Since the Asian crisis of 1997/8, there has been extensive debate about how to strengthen the ‘international financial architecture’. A broad measure of consensus has emerged on crisis prevention, what is needed to limit the frequency and severity of financial crises. Specifically, there is widespread agreement on the need for greater transparency on the part of market participants, stronger prudential supervision and regulation, international standards for sound financial management, and appropriate policies towards exchange rates and the capital account.

Crisis management is more controversial and one of the most difficult issues is the best way of securing ‘private sector participation’. This is the polite expression for measures to ensure that investors ‘take a hit’ and do not escape all losses as a consequence of multilateral assistance for crisis countries. Private sector participation is essential, most commentators agree, in order to prevent IMF rescue packages from creating ‘moral hazard’, encouraging investors to lend without regard to the risks and hence undermining market discipline and the stability of the international economy.

In a new CEPR Report, published jointly with the International Centre for Monetary and Banking Studies in Geneva, Barry Eichengreen assesses the main proposals for reducing the moral hazard caused by IMF bailouts. He criticizes several fashionable approaches to reform, arguing that it is not feasible for the IMF to make its assistance conditional on commitments by private investors to restructure existing loans, roll over maturing issues or provide new money. Often the holders of debt securities cannot even be identified, much less compelled to act collectively. More fundamentally, an IMF promise to stand aside if investors refuse to cooperate is simply not credible. The costs of inaction – a severe economic contraction, an extended interruption to capital market access and a lengthy and difficult restructuring – are too painful for the official community to bear.

One alternative to large-scale financial rescues is imposing a standstill on payments. This is appropriate if the root cause of the crisis is investor panic, Eichengreen suggests, allowing a cooling-off period in which investors can collect their wits. He also draws attention to new evidence from corporate bond markets in 24 countries, which suggests that such a measure does not automatically raise borrowing costs. Unfortunately, empowering the IMF to impose or endorse a standstill raises a host of difficult practical issues that would not be easily overcome.

In any case, many crises are the result of deeper problems of inconsistent policies and disappointing economic performance. With these crises, debt restructuring has to be part of the solution. So while there may still be a case for a standstill provision to provide an umbrella for restructuring negotiations, the key innovation must be a measure that facilitates restructuring, specifically the introduction of ‘collective action clauses’ into loan contracts.

Such clauses are already widely used, Eichengreen notes. Bonds governed by English law typically include provisions enabling the bondholders to call an assembly that can pass resolutions relating to defaults and other aspects of the original agreement subject to majority consent. This contrasts with American law, which allows so-called ‘vultures’ to hold up restructuring. Pursuing this alternative means promoting their more widespread use. The IMF has already taken a first step in this direction by citing the use of collective action clauses as one factor in determining whether countries qualify for its Contingent Credit Line.

Eichengreen points out that more than 40% of all international bonds issued between 1990 and 2000 were subject to English law. If such instruments were even more widely used, the market would have a mechanism with which to restructure problem debts and there would be an alternative to relying on IMF bailouts. And contrary to the claims of some market participants, adding collective action clauses to bond contracts does not necessarily raise capital costs for emerging market borrowers.

As always, reforms should be prioritized, Eichengreen concludes. And doing so means making a judgment about the predominant cause of crises. Most observers take the view that the majority of crises reflect problems with fundamentals, not simply investor panic. They will be inclined to believe that reforms that increase reliance on market forces and limit reliance on the IMF are the best approach and more likely to attract political support. This suggests that collective action clauses, not standstills, should be the priority for those seeking to strengthen the international financial architecture.

This article summarizes ‘Can the Moral Hazard Caused by IMF Bailouts be Reduced?’, Geneva Reports on the World Economy Special Report I by Barry Eichengreen (University of California, Berkeley, and CEPR).