(The IMF exists to achieve sustainable growth and prosperity is governed by and accountable to 190 countries that make up its near-global membership. The IMF was founded by 44 member countries that sought to build a framework for economic cooperation. The IMF was established in 1944 in the aftermath of the Great Depression of the 1930s.)
Countries, similar to companies and individuals, should honor their debts.
However, when a sovereign is faced with the dilemma of default it is a distressing one for both the lenders and borrowers, where paying back the debt requires scenarios where resolutions can be achieved with repayment goals. The current dependence on the international community to bail out the private lenders deters countries from resolving unsustainable debts efficiently and appropriately amongst each other of their own initiative, especially since there is a lack of incentives for lenders and borrowers to do so. The broad ramifications may be an increase in sovereign defaults and international legal issues. The resolution is to alter macroeconomic policy in our treatment of sovereign default. In doing so, one suggested proposal is restructuring sovereign debt by creating formal procedures, an International Monetary Fund (IMF) Country Bankruptcy Court, where lenders and borrowers through a collaborative effort will restructure the debt and the IMF will preside as the governing body through this process (restructuring of debt is not too different than debt restructuring done in the private sectors, just depends on the borrower terms and the lender’s appetite for risk). This forthright approach was suggested by Anne O. Krueger, the First Deputy Managing Director of the IMF in November 2001. She believed that this “formal mechanism” would have served as a “catalyst”, and provide lenders and borrowers a number of protections during the debt restructuring process. In the following based on her proposal, I examine what leads a country to crisis or default.
Sources of Country Crisis & Economic Analysis:
It is arguable that essentially a country in crisis is a product of budget deficits, which triggers a downward-spiral in the economy through other contributing factors, such as the fixed exchange rate leading to an obscene decline in fixed exchange reserves. Also, there exists an inevitable conflict between expanding monetary policy and the fixed exchange rates. This was true in the case of Argentina. When President Carlos Menem took office in Argentina in 1989, the country had piled up huge external debts, inflation had reached 200% per month, and output was plummeting. To combat the economic crisis, the government embarked on a path of trade liberalization, deregulation, and privatization. In 1991, it implemented radical monetary reforms, which pegged the peso to the US dollar and limited the growth in the monetary base by law to the growth in reserves. Inflation fell sharply in subsequent years. In 1995, the Mexican peso crisis produced capital flight, the loss of banking system deposits, and a severe, but short-lived, recession; a series of reforms to bolster the domestic banking system followed. Real GDP growth recovered strongly, reaching 8% in 1997. Then in 1998, international financial turmoil caused by Russia’s problems and increasing investor anxiety over Brazil produced the highest domestic interest rates in more than three years, halving the growth rate of the economy. Conditions got worse in 1999 with GDP falling by 3%. President Fernando De La Rua, who was in office in December 1999, sponsored tax increases and spending cuts to reduce the deficit, which had ballooned to 2.5% of GDP in 1999. Growth in 2000 was a disappointing 0.8% (Argentina website), as both domestic and foreign investors remained skeptical of the government’s ability to pay debts and maintain its fixed exchange rate with the US dollar. Argentina, soon enough was in default.
In addition to such tensions a sovereign may face, the eminent problem which is highlighted in parts of Argentina’s story and which stems from the theory that a potentially healthy economy can experience a “self-fulfilling” financial crisis (Krugman 1999) is attributed to the role of balance sheet problems in limiting investment by the private sector, and the impact of the real exchange rate on those balance sheets which produce such powerfully negative effects on a potentially healthy economy that they lead to, for our purposes, such an enormous “credit constraint” that the sovereign falls in a state of crisis. To illustrate my point, three conditions exit in a “potentially healthy economy” subsequent to each other as the sovereign defaults.
The conditions are as follows.
1. The first is that a “Goods Market” exists and contributes to the crisis,
2. The second is the “Equilibrium in the Asset Market”. The assumption is that capital lasts only one period; this period’s capital is equal to last period’s investment. So, the capital produced through investment and entrepreneurs is equal to the interest rate for this period times the exchange rate on goods for this period, and
3. The third condition for our purposes, is the “Credit Constraint”. With this condition, the assumption is that investment cannot be negative and lenders cannot lend more than half their wealth (I < λW), which is a result of the profits (P) minus the domestic debt (DD), minus the foreign debt (FD); (Q) the exchange rate is applied to the foreign debt for conversion.
If time permitted, applying real numbers to these conditions would indicate that the interaction of these three conditions will result in a depreciating exchange rate, the sovereign’s wealth will be significantly less since the declining exchange rate has already triggered a downward-spiral, and debt would be on the rise. Figure 1 illustrates that as the exchange rate (Q) shifts to the right and continues to do so, the “Credit Constraint Line” at conflict with the “Goods Market Line” results in the sovereign’s debt rising and leading towards default.
The IMF Country Bankruptcy Court Proposal & Economic Analysis:
As illustrated in Figure 1, since lenders will no longer want to lend the sovereign funds, and the sovereign will have no option, but to default as a result of its downward-spiral economy. For such sovereigns the question that comes up is: did Ms. Krueger’s IMF Country Bankruptcy Court proposal rescue them? In order to answer this, we will review the proposal more closely. Ms. Krueger sets up her approach to restructuring sovereign debt on two pillars: firstly, on “reforming the architecture” of the IMF and secondly, on “involving the private sector in crisis resolution”. Regarding the first pillar, she believes since the IMF is focusing on better national policies and reforms, such as “encouraging better communication between IMF and its members, creating the Contingent Credit Line facility offering countries with sound policies a public “seal of approval”, and now with more urgency, assisting to resolve balance sheet problems in the financial and corporate sectors”, today, the IMF is in a better position to have additional powers. These revisions to prevention and crisis management measures were highlighted by Ms. Krueger to justify that if such centralization of power were to occur, the IMF, despite the satirical political machine that it is with a multitude of politically aligned motivations it has had in emerging countries, has the foundation necessary in resolving sovereign debt issues.
To date, there is no IMF Country Bankruptcy Country Court and Ms. Krueger’s proposal, a novel idea and resolution to the dilemma discussed has not happened via the IMF yet. There are however, technical assistance and remedies to resolve sovereign debt default of countries and managing the domestic turmoil caused, offered by the IMF. These resolutions are a solution and aid in restructuring sovereign debt issues, but most of all the economy is in constraint like the “credit constraint” illustrated earlier. My strong inclination is that sovereign default is one of the worst predicaments a country can face: it impacts rising food costs, unemployment, inflation, political unrest likely, reduction in essential healthcare services, and extreme poverty overall. The remedy seems to be a restructuring of debt at favorable terms and a plan in place over time to achieve this goal. What good is the IMF if there is no collaboration or resolution scenarios? The IMF Bankruptcy Court was not “just a novel idea,” but a strong blueprint for resolving the issues of any country in sovereign debt default, and if does ever come to fruition it would lead to aiding many countries with default scenarios and effective resolutions that can also achieve collaborative private sector and public sector support.
Sonal Patney is a corporate and investment banker and author having originated, marketed, structured, executed, and closed over 100 debt and equity financings that ranged from $5M to $4B. As of October 2022, Sonal became an author with the international publishing of her book on sustainable finance debt by Europe Books – “How Should We Think About Debt Capital Markets Today? ESG’s Effect on DCM”. As a graduate of Columbia University, and New York University, she holds an MPA with a concentration in International Economic Policy, and a BA in Political Science, respectively. Her academic research has focused on emerging market countries and trade. Additionally, she has been a pro bono SCORE LI mentor for small business’ and the recipient of a mentoring award from SCORE; a member of varying nonprofit associations and a former Board member of some. She is also a “Contributor” for The Financial Executives Networking Group Journal online on capital markets topics.