Don't Restructure Debt, Reprofile It
The International Monetary Fund (IMF) is considering a big shift in its lending rules. Eager to avoid a repeat of the massive loans it provided to the hopeless case that was Greece in 2010 (pdf)—and Argentina in 2003—the Fund has just released a staff paper that proposes two major changes in its policy framework.
First, the paper argues that the Fund should explicitly recognize that some sovereign crises fall in a messy middle—neither clear-cut insolvency, nor a temporary balance-of-payments problem. This gray zone calls for a new approach to crisis management.
When a sovereign is clearly insolvent, the IMF normally insists that the country default on its major creditors and restructure its debt to them. Without a debt restructuring in such cases, IMF financing would just throw good money after bad by bailing out private creditors and absolving them of poor lending decisions—while at the same time saddling a country’s taxpayers with more debt that can’t be written down.
This proscription on lending to insolvent countries gives IMF members an incentive to prevent crises, and gives creditors an incentive not to over-lend. By making it clear that the fire station has only limited water, countries and their creditors should be more inclined to build fireproof financial houses.
If, instead, a country merely (“merely”!) faces a temporary liquidity gap and the IMF can certify with a “high probability” that the country’s debt will remain sustainable, then the Fund can step in with loans to help see the country through.
The trouble is, the line between insolvency and illiquidity is much fuzzier for a country than a corporation.
A corporation is clearly insolvent when it is unable to pay its debts and its assets are less than its liabilities. For a country, present and future tax revenue represents its major asset. But the size of this asset hinges on how much the government is willing to tax its citizens and how willing the citizens are to tolerate austerity.
This tolerance varies widely: Latvians are legendary for weathering brutal cuts that slashed their annual per capita income by a fifth during the late 2000s. Most governments, fearing revolt, would have thrown in the towel and restructured their debt long before reaching such extremes.
Reprofiling instead of restructuring
Knowing that a debt restructuring increases by half (pdf) the chances that a finance minister could be sacked, most administrations opt to avoid a default any way they can. And sometimes they get away with it. Countries that pundits, Wall Street and even some IMF staff privately wrote off as insolvent—see Turkey and Brazil in 2002—have managed to whistle by the default graveyard with support from the Fund.
So rather than stretching credibility by certifying such cases as sustainable with “high probability,” the proposed new policy would allow the Fund to lend in situations where the outcomes look less certain. Creditors would be asked to defer or “reprofile” their debt-service payments for a number of years, in the expectation that the country’s adjustment program would enable it to return to growth and pick up these payments at a later date.
There are some good precedents for this approach. Faced with looming bulges in their debt-service obligations, Uruguay in 2003 and Dominican Republic in 2005 reprofiled their debt with IMF support. Both recovered quickly and the hit to their creditors was small.
These aren’t cases of “wait and see” but rather “work and see.” The IMF loans don’t eliminate the need for a country that reprofiles its debt to undertake massive reforms. Instead, they give the country the breathing room necessary for these reforms to work.
If they do work, it’s a win for everyone: the country avoids a default, a loss of market access, a potentially disruptive change in government and a massive hit to its standard of living. Creditors skirt a write-down of their claims. And the drag on IMF resources is reduced. Meanwhile, if these reforms don’t work, the country can proceed to a restructuring under fairly orderly circumstances.
A more honest approach to evaluating risk
Reprofiling is arguably a big improvement on the fudge the IMF executive board adopted in 2010 (pdf) to enable it to lend to Greece.
In May of that year, the IMF staff was unable to project with “high probability” that Greece’s adjustment program would make its massive debt burden sustainable. But Europe was unprepared for a restructuring of Greek debt and needed to buy time to get ready.
To permit a loan to Greece that was about five times larger than the country’s normal IMF credit limit, the Fund’s board gutted the “high probability” requirement for certain cases, such as crises inside currency unions, where a default risks triggering an international meltdown.
Like St Augustine’s plea “Lord, make me chaste—just not yet”, IMF board members effectively said “tie our hands, except when we most want them unbound.” Given the risks the world faced, they arguably had little choice: the constraints they had earlier put on themselves were simply too tight.
Many IMF member countries have argued, however, that this change was both ad hoc and unfair: ad hoc because a major policy change was made in the same meeting that approved a loan; unfair because small countries outside a rich economic club such as the euro zone will never qualify for this special treatment.
So the second major proposal in the recent IMF paper calls for the elimination of this exception. This would make the Fund’s credit decisions less arbitrary by moving the IMF’s lending rules back to a sweet spot where they constrain its behaviour, but not so much that the rules have to be cast aside the first time they’re tested.
Even if these two good proposals are adopted by the IMF board later this year, it’s not clear the reprofiling option they would enable will actually be used. There’s still a lot of stigma associated with going to the IMF for help. No country wants to be told its debt isn’t “sustainable with high probability.” So when countries do seek IMF assistance, they will likely still argue that their debt needs neither a relatively gentle reprofiling, nor a more profound restructuring.
The beauty of an IMF-supported debt reprofiling is that it takes the final assessment of sustainability away from the IMF staff and hangs it on the ability of a country’s reformers to convince financial markets that their public finances are sound.