Select Committee on Treasury Written Evidence

Memorandum submitted by Professor Sayantan Ghosal, Dr Emanuel Kohlscheen and Professor Marcus Miller, University of Warwick and CSGR



  This paper relates to the first topic for investigation in the inquiry, namely the impact of globalisation on the current and future roles of the IMF.

  In considering the issues of (a) Reserve Acquisition and Reserve Pooling; (b) Moral Hazard and Political Economy; and (b) Sustainability and Debt Swaps, we draw on three papers we are to present at the Easter Meetings of Royal Economic Society[54], namely:

  (1)  Emanuel Kolscheen: "International Liquidity Swaps: an Assessment of the Chiang Mai Initiative";

  (2)  Sayantan Ghosal and Kannika Thampanishvong "Optimal Sovereign Debt Write-downs"; and

  (3)  Sayantan Ghosal and Marcus Miller: "Growth, sustainability and delay: a

model of sovereign debt restructuring".

1.   Introduction: Setting up the IMF

  When the IMF was established at Bretton Woods in 1944, it was to oversee and help manage a global system of "fixed but adjustable" exchange rates. Countries were only meant to change exchange rates in "fundamental disequilibrium"; and one role of the Fund was to judge whether or not this was the case.

  Another key role for the Fund was to provide short-term financial support to countries experiencing payments difficulties. With speculative flows held in check by controls on international capital movements, it was anticipated that the resources of the Fund would be used for temporary assistance to members in financing balance of payments on current account, Crockett (1977, p 217).

  The contribution of each member to the IMF's financial resources was (and is) determined by its assigned "quota", broadly determined in relation to a country's size and its openness—a quarter paid in the form of widely accepted hard currency, the rest in own currency. A country's quota determines both its borrowing rights and effectively the weight it has in the weighted majority voting of the Executive Board, where decisions require a simple majority, except for constitutional issues where a supermajority of 85% is necessary[55].

  The size of the Fund itself is decided by a vote of the members in the Annual General Meeting of Governors, every five years at least. When it was first established in the 1940s with 45 member countries, total quotas subscribed amounted to about two percentage points of global GDP[56]. Though the 1998 quota review saw a substantial increase in the value of quotas to about $300 billion, the review of early 2003 resulted in no change in quotas. Despite the increase of membership, total quotas are now only about one percent of global GDP[57].

Capital Account Liberalisation

  Increased freedom of transactions on capital account have wrought major changes, however. In the first place, with markets able to anticipate adjustments in pegged exchange rates by speculative flows, the Bretton Woods system of fixed-but-adjustable exchange rates was no longer viable: and it came to an end in the early 1970s, when countries were free to adopt floating exchange rates. Secondly, potential calls on IMF resources could now be driven by adverse capital flows, with the need to speed up IMF lending in response to capital account reversals being discussed as early as 1972 (De Vries, 1985).

  As capital account liberalisation accelerated in the 1990's, "capital account crises" became widespread, beginning with that of the European Exchange Rate Mechanism in 1992-93. After an initial widening of currency bands, the European response has been closer monetary and political integration, leading to the abolition of many national currencies and the creation of the euro. But emerging market countries with implicit or explicit pegs against major currencies have remained exposed to repeated financial crises, beginning with the Mexican peso crisis of 1994-95, and soon followed by the East Asian crises of 1997-98 which the economist Jeffrey Sachs likened to a "bank-run".

  The rise in sovereign spreads consequent upon the Russian default of 1998 exposed many Latin American and other emerging markets with substantial external debts in dollars to self-fulfilling runs. Indeed, in a recent IMF Discussion Paper advocating a Country Insurance Facility, Cordella and Levy-Yeyati (2005, p 3) conclude that there is "an increasing consensus that self-fulfilling liquidity runs have triggered many of the recent financial crises, as sudden increases in perceived rollover risk set off an escalation of interest rates that rendered otherwise sustainable debt levels unsustainable"[58].

  The initial reaction by the IMF to such events was to assemble financial packages ("bailouts") involving levels of assistance much larger than the two-times-quota seen as an appropriate limit for current account crises. IMF disbursements were about five times quota for Mexico (1995), 18 times for Korea[59] (1998), 7.7 times for Brazil (2001 and 2002 combined) and 17 times for Turkey (1999-2001 and 2002 combined)[60]. Latterly, however, the IMF has sought to limit its exposure by recommending policy changes by the debtor—with respect to exchange rate for example—and debt restructuring or "bail-ins" for creditors[61].

  The reaction by many emerging economies has been self-insurance by the accumulation of international reserves. For a sample of 35 emerging markets, reserve holdings measured on this basis has doubled over the last decade—from 8.9% of GDP in 1992 to 18.1% in 2002[62]. Korea and China hold reserves valued at 22% of GDP. There have been moves towards co-insurance at a regional level: and suggestions for novel co-insurance provisions by the IMF.

Key issues for debate

  Ex ante mechanisms to help prevent capital market crises:

    (a)  a shift towards floating—but managed—exchange rates;

    (b)  the increase in owned-reserve positions since the East Asian crises of 1997-98, particularly by countries in the region (Jeanne and Ranciere, 2005);

    (c)  the development of intra-regional co-insurance mechanisms such as the Chiang Mai agreement of SE Asia (discussed in section 2 below);

    (d)  the creation of an automatic Country Insurance Facility (CIF) as a complement to existing IMF arrangements ( Cordella and Levy-Yeyati, 2005); and

    (e)  possible use of capital controls (Levy-Yeyati, 2005).

  Ex post mechanisms for crisis resolution:

    (a)  Collective Action Clauses (see, for example, Sayantan Ghosal and Kannika Thampanishvong, 2005a);

    (b)  The risks that governance problems pose for IMF lending and implications for conditionality (discussed in section 3 below); and

    (c)  Improvements in bilateral bargaining procedures (discussed in section 4).

2.   Ex ante co-insurance: Regional Agreements

  A new form of coinsurance has emerged in East Asia: the network of bilateral swap agreements (BSAs) launched under the Chiang Mai Initiative. A BSA is a bi-lateral arrangement that gives either signatory access to a fixed amount of the co-signatory's international reserves, upon request. China, Japan and South Korea have now signed such agreements with each other and also with Indonesia, Malaysia, the Philippines and Thailand. The total amount of these agreements (U$ 37.5 billion) may be small compared to the volume of international reserves accumulated by the larger economies of the Far East in the last few years: but for smaller economies[63] the amounts involved are significant and already correspond to about four times the reserve tranches of these countries at the IMF[64].

  The network has already been seen by some observers as the first step towards an Asian Monetary Fund. While there is no evidence that BSAs have so far affected bond valuations, Kohlscheen (2005) finds that the network reflects the potential gains from co-operation in that larger agreements have been signed between countries for whom international reserves tend to move in opposite directions. He points out that the same economic logic implies that BSAs could be signed between countries of different regions (eg Asia and Latin America).

  The increase in the prevalence and magnitude of the BSAs (the Chinese government has already pledged to double its commitments) brings important politico-economic questions to the forefront. Although they have yet to be tested, the existence of regional networks that can quickly supply liquidity may provide an additional line of defence and help shield signatories from the perils of sudden capital flow reversals. Bilateral or regional swap agreements could lead to a more efficient use of existing international reserves—possibly reducing the aggregate demand for international reserves. This may change demand for IMF resources from signatories.

  Could the prevalence of such regional arrangements lead to a "moral hazard" problem as countries that are members of such networks underinsure themselves? Given the substantial accumulation of own reserves, this does not appear to be an issue. Note too that 90% of the disbursements are conditional on the existence of an IMF programme.

3.   Governance issues

  Provision of ready access to foreign exchange to help insure against crises may seem a clear welfare improvement: and if debtor countries are well-governed and the use of loan facilities subject to explicit "conditionality", the possible perverse effects on incentives—the problem of debtor moral hazard—may not seem an issue. But what if there are problems of governance and there is an interaction between international bailouts and domestic policies?

  In these circumstances, as two economists from the IMF have argued, "The international financial safety net increases the scope for bad policies as well as good policies. Increasing the borrowing capacity in such circumstances may lead to worse outcomes, not better. International bailouts can help countries implement good policies, but they could also make the consequences of bad domestic policies much worse." Jeanne and Zettlemeyer (2001, p 411).

  In the paper they are to present at the RES conference, Ghosal and Kampanishvong (2006) consider the situation when government is by an elite which is not representative of the population as a whole. Instead of providing public goods, such as health, education and social infrastructure, the elite pursues its own idiosyncratic objectives with an emphasis on short-run payoffs. It may, for example, use public funds for ostentatious investment and conspicuous consumption: additionally, public borrowing offshore may be diverted to finance the acquisition of private bank accounts in safe havens such as Switzerland, where ownership of accounts is not divulged.

  Where poor governance involves domestic distributive conflict and myopia, the authors argue that conditionality imposed by external funding agencies can and should be designed strategically to help deal with such issues. Debt write-downs can be made conditional on government's provision of public goods, for example; and limits may be imposed on new issuance of public debts and on taxes levied on the non-elite[65]. If not, external support may simply provide more resources for the elite to misuse. The paper cited focuses on African countries, but the problems of governance they discuss are much more widespread.

  In emerging markets of East Asia and Latin America, where private external finance is readily available, the provision of financial bailouts may have perverse incentive effects on creditors. For if creditors know they have an exit option, they will have less incentive to monitor the uses to which their funds are being put; and will be willing to lend at lower rates. This problem of creditor moral hazard will be reflected not in high sovereign spreads but by a "rush for the exit" when prospects take a turn for the worse.

  If the creditors do not charge high spreads for the risk of default, who pays? It is a popular fallacy that the international community pays, via the lending programmes of the IMF and World Bank. But it has been shown beyond any reasonable doubt[66] that IMF lending does not mask economic transfers: except for some poor countries, the Fund lends short term and recovers its money. A key feature of the economic programmes that accompany IMF packages is the requirement that the debtor does repay the IMF in full: otherwise the IMF would be driven out of business.

  In the absence international transfers and of a significant write-down of private debt, it is therefore the debtor that pays—and this will typically mean the non-elite. By allowing for exit by the private lenders, but insisting that it is paid in full, the IMF must needs use the conditionality of its lending to extract ex post what capital markets would have charged ex ante: and it is often the non-elite who bear the burden of earlier excess borrowing.

4.   Ex post resolution: Delay in Debt Swaps

  In the late 1990s the IMF took steps to extricate itself from the invidious position of acting as debt collector for careless creditors; the idea being to "bail in" the creditors rather than bail them out. The high point of this attempt came in 2001 when Ann Krueger proposed an official Sovereign Debt Restructuring Mechanism, based on Chapter 11 of the US bankruptcy code, to oversee debt write downs ex post.

  This initiative was rejected, however. Instead, as the case of Argentine has shown, write-downs may need to be negotiated in face-to-face bargains between debtor and creditors, without the intermediation of the IMF[67]. (In future, such negotiations should be expedited by the widespread incorporation of Collective Action Clauses into sovereign debt contracts.)

  While creditors have been "bailed- in" in several recent cases, negotiations proved to be fairly lengthy. Default by Ecuador, for example, which led to a 60% "haircut" (write-down of face-value) took a year to resolve. The defaults by Russia and Argentina, which involved the largest amounts of debt (around $30 billion and $80 billion respectively) and resulted in the largest haircuts (closer to 70%), both took a year and a half of negotiation.

  In the paper they are to present to the RES, Ghosal and Miller (2006) focus on reasons for delay in bargaining, with special reference to the case of Argentina[68]. A model of bargaining is used to show that settlement may well be delayed until the economy recovers: and delay occurs when growth prospects exceed the rate of discount. In addition, however, the need to ensure a sustainable settlement appears to have played a key role in the Argentine debt negotiations, as the debtor was desperate to avoid a repeat experience of default.

  When bargaining is adapted so to reflect concern for sustainability, this tends to increase in the debtor's bargaining power; but asymmetric information about the debtor's situation increases the likelihood of delay. The debtor claims that the write-down is needed to ensure economic viability, but the creditor isn't sure if that is true: delay is one way that the debtor can make the point. Could this been why the Argentine episode involved the longest delay—and largest write-down—in recent sovereign debt restructuring[69]?

  If sustainability is a key factor—but creditors are unsure about the details—the IMF could help to reduce delay by providing reliable information: where sustainability conditions are made common knowledge, there is no need for the debtor to use delay as a signalling device[70]. A potentially serious challenge to carrying out this informational role is that the IMF, as senior creditor, faces a "conflict of interest": there is presumably an incentive to exaggerate sustainability requirements in favour of the debtor so as minimise other claims on the debtor's resources. Perhaps such induced compassion for debtors would be checked by its creditor-dominated Executive Board? If not, this informational task could be delegated elsewhere: to the IADB for example.

5.   Conclusion

  Increased mobility of capital has opened a Pandora's box of issues for discussion. In this submission we have focussed on three that have implications for the IMF: the provision of ex ante co-insurance through regional swaps that could reduce the calls on IMF resources; governance problems in borrower countries which may limit the IMF's incentives to provide co-insurance; and the delays that may attend ex post resolution in the absence of agreement of the parameters involved. The last of these suggests a role for the IMF as provider of information and judgement on issues of debtor sustainability—so long as its credibility is not compromised by conflict of interest.

REFERENCESCordella, T and E Levy-Yeyati (2005) "A (new) Country Insurance Facility". IMF Working Paper No 05/23.

Cohen, D and R Portes (20040 "Towards a Lender of First resort" CEPR DP. No 4615, London: CEPR.

Crockett, A (1975) International Money. Sunbury-on-Thames: Nelson.

De Vries, M (1985) The International Monetary Fund, 1972-1978. Washington:IMF.

Dhillon, A, J Garcia-Fronti, S Ghosal and M Miller (2006) "Debt Restructuring and Economic Recovery: Analysing the Argentine Swap". The World Economy, (forthcoming). Available at:

Ghosal, S and M Miller (2006) "Growth, sustainability and delay: a model of sovereign debt restructuring". Mimeo. University of Warwick.

Ghosal, S and K Thampanishvong (2005) "Bargaining, Moral Hazard and Sovereign Debt Crisis" Mimeo. University of Warwick.

Ghosal, S and K Thampanishvong (2006) "Optimal Sovereign Debt Write-downs" Mimeo. University of Warwick.

Irwin, G, A Penalver, C Salmon and A Taylor (2005) "Dealing with country diversity: challenges for the IMF coinsurance model" Paper presented at LACEA 2005, Paris.

Jeanne, O and R Ranciere (2005) "The optimal level of international reserves for emerging market countries: formulas and applications" Mimeo, IMF.

Jeanne O and J Zettlemeyer (2001). "International bailouts, moral hazard and conditionality" Economic Policy, vol 16, Issue 33, pp 409-32.

Kohlscheen, E (2005) "International Liquidity Swaps: an Assessment of the Chiang Mai Initiative" Mimeo. University of Warwick.

Levy Yeyati, Eduardo (2005), "Tras el canje de deuda vuelve el control de capitales version 2005", Cronista Comercial. Buenos Aires. 26 February.

Rochet, J-C. (2005) "Optimal Sovereign Debt: An analytical approach". Mimeo. University of Toulouse.

Roubini N and B Setser (2004a), Bailouts or Bail-ins? Responding to Financial Crises in Emerging Economies. (Washington DC: Institute for International Economics).

Roubini N and B Setser (2004b), "The Reform of the Sovereign Debt Restructuring Process: Problems, Proposed Solutions and the Argentine Episode" Journal of Restructuring Finance, 1, 1, 173-84.

Porzecanski, A C (2005) "From Rogue Creditors to Rogue Debtors: Implications of Argentina's Default". Chicago Journal of International Law, 6(1) pp.311-32.

January 2006

54   The papers will posted on the Royal Economic Society website; (1) and (3) will feature in a Special Session at the Meetings. Back

55   Though votes are seldom taken, the voting rules are nonetheless important: the fact that the US has a 17% share of the subscriptions means that it has a veto on any change of the Fund's Articles, for example. Back

56   Irwin et al (2005). Back

57   World GDP was valued at $32, 300 for 2002, The Economist, Pocket World in Figures, 2005 Edn. Back

58   See Cohen and Portes (2004) for a similar diagnosis. Back

59   In the case of Korea, however, when outflows threatened to overwhelm the $41 billion assembled as first and second lines of defence in this way, G7 countries engineered a successful "bail in": instead of raising fresh funds to finance the exit of banks, they persuaded their banks to roll over their lending to the country. Back

60   See Roubini and Setser (2004a). Additionally, in most cases except Turkey, the amounts made available were substantially augmented by other bilateral commitments mainly supplied by G7 countries (Roubini and Setser 2004a, Table 4.1). Back

61   Roubini and Setser (2004a) Chapter 4 "Experience with Bailouts and Bail-ins" provides a good review. Back

62   Cordella and Levy-Yeyati (2005). Back

63   Such as the last Indonesia, Malaysia, the Phillipines and Thailand. Back

64   For the Philippines, for example, the $5.3 billion made available through BSAs amounts to about a third of its stock of international reserves. Back

65   In similar vein, Rochet (2005) argues that crisis lending by the IMF may need to be accompanied by a constitutional amendment limiting debt creation by the government. Back

66   See Jeanne and Zettlemeyer (2001). Back

67   See Dhillon et al (2005) for a bargaining approach applied to this case. Back

68   The delay between Argentine default and restructuring (40 months) was a lot longer than the period of negotiation (19 months): this is because the interim administration appointed in early 2002 regarded debt restructuring as outside its competence so negotiations did not commence until President Kirchner was elected in mid-2003 with a mandate to negotiate. Back

69   Some observers argue that the Argentine swap has a new era of the rogue debtor, Porzecanski (2005). If so, one would expect sovereign spreads to rise sharply as creditors "price in" the cost of future write-downs. As yet, there is no sign of that. Back

70   In their assessment of the reasons for delay, add that the IMF can play a key role in coordinating creditors Roubini and Setser (2004b): they also argue that the IMF could orchestrate "debtor in possession" finance, Roubini and Setser (2004a). Back

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