U.S. Department of the Treasury

(Archived Content)

FROM THE OFFICE OF PUBLIC AFFAIRS

We have been through a remarkable period of change in the world of emerging market finance.

Despite the speed and strength of the recovery that followed the recent crises in emerging market economies, and despite the substantial investment in reforms now underway to reduce the vulnerability of these economies to future crises, I think its fair to say that managing the consequences of the growing integration of national economies and financial systems remains among the defining international economic policy challenges of our time. Central to it is the task of reducing the incidence and severity of financial crises in emerging markets.

This is a good time to take stock of the changes that have been put in place and to consider what additional steps could be taken to help contribute to this objective. I thought it would be useful to outline the basic principles that we believe should guide the international community's approach to financial crises in emerging economies going forward. And in this context, I want to outline a set of proposals to improve the process for crisis resolution, including greater transparency in official policy to help facilitate dialogue and cooperation between the official sector and the private sector, and between governments in crisis and their creditors.

Over the past decade, we have seen a dramatic set of changes in the international financial markets -- changes that have substantially increased the opportunities available to emerging market economies to draw on international capital to finance growth. And yet policymakers are still in the early stages of adjusting to the challenges that have accompanied those changes.

Among the most conspicuous of those changes are the increase in the scale of resources available to emerging markets, the increase in the scale and speed with which capital can move across national borders in response to shifting perceptions of risk and opportunity, the huge changes in the composition of financial flows to the emerging markets, the proliferation of new instruments, the dominance of securitized forms of finance, and the spread of complex derivatives, the increased fungibility of financial assets, the new diversity of market participants, both borrowers and investors, the breadth of potential contagion, , the spread of sophisticated risk management practices that can reinforce market movements in times of stress, the much greater capacity for leverage in the system, and the general challenges that arise from the greater disparity between the scale of financial flows that can now move into and out of domestic assets and the relatively limited depth and breadth of some national financial markets.

It is hard to avoid the conclusion that the system was in some sense behind the curve in developing the capacity to manage these new sources of pressure and risk. Policymakers in the emerging markets were behind the curve, and the rest of us were as well.

We have initiated a number of changes over the past few years to help lay the basis for a stronger, more resilient system:

• The level of transparency and disclosure has improved substantially.
• There has been a substantial move toward more resilient and more flexible exchange rate regimes.
• The degree of some types of leverage in the official and private balance sheets of most post crisis economies has been reduced; in particular, the ratio of short term debt to reserves is now more healthy almost everywhere.
• There is greater consensus behind eliminating perverse incentives that encourage certain types of leverage and behind advancing debt management practices that leave governments less vulnerable to liquidity, exchange rate and interest rate risk.
• We are starting to see improvements in insolvency regimes at the national level, and limits on the scope of implicit government guarantees to the financial system that created significant distortions in capital allocation.
• There have been important investments in risk management systems in private financial institutions and in supervisory policy, both in borrowing countries and in countries that supply capital.
• The repair, recapitalization, and restructuring of banking systems in the emerging markets are progressing, aided by much greater support from the international financial institutions and regulatory bodies than existed before.

These changes will help reduce the risk of future crises, but they will not eliminate them. So along with these investments in crisis prevention, we have supported a number of important changes to the international community's capacity to respond to crisis.

• We have equipped the IMF with new resources and new instruments to provide rapid large scale access in exceptional circumstances and at a premium price. And as a complement to this, we have given the World Bank the capacity to lend in emergencies and to offer a broader set of risk sharing instruments and guarantees to help bridge to a return to broader capital market access.
• And we have promoted and supported new approaches for dealing with private claims in crises. From the rollover commitments and debt exchange by external bank creditors in Korea to the comprehensive debt exchanges used to restructure and reprofile bonded debt in cases with more acute financial problems, the market is gaining experience with a variety of responses to diverse circumstances.

These recent experiences with crisis resolution involving private claims are important for the evolution and health of the system. They are important not because they were perfect models of cooperation -- they each provide useful examples of what probably should be avoided in the future. Nor do they provide viable solutions to all problems. They are important because they demonstrate different ways in which bonds can be restructured, relatively quickly, without necessarily causing broad systemic disruption. They are important because they help focus attention on a country's policy performance, risk profile and other factors affecting its capacity to meet its obligations in full and on time. They are important because they help reduce the risk that future investments would be made on the misplaced assumption that they will be protected by official finance. And they are important because they have helped encourage useful initiatives in the private sector for dealing with these problems in the future.

The overriding objective that should shape the official sector's approach to emerging market finance going forward is to build a system that provides for deeper and more durable flows of private capital to emerging market economies. This requires a strong official capacity to act in financial crisis to promote a rapid return to growth and confidence in the diverse cases we are likely to confront, in ways that are good for the system as a whole and do not increase the risk of future crises. You cannot have a viable international capital market without recognition of the importance of contract rights and the equally important recognition that there will be circumstances where sovereigns will fall into acute distress and will be unable to meet all their obligations on time or in full.

Our pursuit of these objectives has been, and should continue to be, shaped by a core set of presumptions:

• It is a crisis country's capacity to design and carry out credible economic policy that fundamentally determines its ability to overcome financial crisis.
• The official sector's capacity to differentiate between temporary problems of confidence and more deep-seated economic and financial problems is essential to its ability to catalyze positive outcomes.
• In a world marked by large flows of private capital, private investors are necessarily part of the solution to financial distress. Private investors should not expect to be protected from adverse outcomes by official action.
• The official sector should be willing and prepared to act forcefully with official finance in exceptional circumstances when it can help catalyze outcomes that are good for the country and good for the system. In a world of more mobile capital, the most effective financial intervention by the official sector may, in some circumstances, be large in relation to traditional measures of access, such as quota.
• The most effective solutions are the most voluntary and cooperative ones that are possible. But it is neither desirable nor feasible to take off the table the possibility that in extreme circumstances, governments may have to run arrears or suspend payment on a broad set of claims.
• If a change in the terms of private financial contracts is unavoidable, the official sector's systemic interest in well functioning markets is best served if investors have confidence that they will have access to information, that they will have the opportunity to engage in a constructive dialogue with the borrower on an appropriate solution, and that their contract rights will be respected.
• No one category of private creditors should be regarded as inherently privileged relative to others in a similar position. Broad equity in the treatment of similarly situated private claims is likely to be a feature of successful restructurings.

In applying these objectives and presumptions to the design of programs in crisis, the challenge is to find the right combination of policy change, official finance, and the treatment of private claims that is appropriate to the circumstances at hand.

To provide greater clarity and certainty about crisis response and help shape the expectations of market participants and policymakers, the G-7 and the IMF have outlined a set of general principles and guidelines to frame official action, while maintaining the necessary flexibility to differentiate among cases. The actions we have taken over the past several years in individual cases also provide a useful guide for the future. But the official sector must preserve the capacity to design and support solutions that are appropriate to the diversity of crises we will confront in the future. In the brief span of the last five years, we have seen a rich mix of crises, from what looked like the classic cases of macroeconomic imbalance caused by fiscal excess or other macroeconomic policy error, to problems of excessive leverage in the banking and corporate sectors. These problems have occurred in countries with substantial differences in payments capacity, in their degree of integration with the international capital markets, in their prospects for return to market access, and in the nature of the financial claims affected. And they have occurred at times of varying degrees of stress in the international financial system. It is not realistic to attempt to design rules or guidelines to provide a meaningful guide for action in circumstances this varied, much less in the uncertain future.

There is a popular view that many recent crises were pure short-term liquidity crises precipitated by contagion affecting otherwise innocent, fundamentally healthy economies. But, in fact, we have not seen a serious financial crisis that did not have important causes in fundamental weakness in policies and institutions in the affected country. Even where the long-term financial and economic capacity of the country seems strong in the face of short-term financial pressure, near-term policy adjustment will be a necessary part of a solution to restore confidence.

Over the past five years, we have taken a variety of steps to help strengthen our capacity to mobilize official finance in response to crisis. In a world of substantially greater capital mobility, it would be both a policy mistake and not be fully credible to foreswear the capacity to respond to exceptional crises with exceptional financial force. And because it is critical to minimize the risk that such new financial capacity will be misused, we have put in place progressively more difficult activation thresholds for accessing the emergency facilities available in crisis - whether from the IMF's newly expanded quota resources, the New Arrangements to Borrow, or supplementary bilateral resources. Several conditions should constrain recourse to exceptional finance:

• It must be reserved for truly exceptional circumstances, such as where there is a broader risk to the stability of the financial system.
• It must be employed only in circumstances when we are confident that exceptional access is necessary to achieve the desired outcome.
• It must be used only when we are confident of prospects of repayment, and must be accompanied by appropriate conditions.
• It must carry premium interest rates and shorter maturities to encourage the earliest possible return to private markets.

It will always be difficult to find the right balance between preserving a credible financial capacity to address exceptional risks and reducing the risk that such capacity distorts financial decisions by governments and investors. Looking at the level, composition and price of today's flows to the emerging markets, I think it is hard to find evidence that such flows are substantially distorted by moral hazard. The probability of default on long-term emerging market debt implied by current EMBI spreads suggests investors do not expect to be protected by official action. In part, this is true because the markets seem to recognize that the scale of official resources potentially available for crisis response is always likely to be limited in comparison to the scale of potential outflows (domestic as well as foreign). In part, this is true because the availability of official finance cannot compensate for the failure of governments to sustain policies necessary for recovery. It should be clear that the official sector should not seek to prevent, even if it could, a country unable to implement a credible economic policy program from falling off the proverbial cliff.

The reality of markets today is that private creditors will necessarily be involved in financial crises in emerging markets; they will not be and indeed cannot be insulated from the risk of losses during periods of distress. When crises happen, the official sector and private creditors share a strong interest in developing ways to resolve collective action problems.

• Where official finance is effective, it will be so because it supports a set of policy reforms that can help induce investors to stay in and can help catalyze a return of private flows.
• In this context, it is encouraging that the private sector was able to agree in 1998 to maintain exposures and then ultimately restructure their claims into longer dated tradeable instruments in Korea, and in 1999, to monitor the rollover of short term claims on Brazilian banks. And it is worth exploring the extent to which market based exchanges for bonded debt could be part of the solution in similar circumstances in the future.
• It is also important that borrowing countries and the markets now have a bit more experience in managing more comprehensive restructurings of sovereign debt, including bonds, in circumstances where the borrower does not have the resources to meet its obligations on time or in full, and where a more substantial change in the profile of a sovereign's external debt is necessary to create a viable financial position going forward.

It should be clear from recent experience that both the appropriate role and scale of official finance and the nature of the contribution of private investors fundamentally depends on a judgment about the country's position on a spectrum that ranges from cases marked by aspects of a run to cases where the country's debt and financial structure is inconsistent with its underlying fundamentals. It should also be clear that there are only shades of grey on this spectrum. In the sovereign context, there are no pure cases of pure insolvency: ability to pay depends in part on will to pay. There are almost certainly no pure cases of pure illiquidity: countries do not encounter significant, sustained financial pressure without some underlying economic weaknesses.

The challenge is to design ways that make it possible to achieve viable outcomes without tilting the system in the direction of encouraging either easy recourse to the practical equivalent of default or market structures that make it untenable for a sovereign to agree with its creditors on a restructuring in cases where one is necessary.

There are a few basic tenets that are important to preserving the right balance between these objectives, and minimizing inevitable tension between them. As I said earlier,

• The most effective solutions are likely to be the ones that are least disruptive to markets and the most voluntary and cooperative in nature.
• Creditors are more likely remain engaged in emerging markets and cooperate if they have confidence that they will have information in crisis situations, the opportunity to engage in a meaningful dialogue with the borrower on an appropriate solution, and the expectation that their contract rights will be respected.
• No one category of private creditors should be regarded as inherently privileged relative to others in a similar position.

There will be cases where the extent of the deterioration in a sovereign's financial position makes dramatic action unavoidable. In such cases, a temporary period of arrears may be unavoidable as the government works to put in place an economic reform program that could form the basis for a broader financial solution with its creditors. It is neither desirable nor feasible to take off the table the possibility that, in extreme circumstances, governments may have to suspend payment on a broad class of claims.

But it would not be appropriate for the official sector to endorse, much less encourage, the early imposition of broad payments suspensions as an attractive solution to crises. The concept, theoretically appealing to some, of a comprehensive standstill as circuit breaker to stem panics and contagion, applied in a world where capital is as mobile as it is today, would be more likely to magnify panic and the resulting economic distress. In countries with strong underlying fundamentals that are adjusting policies to restore confidence, trying to prevent investors from adjusting positions in a rational reassessment of risk would risk turning temporary quasi liquidity problems into deeper, more protracted problems of insolvency.

It also would be counterproductive and inappropriate for the official sector to create the expectation that whenever IMF financial assistance is in prospect, such assistance will come with the condition that the country imposes a financial solution on its private creditors. And we do not think it makes sense to seek to develop a formal capacity in the IMF to protect countries that run into difficulty from legal action; we do not support modification of Article VIII.2.b.

These approaches would severely damage the prospects of creating a more viable market for emerging market finance and would severely damage capacity of the international community to respond to and contain the effects of financial crises when they happen. They would probably increase the scope and severity of crises by precipitating a broader rush for the exits at the first sign of stress, both in the country immediately affected and the emerging markets more broadly, reducing the prospect of achieving an efficient, stable market for the financial assets of emerging market economies.

The complexity of these problems and the inherent uncertainty and rich variety of sovereign financial crises do not relieve us of the obligation to provide as clear and predictable a framework as possible for the process of crisis resolution.

Toward this objective, we believe the official community should adopt a series of steps to establish:

• a clearer framework for official action, clarifying in particular the respective roles of the IMF and the Paris Club;
• more transparency by the official sector in the information and analysis that is provided to market participants; and
• a system that provides more active encouragement of borrowing countries to engage in meaningful dialogue with their private creditors and to develop more effective means of cooperation with their creditors, before, during and after crisis.

There is an unfortunate degree of uncertainty among market participants about the respective roles of the IMF and the Paris Club in circumstances where countries run out of resources and need to reprofile their financial obligations. It is important to note that there will be many cases which will not involve a Paris Club restructuring, and the IMF program will not need to provide appropriate balance between the expected contributions of Paris Club creditors and private external creditors. But it is still worth clarifying their respective roles.

The basic judgments at the core of designing an appropriate response to crisis are made by the IMF. It is the IMF's job, working with the government of the country, to assess the nature and degree of economic adjustment required, the policies that will contribute to recovery, the prospects for restoration of market access, the debt profile that is consistent with a country's medium-term payments capacity, and the appropriate scale of official financial assistance, including, where relevant, the need for rescheduling by Paris Club creditors. These judgments are central to an assessment about the scale of resources that the government should be able to provide its creditors, official and private, and, where the resources are insufficient to pay all obligations in full, the consistency of the broad terms of any restructuring with the country's medium term financial viability. The basic presumption underlying the allocation of available financial resources between private and official bilateral creditors is that the two groups should be paid in rough proportion to their relative shares of obligations coming due in the IMF program period, with appropriate consideration of factor such as accumulated arrears and sustainable debt profiles.

These judgments in turn inform the decision by the Paris Club creditors on whether and how to reschedule their claims, and how to assess compliance with what has been the standard practice of requesting the sovereign debtor to seek comparable treatment from its private creditors.

It is neither the IMF's job, nor the Paris Club's, to micromanage the terms of the financial solution a country seeks with its private creditors, nor to impose a specific form which resolution should take. But the IMF and the Paris Club should expect that a country, when seeking comparable treatment, will aim for the inclusion of all material classes of creditors, and engage in meaningful dialogue with its creditors in the context of achieving a viable payments profile.

To help clarify the basis on which these judgments are made and applied, we believe it would be appropriate for the IMF and the Paris Club to take the following steps:

• As a key element in the process, the IMF should be prepared to support the national authorities in briefing the country's creditors on its financial and economic situation, its expected financial needs, and the policy content of the country's IMF program.
• The official sector should provide for prompt and systematic disclosure of the agreed key financial terms of Paris Club reschedulings and, where comparability is required, the financial terms of restructurings agreed with private creditors.
• The official sector should outline in public the broad factors that will guide a judgment about comparability going forward.
• And the official sector should provide to the market regular and timely data about the scale of Paris Club claims on a country, the repayment profile of those claims, and the incidence and scale of arrears.

These steps can help provide a greater degree of confidence in markets that material information will be disclosed more systematically to all creditors. In this context, private initiatives to make available to borrowers and their creditors a means of communication in crises are particularly helpful.

The official community needs to find a way to encourage all countries to invest in better mechanisms for dialogue and communication with their creditors, both in good times and bad. This is not rocket science. There are a number of good models out there for how to do it well. Good investor relations are obviously in the interest of a country that wants to be able to access the markets. It should be standard practice across all emerging markets. The IMF can play a useful role in more systematically promoting the importance of good investor relations in its normal Article IV consultation with its members.

In crisis, it is even more important that there be better mechanisms in place for communication and dialogue between a country and its private creditors. The official community has to be prepared to make it clear in those circumstances that official financial support will be conditioned on the borrowing country providing creditors with access to all material information about its economic and financial situation, supplemented by the IMF, and entering into a meaningful dialogue with its creditors. The form of that interaction will necessarily vary and should not be mandated by the official sector - it is up to the creditors to organize themselves in a way they find most effective, and it is up to the sovereign borrowers to engage responsibly with their creditors however organized. If a critical mass of creditors decides to form a creditor committee in order to participate cooperatively in the resolution process, it makes sense for a government to talk to that committee. There will be circumstances when negotiated solutions may be the most effective path to resolution, and in this situation committees may be helpful. Other models may be more effective in many circumstances.

When a borrowing country and a critical mass of creditors are cooperating to achieve a debt restructuring, it is in their collective interest to have the widest possible participation in the restructuring and to minimize the extent to which a handful of creditors might seek to impede a successful restructuring or to gain unfair advantage over the cooperative majority. Accordingly, we continue to believe that wider use of contractual provisions such as majority amendment clauses in international sovereign bonds, notably those governed by New York law, would help facilitate crisis resolution. We are encouraged that many investors now recognize that the voluntary use of such provisions is in their long-term interest.

While there is a general recognition of the constraints that make it unrealistic to replicate for sovereigns the workout procedures that are available in our domestic markets for corporate borrowers, it makes sense to make some modest changes at the international level to inject a greater degree of transparency and predictability to how the process of crisis resolution should work. These proposals go some distance in that direction.

But while there are constructive steps that the official sector can take, there also are limits to what the official sector can do. What has perhaps been most striking over the past five years is the diversity of crises we have confronted. The type of trouble that sovereigns encounter will vary significantly - as will the appropriate responses on the part of the official sector, the private sector and the crisis country. Yet it is hard to escape the conclusion that, given the small number of issuers on one side of the market for emerging market sovereign debt, the way each individual case is handled assumes greater importance than it does in a market with a larger number of borrowers. Unfortunately, the sovereigns that get into the deepest trouble are also those least likely to set attractive precedent. Both capacity to pay and capacity to maintain a constructive, cooperative relationship with investors during a time of distress ultimately depend on the same things: political will, the choices a government makes, a government's capacity to deliver. It obviously helps if there is a government with a time horizon of longer than a week, a month or a year. Politics matters as well as economics. Just as the official sector cannot force a country to take a broad range of policy steps that are in its long-term interest, it cannot compel a country to maintain the type of dialogue with its creditors that is the long-run interest of the country, and in the interest of the system. Fundamentally, it is the government of the crisis country that must commit to seeking to resolve its financial problems in a way that lays the basis for its long-run return to financial health and its reintegration into global markets.