Public Information Notice No. 03/42

Public Information Notice: IMF Board Discusses Economic Policy Issues Arising in the Context of a Sovereign Debt Restructuring

April 2, 2003

On February 19, 2003, the Executive Board of the International Monetary Fund (IMF) discussed a broad range of economic policy issues that may arise in connection with a member's decision to restructure its unsustainable sovereign debt obligations.

Background

In extreme cases countries may have unsustainable sovereign debt burdens, that is, find that there is no feasible set of macroeconomic policies that would allow them to regain medium-term viability without a reduction in their debt. Sovereign debt restructurings typically take place under very difficult macroeconomic circumstances, and often in the midst of a broader loss of confidence that could quickly escalate into a full-blown currency and banking crisis. In such a difficult environment, the debt restructuring itself, while necessary to provide a lasting solution, could temporarily contribute to intensifying the strain on the domestic economy.¹ Therefore, efforts to restructure sovereign debt will generally require a macroeconomic response to the widespread disruption that is likely to occur, and to help the country emerge from the crisis and regain sustainability.

In the context of the work on improving the crisis resolution framework, Executive Directors discussed a paper, "Crisis Resolution in the Context of Sovereign Debt Restructuring - A Summary of Considerations." The paper provided a preliminary overview of the complex policy issues involved in sovereign debt crises, and of the broad considerations that should guide an effective policy response aimed at restoring confidence, limiting spillovers and capital flight, and contributing to a credible exit from the crisis.

The paper examined three sets of broad considerations that arise in the context of a sovereign debt restructuring. First, how to create a framework that assures that the debt structure emerging from the restructuring process is consistent with the adjustment effort and restores external viability? Second, how to resolve a country's financial crisis while limiting the disruptions associated with a sovereign restructuring on other sectors of the economy, in particular the banking system? And third, what should be the role of the Fund during a sovereign debt restructuring? These issues are of critical importance for the resolution of crises when a sovereign debt restructuring is necessary, either because the sovereign's debt situation is directly the source of the country's financial difficulties, or because the costs of a crisis originating in the non-sovereign sector have made the sovereign's debt unsustainable.

Executive Board Assessment

In the context of the discussion on crises resolution in the context of sovereign debt restructuring, Directors emphasized that the choices facing the member in such situations are bound to be very difficult, and that everything needs to be done to strengthen domestic policies and institutions and reduce vulnerabilities to prevent crises from occurring. Directors also noted that decisions will have to be taken on a case-by-case basis, given the complex policy environment facing a member with an unsustainable sovereign debt. They nevertheless saw merit in discussing some general considerations which would be helpful in guiding these decisions.

Directors noted that debt difficulties can quickly get out of hand, spill across economic sectors, and result in serious financial difficulties for the sovereign. In situations where a substantial amount of sovereign claims are to be restructured, the process is likely to involve considerable strains on the domestic economy. Directors stressed that prompt and decisive action to strengthen macroeconomic and structural reform policies, as well as an early engagement with creditors toward a collaborative restructuring agreement, will contribute to keeping the costs of a debt restructuring decision to a minimum.

Defining the adjustment path

Directors underscored that in sovereign debt crises the overall policy objective should be to correct macroeconomic imbalances, limit potential disruption to the domestic economy, stem capital outflows, and restore confidence with a credible resolution of the member's debt problem. A realistic exit from a debt crisis will require a new debt structure consistent with the sovereign's debt-servicing capacity and fiscal position over the medium-term.

Directors considered the magnitude of the immediate fiscal adjustment, as well as the path of the primary fiscal position over the medium term, as key components of the effort to re-establish sustainability. They noted the challenges which a sovereign may face in designing an appropriate adjustment path in an unsettled macroeconomic environment. Directors underscored that the choice of a fiscal adjustment path after a restructuring decision can send a strong signal about the authorities' commitment to restore sustainability, and emphasized, in this context, that debt restructuring cannot substitute for policy reforms.

Directors noted that the effort required to regain debt sustainability would depend on the medium-term growth rate of the economy, real interest rate and exchange rate developments, and the scale of financing from domestic and international capital markets. They recognized, however, that the uncertainty surrounding the future prospects of an economy emerging from default inevitably complicates the task of judging the needed adjustment effort. They underscored the importance of the sovereign's engaging in an open and constructive dialogue with its creditors throughout the restructuring process.

Dealing with banking crises

Directors noted that, in the event of sovereign debt restructuring, the financial position of banks and other financial intermediaries could be severely affected. Banks may be vulnerable to a deterioration in credit quality as a result of debt-servicing difficulties in the household and corporate sectors; exchange rate risk due to currency mismatches on and off their balance sheet; and deteriorating liquidity conditions as a result of deposit withdrawals; in addition to direct exposure to holdings of government debt instruments. Directors agreed that a combination of these factors in recent crises had contributed to widespread bank distress and exacerbated dislocations in the domestic economy.

Directors stressed the importance of protecting the viability of the domestic financial system in the context of a sovereign debt restructuring, while agreeing that there may be cases in which it will not be possible to restore debt sustainability without a reduction in the real debt a sovereign owes to the domestic banking system. In such cases, debt restructuring would inevitably impose losses on banks in terms of both the value of the banks' assets and income.

Directors agreed that the initial priorities in a crisis for the domestic banking system should be to restore confidence, safeguard the payments system, and minimize disruptions to credit flows. Members should seek to develop a viable approach to obtaining the necessary reduction in the sovereign's real debt burden, taking into consideration the impact of alternative measures on the banking system, and the country's circumstances.

Directors noted that developing a comprehensive strategy for dealing with the banking system would be a challenging task. First, the debt restructuring is likely to limit the effectiveness of conventional resolution tools involving the use of public debt instruments, as they may not be effective when a sovereign has defaulted on its obligations. Second, the extension of a blanket deposit guarantee may also not be credible when the sovereign is unable to service its own debt. Third, in the midst of the crisis, it may be difficult to ascertain the true solvency conditions of individual banks, straining the authorities' capacity to strengthen viable institutions and remove nonviable institutions from the system.

In cases where conventional policy measures are not feasible or would fail to contain the crisis, countries have used a range of administrative measures as a last resort to avoid uncontrollable runs on the banks. Such measures, ranging from temporary and limited bank holidays to rescheduling, securitization, or temporary restrictions on deposits, can serve the dual purpose of mitigating the pressures on the banking system and limiting the scope for capital flight. While these measures may provide some immediate relief to banks vulnerable to large-scale withdrawals of deposits, Directors nevertheless stressed that they carry a very high cost in terms of further damaging confidence, and could possibly undermine the rule of law. They cautioned that any such measures should be considered only where no other option is available to contain the crisis. As soon as the circumstances permit, the priority should be to formulate a comprehensive strategy for systemic bank restructuring to restore financial sector soundness.

Use of exchange controls

Directors noted that the announcement of a sovereign debt restructuring could trigger a general loss of confidence in claims on the sovereign—-including the currency—resulting in capital flight and severe pressure on the foreign exchange market. Similarly, a crisis of confidence in the banking system may result in depositors' seeking to place their liquid assets offshore and in foreign exchange. Directors considered that, in extreme cases where a tightening of financial policies and exchange rate flexibility are not successful in staunching outflows, the authorities may feel they had little choice but to temporarily impose or tighten controls on both capital and current international transactions to moderate such pressures. At the same time, however, Directors noted that evidence on the effectiveness of exchange controls is mixed, that an adjustment of the exchange rate and the unwinding of balance sheet overhang are important parts of the adjustment process, and that the threat of controls could lead to an earlier exit of capital.

More generally, Directors stressed that controls are not a substitute for sound macroeconomic policy measures. They are costly to administer, tend to lose their effectiveness over time, and can create significant distortions, by creating a culture of rent-seeking, promoting the emergence of parallel markets, and raising governance issues. In addition, they may be difficult to monitor and enforce in countries that have liberalized their markets for some time and where the necessary infrastructure is no longer in place. Some Directors cautioned that, in imposing controls, a country needs to consider the effects of such measures in undermining the rule of law, with potentially adverse consequences for the economy. Those Directors who commented on the justification for controls noted that when controls are employed, they need to be sufficiently comprehensive, enforceable, implemented on a timely basis, and part of a broader policy package. In accordance with Fund policies, they should be tailored to the specific circumstances of the individual member and designed to be nondiscriminatory and terminated as soon as circumstances allow.

Coordinating framework

Directors recognized that restoring sustainability could require restructuring agreements to be reached with several groups of creditors. In cases where a comprehensive restructuring of different types of claims is necessary, the member should engage simultaneously with all its various creditors on the best way to reach an overall payments profile consistent with the adjustment path and the objective of regaining sustainability. Directors acknowledged that there are also circumstances where a targeted debt restructuring, aimed at a subset of creditors may be appropriate. Several Directors saw the development of a Sovereign Debt Restructuring Mechanism (SDRM) as a needed response to the present lack of a formal framework for coordinating a comprehensive debt restructuring. Directors also viewed the ongoing work by the official sector and private parties on the systematic inclusion of collective action clauses in new sovereign debt issues as a key response.

Directors considered that, in cases where a member seeks a Fund arrangement, the Fund-supported program would help anchor discussions between a sovereign debtor and its creditors. The program would lay out the overall payments profile consistent with the country's monetary and fiscal program and, in this respect, clarify the broad envelope for the servicing of claims held by different creditors. In addition, during the period when the member is negotiating a restructuring with its creditors, if it has interrupted payments to them, the conditions of the Fund's policy on lending into arrears would apply. Under this policy, the member would be expected to maintain a constructive dialogue with its creditors, while the Fund would continue to make disbursements conditional on satisfactory economic performance, and on progress toward a restructuring agreement to restore balance of payments viability.

Role of Fund financing

Directors underscored that Fund financial assistance to a member in the process of restructuring its debt should support the member's effort to reach a sustainable growth path as soon as possible. Most Directors agreed that Fund financial assistance may be used to reconstitute foreign exchange reserves, provide financing for needed imports of goods and services, and support the rehabilitation of the domestic banking system. The role of other IFIs was also stressed in this context. Directors emphasized, however, that Fund financing should not be used directly to underwrite liabilities of the financial or corporate sectors, finance payments to creditors whose claims were being restructured, or to accommodate large-scale capital outflows.

Most Directors considered that Fund lending in debt restructuring cases would be expected to be within normal access limits, in recognition of the member's precarious debt situation until the process of restructuring is completed. Directors generally recognized that there may be rare cases where exceptional access may be warranted. However, Directors stressed that any such cases would require strong justification, and the recently agreed procedural safeguards for exceptional access would be applied. A few Directors were hesitant to allow for any possibility of exceptional access in debt restructuring cases.

Areas for further work

• The discussion highlighted a number of areas in which further work is required. Directors endorsed the work program proposed by staff, including:
• The formulation of a concrete proposal for a statutory sovereign debt restructuring mechanism (SDRM).
• A review of the ongoing work by the official sector and private parties on designing and promoting the inclusion of collective action clauses in new sovereign debt issues, and of their use in the marketplace.
• A review of the application of the recent framework on assessing debt sustainability.
• The elaboration of best approaches to the resolution of systemic banking problems and the treatment of other financial intermediaries.
• Creditor coordination issues, including inter-creditor equity considerations and the treatment of official bilateral and private sector claims.
• A review of issues pertaining to the restoration of a member's access to the international capital markets following a debt restructuring.