Redesigning the international lender of last resort

ABSTRACT This paper is concerned with the issue of how to balance bailouts (or "lending into arrears") with debt reductions (or "private sector involvement") in the resolution of sovereign debt crises. It provides a review of recent proposals for improving the sovereign debt restructuring process. In addition to defending a sovereign bankruptcy proposal we have put forward in recent work, this article proposes a major reorientation of the IMF's role in sovereign debt crises. I. INTRODUCTION Since the Mexican Debt Crisis of 1994-95, which gave rise to an International Monetary Fund ("IMF") bailout of unprecedented size, there has been a raging debate on how the IMF should handle sovereign debt crises. Despite the successful resolution of the crisis and Mexico's quick repayment of all its emergency debt, the sheer size of the intervention has raised worries that bailouts could cause significant sovereign debt market distortions. These concerns, in turn, have led to a reconsideration of the prevailing wisdom that the IMF can and should act as the de facto international lender of last resort ("ILOLR") by arranging bailouts in response to major sovereign debt crises. As is now widely recognized, the problem with a purely bailout-based policy is that it requires ever larger funds to be credible and successful. It also invites undesirable policies by debtor countries. The prospect of a bailout encourages sovereign debtors to borrow more than they should, and it tempts them to resort to highly risky fixed exchange rate policies as a quick fix towards macroeconomic discipline.1 Of course, the worst debtor misconduct can be controlled to some extent by imposing conditions on the debtor country before granting a rescue program, but more often than not, the IMF finds itself in a weak bargaining position at the onset of a debt crisis. How credible is the IMF threat to withhold a financial aid package when a potentially contagious debt crisis is about to erupt? And once the bailout has been granted, why should the debtor country abide by the conditions it agreed to? Because of the potentially enormous financial commitment a pure ILOLR policy requires, and because of the moral hazard it may induce in sovereign debt markets, it is now widely understood that bailouts need to be supplemented by at least a partial "bailin" of the private sector. According to this view, the IMF's involvement in a debt crisis should be conditioned on debt reduction or rescheduling by private sector lenders. Private creditors should be required, that is, to share at least some of the costs of resolving a crisis. Despite this emerging consensus on the importance of private sector involvement, however, there is still considerable disagreement on the appropriate balancing between bailout and bailin, and on the best process for crisis resolution and debt restructuring. The most ambitious overhaul of IMF policy contemplated so far involves the introduction of some form of bankruptcy institution for sovereigns and envisions a single forum where the extent of debt reduction and the size of new emergency lending would be decided simultaneously. There was considerable discussion and research of this strategy-which the IMF calls a Sovereign Debt Restructuring Mechanism ("SDRM")-from late 2001, when the IMF first announced its support for a sovereign bankruptcy framework, up to the G-10 meetings in April 2003, when the IMF's proposal was shelved. Despite all the writing and debates, many open questions were still unresolved at the time of the G-10 meetings, including the role of the IMF in an SDRJVI regime. No doubt these questions would have received further attention if the SDRM proposal had gone forward. But in the aftermath of the SDRM debate, no clear new role has been marked out for the IMF and no clear rules have emerged to direct the IMF's balancing of bailins and bailouts in future debt crises. As a result, the IMF now finds itself at a crossroads. …