A Valuable Stick

Financial crises in developing countries happen. Thankfully, they are not as frequent as they were in the 1980s but, as anyone in Argentina could report, the mess is worth avoiding. Developing countries, private sector creditors, rich country finance ministers and the International Monetary Fund share the same goals in trying to prevent crises and improving crisis resolution but cannot agree a common strategy. They made little progress at the IMF meeting over the weekend.

Almost no one is satisfied with the lack of a procedure for resolving debt crises in developing countries. Because defaults tend to be anything but orderly, creditors are prone to withdraw their funds when a country faces a temporary liquidity problem rather than a chronic solvency crisis. That can precipitate just the financial crisis everyone wanted to avoid.

In other instances, individual bond holders can hold out against a necessary debt restructuring, rendering an agreed solution impossible. And international efforts to overcome these two problems by offering IMF-backed loans to countries in difficulty have increased the chances of financial crises occurring. The prospect of a bail-out pours too much oil into the wheels of international finance.

The crux of the argument is whether the private sector can arrange a device to allow a country in difficulty to restructure its debt, or whether a quasi-judicial procedure, overseen by the IMF, is required.

Private sector creditors argue that the best route is to insert collective action clauses in sovereign bonds, which would provide some reassurance in a liquidity crisis and ensure that individual creditors cannot block a debt restructuring agreed by a large majority of bondholders. Many developed countries, including the UK, are now inserting such clauses into newly issued external debt. If collective action clauses were routine in all sovereign borrowing, they claim, orderly restructuring would be possible.

But the private sector still has some way to go before it convinces international financial institutions that it has found the solution. Many borrowing nations remain wary of collective action clauses, for fear of signalling their propensity to default. There are also real worries about whether the agreements can be enforced over many different classes of creditor and liability. And the incentive to include such agreements is weak. Many lenders and borrowers rather like the backstop of a potential IMF bail-out.

Hence the need to continue to pursue an alternative: the IMF's sovereign debt restructuring mechanism. This Chapter 11-style bankruptcy procedure is hated by many private lenders, who are threatening to withhold new funds from developing countries if an outside institution were granted the right to authorise a standstill on interest payments. But the international community and the IMF are right to continue with the idea. It might just be the stick required to force the private sector to implement its own solution.