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Wucker: Passing the Buck: No Chapter 11 for Bankrupt Nations - World Policy Journal - World Policy Institute

WORLD POLICY JOURNAL

ARTICLE: Volume XVIII, No2, Summer 2001

Passing the Buck: No Chapter 11 for Bankrupt Nations
Michele Wucker

[Go to interactive discussion forum]

Just over a decade after the debt crisis of the 1980s found a medium-term fix, the problem of international debt still makes headlines. There was Mexico's 1994 devaluation and the resulting "Tequila Crisis." Then there was the Asian economic crisis, which began in mid-1997, with Thailand, Indonesia, and Korea requiring International Monetary Fund bailouts. Ecuador, Russia, Pakistan, and Ivory Coast have since defaulted on their foreign debt. More recently, Brazil, Argentina, and Turkey have threatened to do so.

The troubled cases point out the alarming reality that the international approach to sovereign debt is still jury-rigged. Commercial bank lenders and the "official sector"Žthe Paris Club1 of 19 creditor governments, the U.S. Treasury, and the international financial institutions, or multilaterals, including the International Monetary Fund (IMF), the World Bank, and the regional development banksŽcontinue to bicker about their responsibilities to prevent financial crises and help debtor countries get back on their feet.

Commercial lenders are still smarting over the Paris Club's insistence in April 1999 that Pakistan ask private creditors to reschedule their bonds before governments would fork over any money. And the banks accuse the IMF of having approvedŽat least tacitly if not overtlyŽof Ecuador's defaulting on its foreign bonds in August 1999 in an experiment to see if private creditors could be coerced into helping bail out poor countries. Meanwhile, governments and official-sector creditors, reciting a familiar litany, accuse the private sector of being only too eager to make a buck but unwilling to pay its share to pull countries back from the brink of default.

All of this quarreling delays help and deepens crises. In the countries that can least afford to lose jobs, businesses close their doors. Governments cannot afford to pay teachers or workers, much less continue to provide even the most meager social services. And it underscores the sad reality that there still is no set of international bankruptcy rulesŽno Chapter 11 for nationsŽthat will stave off creditors and find a fair way of getting debtor countries back on their feet.

Creditors have made only limited progress in learning how to fix crises; yet sovereign debt problems remain a serious threat to the global economy. A default in, say, Argentina, could set off a chain reaction: losses for the big foreign banks to which Argentina owes $70 billion, leading to an immediate increase in interest rates charged to other emerging-market borrowers, a dramatic slowdown in economic growth not only in Argentina but around Latin America, and heightened economic uncertainty that could send other countries over the edge.

"Countries do not go bankrupt," Citibank chief Walter Wriston declared, with unfortunate timing, in 1982, just after Mexico declared a moratorium on foreign debt payments, kicking off a decade of debt crisis in Latin America and in developing countries elsewhere. Countries may not close their doors and disappear like companies can, but they do indeed go bankrupt. Over the last 200 years, the domino effect of collapsing national economies has threatened the world economy five times. In 1990, at the nadir of a decade-long debt crisis, 55 countries were foundering. Debt worth $335 billion was defaultedŽnearly one in every three dollars on loan to sovereign nations. Over the course of the 1990s, an average 22 percent of sovereign debt was in default.

As the year 2000 ended, the picture was considerably brighter. The credit rating agency Standard & Poor's calculated that 26 countries were in default on $69 billion of borrowing, or about 7 percent of global debt Ža far cry from the 1980s. But this should not be a reason for complacency. S&P has also calculated that corporate borrowers marked their highest default rate ever in the first quarter of 2001: a total of $37 billion in defaults by 48 companies worldwide, mainly below-investment-graderated firms in the United States. This hurts all borrowers because when risk in one part of a sector increases, financing costs rise across the board.

Developing-country debt is often marketed to the same investors who buy subinvestment-grade U.S. corporate debt, so a rise in the risk premium for this marketŽnow euphemized as "high-yield" and no longer called "junk bonds," at least not by those who sell this paperŽmakes it harder for many developing countries to raise funds. Worse, small rises in interest rates in the United States are usually magnified when investors pass on the higher borrowing costs to emerging-market countries and companies with lower credit ratings.

Argentina and Turkey are still teetering on the edge of default, both victims of past overconfidence, overspending, and overdependence on fresh money from international lenders. During the "emerging markets" boom of the 1990s, governments had an easy time borrowingŽespecially Argentina, which had charmed investors with its big sales of state enterprises and a dollar-currency peg that tamed hyperinflation. As the decade ended, however, and investors dumped emerging markets for the technology bubble, Argentina sank into recessionŽand suddenly its debt was growing faster than its economy. By mid-2000, it was clear that Argentina would have a harder and harder time keeping up with its $160 billion debt, which amounts to around half of the country's gross domestic product, higher than its 1990 debt-crisis level of 44 percent of GDP.

Similarly, Turkey's government was already spending beyond its meansŽwith deficits close to 12 percent of GDPŽwhen the country's banking system collapsed last year. Its combined foreign and domestic debt rose to 60 percent of GDP, and the country was having trouble supporting its currency, the lira.

Argentina's problems only got worse last fall as the crisis unfolded in Turkey, frightening investors and thus making it harder for all emerging-market countries to get financing. The IMF came to the rescue in December 2000, leading a $10 billion rescue package and encouraging privatesector banks to help restructure Turkey's debt, followed by a $40 billion rescue package aimed at heading off an Argentine default. Neither was enough. This spring, after Turkey was forced to devalue its currency despite the earlier bailout, the IMF increased its aid package to $19 billion. Argentina went to investors to convince them to lend it $20 billion in longer-term money to replace bonds coming due over the next few years.

The global economic slowdown and continued uncertainty in the U.S. economy are only making the problems worse in developing countries. Without a coherent approach to sovereign debt, each new financial crisis will continue to exacerbate the problem.

Yet the tangled motives of and constraints on the main international players mean that some apparently positive short-term alternatives can do even more damage in the long run. What should the world do when countries go bankrupt?

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No More "Miracles"
When Mexican finance minister Jesus Silva Herzog announced in 1982 that his country could no longer pay its debt, he inaugurated the worst decade for debt since the 1830s, when a British-led global lending boom ended in financial crisis. The crisis of the 1980s was also the result of a boom (oil in the 1970s) followed by a crashŽthis time caused by Federal Reserve chairman Paul Volcker's inflation squeeze. The base rate to which loan rates were pegged rose above 20 percent, magnifying the costs of the loans taken on in the 1970s. One country after another caved in, until most of Latin America was in crisis.

Much of the credit for ending the debt crisis goes to then-U.S. treasury secretary Nicholas Brady's eponymous 1989 debt restructuring plan, which rapidly brought 15 of the largest debtor countries back from the brink of bankruptcy. The Brady Plan gave limited relief from commercial debt (but not from multilateral debt, although the multilateral lending institutions did agree to kick in some new money). It repackaged the old defaulted loans into $150 billion in "miracle" securitiesŽBrady bondsŽthat investors agreed to buy because the new bonds were partly guaranteed by collateral sitting in a New York escrow account. The collateralŽa mixture of U.S. Treasury zero-coupon bonds that would pay back full principal upon maturity, and AAA-rated U.S. corporate bonds that helped back up to a year of interest paymentsŽwas paid for largely by the IMF.

Banks that had written off large portions of the defaulted loans could exchange the bad paper for new bonds that they could then sell to a broad base of investors. With the banks awash in profits, and everybody breathing a sigh of relief, nobody wanted to talk about how to handle the next debt crisis. The regular meetings among creditors fell off. The developing cooperation between the private-sector banks, Paris Club national creditors, and the multilateral institutions fell victim to benign (though ultimately damaging) neglect.

It may be said without disrespect to Nicholas Brady that some of his plan's success had to do with good timing: as countries were restructuring their debt, the world was undergoing a massive expansion of liquidityŽthe term bankers use for how much money is available in the world economy to countries and companies. Unfortunately, the liquidity boom also helped set the stage for problems that are now becoming evident; it was too easy to borrow.

In the early 1990s, U.S. interest rates dropped, sending investors all over the globe in search of higher-yielding alternatives. They found it in the less-developed countries (LDCs), which also happened to be opening their economies to foreign investment and selling off state enterprises. Almost overnight, the LDCs became "emerging markets" riding a global cash wave. By the late 1990s, Argentina, Brazil, and Mexico were doing so well that they used cash reserves to buy back the Brady bonds. Their credit ratings had improved in the meantime, allowing them to refinance their debt with new money borrowed at much cheaper rates. After Brazil exchanged over $5 billion in Brady bonds for newly issued 40-year bonds in a global debt swap last year, Nicholas Brady himself declared that the Brady Plan had become obsolete.

This was good news: a plan devised to resolve a crisis had, by and large, achieved its goals. But even as the Brady Plan was working its "magic," issues had arisen that pointed to the need for a "fair-weather" plan to deal with the problem of sovereign debt.

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The Myth of Moral Hazard
The Brady Plan did not solve the debt problem; its main achievement was to restore private capital flows to developing countries. Since 1990, debtŽmeasured both by amount and relative to the ability of nations to payŽhas fallen in some but not all countries. What has fallen dramatically is the "official sector" portion of that debt, as multilateral creditors have encouraged larger private-sector capital flows to developing countries.

When there are problems in the global financial system, the changing relationship between official and private creditors becomes a serious obstacle to efforts to stabilize troubled economies. Many private-sector bankers relish the irony that the acronym for international financial institutionŽ"IFI"Ž is pronounced "iffy." The IFIs measure their success by how quickly private-sector capital becomes available again after a crisis, and by how much capital flows to countries over the medium term.

Yet when it comes to picking up the pieces when a nation defaults on its debt, official creditors admonish the banks for having made speculative investments and argue that bailing out a broke country is tantamount to bailing out investment bankers. Invoking the weighty words, "moral hazard,"2 they also fret that bailing out countries that run into trouble encourages irresponsible policies on the part of governments and irresponsible behavior by investors.

Naturally, investors know when they buy highly speculative emerging-market bonds that there is a significant chance of default; the deeply discounted prices and high returns reflect this. And there have indeed been dramatic cases of wildly irresponsible investment. In 1822, investors shelled out £200,000 for bonds from the "Central American Kingdom of Poyais." The bonds were in such demand that buyers even bid the price up after they were issuedŽthis was before the anxious buyers discovered that Poyais did not exist but was a phantom cooked up by its selfappointed king, the Scottish adventurer Sir Gregor MacGregor.

Luckily, such baroque excess is rare. But the Brady Plan created new kinds of moral hazardŽand new questions about how to deal with debt problems. By chopping up loans into widely sold bonds, the program dramatically broadened the base of investors who financed developing countries. Debt once owed to commercial banks now went into the portfolios of mutual funds, hedge funds, and pension funds. This had its benefits and drawbacks.

It meant that the original creditors did make "new" profits since they had already written off large portions of bad loans and could count as profit the increase in value of the new Brady bonds as emerging-market economies improved. But new bond investors had also been quick to note how much potential there was to make money from the rise in prices of emerging-market securities as these economies were restructured and restored to creditworthiness.

This led to problems when private and official creditors argued about who would forgive principal in later meltdowns. If private investors had bought a bond at, say, 40 cents on the dollar, it was easier for the official sector to argue that the bondholders should forgive some principal. The seductively low prices on defaulted debt also created a new class of rogue investors, to whose dealings the term "moral hazard" could be applied without being unfair. Such investors would try to avoid having to agree to forgive debt when efforts were being made to restore creditworthiness after a default.

This happened in 1994, when the Dart family, a group of wealthy private investors, nearly scuppered Brazil's $54 billion Brady restructuring by refusing to sign on to the debt forgiveness portion of the deal; they nearly had enough clout to do so because they held over $1 billion of Brazilian government debt (this represented face value; the Darts had paid much less than that, having bought the defaulted loans at a deep discount). Last year, the U.S.-based hedge fund Elliott Associates, in a case involving Peruvian debt, succeeded where the Darts had failed. They had bought defaulted 1980s Peruvian government loans at a deep discount and then refused to go along with a 1997 Brady-style restructuring. A U.S. court eventually awarded the investors full principal plus interest, penalties, and fees totaling $45 million over their investment of approximately $13 million. Peru tried everything it could to avoid paying, but it finally had to hand over $58.45 million last fall.

Investors are not the only players susceptible to moral hazard. Bilateral international lending has often involved a heavy political componentŽespecially when the Cold War was at its height. It has also often benefited the creditor nations, notably when the loans were for military equipment, often conditioned on the purchases being made from firms based in the creditor nation. During the Cold War, loans were made to wartorn countries, particularly in Africa, that are now in such bad shape that they are unlikely ever to be able to pay. Many of these countries are at last having some of their debt forgiven, under the slow-moving World Bank's Highly Indebted Poor Countries Initiative, or HIPC.

And what of countries that follow prescribed "good economic behavior" that turns out to have been misguided? The multilaterals have been silent on the question of what their responsibility is when, in what may be described as reverse moral hazard, their own policies are part of the problem.

Take Argentina, which at the beginning of the year 2000 won a $7.6 billion credit line from the IMF after newly elected president Fernando de la Rúa pushed a massive package of tax increases through Congress. While the tax increases were not entirely to blame for Argentina's woes, they undoubtedly played a big part in keeping the economy from emerging from recession. By the end of the year, predictably, Argentina had to go back to the IMF for a bailout package of nearly $40 billion (including the previous $7.6 billion credit line, which it had not tapped for fear of alarming investors even further).

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Just Small Enough to Fail?
International creditors approach countries that are viable or could be made to be so (Argentina, Brazil, Turkey, Mexico), very differently than they approach either highly indebted poor countries or those unfortunate countries, like Ecuador, that fall between the two extremes. Private investors complained bitterly about the way the IMF allowed Ecuador to default in 1999Ž this in contrast to the international rescue package it had helped put together for Brazil the year before, just weeks before Brazil had to devalue its currency. The private sector ("the market," in creditors' mildly affectionate term) noted that while Brazil was treated as too big to go under, Ecuador was considered to be small enough to let fail.

Certainly, the small Andean nation played a big role in driving itself into the groundŽthough it was a death easily foretold. Ecuador has never been a safe bet: from 1800 through 1995, it stopped payment four times and was in default for an astonishing 115 years during that period. When it converted old defaulted loans into shiny new Brady bonds in 1994, money was flowing freely around the globe, and nobody wanted to think about the boom times ending. At the time, a handful of forthright emerging-markets debt traders said that they believed that the only way the country could afford to start repaying its debt was if the speculative emerging-markets bubble did not burst. But the bubble did burst with the Asian economic crisis of 1997 and Russia's devaluation and default in summer 1998. Worse, Ecuador booted out the reformers who had restored the country's creditworthiness, and in 1996 it elected a president, Abdala Bucaram, who called himself "El Loco"Žthe Madman. Months later, he got the boot too. As the political situation deteriorated, El Niño's violent weather ravaged the country and international prices for Ecuador's oil exports plummeted.

Ecuador failed to make a $96 million interest payment in August 1999, earning it the dubious honor of becoming the first country to default on its Brady bonds (Ivory Coast later became the second in this club of pariahs). The default caused a major strain in relations between private and official-sector creditors. Bankers accused the IMF of having waited too long to act, thus deepening the crisis. The IMF evenually agreed in early 2000 to contribute funds and its blessing to a $2 billion international support package to help Ecuador get back on its feet.

In August 2000, nearly all of Ecuador's bondholders agreed to take another "haircut" (slang for forgiving a portion of the debt), this time for 40 percent. New bonds, with 12-year and 30-year maturities, were issued. Interestingly, they carried a special provision that increased the principal to be paid back to the banks if the country defaulted again. Intrepid investors approvingly made a note of that this spring when Ecuador's congress balked at approving new taxes on which the IMF had insistedŽmuch as it had done with Argentina's ill-fated programŽas a condition for providing new loans; an IMF withdrawal would force the still-strapped country to stop paying interest on its bonds once again.

The Paris Club's role remains up in the air; last fall it agreed to delay payments that otherwise would be due on some of Ecuador's obligations but sidestepped the issue of possible reduction of the debt until Ecuador had made more progress on its IMF targets. It may be a long wait. This bottom line is that Ecuador committed itself to payments that no country could reasonably continue to make for long.

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The Players, Neutral or Otherwise
Creditors on all sides now see Ecuador as a major test case, without which the later approaches to Argentina and Turkey might have been quite different. Eduador's default certainly put the private sector on new footing in the argument over who would take the next haircut.

As Ecuador was going under, the IFIs and the Paris Club were demanding "burden sharing" from bankers. The official sector insisted that it would not provide help until the private sector agreed to share the pain when lending goes bad. In twice granting Ecuador favorable terms, private bankers had put the ball back in the official sector's court, challenging the official sector to extend as much forgiveness as the private creditors hadŽa challenge that was especially explicit because the Paris Club had yet to decide Ecuador's fate.

The IFIs and the Paris Club quickly softened their language, speaking now of private sector "involvement" and opening the door to the banks' voluntary participation in rescue packages. But the three groups' interests inherently conflictŽthus the ongoing argument about whether they are all bearing equal and fair weight in helping distressed countries.

As "preferred creditors," the IFI's insist that they must be paid in full or else lose their coveted top-investment-grade credit rating. Without that, they must pay higher interest rates on their frequent international borrowing. Such higher costs would decrease the amount of money available for their operationsŽand make it harder for them to lend at below-market rates. That is part of the reason why they, unlike private banks, refuse to write down debt except under the HIPC initiative. To be eligible for HIPC debt relief, though, countries must be in an extremely bad way; even beleaguered Ecuador is not poor enough. Without a protective "preferred creditor" umbrella, the private sector takes on more risk and expects to be compensated for it. That has been clear in the banks' ongoing participation in retiring short-term Argentine debt and lending via new, longer-term securities: the interest rates on the new debt are up to 1.5 percent higher than on the old paper.

Private-sector creditors are much more likely to account for the true market value of their lending. If a bank holds bonds in an active portfolio, it must reflect the market value of these assets; that is if the price of a bond that was bought at 100 cents on the dollar ("par") falls on the secondary market, the bank must record the lower market price as the value of its assets. Banks that have made loans (which these days are usually syndicated through a group of banks) that they intend to hold to maturity write off the loss if it has become clear that the borrower's ability to pay has been seriously compromised. Thus, it is much easier for private bankers to take a haircut.

Like the IFIs, the Paris Club does not "mark to market." Typically, its way of dealing with debt is to grant grace periods and stretch out maturities. Donor governments must explain to their own voters why they are using taxpayer money to forgive debts. But if the Paris Club's members were to mark the value of their loans to market, they would have a lot easier time convincing citizens to consider reducing the debt of countries without the means to pay.

The United States, the biggest of the bilateral lenders, has become increasingly hesitant to contribute to international bailouts, either directly or in support of the international financial institutions' efforts. And as the IMF's biggest contributor, it has sway over the multilateral's role in international rescue operations. A growing contingent in Washington policy circles has pushed for cutting back the IMF's role in supporting developing economies. (Some time after the Asian crisis, the term "emerging markets" began to fall out of fashion.)

Speaking to a group of high-powered investors assembled by the Council of the Americas in May, Treasury Secretary Paul O'Neill criticized the multilaterals and reiterated his well-known reluctance to involve the United States in bailout plans: "If they aren't more frequently associated with success than they have been in recent times, then it's going to be harder to generate funds for future initiatives." He also put the onus on debtor countries themselves. "If a country willfully carries out bad policies, we can say we're not going to be there when the chickens come home to roost."

Under pressure from increasingly hesitant contributors and increasingly vocal critics, the multilaterals have been reducing their lending to developing countries except for large international rescue plans, which have been getting bigger and bigger. Focusing on prevention, the IMF has also developed the Contingency Credit Line (CCL), a "rainy-day" fund negotiated during good times with countries that do not appear likely to be in need of it at any time soon ŽMexico was first in line. Unfortunately, the CCL does not do anything at all for the countries that really need such support.

"Our objective should not to be to have more and bigger rescue packages, but to reduce the frequency and severity of crises," Horst Kohler, the German banker who now heads the IMF, told investors in May. Since taking over last year, Kohler has instituted an informal but regular dialogue with private-sector leaders, winning praise for his efforts. He has also formed a capital-markets consultative group that will focus on preventing crises and reducing vulnerability.

But future debt workouts will depend on all of the players coming to an understanding on who will do how much, and at what cost. Efforts to set up a coordinated approach to debt crises should continue, and perhaps even intensify, instead of being allowed to lapse during times of relative calm Žlike a leaky roof that only gets attention when it rains.

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The Beginnings of a Truce
Harvard University's Jeffrey Sachs, a prominent advisor to nations on the brink of insolvency, has laid out a blueprint for cases of severe financial stress.3 Under his plan, bankrupt countries could turn for rescue to a legal framework that provides a timeout from debt payments in order to give deep economic restructing a chance to work. There would also be a mechanism to coordinate creditors and ensure that all creditors received fair treatment as the troubled country decided who would be paid when and how much.

Sachs's recommendations offer a starting point for resolving other issues, such as how to prevent crises from decimating the real economy and making things worse, and how to balance the conflicting interests of creditors. However, there is significant opposition to the idea of mandatory standstills within the financial community. Provision 8(2)b of the IMF charter allows governments to request a standstill, that is, temporary relief from payments along the lines of a U.S. Chapter 11 bankruptcy, but doing so would probably magnify a country's problems by scaring off investors. "A country can always call a standstill itself. But it should be done in an orderly fashion," says Citigroup vice chairman William Rhodes, who headed many of the bank advisory committees that helped countries negotiate their way out of the debt crisis of the 1980s.

It has proved hard to establish anything remotely resembling an international bankruptcy court or sovereign debt arbiter. In some ways, the organization that has come closest to playing this role is the IMF, since its stamp of approval on a country's economic policies is often the signal for the Paris Club to grant relief and for investors to start lending. In view of its "preferred-creditor" status, however, the IMF is far from the most objective judge of what the various creditors' roles should be. "There are concerns about an IMF role as international tribunalŽit's not a neutral player. No judge in his right mind would ever take a case where he was a major creditor," says Charles Dallara, director of the Washington-based Institute of International Finance, a group that represents private banks.

While the market can register immediate approval or disapproval of a country's economic policies by bidding the prices of a country's securities up or down, the IMF and the Paris Club have a far more direct policy influence. Thus, there is also an argument to be made for their withholding funds in a carrot-and-stick approach. Chastened by the near anarchy surrounding the debt crises of the recent past, lenders have come to see the need for a coordinated case-by-case approach to the problem. There is no rigid framework, but the rough terms of their informal truce look like this: multilaterals provide new lending quickly, private-sector banks agree to restructure and forgive some debt, and the debtor government and Paris Club creditors agree to short-term grace periods and to reschedule debt. And private creditors agree to participate in voluntary restructurings and promise to keep money flowing under certain conditions.

The other area where there has been significant progress is in the reestablishment of regular dialogues between the private sector, the Paris Club, and the international financial institutions. Private-sector creditors were particularly incensed with the Paris Club over Ecuador, but the group of creditor nations has now begun meeting regularly with the Emerging Markets Traders Association, the Emerging Markets Creditors Group, and the Institute of International Finance. Importantly, the Paris Club has agreed to make public its rationale and conclusions for determining whether a debtor is treating its private and official creditors equallyŽthough the creditor nations continue to insist that they (not the private sector) will determine exactly what is fair.

Some economists argue that postponing debt workouts may end up causing more problems in the long run. This spring, as Argentina was undergoing one of its recurrent paroxysms of panic, a group of economists suggested that the country should carry out a preemptive default and press its debt holders to forgive 25 to 30 percent of face value. In return, the debt would be restructured in such a way as to give bondholders direct participation in the country's higher revenues as the underlying economy improved.

Less debtŽor at least less of the highest-risk debtŽis the goal of private-creditor watchdogs as well. The latest recommendations of the Basel Committee, which monitors international banks' policies for reducing country risk, aim to reduce the potential domino effect that bankruptcies could have on the global financial system. Putting tighter risk policies in place is a healthy start but is likely to have an unwanted side effect. Bank lenders say privately that the real effect will be to increase the price of loans to medium-rated countries and reduce the amount of money available.

That, in turn, brings us back to the old vicious-circle conundrum: if the high cost of servicing debt is what is dragging down economies and preventing them from investing in themselves, then are the current solutions enough? Or do they simply beg the question of what to do when there is simply too much debt? One of the problems in Ecuador's restructuring was that the only way it would have been able to keep its 1994 Brady agreement was if everything went right. In a way, the "solution" to its debt problem only condemned it to a future cycle of default and restructuring. The World Bank's HIPC initiative, though many critics call it a day late and dollar short, recognizes that in some cases it is best to start wiping the slate clean if countries agree to invest in health and education and follow sustainable economic policies.

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A Lasting Solution
Too much debt and not enough money to pay is a fairly simple equation, if not a happy one. International rescue plans have not gone far enough toward recognizing this. And as the last decade has shown, it is too easy for debtor nations to resume piling on debt once money starts flowing in again. In times when the international markets are flush with cash, investors are much more willing to take on additional risk and thus can create the illusion that a debtor country has miraculously "solved" its problems after a crisis. The solution to debt crises lies as much in the lull after a default and restructuring as it does in the mechanics of the restructuring itself. A long-term solution to the problems of debtor nations would be to use money raised during good times to reduce their overall debt burden and to provide a cushion when times get bad. Mexico's efforts in this regard have been exemplary. It has kept its budget balanced, used its rising credit rating to lower its debt servicing costs, and, most important, reduced its debt levels to 30-year lows.

The willingness of creditors to resume a regular, constructive dialogue on the problem of debt is a step in the right direction, as is the progress the debtor nations have made over the past several years in making readily available information about their budgets, monetary policy, and efforts to spread out debt payments instead of allowing several large obligations to come due all at once. The next step is for creditors and debtors to focus their discussions on ways to keep debt crises from recurring.

Multilaterals need to incorporate more flexibility in the economic policies they mandate and be more accountable in the event their policies make it harder for a country to keep up with its debt payments.

Creditors must continue to revisit the question of what "fair treatment" meansŽand what the costs are of continuing to divide responsibilities as they now do. Although it is "easier" for the private sector to write off debt than it is for the multilaterals and the Paris Club to do so, frequent write-offs mean that the private sector ends up having to charge more for the money it lends to developing countries.

Meanwhile, the IFIs and the Paris Club have been limited to lending new money Žwhich often goes largely toward keeping up payments on existing debtŽor granting grace periods. In the end, these realities lead to the creation of more debt and the prolongation of the problem.

In their approach to struggling countries, the IFIs and the Paris Club must focus far more explicitly on the goal of reducing debt. Considering the political goals behind Paris Club lending, member governments arguably have received nonfinancial compensation far beyond the usually below-market rates they charge. Paris Club debt is thus a clear candidate for forgivenessŽespecially if it is tied to policies that promote growth. A possible test case for such a plan has been proposed by the Dominican Republic, which has asked the United States to forgive portions of Dominican bilateral debt if the Caribbean nation uses the resulting savings for development projects on the poverty-stricken border with Haiti.

If the multilaterals cannot forgive debt without harming their preferred-creditor status, they should turn their efforts instead toward finding ways to reduce the cost of servicing debt to debtor countries. Some multilateral lending institutions, notably the World Bank and the Inter-American Development Bank, have begun guaranteeing bonds issued by countries in distress, including Argentina and Colombia. This divides the burden and lowers costs to debtor countries. And the multilaterals can hardly accuse investors of moral hazard if they contributed the collateral that convinced the investors to lend in the first place.

Reducing the cost of debt, however, makes borrowing more attractive. So as not to fall into this trap, debtors and creditors alike must make it a priority to reduce and restructure existing debt in ways that make it easier to manage.

Restructuring and improving the supervision of domestic banking systems during good times can also help a country keep bad times from getting worse; this has proved to be the case in the Philippines, Brazil, and Argentina. "Safe and sound banking systems are paramount to avoiding the default trap," says Citigroup's William Rhodes.

In his recent book, The Volatility Machine (Oxford University Press, 2001), veteran emerging-markets banker Michael Pettis argues that debt crises are virtually inevitable in small and medium economies because international liquidity conditions over which they have no control are what drive investment to or from them. He argues that countries should put more effort into structuring their finances in order to protect themselves. This includes active liability management, including the issuance of debt in their own currencies. This can reduce the impact of debt crises by sharing the benefits and costs of liquidity shifts with investors and has the advantage of dovetailing with efforts to develop local-currency capital markets. These nascent markets encourage domestic savings to stay in the country and provide a vehicle for growing local pension-fund and mutual-fund investment. These funds can in turn be channeled into domestic industry, boosting the economy and increasing a country's ability to meet its obligations.

Other mechanisms are needed to reward good behavior and meet the need for deeper relief. Countries could lower costs by using special structures like the value-recovery-rights warrants attached to Mexico's Brady bonds; the warrants allowed Mexico to pay a lower interest rate in exchange for the promise to pay more when prices for its oil exports rose.

In the end, some of today's dilemmas stem from too much of a good thing. The emerging-markets boom that followed the 1980s debt crisis made it too easy to borrow and to lend. But the recent financial crises make it evident that think-first, pay-later policies only end up fraying both ends of the debt rope. A better approach is to plan ahead during easy times so the players don't end up arguing while passing the buck.

Notes

1. The Paris Club is an informal group of official creditors (including the G-8 nations, ten other European nations, and Australia) whose role is to coordinate sustainable debt relief for economically troubled nations. The first meeting with a debtor country was in 1956 when Argentina agreed to meet its public creditors in Paris. Since then, the Paris Club has negotiated 334 agreements for 75 countries on debts totaling $374 billion.

2. The risk that a party to a transaction has not entered into a contract in good faith, has provided misleading information about its assets, liabilities, or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. [Source: International Financial Risk Institute]

3. See Jeffrey Sachs, "Do We Need an International Lender of Last Resort?" Graham Memorial Lecture, Princeton University, 1995; and "Creditor Panics: Causes and Remedies," October 22, 1998. Both available online at http://www.cid.harvard.edu/cidpublications/hiid/newnote.html.

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