Proposals for Bailing In the Private Sector: A briefing note
The concept of “bailing in”, sometimes described as “private sector involvement” (PSI), has become a prominent theme in proposals for global financial reform in the wake of the emerging markets financial crises in Asia, Russia and Brazil during 1997-98. The G-20, the Financial Stability Forum and the IMF are currently considering various sorts of bailing in mechanisms. The principle is simple: how to prevent short-term private investors from fleeing emerging markets during times of instability. ‘Bailing in’ is meant to stem the disastrous effects of sudden reversals of short-term capital flows on foreign exchange liquidity, exchange rates and solvency within crisis economies. It also hopes to force short-term investors and creditors to bear a portion of the costs of crisis, rather than being bailed out through heavily conditioned international rescue packages (a prominent theme in critiques of past IMF rescue packages). Finally, as proposed by groups such as the IMF, bailing in is intended as an alternative to outright default on sovereign debt obligations. In this sense, it is seen as a safeguard of general systemic stability, and a way of ensuring a speedy return to national credibility in international financial circles, thus ensuring future access to global capital markets.
A number of more specific mechanisms have been proposed as means to encourage ongoing private sector involvement in the prevention and resolution of financial crises. These include:
These are focused primarily on short-term interbank credit lines (i.e. short-term lending from international to domestic banks). In this ad hoc approach, the monetary authorities in the key financial centers (e.g. the U.S. Federal Reserve) apply ‘moral suasion’ to persuade creditor banks under their supervision to maintain exposure in crisis economies, and to cooperate in debt restructuring (thus, ‘concerted rollovers’). A recent example can be found in the 1998 Korean bailout, but it also describes the response of the U.S. Treasury to threatened Latin American defaults in the early 1980s. Groups such as the IMF which have opposed more formalized institutional structures (e.g. an international insolvency court) have favored this sort of ad hoc approaches for their flexibility and adaptability to the circumstances of individual crises.
Con: The willingness of creditor governments and banks to participate in concerted rollovers will depend heavily on the perceived ‘systemic significance’ of debtor economies. Historically, they have worked best where creditor governments (especially the U.S.) have perceived a strong national interest in encouraging a concerted rollover. There is also a danger that the prospect of impending rollovers (e.g. news that a country has entered into talks with the IMF) might spark the very sorts of runs they are intended to mitigate, as creditors rush to get out before being trapped in a concerted rollover.
Guaranteeing New Debt
In this scenario, official creditors (including the international financial institutions) would offer full or partial guarantees (‘enhancements’) of new debt extended during times of financial instability. This is seen as a way of persuading risk-averse creditors to extend financing during or in the wake of financial crises, thus easing foreign exchange liquidity and solvency crunches. It is also seen as a way of leveraging (i.e. maximizing the effectiveness of) limited official lending resources (Nb: the principle here is the same as the ‘Brady Bonds’ of the 1980s, except that guarantees are offered to new, rather than existing, debt).
Con: Enhanced debt has in the past been more expensive for developing countries (i.e. offered at higher interest rates). Concerns have been raised that the limited official resources available for other types of lending might be crowded out by the extensive use of official debt guarantees. It is also feared that the accumulation of highly inflexible debt could contribute to future financial crises. As practiced by the IMF and World Bank, debt guarantees have also been closely tied to ‘policy performance’, thus becoming another means of enforcing conditionality.
Contingent Credit Lines
Private: These would function as a sort of insurance policy: countries would pay a negotiated fee to private banks for access to a standing line of credit, which could be drawn upon in times of crisis (as defined by contractually agreed upon ‘triggers’). This would ensure an inflow of liquidity (including much-needed foreign exchange) that would help to counter capital shortages in financial crises.
Con: Identification of an appropriate trigger mechanism could prove contentious. Creditor banks are likely to design their CCLs in such a way that credit lines are invalidated in crises perceived to be brought about by ‘irresponsible’ behavior on the part of borrowing governments. (By crude analogy to the insurance principle, you can’t collect fire insurance if you burn your own house down). Despite their limited introduction in Argentina and Mexico, it is also unclear whether private banks would be willing to furnish such credit lines (at affordable prices) to all crisis-prone economies. The high price of CCLs might make them unattractive or unfeasible for many developing countries.
IMF: These were introduced in April 1999. The IMF CCLs operate according to the same general insurance principle of private CCLs, but are focussed specifically on combating contagion effects within ‘fundamentally sound’ economies faced with a sudden loss of investor confidence due to events elsewhere.
Con: ‘Fundamentally sound’ here as elsewhere generally indicates countries who adhere closely to the IMF economic model. Access to CCLs is thus likely to reflect countries’ relative standing in the eyes of the IMF and the vigor with which they pursue IMF-sanctioned structural adjustment programs. As indicated by IMF statements linking CCL eligibility to progress in policy reform, CCLs are, like the instruments described above, likely to strengthen IMF conditionality.
In this proposal, debt instruments would be structured to vary countercyclically against overall economic developments; that is, in good times, debt payments would be increased (or payment schedules accelerated), while in crisis times, debt payments would be lightened (or payment schedules decelerated). Like the other options listed above, this requires some sort of contractually agreed upon trigger. For economies heavily dependent upon a single export, this might be the world price of a particular commodity – e.g., for oil exporters, this might mean floating the debt-service burden against the world price of oil.
Con: The problem of assigning responsibility for crisis and defining an appropriate trigger remains. The oil example is probably the easiest and clearest-cut example, because the trigger (the world price of oil) would be so clearly external to a small indebted economy. Things are more complicated in the case of factors over which national governments are supposed to have some control. IMF economists describe the ‘moral hazard’ likely to result if debtor governments know they have debt-service insurance or CCLs to fall back on, and use that insurance as way of avoiding painful but necessary structural changes. To overcome this, most proposals seek to make debt-service insurance arrangements dependent upon triggers that are ‘objective’ (i.e. beyond the influence of debtor governments), and to limit contractual obligations in circumstances in which the actions of recipient governments are perceived as a contributing factor to the crisis. Thus, like the IMF-led initiatives described above, debt-service insurance arrangements may strengthen conditionalities (in this case, market conditionalities) that restrict the room for an independent monetary and fiscal policy.
Bond Restructuring (Collective Action Clauses)
In contrast to earlier crises, where most of the debt was owed to a relatively small group of international banks, much of the current short-term debt burden is owed to a more diverse group of private holders of sovereign bonds. The diffuse character of bond-holders makes reaching agreement on restructuring bonds (e.g. extending maturity dates) extremely difficult. Various official bodies (e.g. G10, IMF) have proposed that ‘collective action’ or ‘sharing’ clauses be written into sovereign bond contracts, which would allow qualified majorities to negotiate changes in the terms of the bond (including maturity dates) without threat of legal action by dissenting bond-holders. This would facilitate countries’ ability to reach agreement with creditors during times of crisis.
Con: Presently, most sovereign bond issues do NOT include such clauses. The fear has been expressed that their inclusion will reduce the value of developing country bonds (because investors will perceive them as riskier), thus increasing the costs of raising capital on global markets. Developing countries have accordingly been reluctant to include collective action clauses in their bond contracts. The IMF has urged developed countries to take the lead by introducing collective action clauses into their own new bond issues, as a way of standardizing their use (Canada introduced such clauses into its foreign currency bond issues in April 2000).
Official Canadian Positions
Minister Martin has supported the principle of private sector involvement in dealing with financial crises, while endorsing a strong management role for the IMF in monitoring national financial sectors and disseminating information. He has rejected the Meltzer Commission’s recommendation that IMF crisis lending be limited to 120 days (plus a single rollover period, with penalty), arguing instead for the IMF’s need for flexibility in responding to crisis situations. Minister Martin has supported two proposals related to bailing in efforts: first, the introduction of collective action clauses in sovereign bonds (as noted above, Canada took this step in its own bond issues in April 2000); second, the idea of debt stand-stills, described by Martin before the House Standing Committee on Foreign Affairs and International Trade (May 18, 2000) as “a temporary halt on the repayment of debt” that “creates a breathing space during which a country could negotiate with its creditors and devise a solution to its underlying problems.” Minister Martin suggests several possible forms a stand-still mechanism could take: first, a universal debt rollover with a penalty (UDROP); second, a clause written into international debt contracts allowing debtors to suspend payments for a period of time in response to crisis situations; third, revising the articles of the IMF to empower it to declare a stand-still at times of crisis. This is an intriguing notion, although it does raise concerns similar to those for the other instruments noted above, including the possibility of increasing perceived risks and thus the cost of borrowing on private capital markets, and, in the latter instance, an enhanced role for the IMF in setting the terms under which stand-stills are likely to be granted.
Minister Martin has also expressed verbal commitment to a broader process of NGO and civil society consultation in the context of international financial reform. Before the House Standing Committee on Foreign Affairs and International Trade (May 18, 2000), for example, Martin claimed:
“Ever since entering public life, I have found dialogue with NGOs and the other members of civil society to be incredibly and extremely beneficial and important. If anything, this process of consultation and dialogue must be enhanced, and I intend, in my role as the G-20 chair, to ensure this happens.”
Bailing in the private sector would, in principle, seem to be consistent with NGO concerns regarding the distribution of responsibility for crisis situations (i.e. the principle that the burden of crisis be shared among all those involved in creating it, including the foreign private sector). The enhanced flexibility of some of the debt instruments described above (e.g. debt-service insurance, CCLs), if feasible, might also help to mitigate the worst extremes of financial swings and the economic and social damage they produce.
As always, however, the devil is in the details. As noted above, each of the proposals currently on the table carries significant drawbacks. Most generally, market-based measures to lock in private investors during times of crisis (e.g. through debt-service insurance, private CCLs, collective action clauses in bond contracts) seem likely to inflate the cost of borrowing during ‘normal times’ for developing countries. Developing countries CAN achieve a heightened degree of security in their foreign borrowing relationships through these mechanisms, but this security will ultimately be paid for in higher premiums or interest rates, as the market prices for risk. Put simply, if investors face a heightened prospect of being ‘trapped’ in a future financial meltdown, they will either a) be reluctant to extend credit, or b) demand a higher return on their investment as compensation. It is possible that the cost of the various market-based bailing in arrangements will make them unfeasible or unattractive options for crisis-prone economies.
In addition, each of the mechanisms described above has the potential to further tie the hands of economic policy-makers in developing countries. There is a very real prospect that a degree of stability may indeed be bought through these various mechanisms, but at the price of a further restriction in the effective autonomy of national economic decision-making. The question of bailing in, as currently proposed, is thus intimately connected to long-standing questions of surveillance and conditionality. This is made explicit in the various IMF-related proposals (concerted rollovers, debt guarantees, CCLs) each of which is contingent, to varying degrees, on the ‘correct’ policy behavior of debtor governments. These are entirely consistent with a second strand of official response to the recent economic turmoil, which has called upon the IMF to strengthen its surveillance of the financial sectors and policies of developing countries. Alternatively, increased use of the market-based insurance mechanisms outlined above (private CCLs, debt service insurance) seems likely to strengthen a ‘market conditionality’ no less stringent than that imposed by the IMF. Governments may find it impossible to pursue particular sorts of fiscal and economic policies without invalidating their CCLs or debt service insurance arrangements.
Thus, while the principle of bailing in would seem worthy of NGO support, current efforts in that direction raise troubling political questions of conditionality. The debt-relief push and the resulting HIPC initiative may provide an instructive historical parallel here: debt HAS been forgiven (in large part through the tireless and dedicated work of the Jubilee campaign folks) but this has also been linked to a significant extent to policy performance. Are there lessons we can learn from the debt-relief initiative, from its striking successes, but also its limitations? Are there ways of pursuing the principle of bailing in without strengthening the hand of the IMF or private capital markets? It seems necessary and important to delink, to the greatest possible extent, the question of bailing in from enhanced conditionality. Strategies need to be developed that make stability and the (relative) autonomy of national decision-making mutually compatible goals.
Any adequate critique of current bailing in proposals would, of course, also take account of what is not being talked about in official discussions concerning stabilization, including:
- capital controls (either at the national level or internationally via some sort of Tobin tax)
- an international bankruptcy court
- the possibility of default in the face of odious or overwhelming debt obligations
Halifax Initiative Coalition
 Bond issues, both corporate and sovereign, have replaced bank lending as the largest source of short- to medium-term financing in many developing countries.
 Every IMF pronouncement on the possibility of bailing in to date has been prefaced by a commitment to the ‘sanctity of contract’ – explicitly ruling out the option of default. Two (familiar) arguments are mobilized to support this: first, defaulting countries will find it difficult/expensive/impossible to access future credit on private capital markets; second, that the ‘moral hazard’ of letting debtors off the hook will encourage future reckless borrowing behavior or lax supervisory standards.