>Personally, I've always been in favour of default
>and let-the-chips-fall-where-they-may.
Financial Times - May 10, 2001
COMMENT & ANALYSIS: Default without disruption: Adam Lerrick and Allan Meltzer present a new approach for the IMF to emerging market crises:
By ADAM LERRICK and ALLAN MELTZER
Now it is one more last chance for Turkey. For the ninth time in the past six years, the arbiters of the international financial system have been confronted with two unpalatable options: bail out a developing country and its lenders or risk a crisis that might endanger the global economy. The probability of catastrophe may be small but the penalty is intimidating. Intervention has always been chosen even when it has been clear that the solution would be short-lived, that emergency funds would benefit speculators and that promises of reform were unlikely to be kept.
A third and better option exists for the international lender of last resort - one that lies between total bail-out and abandoning the market to chaos.
Since the Mexican rescue in 1995, Dollars 250bn in risk has been transferred from private sector balance sheets to official lenders. With the exception of Russia in 1998, where the turmoil overwhelmed salvage efforts, the markets have not suffered a single dollar of loss on lending to large emerging governments.
Repeated intervention subverts the incentives that are the moving force of market behaviour. Bail-outs obviate the hard choices - default or reform for troubled borrowers, sound lending judgments or failure for investors - and substitute a free ride on taxpayers from the Group of Seven leading industrial nations.
Only default and the losses that follow will recreate the incentives that restore balance to the system. Yet the multilateral agencies fear default, more than either debtors or creditors, because it is seen as a catalyst of panic. As investors flee, the need for cash spreads from the bonds of the crisis country to other emerging governments and finally to unrelated asset classes as investors sell whatever can be sold. Markets close.
To prevent panic while permitting the market to operate is the classic role of the lender of last resort. But past massive cash infusions to borrowers have moved beyond this mandate and encouraged larger and more frequent crises. The alternative is not widespread disruption and repudiation of contracts but constructive default that provides an orderly correction for the errors of borrower and lender alike.
We propose that the International Monetary Fund, together with other official lenders, build an AAA floor of support by offering threatened governments a facility that is ready to buy any and all debt to the private sector at a cash price well below its expected restructured value. With this floor firmly in place, the financial system would be insulated from contagion and the uncertainty that leads to panic. Private lenders would bear losses - but losses with predictable limits. At completion, debt burdens would be reduced to sustainable levels.
Three announcements complete the constructive default framework: first, a moratorium on all payments of interest and principal to the private sector; second, a prompt restructuring of the debt with a projected write-down that would make the debt burden sustainable; and third, an IMF commitment to protect other emerging economies affected by the crisis.
At first, prices of the country's bonds would fall below the expected write-down level but they would stabilise above the official guaranteed floor of support. As the market realises that bail-outs are over, a rational downward adjustment in the bonds of all emerging economies would reflect their true risk. The IMF floor should be set low enough to be unattractive to all but the most desperate investors but high enough to forestall uncertainty and panic selling. There is a trade-off. The lower the floor, the less its stabilising effect. The higher its value, the greater the probability that investors will sell to the IMF facility.
Exposure would be limited for the IMF, even if all creditors accepted the support offer. The private sector would absorb the entire cost of the write-down, balanced by the high returns that emerging markets offer. The crisis country would reduce its debt burden to a sustainable level. The IMF would hold a secure claim on a now creditworthy borrower, rather than a mounting claim on a questionable borrower whose rollovers camouflage delinquent debt service. The intervention would be final rather than piecemeal and temporary.
A credible prospect of default will alter behaviour far more than IMF admonition. Capital would again weigh risk in the lending equation and funds would flow at attractive rates to sound emerging governments. Countries would realise that only prudent policies and secure financial systems gain access to resources for growth. The official sector would step back from its current role of guarantor of speculative capital to a true lender of last resort that responds to market failure yet preserves market discipline. Fewer crises would be the result.
Adam Lerrick is director and Allan Meltzer is chairman of the Gailliot Center for Public Policy at Carnegie Mellon University. For a longer version of this article, go to www.ft.com/personalview
Copyright: The Financial Times Limited