The Mexican crisis of 1994/5 came as a rude surprise to the international policy-making community. It revealed serious confusion over how markets, governments, and multilateral institutions like the IMF should deal with financial crises of heavily indebted countries. And it laid bare a remarkable lack of planning for the international debt threat in a world of globalized bond and equity markets.

A recent CEPR Report presents a new response to the debt threat. Authors Barry Eichengreen and Richard Portes believe that there are workable alternatives to either ‘throwing money at the problem’ with a bailout from official funds or taking a ‘hands off’ position that runs the risk of chaos and contagion. They offer an agenda for reform of the debt restructuring process in which:

• Rapid action could halt the creditors’ rush for the exits, preventing the panic from destabilizing the country’s banking system and severely dislocating its economy.
• The quick conclusion of debt restructuring negotiations between bondholders, banks, official creditors and the indebted government would be facilitated.
• Where an injection of funds is essential to prevent the crisis from spilling over into the banking system or spreading to other markets, the pump would be primed by the limited provision of funds by the IMF, conditional on policy reforms to encourage the market to supplement official funds.
• Crisis management measures would be administered in an incentive-compatible way that encourages governments to release information on economic conditions in a timely fashion.

The Report analyses a variety of existing approaches to coping better with Mexico-style crises. These include changes in the provisions of loan contracts and bond covenants; the creation of bondholders’ steering committees; establishment of a venue for bilateral negotiations between bondholders’ representatives and the government of the indebted country; and closing the courts of creditor countries to dissident creditors by statute or treaty. One particularly prominent proposal is for a bankruptcy procedure for developing countries analogous to Chapter 11 of the US bankruptcy code.

Eichengreen and Portes find problems with each of these proposals. The creation of bondholders’ committees would not halt the creditors’ rush for the exits. Countries that have been reluctant to suspend debt service payments unilaterally for fear of damaging their reputations would have no incentive to behave differently. Settlements would still take time, and the injection of new money would remain difficult. Closing the courts to creditors would prevent dissident creditors from using legal means to hold up a restructuring, but would not address the other problems with current procedures.

The authors also regard an international court with powers analogous to those enjoyed by US bankruptcy courts as a non-starter, given the very great legal obstacles to implementation. Even operating under a treaty, such an international court would be unlikely to possess the powers of a national court to enforce seizure of collateral, given sovereign immunity. Nor would it be able to replace the government of a country in the way that bankruptcy courts replace the management of firms. The danger of moral hazard would be great.

Despite their critique, the authors’ proposals include elements of the alternative approaches. A quick initial reaction to a gathering crisis is essential, and their first recommendation is that the IMF should more actively transmit signals about the advisability of temporary unilateral payments standstills. Governments can impose the equivalent of a standstill by suspending debt service payments. But they hesitate to do so for fear that they will jeopardize their future credit market access.

Encouraging the IMF to advise the debtor and issue opinions on the justifiability of a stay of payments would give the Fund an important signalling function. A government that received approval for its standstill would suffer relatively little damage to its reputation, while the possibility that the Fund would not approve would discourage governments from utilizing the option strategically. Naturally, the IMF should limit its advice to the debtor government before the fact and share its opinion with the markets only ex post.

Creating a single international Bondholders’ Council would eliminate uncertainty about the locus of authority in negotiations. It would be responsible for restructuring bonded debts, while the London and Paris Clubs would retain their responsibility for bank loans and official credits. Discussions between debtors and the Paris Club, the London Club and the Bondholders’ Council would rely on a specially constituted conciliation and mediation service designed to minimize the danger of an extended deadlock.

Changes in bond covenants to permit a majority of creditors to alter the terms of payment would prevent dissident investors from holding up a settlement. To make this palatable to potential lenders, dissident creditors would have recourse to an arbitral tribunal. To prevent a negotiated agreement or the findings of the arbitral tribunal from being disputed in court, loan agreements would specify that objections by minority creditors be subject to the tribunal’s arbitration.

Strengthened IMF monitoring and conditionality would reduce the likelihood that financial problems recur. The knowledge that any new money injected in conjunction with a debt restructuring (and even Fund sanction for a country’s unilateral standstill) is predicated on stringent IMF conditions would work to minimize the likelihood of such difficulties arising in the first place.

Frequent IMF monitoring of economic conditions in debtor countries and timely dissemination of information by the Fund would strengthen market discipline. Increased resources available to the Fund would allow, where appropriate, injection of new money on the requisite scale.