UDROP – NEW FINANCIAL ARCHITECTURE

The world could be spared some of the worst effects of major international financial crises if debtors were given a breathing space to meet their obligations when credit markets seize up. A paper published by the Centre for Economic Policy Research develops the concept of a debt rollover option for foreign currency borrowers. This would limit the destructive consequences for the real economy of a crisis of the kind that occurred two years ago in East Asia. The authors, Professors Willem Buiter of the Bank of England’s Monetary Policy Committee and Cambridge University, and Anne Sibert of Birkbeck College, University of London, call their version UDROP (Universal Debt Rollover Option with a Penalty).

In essence, a foreign currency borrower would, when the debt matures, be able to defer repayment for a fixed period through the exercise of a debt rollover option.  The terms of the rollover would be negotiated with the creditor at the same time as the original loan. The option would be exercised at the discretion of the debtor.  The proposal aims to prevent solvent borrowers being forced into unnecessary and socially costly default by a rollover crisis brought about by disorderly financial markets.  It will improve global economic performance to the extent that it helps countries that are solvent and willing to pay, but are prevented from doing so because international financial and credit markets have a temporary seizure.  Thus South Korea would have benefited from such a scheme, but it would have been irrelevant in the case of Russia, which is insolvent even when financial markets are orderly.

When the crisis struck in 1997, Korea faced huge short-term foreign currency debts which totalled more than the central bank’s reserves. The proposed debt-rollover scheme might have enabled it to work its way out of these short-term financial problems without recourse to the same contractionary measures that inflicted such damage to the real economy from mid-1997 onwards.

This central problem is characteristic of many financial crises. Professors Buiter and Sibert write, ‘UDROP is meant to address the situation where a large number of people all try to leave a room simultaneously through a small door, hotly pursuing a limited number of prizes that will be handed out on a first-come first-served basis.’

The mechanism would be rule-based and negotiable between debtor and creditor. The only involvement of any outside agency might be to declare the existence of disorderly market conditions, which could be made a precondition for the exercise of the option by individual borrowers. Central banks could perform this role at the national, and the IMF at a global, level.