Bailing In The Banks.

A top central banker gives his prescription for involving the private sector in the resolution of debt crises in emerging countries.

As a consequence of the Mexican debt crisis of 1994-95, and subsequent crises in other emerging markets, the international official community has launched a broad-based initiative to improve the functioning of the international monetary and financial system, and thus, to stabilize growth and employment in the world economy. From the outset, backward-looking proposals aimed at "throwing sand in the wheels of international finance" have rightly been discarded from the agenda. The thrust of current efforts is to ensure that the financial markets function more efficiently. This strategy should help foster more stable flows of private resources towards emerging market economies.

The components of this crisis-prevention approach can be grouped under two headings: improving economic fundamentals and increasing transparency. Everyone agrees on the need to strengthen crisis prevention by means of sound economic policies. This includes an appropriate sequencing of capital-account liberalization, the choice of well-suited exchange-rate regimes, and the improvement of debt-management policies aimed at avoiding high levels of short-term foreign currency-denominated net debt, in particular. Moreover, deep-seated fragilities in the financial systems of debtor countries should be eradicated as quickly as possible to reduce both the dependency of those countries on foreign capital and their vulnerability in the event of a crisis. Here, strengthening banking supervision has the highest priority.

Beyond economic and financial reforms, more needs to be done to enhance the transparency of markets. More disclosure of relevant facts should enable creditors to discriminate among debtors more effectively. As a first step, information on the results of International Monetary Fund surveillance is now made public on a regular basis, while respecting the confidential character of the dialogue with member countries. Moreover, the Financial Stability Forum, established early in 1999 on the initiative of former Bundesbank President Dr. Hans Tietmeyer, recommended assessing countries' performances against a number of international standards adopted by all countries. The objective is to improve policies, market infrastructures, and data dissemination. On a voluntary basis, the IMF will review and publicly report on compliance with the most important standards. Many market intermediaries, however, are not yet aware of these efforts and their importance. Without more awareness, the private sector cannot be expected to place much emphasis on borrowers' observance of these codes and standards.

While the strengthening of economic policies and enhancing of transparency "only" require patience and perseverance, controversy pervades the international debate over the extent to which private creditors should be involved in the resolution of debt crises. The official financial support provided to Mexico and its private creditors in 1995 at hitherto unprecedented levels opened the floodgates to similar interventions by the official community in Asia and Latin America.

Such developments must not continue. Instead of responding to international debt crises by demanding ever-larger official financing, the private sector itself should contribute substantially to resolving future capital-account crises of emerging markets. Financial markets will only function as desired if, to quote Federal Reserve Chairman Alan Greenspan from his recent address to the U.S. Council on Foreign Relations, "investors bear the costs of their bad decisions and bad luck and reap the benefits of their good decisions and good luck." The official community should therefore avoid shielding investors from losses. Otherwise, given the premiums investors can earn on their exposures to emerging markets, excessive risk-taking would be encouraged. The detrimental impact of past bailout operations on investors' behavior cannot be overlooked. Heavy short-term financial investments in Russia before the crisis of 1998 were the most important example of -- fortunately unfulfilled -- moral hazard in international finance. Private sector involvement in crisis resolution is therefore the key to crisis prevention.

To ensure an appropriate degree of private sector involvement, the official community should pursue a strategy that can be summarized in five major points:

Developing trusting relations. In a crisis, debtor countries should do all they can to reach a cooperative solution. This might be more successful, the better heavily indebted countries and market intermediaries can work together towards forming lasting relationships based on mutual trust and reliability. Examples already exist. Good debtor-creditor relations will also facilitate the conclusion of liquidity-support arrangements with the private sector, such as contingent credit lines, call options on inter-bank credit, and debt-service insurance.

Limiting official financing. The recourse of debtor countries to the IMF should be clearly limited in terms of quotas (as would be the case in the event of traditional current-account crises). Moreover, the higher the financial support requested, the greater should be the interest charges, the degree of conditionality, and the involvement of private creditors. Any additional financial support should only be considered under exceptional circumstances that include systemic risks that could engender a serious dampening of real economic growth worldwide. One option could be that exceptional official financing would require a very high majority on the IMF Board. Such important safeguards against excessive official financing would amount to establishing a kind of "constructive ambiguity." Let me also mention why I do not share the view that a world without highly flexible official financing could provide incentives to rush for the exits at the first glimpse of a crisis. Limiting official financing would result in a process whereby financial investments would be more closely aligned with underlying risks. As a result, crises would happen less often, and they would be less serious if they occurred, thus reducing the incentives for capital flight.

Sharing the burden. If debt rescheduling becomes unavoidable because of a limited availability of IMF money, an equitable burden-sharing between the Paris Club and private creditors should be ensured. The contributions of both groups of creditors should more or less match their respective shares of the debt service due during the relevant adjustment period. Equal treatment of private creditors is called for not only to foster appropriate risk assessment by lenders, but also to prevent moral hazard on the part of borrowers.

Treating creditors equally. The IMF should not be directly involved in bilateral negotiations between the debtor country and its private creditors. It would be the debtor country's responsibility to negotiate with its creditors as to the requisite amount of private sector contributions--determined on the basis of the official sector contributions--to be raised. In cases where restructuring of Paris Club claims is not required, short-term rollover arrangements may often appear to be satisfactory. However, the official community has repeatedly underscored that negotiated solutions will only be achieved if the debtor country involves all materially significant creditors and aims for equal treatment of all. The introduction of collective action clauses in new international bond issues of emerging market countries would be helpful in that respect. It is not justified to assume that such clauses would raise the financing costs of debtor countries. Given the fact that international bonds, which have become a major channel for capital flows to emerging markets, can no longer be considered sacrosanct in a crisis, all facilities that would help resolve collective action problems would be an advantage.

Setting moratorium guidelines. In exceptional circumstances--that is, if negotiations with private creditors have stalled or if a crisis has suddenly struck with great force--the debtor country may be obliged to suspend payments on its international official debt and even impose restrictions on capital movements. Such payment suspensions, also called standstills or moratoriums, are the logical implication from limiting official financial support. It is agreed that the IMF may lend into arrears if the country were willing to make the necessary adjustments and seek an equitable settlement with its creditors. Lending into arrears, which could be seen as implicit official sanctioning of a standstill, should help negotiate a comprehensive solution as early as possible.

The argument: The IMF's informal approval of a standstill would serve as a signal that the debtor country is willing to do everything in its power to maintain, as far as possible, the value of the creditors' non-performing claims. To emphasize the exceptional character of payment suspensions, it would be useful if a few guidelines for standstills were determined, the observance of which the IMF could consider before lending into arrears. I do not believe, however, that it would be necessary to empower the IMF to impose on individual creditors a stay on litigation in the case of standstills. During recent crises, litigation by individual creditors did not play a role, given the widespread lack of attachable assets. Moreover, such powers would be irrelevant, as far as London Club rules or collective action clauses for bonded debt applied.

Although an agreed framework for private sector involvement is still lacking, it must be recognized that progress has been made in the right direction when it has come to the actual management of crises. In a number of recent insolvency cases of smaller countries, the IMF and Pads Club have successfully insisted on financing contributions from bondholders. Furthermore, the decision not to bail out Russia in the crisis of 1998 has shown that the "too-big-to-fail" assumption can be false. However, there remains uncertainty as to how so-called liquidity crises--of larger countries in particular--might be resolved in future. In my view, a presumption of limited official financing must be the rule in all cases. Such an approach is the only way to credibly address the problem of moral hazard. Under these conditions, there would be strong incentives for both creditors and debtors to reach voluntary solutions. As a consequence, standstills would remain--as they should--a rare event in international finance.

Jurgen Stark is Deputy Governor of the Deutsche Bundesbank.