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Toward a Lender of First Resort

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If interest rates (country spreads) rise, debt can rapidly be subject to a snowball effect, which becomes self-fulfilling with regard to the fundamentals themselves. This is a market imperfection, because we cannot be confident that the unaided market will choose the "good"over the "bad" equilibrium. We propose a policy intervention to deal with this structural weakness in the mechanisms of international capital flows. This is based on a simple taxonomy that breaks down the origin of crises into three components: confidence (spreads and currency crisis), fundamentals (real growth rate), and economic policy (primary deficit). Theory then suggests a set of circumstances in which a lender of first resort would be desirable. The policy would seek to short-circuit confidence crises, partly by using IMF support to improve ex ante incentives. Theory also illuminates the potential role of collective action clauses in reducing the risk of self-fulfilling debt crises.
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WP/06/66


Toward a Lender of First Resort

Daniel Cohen and Richard Portes







© 2006 International Monetary Fund
WP/06/66

IMF Working Paper

Research Department

Toward a Lender of First Resort

Prepared by Daniel Cohen and Richard Portes1

Authorized for distribution by Paolo Mauro

March 2006

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

If interest rates (country spreads) rise, debt can rapidly be subject to a snowball effect,
which becomes self-fulfilling with regard to the fundamentals themselves. This is a market
imperfection, because we cannot be confident that the unaided market will choose the
“good”over the “bad” equilibrium. We propose a policy intervention to deal with this
structural weakness in the mechanisms of international capital flows. This is based on a
simple taxonomy that breaks down the origin of crises into three components: confidence
(spreads and currency crisis), fundamentals (real growth rate), and economic policy (primary
deficit). Theory then suggests a set of circumstances in which a lender of first resort would
be desirable. The policy would seek to short-circuit confidence crises, partly by using IMF
support to improve ex ante incentives. Theory also illuminates the potential role of collective
action clauses in reducing the risk of self-fulfilling debt crises.

JEL Classification Numbers: F33, F34

Keywords: market discipline, sovereign debt, country spreads, financial crises

Author(s) E-Mail Address: dcohen@elias.ens.fr; rportes@london.edu


1 Cohen is professor of economics, École Normale Supérieure (PSE), director of CEPREMAP and
Research Fellow, CEPR; Richard Portes is professor of economics at London Business School and
École des Hautes Études en Sciences Sociales and President of CEPR. This paper was written while
Cohen was a visiting scholar at the IMF and Portes was visiting Columbia Business School. It draws
on a report prepared for the Conseil d’Analyse Economique (Cohen and Portes, 2003). The authors
are grateful for comments by Laurence Bloch, Eduardo Borensztein, Jean Pisani-Ferry, and
participants at a CAE meeting, the IMF-Bank of Spain conference (Madrid, June 2004), the
Reinventing Bretton Woods—Austrian National Bank conference (Vienna, June 2004), and the
Reinventing Bretton Woods—World Economic Forum conference (Rome, July 2004).


- 2 -

Contents
Page
I. Introduction ........................................................................................................................3
II. The Financial Crises of the 1990s Were Different from Those of the 1980s .....................5
III. Debt Crises of the 1990s: A Taxonomy.............................................................................7
IV. Confidence Crisis and Crisis of the Fundamentals: A Theoretical Benchmark ...............10
A. A Model of Sovereign Debt .....................................................................................10
B. Default Risk..............................................................................................................11
C. Equilibrium Strategies..............................................................................................12
D. The Potential for Multiple Equilibria.......................................................................13
E. Ex Ante Devices to Avoid Self-Fulfilling Debt Crises ...........................................13
F. Conclusion of the Model .........................................................................................15
V. Our Policy Implications: Collective Action Clauses and Lender of First Resort.............15
A. Collective Action Clauses.........................................................................................15
B. Lender of First Resort ..............................................................................................17
Appendix..................................................................................................................................20
References................................................................................................................................23

Tables
Table 1. Crises Episodes: Selected Indicators .........................................................................6
Table 2. Summary.....................................................................................................................7
Table 3. Decomposition of Debt Dynamics..............................................................................9

Appendix Tables
Table A1. Taxonomy of Debt Crises A.................................................................................20
Table A2. Taxonomy of Debt Crises B.................................................................................21
Table A3. Taxonomy of Debt Crises C.................................................................................21
Table A4. Pre-Crisis Spreads................................................................................................22







- 3 -

I. INTRODUCTION
The discussions on the international financial architecture that followed the Asian crisis of
1997–98 revived the debate over the international financial architecture. Drawing the lessons
of the crisis, Stanley Fischer (1999) first proposed that the IMF act as international lender of
last resort (ILLR). In November 2001, Anne Krueger, his successor as First Deputy
Managing Director of the IMF, advocated a Sovereign Debt Restructuring Mechanism
(SDRM) to facilitate a declaration of insolvency for an over-indebted country along the lines
of Chapter 11 of the U.S. Bankruptcy Code (Krueger, 2001). One institutional manifestation
of the Fischer proposal was the Contingent Credit Lines (CCL) facility, which would have
enabled a country affected by a contagion crisis to draw on additional lines of credit. No
country made use of this facility, however, and it was eventually shelved in early 2004. The
Krueger proposal has not been implemented either. Despite subsequent revisions that reduced
the role of the IMF (Krueger, 2002), the proposal was also shelved at the April 2003
meetings, partly because it would have required an amendment to the Articles of Agreement
(IMF, 2003).

Both these proposals (ILLR and SDRM) have proved too ambitious in the policy
environment. As argued by many commentators (e.g., Jeanne and Wyplosz, 2001) an ILLR
must have at its disposal either the resources to inject an indeterminate quantity of fresh
liquidity or perfect information regarding solvent and insolvent financial intermediaries. As
the latter assumption is virtually ruled out by the very nature of financial crises, the former
is tantamount to giving the IMF the means to create liquidity ex nihilo. Such a transfer of
monetary sovereignty, which was extremely difficult to implement in the European case,
seems totally unrealistic on a world scale. If there is to be a world LLR, it is rather for the
large central banks (the U.S. Federal Reserve, the European Central Bank, and the Bank of
Japan) to play this role.

Anything along the lines of the Fund’s SDRM proposal has appeared to be infeasible for the
same political reason. Setting up an international court with authority over the handling of
sovereign debt would entail a substantial transfer of sovereignty, in order to give the court the
statutory basis for suspending legal procedures against a country. Nevertheless, there is no
doubt that the Krueger initiative dramatically changed the terms of the discussion and gave
impetus to the adoption of Collective Action Clauses (CACs) (see our discussion in Cohen
and Portes, 2003).

Beyond the political constraints, these policy developments also have been criticized on a
more analytical ground. When financial crises erupt, the action taken by the IMF either as an
LLR or through an SDRM cannot ignore the underlying causes. It is not appropriate to treat
in the same manner a country that is the victim of an unforeseeable loss of market confidence
and a country where the macroeconomic indicators have long been unsatisfactory and which
therefore is borrowing at abnormally high interest rates. It is for dealing with situations in
which a country is suffering from a lack of confidence unjustified by any major deterioration
in its fundamentals that the ILLR approach would be useful. It is for dealing with situations
in which the debt no longer bears a relation to the fundamentals that the procedures involving
bankruptcy or debt reduction might be viewed as essential. Correctly applying such a
distinction is very difficult under the pressure of time, when a crisis erupts. This is partly




- 4 -

because there will always be doubts over the motives prompting investors to withdraw their
confidence.

The doubt regarding the nature of crises explains the risk of moral hazard. Because it is not
always possible to distinguish the “good” debtors who have been unlucky from the “bad”
who have continued to implement unsustainable policies, intervention by the IMF has
continually swung between too much and too little. It was to circumvent these difficulties
that the Meltzer Commission (2000) proposed confining the Fund’s scope for action to only
those countries that “pre-qualify” based on strict criteria of indebtedness and transparency.
But this proposal offers nothing for the countries that fall outside the scope of such pre-
qualification, and this is hardly feasible.

Another key reason why distinguishing between confidence crises and crises of fundamentals
is difficult is that the former often rapidly turn into the latter: if interest rates rise, debt can
rapidly be subject to a snowball effect, so that the initial worries about debt levels then
become self-fulfilling. In other words, there are multiple equilibria: low rates represent one
equilibrium, high rates another. This is the argument used by Williamson (2002) to
characterize the Brazilian situation at the time: the debt was at a level made unsustainable
by high interest rates but would rapidly be brought down to a sustainable level (given the
government’s primary surpluses) by low interest rates.

It is this dual dimension—ambiguity regarding crisis situations, partially self-fulfilling
capacity of negative judgments on a country’s situation—that leads us to propose a policy
intervention to deal with this structural weakness in the mechanisms of international capital
flows. We argue that IMF members should be able to commit themselves ex ante, should
they so wish, to an “indebtedness regime” (similar to the “fixed exchange rate regime” to
which they subscribed for many years) that makes it possible for them to carry out preventive
action regarding the evolution of debt. The idea is to give them the means to act before the
snowball effect comes into play, given that analysis of the debt build-up mechanism shows
that it takes time, and therefore provides time, before the situation becomes explosive. This
indebtedness regime would be based on the spreads paid. For the sake of simplicity, let us
suppose here that a country undertakes never to borrow at spreads greater than 400 basis
points. The indebtedness regime signifies that the country will take all necessary steps to
hold its indebtedness down to a level compatible with this level of interest rate. If the regime
is “credible,” in other words if investors are convinced that rates will never go above this
level, multiple equilibria can be ruled out, in that the mechanism “coordinates” expectations
on a low level. Moreover, and in our view more importantly, this indebtedness regime has the
merit of committing the country to a prudent strategy. It would avoid the widespread
temptation to allow problems to accumulate before tackling them and in so doing to become
vulnerable to a crisis of confidence, which it is then too late to avoid.

An indebtedness regime of this kind implies active commitment, on the part not only of the
country but also of the IMF. Rather than intervening ex post, when the country has lost its
access to the financial markets, the mechanism we propose is that the IMF should launch an
adjustment program with the country early on, while the country keeps its access to the
markets. Arguably, any adjustment program will be milder if applied before the crisis rather




- 5 -

than after. The debt will be lower and the country will have “demonstrated” its resolve to act
promptly. The preventive measures will avoid questions being posed too late, when the only
remedies are extreme shock treatment or default. Furthermore, to the extent that fresh IMF
resources may make a difference, they reduce the importance of the snowball effect of high
interest on the dynamics of debt. This point, however, is secondary in our view to the merit
of taking preventive action.

Obviously, these preventive measures will not solve all the problems. If a country fails to
avert the crisis, steps have to be taken. The resolution of the crisis, through a restructuring of
the debt in the case where it is unsustainable or through its consolidation in the case of a
liquidity crisis, would take place, as usual, under the aegis of the IMF. On the side of the
creditors, CACs are the essential instruments making it possible to reach rapid agreement.
We propose two simple innovations in this respect. First, if the markets themselves do not
implement CACs comprehensively, then the principal financial centers (in particular, New
York and London) should adopt a coordinated measure prohibiting debt issues that do not
contain CACs. Second, we propose the creation, alongside the Paris Club (dealing with
sovereign debt) and the London Club (dealing with bank debt) of a new club to handle bond
debt, that might be called the New York Club. A slim-line committee to coordinate these
three clubs could also be set up.

The rest of the paper proceeds as follows. We first examine the differences between the debt
crises of the 1980s and the debt crises of the 1990s. We show that confidence (or lack
thereof) played in the 1990s a substantial role in explaining the debt dynamics of a number of
countries. Specifically, we propose a simple taxonomy making it possible to break down the
origin of crises into three components: a crisis of confidence (spreads and currency crisis), a
crisis of fundamentals (real growth rate), and a crisis of economic policy (primary deficit).
As we shall report, there is no such thing as a “pure” situation in which the confidence crisis
fully explains the debt crisis, as in the multiple-equilibrium model. On the other hand, there
are indeed cases (more in line with intuition) where up to 40 percent of the accrued debt of
the most indebted countries stems from interest payments and currency crises.

We then present a theoretical model in which we show that self-fulfilling debt crises (à la
Calvo, 1988; or Cole and Kehoe, 1996, 2000) can happen only when debt restructuring is
expected to be inefficient, ex post. In our model, a country whose fundamentals are not
affected by debt dynamics is indeed immune to confidence crises. In cases where this is not
the case, in practice the most likely scenario, we then show the benefit of a commitment
device on debt dynamics in order to avoid confidence crises. In the last section of the paper,
we draw the policy implications of our analysis: the comprehensive use of CACs to facilitate
efficient debt restructuring and the creation of an International Lender of First Resort (ILFR),
implemented by the IMF, to provide the commitment device that precludes self-fulfilling
crises.

II. THE FINANCIAL CRISES OF THE 1990S WERE DIFFERENT FROM THOSE OF THE 1980S
In the period leading up to 1982, when Mexico suspended payment on its debt, spreads were
very low, rarely exceeding 200–250 basis points, as most bankers at the time thought that
countries did not default. Spreads on both Mexican and Brazilian debt did rise in the few




- 6 -

months before the debt moratorium, but the syndicated bank lending of the 1970s and early
1980s showed no signs of repeating the 1930s. Although spreads did vary somewhat with the
characteristics of the borrower, there was no perceptible market discipline. The bulk of the
financial crises involved syndicated loans with very low spreads, and the average real rate of
interest on sovereign borrowing in the 1970s was negative. The debt crisis of the 1980s was
not anticipated by the lenders. The resolution of the crisis took several painful years, during
which Latin American economies stagnated—to the point where income per capita returned
to the late 1960s’ level, in what has often been called a lost decade.

The nature of the debt crises changed in the 1990s. The agents were different: corporate
borrowers joined sovereign debtors. Lenders were different, too, comprised increasingly of
bondholders rather than bank loan syndicates. The 1980s story, according to which high
public deficits created high debt and eventually interest rate rises brought major crises, is not
the only one at hand. Confidence crises, through exchange rates or through interest rates,
created new scenarios. Crises became more complex: the Asian crises, the Mexican crisis, the
Russian crisis give a range of cases that are difficult to subsume under one story. Some crises
were expected, some were unexpected, and quite often, for good reasons.

As examples of “foretold” crises, take the cases of Argentina and Ecuador; at the other
extreme, take Korea or Mexico.

Table 1. Crisis Episodes: Selected Indicators
(data two years before the crisis, percentage points unless otherwise indicated)

Case
1
Case 2
Case 3
Foretold Crises
Unexpected Crises
Foretold Crises without
Apparent Disequilibria
Argentina
Ecuador
Mexico
Korea
Turkey
Russia
Debt/Exports
380
250
180
76
194
121
Debt/GDP
36
85
35
25
54
26
Spreads
623
597
367
106
738
800
(basis points)
Current account
-5
-11
-7.2
-1.9
-0.7
0.7
(percent of GDP)
Source: authors’ calculations based on International Financial Statistics, IMF; and Global
Development Finance
, World Bank.

From the comparison of these two cases, it is fairly clear that Argentina and Ecuador were
fundamentally insolvent, at least with respect to one of the two criteria that are commonly
used: debt-to-export ratio above 200 percent and/or debt-to GDP ratio above 50 percent
(note, however, that it takes both indicators to anticipate a crisis, on which more later). Huge
spreads were paid, and at the time when the crisis erupted, no lender could claim that it was
taken by surprise. Yet despite this apparent market awareness, many lenders were taken by
surprise, and the discipline of higher spreads had little perceptible effect on the policies of




- 7 -

Argentina or its creditors. Argentina was able to borrow at excessive spreads, which simply
worsened its fiscal position and exacerbated the crisis and its consequences. This is a case
where a write-down of the debt was needed in order to return as soon as possible to
sustainable growth.

Case 2 is exactly the opposite. No major macroeconomic disequilibria were observable,
insofar as the outstanding stocks were concerned; spreads were correspondingly low. In the
case of Mexico, however, it was clear that the large current-account deficit was creating
liquidity pressures. In contrast, Korea failed by none of these criteria. Indeed, its weakness
came from elsewhere, i.e., the short-term nature of its debt. As the current account
demonstrates, however, there was no particular need for a major exchange rate adjustment.

In Case 3, the sovereign risk pertains to the nature of the debtor. Despite good
macroeconomic performance, creditors could examine the macroeconomics and perceive
the risk of default that the shaky government or the shaky banking system could create.
The spreads were correspondingly high.
Let us summarize the discussion so far with the following:
Table 2. Summary

High Debt Low Debt
Low Spread
None
Case 2
High Spread
Case 1
Case 3

Compared to the 1980s, then, it does not appear to be the case that large disequilibria went
unnoticed by the markets. As we now discuss, the high-debt/low-spread cell is empty. In this
sense, market discipline has improved.
III. DEBT CRISES OF THE 1990S: A TAXONOMY
We present in the Appendix the list of countries that signed a program with the IMF during
the 1990s. We distinguish three groups of countries according to the nature of the program.
Group A (“hard crises”) includes all countries which have experienced one EFF (Extended
Fund Facility); group B includes all (other) countries which have experienced more than one
SBA (Standby Agreement) in a row (intermediate crises); group C includes all countries
which have experienced only one SBA (short crises).

Except for a few cases to which we shall return, the three groups behave as one would
expect. Debt is high in group A, moderate in group B, low in group C. More specifically,
the debt-to-GDP ratio is significantly higher in group A, where it stands at 75 percent, on
average. In both groups B and C it is a little over 50 percent, which is the conventional
wisdom threshold for a risk of debt crisis (see Cohen, 2003). While the debt-to-GDP ratio
is a good predictor for being in A rather than in B or C, the debt-to-export ratio is instead
a discriminating factor for being in B or C: it stands at 200 percent for group B (again,
200 percent is the conventional wisdom number); it stands well below on average for group
C, at about 150 percent.





- 8 -

There are a few exceptions to this broad pattern. In group A we find Russia, which despite
good macroeconomic data had to resort to an EFF in the face of its inability to raise foreign
funds (as reflected by the huge spread paid on its debt). A similar story comes from
Colombia, a country where domestic policy uncertainties were the critical problem, more
than any macroeconomic imbalance. In group B, there are a few exceptions to the rule that
debt-to-GDP is high, but these countries, such as Brazil or India, often have a high debt-to-
export ratio (well above the 200 percent threshold); these are relatively closed countries for
which both indicators are needed to assess the overall solvency of the country. The only
exception in group B is Uruguay, where both ratios are relatively low and which appears to
be a prima facie case of contagion from risky neighbors. In group C, Nigeria is a mirror
image of Brazil or India: high debt to GDP but low debt to exports, which is easily explained
by the outward orientation determined by oil exports.

An additional statistic shows the share of public external debt in total external debt for
each of the groups. Public debt represents, respectively, 90 percent, 80 percent and
70 percent of total external debt in groups A, B, and C.

The key to our story is the spread paid on the debt. All countries in groups A and B paid high
spreads well before (at least two years before) the crisis occurred. At the other extreme, all
countries in group C were paying low spreads even one month before the crisis exploded.
Their crises were basically unpredictable, or if predicted, not expected to last very long.

We can summarize these findings so far as follows: Major crises (types A and B) are old-
style crises: high debt (in the sense of either debt/GDP above 50
percent or debt/exports
above 200 percent) and mostly public. They are predictable at least two years ahead of time.

Let us now shed some light on the nature of the debt dynamics. The self-fulfilling story is
one in which a high spread causes high debt rather than the other way around. Although this
phenomenon is theoretically plausible, it is not easy to show empirically that it is indeed
convincing. In order to shed some light on this debate, we have decomposed the debt
dynamics into the following identity:

Increase of the Debt-to-GDP ratio =
real interest rate * Debt-to-GDP ratio
- Growth rate of the economy * Debt-to-GDP ratio
- Primary Surplus/GDP

The real interest rate is the nominal rate (risk-free rate + spread) adjusted for the deviation of
the exchange rate from PPP. The dynamics are computed up to the year of the debt crisis
itself. We present this decomposition in Table 3 by dividing each of the three terms of the
right-hand side by the sum of their absolute values (the sum of absolute value then adds to
one).



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