In this guest post Peter Doyle, a former senior IMF economist, argues for the sovereign insolvency regime to be brought in line with that for banks, starting with Venezuela.
The prior instalment of this sovereign insolvency blog trilogy concluded that “output foregone” is huge in highly-indebted IMF programme countries with high growth potential.
That is because in such cases, IMF programme design prioritises debt recovery ahead of activity. It imposes exorbitant primary surplus targets, wrecking the balance between primary spending and low taxes that is necessary to realise high productive potential.
Jamaica is a case in point. After a decade of compliance with IMF conditionality, including primary surpluses of 7-9 per cent of GDP to service old debt, Jamaican output is now only 10 per cent higher than in 2009. Had those IMF programmes merely matched the growth of Jamaica’s best-in-class macroeconomic peers over the decade, that number would be 50. That 40 percentage point gap is, to borrow William Shakespeare’s apt phrase, the “pound of flesh” that the IMF demanded for Jamaica to pay down its debt by 30 points to 110 per cent of GDP.
Sadly, the IMF’s almost Trumpesque inability to admit culpability in Jamaica and elsewhere is not just silly. It takes the IMF “out of the game” of figuring out how to reform sovereign insolvency arrangements so as to avert the output-forgone losses that its decade of programmes in Jamaica brings into such sharp relief.
Too bad. But with global growth at a premium post-GFC and so many highly-indebted developing countries liable to such growth-hostile IMF programming, that inquiry can and should proceed nevertheless.
So for just a few moments—and in the spirit of George Bernard Shaw’s “But I dream things that never were; and I say ‘Why not?”—suspend your disbelief. Contemplate what a regime of potential-growth-securing deep writedowns of sovereign debt would look like.
Such a regime would be pre-emptive. Debt write-offs would be triggered when servicing debt required primary surpluses at the expense of growth, not waiting, as now, until IMF Debt Sustainability Analysis (DSA) shows debt rising unsustainably. As in Jamaica, the distinction between these two is critical for high-growth-potential (developing) countries.
There is a striking precedent for this approach: the FDIC’s pre-emptive resolution regime (PRR) for banks. The PRR does not wait for insolvency to trigger restructuring, but pre-empts that.
So, by placing them side-by-side, consider what the FDIC PRR architecture implies for the bare bones of a Pre-emptive Sovereign Insolvency Regime (PSIR).
As detailed here, on the bulk of its dimensions, the PRR model carries over exactly to a PSIR. These include that:
where the purpose of the PRR is to prevent output potentially lost due to bank runs and systemic crisis implying that non-systemic institutions are not subject to the PRR, so the PSIR would aim to prevent losses due to “output foregone” and as a consequence, low growth potential and systemic countries (G20) would not be subject to the PSIR;
where the PRR intervenes pre-emptively when net worth is still 2 per cent of assets and restructures to immediately reestablish a buffer relative to that trigger, a PSIR would intervene when a DSA requires primary surpluses above, say, 2 per cent of GDP and write down debt sufficiently to immediately reestablish a buffer relative to that trigger;
and where as well as debt write offs, the FDIC can also force management changes and mergers, the PSIR would also set non-fiscal conditionality, all enforced by staggered conditional financing.
Still, five adaptations to the PRR architecture would be needed to apply it to sovereigns, as elaborated here. One such adaptation includes the source of its authority. Write-offs under the PRR are secured by US law for subsovereign entities (banks). But creditors have to be stopped from blocking sovereign debt write-offs by different means, in particular by shielding all assets of a sovereign undergoing a PSIR operation from court seizure in reserve currency areas (US, UK, Euro), and by expanding the IMF’s “lending into arrears” policy to cover all of a sovereign’s financing in PSIRs until private flows resume.
So just as the PRR blocks old creditors’ ability to stop restructuring and—by speed, immediate buffer reconstruction, full financing, and mandatory management changes—secures swift non-disruptive implementation, so the PSIR can and should do likewise.
Such a PSIR is not a panacea. As with the PRR, some crises will still occur, and some authorities may reject PSIR conditionality despite the cap on required primary surpluses.
But where the authorities are committed to “do as told” (as in Jamaica evidently was from 2009), PSIR delivers sane instructions by shielding such authorities’ compliance from abuse by their old creditors at the expense of high growth potential. And, as with FDIC interventions, it secures speedy non-disruptive debt workouts for their populations.
Much output potential may thereby be realised. The numbers will vary from case to case, but output gains are of the order of 40 per cent of GDP over a decade and pertain to some 40 per cent of developing countries. This is a very big deal.
Further, the current Alice in Wonderland sovereign insolvency world—stalked by vulture funds, creditor committees, rogue banks and rogue judges, derivatives traders, the Paris Club, arm-twisting bank regulators, Belt-and-Road and Russian operatives, holdouts, and scary gun-for-hire super-lawyers—would effectively vanish. Creditors will still squabble over pari-pasu treatment across classes of claims after any PSIR operation to their heart’s content. But this would no-longer hold sovereign debtors to ransom, only delaying settlement execution. So expect this Lewis Carroll world to straighten out toute suite.
All happy prospects.
But for any of it to happen, the key reserve currency areas would have to legislate to shield PSIR sovereign assets from seizure, and several IMF sacred cows would need to be slaughtered for it to act as effective PSIR agent. In particular, IMF lending operations would have become proactive and, like those of its FDIC mentor, politically independent, both profound changes. It would lend directly to sovereigns, not just to central banks, albeit a precedent already set for Currency Boards. It would lose unqualified senior status under PSIR lest loss burden-sharing among creditors becomes too skewed and/or restoration of the macro buffer becomes infeasible if there is a series of PSIRs for an individual country. And with macroeconomic buffers immediately reestablished by the associated debt write down, the IMF should lend under PSIR at penalty rates to encourage beneficiary sovereigns to return to non-IMF financing as soon as possible. An IMF would be core to a PSIR, but not the IMF as we now know it.
But because sovereign insolvency arrangements are to macroeconomics what binary code is to computing—elemental and invisible—the benefits of such a reformed IMF at the heart of a PSIR would be pervasive.
Most fundamentally, the risk-return incentives of private creditors would be aligned with the risk-return trade-off for growth in PSIR countries. In short, lenders would longer be able to force repayment by driving a country below output potential. Thus, the entire PSIR construct constitutes the ultimate warrant.
That would make creditors far more careful, curbing procyclical lending in commodity booms and other kinds of disruptive capital surges to PSIR-eligible countries. That in turn would ease the burden on capital controls and other policy adjustments by addressing these capital flow problems at their roots.
And if a “bad guy” seizes political power and runs riot, the country won’t be saddled with his unproductive debts ever after. A PSIR thus also puts an end to that form of path dependence in development, starves “the bad guy” of credit at an earlier stage in his misdoings, and (finally) gets to grips with the problem of “odious debt“.
A PSIR does all this by placing the onus for the quality of lending on the shoulders of those best resourced to carry it effectively, creditors, rather than on the governance structures in developing countries which are, virtually by definition, the least able to bear it effectively.
It would also supply some of the “missing defaults” post-GFC, in particular, those which, like Jamaica, are missing because of “output foregone”. With the IMF classifying 40 per cent of developing countries as in or near debt distress, it would boost the disappointing progress overall in poorer countries catching up to richer ones.
It would also reduce incentives of countries in aggregate to hold excess international reserves by attenuating “IMF stigma” by restoring the IMF to its founding objective of safeguarding activity rather than securing debt service.
A PSIR would also (one earnestly hopes) finally force an end to the absurdity and doomloop amplifying effects of the Basel III zero risk weights on bank lending to sovereigns.
Further, by capping the primary balance and not the debt ratio (as the present IMF redzone implicitly does), the PSIR also accommodates the fact that the global real risk free rate has trended down to zero or even negative. The implications of that trend for public deficits and debt, all basic macro, were reiterated in the most recent AEA presidential address.
Such a PSIR does all this because it reflects that the whole CACs vs SDRM debate in the early 2000s missed the point. The crux of the matter is not how losses are allocated among creditors and by whom after a default, but when the trigger is pulled and by whom. This PSIR fixes that.
And Venezuela. If ever a country needed to secure the right balance between primary spending and low taxes, spared of the predations of its old creditors, it is Venezuela now. Having descended so low, it has already not only passed the proposed PSIR trigger but has even gone way beyond the IMF’s current debt-sustainability trigger. Nevertheless, the PSIR is still the way forward because it maps out how to secure the necessary debt writedowns promptly, smoothly, and in a way that immediately re-establishes Venezuela’s macroeconomic buffers, creating conditions for recovery and new private capital inflows.
In confirming Venezuela’s PSIR eligibility, its fiscal balance should be measured with oil revenues recorded as if it ran a Norway-style Sovereign Wealth Fund—ie, with dividends from the theoretical SWF, not gross oil receipts, recorded above the line. And Maduro’s putative replacement must also confirm—which to my understanding, he has yet to do—via the PSIR’s welfare and structural non-fiscal conditionality, that his administration will tackle the gross inequities which spawned the potential-output-destroying Chavez and Maduro regimes in the first place.
It may be Venezuela’s gross compounded misfortune that its fate now rests in the hands of the likes of Messrs. Trump and Rubio. But a PSIR there, defended by US (and other reserve currency area) legislation shielding PSIR sovereign assets from seizure, and led by a reformed IMF as outlined above, frames the macroeconomic route which they should take to rescue Venezuela now.
And they should do, expressly setting a precedent with Venezuela, in order to establish the PSIR worldwide. In so doing, they would open up new possibilities not only for Venezuela, but also for Jamaica, and for many other developing countries in its debt predicament.
Not going to happen
And so we circle back to Bernard Shaw’s disturbing question: “Why not?”
It’s not because of Trump and Rubio, nor because of technical issues: the PSIR is modelled on the most successful pre-emptive regime known; the output effects are enormous; it matches the limited liability principle at the heart of all other insolvency arrangements; and as with the PRR, it quickly re-establishes conditions for orderly private financing.
The reason why the PSIR won’t happen is because in corporate, personal, and banking insolvencies, both the creditors and the debtor reside (and vote) in the same political jurisdictions. So though old creditors press hard for the right to unlimited recovery, debtors fight back establishing limits on their liabilities, hence limited liability. Not so in matters of international sovereign lending. Here, creditors generally reside in different political jurisdictions from debtors. So the negative global effects of unlimited rights of recovery of sovereign claims typically finds ineffective expression in the political processes of creditor countries. So, when push comes to shove, such countries will not shield foreign sovereign assets from seizure nor assent to the associated IMF reforms for a PSIR. In this realm, they are captured by old creditors at the expense of both new creditors and the global good.
Thus, the IMF enforces the bond undertaken by the Merchant of Venice. The only thing standing against this and the consequent macroeconomic malpractice thereby inflicted on the developing world in the name of macroeconomics is the profession itself. If only to protect our own credentials, we should protest loudly that there is a far better alternative: a PSIR.