credit weakens and bridge funds offer breathing room that permits borrowers to restructure outstanding debt and to seek long-term financing from both the capital markets and the development banks for genuine structural reform. A short maturity of the contingent financing, one year or less when drawn, is appropriate.
Options and notes, both publicly traded, are the mechanisms that modernize the classic stand-by line. Put options written by qualifying private-sector institutions would be purchased at auction by the Fund. These contracts would give the IMF the ability to sell at any time, over a predetermined medium-term period, floating-rate notes issued by the five core emerging governments. Terms of a short maturity and a high floating interest rate, combined with the large size of the issues, will ensure liquidity. A separate series of options would be created for each of the systemically important developing economies, rather than a composite option on a basket of the borrowers that would reduce the potential universe of sellers and increase the cost. Smaller programmes would be tailored to the needs of other nations that choose to participate.
Standard lender-of-last-resort terms would apply: penalty interest rate, short maturity and a high level of protection. An example: total principal amount of underlying notes per borrower: $10 billion; life of put options: one to three years; term of underlying notes: one year; interest rate on notes: three-month Libor plus 7%; minimum denomination of option: $10 million principal amount of underlying notes.
|
View graph. |
||||||
If default under existing liabilities is required in the restructuring process, the new mechanism functions without danger of the attachment of fresh funds by old creditors.
Contracts run between contingent lenders and the IMF, not the crisis borrower, and IMF disbursements are exempt from attachment under sovereign immunity law. There is no credit exposure for the Fund in its pass-through function and there will be no confusion in creditor rank should the IMF provide additional financing in tandem with the proposed contingent facility. Private-sector institutions would have market standing and would not benefit from the IMF’s preferred creditor status.
Risk is diminished for the private sector by conditions on the exercise of the options and the release of the funds – either agreement to an IMF-sanctioned adjustment programme or fulfilment of the preconditions of an IMF Contingent Credit Line (CCL). There is no requirement of official financing. But, the risk is not transferred to the taxpayers of the Fund’s creditor members as occurs in classic IMF intervention.
What happens when a crisis occurs? After a core emerging country has agreed to an IMF economic adjustment programme or fulfils the preconditions under a CCL, the Fund has the ability to draw immediately upon private-sector lenders for emergency financing. The crisis country would issue notes to the Fund and the Fund would exercise its option to sell the notes to the current option counterparties at 100% of principal amount. The proceeds of the note sale would pass through the IMF to the borrowing nation.
A $50 billion market
A securitized, liquid marketplace will attract a spectrum of institutions beyond the traditional commercial bank universe that has dominated contingent credit lines in the past.
By establishing an ongoing substantial demand, the IMF will precipitate a supply response and promote the development and competitiveness of the market.
A staggered offering schedule will smooth absorption and protect against times of crisis when markets are effectively closed. Every quarter, the IMF would buy, through competitive tender, one-year put options covering $1 billion principal amount of underlying notes for each country and three-year put options covering $500 million principal amount of underlying notes for each country. Since only 15% of the options will be rolled over at any given auction, at least 85% of contingent financing will always be at hand, permitting postponement of bidding until functioning markets are restored. After three years, this new source of emergency financing would generate a sum equal to half the IMF’s effective resources – $50 billion, or $10 billion for each of the core emerging economies.
To minimize counterparty risk, sellers of the options would be confined to industrialized countries and must meet qualifying criteria, among them: minimum long-term ratings of A, minimum asset levels and maximum levels of options written in relation to capital. Among these institutions, the options would be freely assignable in minimum denominations of $10 million principal amount of underlying notes. Options would be exercised on a pro rata basis within each option class and the underlying notes, when issued, would be exchange-listed and freely tradable in standard market denominations. All notes issued on the same date would be identical, regardless of the option class, to ensure maximum liquidity.
Effective pricing will be assured by a competitive universe of participants, comprised of the 10 commercial banks that lead the syndicated loan business and the seven major financial institutions that make markets in emerging economy credit and spread risk through derivatives. For these last, the limited availability of instruments for hedging mechanisms is a constraint on growth.
This is particularly severe in the case of China, which has not issued substantial amounts of foreign-currency denominated debt and tightly controls its foreign exchange and domestic financial markets. As the five core developing economies continue to increase the supply of their debt instruments and liberalize their domestic capital and foreign exchange markets, the capacity of the derivatives market to hedge will be augmented and, with it, the ability to offer and trade the options.
Costs that are shared
The cost of the contingency structure will become ever more competitive as the market develops. Currently, in the syndicated loan market, this amounts to 0.35% to 2.75% per annum while in the credit derivative market, the price of the put options approximates 1.5% to 3.% for the one-year options and 1% to 2.1% per annum for the three-year options, depending upon the borrowing country.
| Allan Meltzer | ||||||
Convergence of the two markets, with attendant uniform pricing and an increased value on liquidity, will be driven by currently proposed regulations and accounting reforms advanced under the Basel Committee on Banking Supervision and the Financial Accounting Standards Board and the International Accounting Standards Committee. Mark to market, or fair value accounting, of all financial assets will force commercial banks to price loans on true economic terms or face immediate earnings and balance sheet losses.
New capital adequacy standards will promote consistency between banking book and trading book treatments and eliminate incentives for regulatory capital arbitrage.
Since global financial stability is a prime public good, its cost should be shared by all who benefit from prosperity in the world economy. This justifies subsidization of a programme in which option premiums are divided equally between the Fund and each protected country. To ensure a fair distribution of the IMF’s share of costs among its creditor and debtor members, financing would come from raising the rate of charge on all loans and lowering the rate of remuneration on credit balances of donor nations. Adjustments to each of 0.25-0.35% per annum will cover the initial five core economies.
This is a small price to pay to engage the private sector and to leverage Fund resources on a significant scale.
Toward a new IMF
Today, the IMF is engaged in a process of continuous intervention providing emergency resources to some 30 countries. Should market-based contingent financing expand to serve a broader spectrum of IMF members and grow to provision $100 billion or more of funds, there may come a time when Fund lending will become redundant.
This would redefine the institution as a stalwart lender of last resort, ever vigilant but seldom in action.
Adam Lerrick, formerly head of product development at Credit Suisse First Boston, served as senior advisor to the chairman of the International Financial Institution Advisory [Meltzer] Commission of the US government.
