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New IMF and G-7 Strategies Needed to Resolve International Financial Crises

September 28, 2004

Washington, DC—A new Institute study of the financial crises that have recently plagued the world economy reaches a number of surprising conclusions:

• Private creditors have contributed far more emergency financing in recent crisis cases than is commonly assumed. In some cases, private creditors have been bailed in as part of a planned rescue (Korea, Pakistan, Ukraine, and Uruguay). In other cases, a rescue program failed before most creditors could get out (Argentina and Russia).
• Sovereign bonds have not been the most important source of financial pressure on crisis countries. The roll-off of cross-border bank credits and domestic bank deposits are typically bigger drains.
• The absence of bankruptcy-style protection from litigation is not the most important problem that arises in a sovereign debt restructuring. Rather the biggest risk is that a sovereign restructuring will trigger a broader collapse of domestic confidence, a run on the banks, a run on the currency, and Argentine-style economic and financial collapse.

Bailouts or Bail-ins? Responding to Financial Crises in Emerging Economies by Nouriel Roubini and Brad Setser provides the first comprehensive analysis of the series of international financial crises that started with Mexico in 1994–95. It assesses the recent large IMF loans to Argentina, Turkey, Uruguay, and Brazil (in 2001–02) as well as earlier lending to Mexico, the Asian crisis countries, Russia, and Brazil (in 1998–99). It integrates analysis of large IMF loans with analysis of attempts to convince private creditors to provide emergency financing to crisis countries, whether alongside the IMF or as a substitute for large-scale IMF lending.

Roubini and Setser propose a new framework for official international response to financial crises based on the following five core principles:

1. The IMF should be more willing to distinguish between countries and make hard judgments early on. Similar crises should be treated similarly, but not all crisis countries should be treated the same. The IMF has been too willing to give out large sums of money no matter how large the crisis country's debt levels and then hope that the country's problem proves to be one of illiquidity rather than insolvency.

   Countries that get into trouble despite modest deficits and little accumulated debt—like Mexico and Korea—are better financial bets than those that get into trouble with larger debts and little proven ability to reduce their deficits. These modest-debt countries are candidates for large IMF loans to provide the funds needed to meet their financial obligations while they make needed adjustments to regain market credibility. Countries such as Argentina and Ecuador, with too much overall debt relative to their ability to increase their payments capacity in addition to too much debt coming due tomorrow, need to find the best way of reducing their debt. Countries that fall in the middle need something in the middle—often maturity-extending restructurings that keep interest rates low but avoid outright debt reduction—like Ukraine, Pakistan, and Uruguay.

2. The IMF needs a more honest and realistic access policy to guide its lending decisions . Current access limits no longer reflect the IMF's actual norms for lending to major emerging economies facing “capital account” crises. Setting higher limits for a new IMF crisis facility tailored to address the needs of major emerging economies, and then sticking to them in all but the most exceptional circumstances, would tighten access to IMF lending. The precise limits can be debated; we suggest 300 percent of quota in the first year and 500 per cent of quota overall. The G-7 needs to stop pretending that the IMF is going to get out of the business of providing “liquidity insurance” to emerging economies and start figuring out how best to use the IMF's lending capacity.

3. IMF lending and a coercive debt restructuring can be complements rather than substitutes . Lending new money to a country that has to seek a restructuring because it already has too much debt is counterintuitive. However, it may still be the right way to help cushion the blow to the domestic economy likely to result from even a necessary debt restructuring. Lending to a country going through a debt restructuring can limit the risk the restructuring will trigger a broader run, systemic financial distress, and severe output collapse. It also gives the IMF the leverage to help shape the country's overall economic policy. The prolonged stalemate in Argentina shows the consequences of the G-7 and IMF pursuing a “hands-off” policy in a complex crisis.

4. Banks remain as important as bonds. Cross-border interbank credits have gotten off the hook too easily in recent crises despite being a prime source of financial pressure. At times, short-term creditors of a crisis country will need to be persuaded to refrain from exercising their option to exit to increase the odds a country will emerge from its crisis. The IMF also needs to be willing to fund a domestic lender of last resort during an external restructuring, to limit the risk the restructuring will prompt a run on the local banks, fuel a free fall of the currency, and lead to broader economic collapse. However, the IMF should support domestic lenders of last resort only in countries that are making clear efforts to clean up and reform their banking systems.

5. The G-7 should not rely on the IMF to save countries that are too strategically important to fail . The IMF is a universal institution that needs to respond similarly to countries with similar financial problems. The IMF should not be used as the G-7's geopolitical slush fund. If the G-7 wants to give a politically important country like Turkey a special break, it should do so on its own.

A framework based on these principles would address the main weaknesses of the G-7's current approach to crises. Talk of limiting IMF lending has not translated into smaller bailouts or produced consistent lending decisions. The IMF's total lending to the major emerging economies now exceeds its total lending at the peak of the Asian, Russian, and Brazilian crises. Rather, IMF lending programs have tended to increase in size as countries' debt levels—and resulting financing needs in the absence of a debt restructuring—increase in size. The range of problems addressed by large-scale IMF lending has expanded dangerously and now includes providing large medium-term—or perhaps long-term—loans to prevent large government debts from spiraling out of control.

The G-7 and IMF's approach to debt restructuring has been no more coherent. The IMF and the G-7 have not been willing, at least for large countries, to play an active role either in inducing a change in an unsustainable exchange rate regime or in helping a country through its debt restructuring. The current “hands-off” approach has weakened the IMF's ability to resolve crises in an orderly way. False expectations have been created that a better process for restructuring international sovereign bonds will reduce IMF lending and let the IMF disengage from the debt restructuring process.

Financial crises are not all alike. They include currency crises, sovereign debt crises, banking crises, and systemic corporate crises. Such crises are often linked since prevalence of foreign currency–denominated debt in most emerging economies means that currency crises often become payments crises. No matter what the cause, the core options in a payments crisis are the same. One option (“bailout”) is a rescue loan from an international financial institution, such as the IMF, or from a major country like the United States. If all goes well, the country regains access to financing from private markets, money starts flowing back into the country, reserves rise, and the country can repay the IMF. But the IMF never makes available enough money so that everyone—including all domestic investors—can exit without taking losses; success is not guaranteed. The other option (“bail-in”) is to encourage the country to ask its creditors to agree to roll over or reschedule their maturing claims, which requires at least the implicit threat that the country will halt payments if the creditors do not agree. A bail-in typically only addresses the category of financial claims that poses the biggest immediate threat. Thus, in practice, the IMF and the G-7 have to choose among a partial bailout, a partial bail-in, and a combination of a bailout and a bail-in.

About the Authors

Nouriel Roubini is an associate professor of economics and international business at the Stern School of Business, New York University. He was a faculty member of the economics department at Yale University (1988–95). He was senior economist for international affairs at the White House Council of Economic Advisers (1998–99) and senior adviser to the undersecretary for international affairs and the director of the Office of Policy Development and Review at the US Treasury Department (1999–2000). He has been a long-time consultant to the International Monetary Fund and a number of other public and private institutions. He is a fellow at the National Bureau of Economic Research and the Centre for Economic Policy Research. He is coauthor of Political Cycles: Theory and Evidence (MIT Press, 1997).

Brad Setser is a research associate at the Global Economic Governance Programme at University College, Oxford. He was an international affairs fellow at the Council on Foreign Relations and a visiting scholar at the International Monetary Fund (IMF). He served in the US Treasury from 1997 to 2001, where he worked extensively on the reform of the international financial architecture, sovereign debt restructurings, and US policy toward the IMF.  Among other positions, he was the acting director of the US Treasury's Office of Policy Development and Review and its Office of International Monetary and Financial Policy.

About the Institute

The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. The Institute's staff of about 50 focuses on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and covers all key regions—especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site.