An Important IMF Reform
The world became a bit safer last month—at least at one margin. The International Monetary Fund (IMF) adopted a lending reform with important implications for the future stability of the world economy.
To understand the reform, one has to start with financial globalization. Over the past few decades, cross-country financial flows have increased, and countries have built both large asset and liability positions, often in the range of 50 to 100 percent of GDP. Their net liabilities may be small or even negative. But in an external crisis, what matters is not net but gross liabilities, at least those that are relatively liquid. This is the amount of money that can potentially leave the country if investors decide to repatriate their funds.
This raises challenges for IMF lending.
When dealing with a country that needs external financing, the IMF often faces a difficult choice. It has to decide whether the country is facing a solvency problem, which requires debt restructuring as part of the program, or whether the country is facing a liquidity problem instead, in which case debt restructuring is not needed. But distinguishing between a problem of solvency or liquidity is often difficult at the start and only becomes clear as time passes.
This suggests that, unless the choice on whether to restructure debt is clear from the start, it is best to wait until what should be done becomes clearer. But this raises a fundamental issue. While the decision is postponed, the IMF program must be ready to provide enough funds to pay any creditors who want to exit before debt restructuring happens, were it to happen. Given the size of gross liabilities, covering such creditors may require a very large program. And should debt restructuring be required later, it will involve very large haircuts on those creditors who remain. Indeed, by then, there may be so few private creditors left than even a full write-down of their claims may not be sufficient to make debt sustainable. In that case, the country's ability to reimburse the Fund may be in question.
This conundrum, however, can be solved in a conceptually straightforward way. If the choice is uncertain at the start, the Fund should wait until it becomes clearer—but it should also implement, from the start, an extension of maturity on all or most creditor claims (the term used by the Fund is "debt reprofiling," the delay of principal payments falling due during the program, with little or no decrease in the net present value of those payments).
Doing so means that if and when debt restructuring takes place, it will fall on a larger set of creditors, with smaller haircuts for each one. And by avoiding the need to have the funds to repay those creditors who would have exited, the program can be much smaller in size than it would otherwise need to be. There are other benefits, too: The "financing" provided by the reprofiling can provide space for a more gradual, and thus less growth-damaging, fiscal tightening. And politically, the potential bail-in of private creditors makes it easier to push through the fiscal and other reforms (usually needed in such situations) with taxpayers.
Allowing such reprofiling is what the reform passed last month has done. Until now, the rule for large (so-called "exceptional access") IMF programs was that, unless debt was judged to be sustainable with "high probability," debt restructuring had to be done at the start. Following this rule implied that debt restructuring would take place even if, ex post, it could sometimes have been avoided. But the rule also led to the temptation to create arbitrary exemptions for "systemic cases," or to pretend that debt was sustainable even when it was not, so as to avoid debt restructuring at the start.1 This in turn did not fool creditors and often led them to exit as fast as they could. By allowing for reprofiling in cases where debt sustainability is not clear-cut, the new rule makes it easier to make the right decision without imposing unnecessary costs. It also requires private investors to accept the consequences of the risks they are paid to take, which should help instill more discipline in sovereign debt markets and make future crises less likely.
Last but not least, by allowing for much smaller programs, this reform implies that the Fund will most likely have enough funds to help countries in trouble in the future.
1. Another part of the reform is indeed the removal of the so-called "systemic exemption." More details on that are best left to another post, but the Fund's own candid discussion can be found on its website.