Too many risks, too few rewards
Capitalism and serfdom
The spectre of intervention
Can the IMF play supercop?
A breathing space for the IMF
Banks and bad policies must share more of the pain
The IMF treatment isn't working. As Ricardo Hausmann, chief economist at the Inter-American Development Bank, points out. "Tranched, conditioned IMF support simply doesn't do the trick of calming markets down." The IADB thinks that Argentina has something to offer. Argentina's instrument of better market discipline is a corset and safety-harness rolled into one. It consists of a contingent repo which allows the country to borrow up to $7.3 billion from 13 private lenders at Libor plus 205 basis points. The daily valuation of the collateral, mostly Argentina's own dollar bonds, is a way of telling the country's finance officials, and president Menem, how they are doing. Argentina posts collateral set at 125% of the loan. If the market value of the bonds falls by 5% or more, there's a call for more collateral. If the drop is more than 20% the new collateral must be in dollars. But so far Argentina hasn't drawn on the facility. It's a standby for the bad times, which costs the country 35bp a year.
Argentina's central bank set up this arrangement in the wake of the 1994/95 Mexican crisis. The central bank became the middle-man between commercial banks in Argentina - which hold much of their reserves in semi-liquid dollar-denominated Argentine government Eurobonds - and the international banks on the other end. The repo makes those bank reserves in Argentina a little more reliable and turns the largest international banks into the country's lenders of last resort.
The country learned a painful lesson in 1995 when the economy went into a tailspin, thanks to a banking panic triggered by the Mexican devaluation. Banks in Argentina were forced to liquidate other assets during the crisis and that led to a terrible credit crunch. But Argentina could probably have escaped unscathed by recession, had bank reserves been more liquid.
So, the repo - signed in 1996 - now gives local banks in Argentina the option to raise more cash by sending their collateral to the central bank. And the central bank has the agreement with the international banks. But, even in tough times like last October, the central bank has held off using the repo. Argentina withstood the shock waves from Asia with very little effect on growth and investment.
The IADB's Gavin points out: "The ultimate test of a scheme like this is if it never gets put to use. Just the promise to act if necessary makes investors confident enough so that they won't run for the exits."
The 35bp that Argentina spends to keep the credit line open is a small price to pay for what amounts to renting extra reserves. In fact, it's much cheaper than owning gold, foreign currency or even American T-bills. And Argentina has the collateral for this deal because most of the country's reserves consist of its government's international bonds.
Mexico installed a similar standby in November of last year. Thirty-one international banks agreed to provide the country with $2.5 billion in loans, should Mexico need them to rollover foreign debt at a time of turbulence. So far, it hasn't.
Hausmann at the IADB thinks that a lot of other countries should have these arrangements as well. Without them, countries should think twice about borrowing in the international markets.
"If this becomes the standard," he says, "it would segment the countries." Those who set up these arrangements would have insurance to cover their need for dollar liquidity. Countries without them would tend to get less capital from abroad and would consequently be less exposed to the risk from harm which excessive flows might otherwise cause. Or, to put it another way, standby credit lines can protect countries against liquidity crises. But insolvent countries wouldn't get them.
Hausmann's own proposal differs from Argentina's repo in some ways. First, he wants a mechanism to rely more on price and less on collateral, to tell the country how it's doing. The credit line would be renewed and the price would be reset at regular intervals, possibly once a year. If the cost went up, that would send a clear signal that problems were getting worse and provide incentives for the government to deal with the fundamentals. That's a message which a pile of gold or foreign currency - conventional reserves - just can't send.
Hausmann wants the IADB to commit $5 billion of its capital to offer standby credit to countries in Latin America. Commercial banks would put up another $15 billion. But it wouldn't stop there. "The more the merrier," he says. He thinks that, if his proposal got rolling, the World Bank and the other regional development banks would climb on the bandwagon. And he would be happy if the IMF even took the lead.
But why should public money go into these deals, if Mexico and Argentina can do them without it? For starters, the IADB's presence would reassure sceptics among borrowers that the credit would be there when they needed it and could be used. Also, smaller countries without a major presence in international capital markets might not have enough leverage to make these deals happen on their own.
But they shouldn't count on the IADB forever. Other needs will gradually reduce the $5 billion which IADB wants to put into the project. Hausmann's goal is for the IADB to help create a broad and active market, and then to move on.
Standbys work for Argentina
Would it work? Chris Gilfond, vice-president and co-head of Latin American capital markets at Salomon Smith Barney, points out: "The fact that it's there provides a level of comfort that people doing business with banks in Argentina don't have in a lot of other countries."
The credit line covers about 10% of all bank deposits in Argentina. That's high. It comes on top of other liquid bank reserves covering 20% of the deposit base. And Argentina has sworn itself to keep enough additional reserves on hand, under its "convertibility plan", to match the entire monetary base, dollar for peso.
But Joyce Chang, an emerging markets debt strategist at Merrill Lynch, thinks that standby credit is not always an attractive form of lending. "Many banks will participate in repo facilities for relationship purposes," she says. "But this is not highly profitable and it uses up credit limits." Cultivating relationships with some of the better credit risks like Argentina and Mexico can be worthwhile. But those countries have already gone through a crisis and restructured. So, Chang sees contingent repos as a post-crisis alternative.
A weakness of the IADB proposal, suggests Lex Rieffel, of the Institute of International Finance (IIF) in Washington, is that it tries to make a single generic product fit the diverse needs of many different countries. Rieffel also believes that the best standby would be strictly commercial. "Indeed," he says, "it might be viewed as a step backward if Mexico or Argentina were to negotiate one with the IADB now."
Catherine Mann, senior fellow at the Institute for International Economics (IIE) in Washington, is concerned that the Hausmann proposal would put the burden principally on the borrowing country. But she thinks that creditors should also pay to put the insurance mechanism in place. Mann points to problems on both sides of the market. She is therefore promoting the idea of creating a deep and liquid market for credit insurance options. Mann dealt with sovereign debt issues at the US Federal Reserve until this year.
Mann's credit insurance options would work like this. Countries would borrow in the credit markets, just as before. But a third party would enter the picture: the option writer. Lenders could therefore buy insurance against the risk that the country's credit-rating would go down, that it might default or that it might extend the maturity of the instrument.
These options would redistribute risk from those who can't bear it to those who want to and can. The options would drive a wedge between the borrower and the lender, reducing the supply and demand for credit at the margin. Mann likes that because she thinks that there's a problem with how much credit has been provided, and how it is priced, as well as inadequate diversification on the creditor side.
Mann points out that not all creditors would buy the insurance. And that would also be a good thing because it would create more diversity within the creditor community. So, they wouldn't all rush for the exits at the same time. Panics and herding would not be as serious.
With these options, institutions such as pension funds and insurance companies - which would otherwise need to unload low-rated bonds - would not be forced to sell into declining markets. And banks, which must add to their loan-loss provisions when payments are delayed, might react differently as well. For their part, inter-company creditors - which would otherwise write off receivables - could also continue to report revenues.
Mann says: "These creditors wouldn't need to call on the IMF in case of a crisis, if they were insured up front and paid for it." But it's not clear who these magic option-writers would be.
Even Mann and Hausmann concede that crises will still occur - though less frequently and less seriously - if their proposals or something like them eventually catch on. Others have meanwhile been thinking about how the large global banks can help the IMF once a crisis breaks out.
Ernest Stern, managing director at JP Morgan and formerly second-in-command at the World Bank, thinks that the emphasis should be on closer integration of Fund programmes with support from the capital markets. Rather than looking back and asking who is being bailed out - a term Stern says he can't fully comprehend - Stern recommends looking forward and asking: "How can you sustain capital market action and get the private sector to participate earlier than perhaps it normally would?" Stern thinks there are realistic possibilities if the approach is voluntary and it relies on market rates. But what exactly does he have in mind?
Floating spread bonds
A bond issue, of course. Stern thinks that a floating-spread - not a floating-rate - instrument would do the trick. "The key is to design the instrument so that the spread wouldn't need to be paid for a long time," he says, "and also to provide flexibility so that the interest rate can come down if and when conditions improve - either through resets or floating spreads or whatever." That way, Stern believes: "You could do a bond issue, even shortly after a crisis, as part of a Fund programme."
Today, JP Morgan is keeping its bond spread proposal under wraps, anxious not to give the competition a free ride. The question is, which investors would buy securities whose credit premium is designed to shrink or widen along with market perceptions. There's no reward there for being smarter than the market.
Yet another proposal is to tamper with debt seniority. In the past, lawyers have been quite clever about finding ways to confer de facto seniority on new lending in order to protect it from possible default.
Lee Buchheit, an attorney who specializes in sovereign debt problems at the New York firm Cleary Gottlieb Steen & Hamilton, points to precedent: "If you go back to what happened in the 1980s and look at what debt wasn't restructured - the so-called excluded debt - there were a number of different types of debt that were pretty common to most of the countries." One of those categories was trade finance. The debtors and the banks wanted to give it preferred treatment. "So, people very often say 'let's call this a trade financing' when they enter into new transactions today," says Buchheit.
Why? "Because if the balloon goes up in Ruritania and if the past is any guide," he says, "trade finance will be treated differently from unsecured commercial bank debt." There have been many efforts since the debt crisis ended in the early 1990s to "pigeon-hole" financings into categories that had been regarded as excluded debt.
Bonds, of course, used to be another category of excluded debt. In 1982, when the debt crisis started, developing countries had relied almost exclusively on commercial bank financing. The question came up whether or not to reschedule the bonds of countries in the process of restructuring their bank debt. But there weren't many of them and it wouldn't have provided much relief. Buchheit also points out that bonds can be very difficult to restructure - particularly bearer bonds.
And everybody knew that at some point the debt crisis was going to end. "When it ended," he says, "everyone expected the commercial banks to spend some time licking their wounds." These countries were going to need financing: so, not defaulting on the bonds kept that market sweet.
But Buchheit warns about using these safe havens today. "It's not foolproof by any means," he says, "because all of these instruments can be undone by their own success." If a country has a large amount of commercial bank financing that is dressed up as trade finance, Buchheit points out, one of the other creditors is likely to say: "Come on, that's not really trade finance. Rescheduling it would not seriously interfere with access to trade finance. It was just an effort to avoid the unpleasantries of a workout."
And the bonds were insulated from any rescheduling only while they were a trivial component of the country's external debt stock. "But to the extent that they now represent a huge slug of it," Buchheit says, "they become a target."
Richard Gitlin, an international debt restructuring specialist with the law firm of Hebb & Gitlin, detects at least one bright spot on today's emerging market debt scene. He believes that countries without adequate systems for resolving their corporate debt problems - both out-of-court negotiating procedures and supplemental in-court systems - are gradually putting them in place.
Creating systems for resolving interbank debt, however, is much trickier because implementing loss-sharing in a crisis can be extremely difficult and dangerous. Here, Gitlin recommends that countries should be prepared to restructure their banking systems more promptly and efficiently. That way, the countries would not be held hostage to bank creditors because they did not have a systemic bank restructuring plan.
Dealing with sovereign debt restructuring is the most difficult of all. Setting up an international bankruptcy court does not appear to be on the cards. So, the options are narrow from a legal point of view. Here, the resolution of sovereign debt crises could be eased by changes in the up-front lending documentation, particularly in the areas of voting provisions and means of compromise.
At Washington's Brookings Institution, Robert Litan, the director of economic studies, thinks that this area calls for some clear-cut rules. "The problem with not having clear rules," he says, "is that you have policy-making by seat-of-pants. But policy-makers can flinch all too easily. And investors, knowing that they will flinch, will put too much money into the wrong places at the wrong prices. Too much discretion inevitably leads down the road to moral hazard."
So, America's shadow financial regulatory committee - on which Litan serves - has weighed in with a call for mandatory haircuts to ensure that governments, private equity investors and creditors all bear the consequences of their decisions. The haircuts would come in the form of minimum automatic reductions of the principal of foreign currency loans to banks in countries which receive IMF support. But the clippers would not go into action unless creditors withdrew from the country or failed to roll over their paper before the IMF loans were paid back. On the other hand, interest rates on loans which stayed in the country would not be allowed to rise.
Countries which refused to apply these haircuts would no longer get help from the Fund or they might be required to pay a penalty rate for IMF loans. The shadow committee believes that this approach would lead to better loan pricing.
Rieffel at the IIF warns: "Automatic procedures, like the shadow committee's proposal, go against the grain of the market." He says that one of the most important lessons of the 1980s debt crisis is that voluntary workouts for private lending work best when they include an element of choice. This is largely because lenders have widely varying risk tolerances and exposures. They also operate within regulatory regimes that can treat non-performing loans in remarkably different ways.
According to Rieffel: "Dealing in the banks is OK but don't bind them in." At Brookings, Litan disagrees: "The rules proposed by the shadow committee are designed to find a halfway house between having some kind of safety net but not one that can be abused. You can always knock off the international lender of last resort - the Fed or the IMF - and in theory that would solve the moral hazard problem." But then, of course, there wouldn't be any safety net in the event of a crisis.
Morris Goldstein, the IMF's former deputy director of research and now Mann's colleague at the IIE, believes that one key step for addressing the moral hazard problem is for developing countries to adopt deposit insurance systems that are "incentive-compatible and that place large uninsured creditors of banks at the back of the queue when failed banks are resolved".
Emerging-market bank debt may start out in the private sector but it often winds up with the sovereign. Goldstein thinks that their governments could adopt several features of America's 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) to good advantage. He particularly recommends the provision which makes it difficult for regulators to protect all creditors fully when the bank is "too big to fail". Another worthwhile aspect of FDICIA is called "prompt corrective action" - a system of progressively harsher measures if bank capital falls below specific "trip-wires".
Can these new approaches motivate private lenders to help the IMF and others in the official community restore calm in global markets? And will that allow developing economies to return to the growth rates of the recent past? It is sobering to recall that, as recently as the 1980s, political forces effectively opposed large-scale bail-outs to resolve the Latin American debt crisis. And the opponents were correct. Bailing out countries rewards bad behaviour. But that choice condemned Latin America to a decade of lost growth and missed opportunities.
The events which are now unfolding could be more momentous. "My sense is that we are witnessing an extremely rare situation - something one might see once every 75 years or so," says David Folkerts-Landau a senior manager at Deutsche Bank. But if these events all come a cropper and the IMF runs out of money, the Fund could also turn to a last resort.
Nobody likes to talk about it, but officials in Washington are quietly debating whether to reinterpret part of the IMF's charter - Article 8(2)b. The effect of such a move could be devastating. This part of the IMF's charter allows countries to control what it calls "exchange contracts" for the purchase and sale of their own currencies, so long as those controls don't violate other aspects of the Fund's articles of agreement.
Not many people have been affected so far because the courts have taken a narrow view. They've said that 8(2)b applies to currency trading and nothing else.
But investing across borders also involves what could be described as "exchange contracts" to convert foreign currency and this is where there is enormous scope for expanding 8(2)b in order to restrict foreign debt payments whenever a crisis breaks out. That would be a radical break with the past which would shift the balance dramatically towards borrowers. But with bail-outs under fire, this approach just might look tempting.
The prospect is extremely disturbing to observers such as Nancy Jacklin, a partner at Clifford, Chance in New York. She warns: "I certainly couldn't predict what the effects might be." But key players have been arguing behind closed doors that it would be the ultimate way to make bank lenders more responsible.