Managing International Financial Crises: Alternatives to "Bailouts," Hardships and Contagion
CRS Report for Congress
Managing International Financial Crises:
Alternatives to “Bailouts,” Hardships and
Updated February 3, 2003
Martin A. Weiss
Analyst in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Consultant in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Congressional Research Service ˜ The Library of Congress
Managing International Financial Crises: Alternatives to
“Bailouts,” Hardships, and Contagion
Since 1995, a number of measures have been adopted to help prevent future
international financial crises. Similar progress, however, has not been made in the
management of such crises. Currently there is no clear alternative to large loans
(often called bailouts) by the IMF or letting the debtor country fend for itself (which
may lead to severe recession in the debtor country and/or the spread of the crisis to
other countries). Two recent proposals — one by Anne Krueger of the IMF and the
other by John Taylor of the U.S. Treasury - aim to resolve this dilemma by
establishing a more orderly and predictable way to manage financial crises.
Anne Krueger proposes to establish a framework, based on bankruptcy
procedures in the United States, to restructure unsustainable sovereign, or country,
debt. John Taylor proposes that collective action clauses (which specify the
procedure to be followed when a country needs to restructure its debt) be included
in debt contracts. The IMF proposal has been described as a more centralized,
structured approach, while the Treasury proposal is considered a decentralized,
Both proposals are concerned with sovereign country debt owed to private
creditors, such as banks or bondholders. Moreover, both proposals involve the
private sector in managing crises, would probably reduce the need for large IMF
loans in the future. A major difference is how they would be implemented. The IMF
proposal would likely require a change in the IMF’s Articles of Agreement, while the
Treasury proposal might require incentives to encourage lenders and borrowers to use
collective action clauses in their debt contracts.
Both proposals are fairly broad and do not specify all the details involved in
implementation. The important contribution of these proposals is that they are
stimulating a debate about how to better manage international financial crises.
Opinion in the international financial community is divided on support for the
two proposals. Some economists favor the IMF proposal, and others the Treasury
proposal. The private creditor community discouraged the IMF proposal, but
supports collective action clauses along with establishment of a private sector
advisory group. Many of the debtor countries oppose collective action clauses, which
they believe will cause an increase in interest rates they pay. The major industrial
countries support both proposals, but maintain that the Treasury proposal, which is
easier to implement, should be acted on first.
More orderly procedures for sovereign debt restructuring are of interest to the
Congress because they might reduce the number and severity of international
financial crises. This, in turn, might reduce the need for additional funding for the
IMF, or for direct U.S. loans (which were given in the Mexican crises of 1995).
Moreover, if an amendment to the IMF Articles of Agreement were needed to
implement a proposal, the Congress would have to vote on it.
In troduction ......................................................1
Causes and Effects of Crisis.....................................3
Response of the International Monetary Fund........................5
Criticisms of the IMF...........................................7
IMF Reforms to Prevent Future Crises.............................8
Managing Financial Crises ..........................................9
Collective Action Problem and Clauses............................9
The IMF Proposal for a Sovereign Debt Restructuring Mechanism
The U.S. Treasury Proposal for Collective Action Clauses (CACs)......14
Analysis of the IMF and Treasury Proposals........................15
Perspectives of Economists, Private Creditors, Emerging Market
Countries and Industrial Countries...........................16
Implications for Congress..........................................19
List of Figures
Figure 1. Net Private Capital Flows to Emerging Markets..................3
Figure 2. IMF Credit Outstanding
List of Tables
Table 1. Growth Rate of Major Crisis Countries.........................5
This report was prepared under the general supervision of Raymond J. Ahearn,
Specialist in Trade Relations, CRS.
Managing International Financial Crises:
Alternatives to “Bailouts,” Hardships, and
International financial crises have become more numerous and serious since the
Mexican peso crises erupted in 1995. The International Monetary Fund (IMF) has
responded by supplying funds in larger amounts to debtor countries, resulting in the
charge that the IMF bails out banks and bondholders. Currently there is no clear
alternative to large loans or letting the debtor country fend for itself (which may
lead to severe recession in the debtor country and/or the spread of the crisis to other
countries). Two recent proposals — one by Anne Krueger of the IMF and the other
by John Taylor of the U.S. Treasury — aim to resolve this dilemma by establishing
a more orderly and predictable way to manage financial crises.1
The Krueger proposal would establish a framework, based on bankruptcy
procedures in the United States, to restructure unsustainable sovereign debt. In the
Taylor proposal, collective action clauses, which specify the procedure to be followed
when a country needs to restructure its debt, would be included in debt contracts.
Both proposals are fairly general and do not specify all the details involved in
implementation. However, both proposals are stimulating a debate about how to
better manage international financial crises.
The IMF and Treasury proposals are concerned with sovereign or country debt
owed to private creditors, such as banks or bondholders. Both proposals seek to
deepen the involvement of the private sector in managing the crises. Since low-
income developing countries are usually unable to obtain loans from private
creditors, the IMF and Treasury proposals would apply mostly to middle-income
The goal of the IMF and Treasury proposals is to better manage international
financial crises. These proposals are part of continuing discussions on “reforming
the architecture of the international financial system” which began shortly after the
Mexican crisis of 1994-95 and gathered strength in the wake of the Asian crisis of
1 A number of other proposals are summarized in Eichengreen, Barry. Toward a New
International Financial Architecture: A Practical Post-Asia Agenda. Institute for
International Economics. Feb. 1999, pp. 124-132. This CRS report focuses only on the IMF
and Treasury proposals since they have received the most attention recently.
2 Examples of middle income countries are Argentina, Brazil, and Thailand. Examples of
low-income countries are Nigeria, Pakistan, and Azerbaijan.
prevention and management. Although a number of steps have been taken to
prevent future crises (see p. 8), less has been accomplished to better manage crises.
The main purpose of this report is to analyze the issues involved in sovereign
debt restructuring and collective action clauses. The report begins with background
information on the causes and effects of financial crises, and the IMF response to the
crises. The IMF and Treasury proposals are next described and critiqued. The report
concludes with an analysis of the two proposals, and their implications for Congress.
Questions posed in this report include: Why is a more orderly procedure
needed to restructure unsustainable debt apparently needed? How are the IMF and
Treasury proposals similar and how do they differ? What is the role of the IMF in
each of the proposals? What are the views of leading economists, private creditors,
sovereign borrowers, and the industrial countries on these proposals?
It is important to note that this is an economic, not legal, analysis. Furthermore,
it is an overview of the main issues involved in the proposals, not an exhaustive
study of all the details and ramifications.
Congress is interested in more orderly procedures for sovereign debt
restructuring because they might reduce the number and severity of international
financial crises. This, in turn, might reduce the need for additional funding for the
IMF, or for direct U.S. loans (as in the Mexican crisis). Moreover, if an amendment
to the IMF Articles of Agreement were needed to implement a proposal, the Congress
would have to vote on it.
Borrowing countries having trouble servicing their debt are generally extremely
reluctant to declare default. A major incentive to avoid default is that creditors may
be unwilling to make future loans. Without foreign capital, a country’s economic
growth rate will be restrained. In some cases borrowing countries put off defaulting
until their situation is desperate, which makes the problem much more difficult to
Borrowing from abroad to finance economic growth has a long history in both
the United States and other countries. For example, foreigners in 1900 held $3.13
billion of U.S. railroad bonds. Defaults have occurred many times in history, and
the debtor countries have usually been able to borrow again in foreign markets after
a period of time has elapsed if creditors perceive them worthy. Despite the fears of
borrowers, defaults historically have not had a permanent effect on a country’s ability
to borrow abroad.
3 Willis, James F. and Martin L. Primack. An Economic History of the United States, 2nd
edition. New Jersey, Prentice Hall, 1989, p. 245.
Causes and Effects of Crisis
The important contribution of global private capital flows to economic growth,
especially for developing countries, is well recognized. Investment opportunities are
often high in developing countries, while domestic investment funds may be scarce.
This means that interest rates rise, which attracts foreign funds, and the resulting
investment increases productivity, gross domestic product (GDP), and living
Capital inflows, however, can be abruptly reversed when foreign creditors lose
confidence in the ability of a debtor country to repay. In recent years, advances in
telecommunications and technology have meant that the spread of news is almost
instantaneous. Thus, adverse economic or political developments may lead creditors
to suddenly “run for the exit.”
Figure 1. Net Private Capital Flows to Emerging
1991 1993 1995 1997 1999 2001
1990 1992 19 94 19 96 1998 2000
Source: IMF World Economic Outlook 2002, p. 29, website: imf.org.
The large growth and volatility of capital flows to developing countries since
1990 are shown in Figure 1 above. Net capital flows to developing countries
increased from $36 billion in 1990 to $234 billion in 1996. However, the flows fell
abruptly in 1997 to $112 billion, and continued declining until they reached $8
billion in 2000. By the year 2001, net capital flows increased again to $31 billion,
about the same as in 1990. Clearly, the Asian crises of 1997-98 and the Brazilian
and Russian crises of 1998 had an adverse effect on international capital flows to
The causes of financial crises are complex and may differ from country to
country. Prevention of future crises requires at least a general understanding of the
causes of past problems. The causes listed below are often interrelated, and more
than one factor may have contributed to overborrowing.4
!Relaxation of capital controls by emerging market economies in the
early 1990s, along with perceived high growth opportunities, led to
a surge in capital flows that was perhaps not justified by the risk;
!Weak national banking and financial systems along with poor
supervision and inadequate regulation in emerging market
economies contributed to lax lending standards;
!Overvalued exchange rates in some countries, such as Mexico and
Argentina, led to a deterioration in export competitiveness and a
growing current account deficit;5
!Poor debt management policies culminated in high short-term debt
denominated in foreign currencies relative to central bank holdings
of foreign currencies. (For example, before each crisis began, the
ratio of short-term debt to reserves was 2.6 in Mexico, and 1.5 or
higher in South Korea, Indonesia and Thailand.);6
!Lack of adequate information on emerging market economies meant
that financial markets could not properly evaluate the true risk of an
The financial crises left the debtor countries cut off from foreign capital flows
that were important to their economic growth, at least for a while. The reduction in
capital inflows drove up interest rates in the developing countries and slowed their
investment. Higher interest rates also threatened the financial health of banks and
firms in the debtor country.
As shown in Table 1 below, real GDP declined in all countries experiencing
crises (see the shaded cells in the table), leading to unemployment and hardship.
4 See also Safeguarding Prosperity in a Global Financial System; The Future International
Architecture. Report of an Independent Task Force Sponsored by the Council on Foreign
Relations. Hills, Carla A. and Peter G. Peterson, Co-Chairs. Published by the Institute for
International Economics. 1999, pp. 43-92.
5 See also CRS Report RS21072, The Financial Crisis in Argentina, by J.F. Hornbeck.
6 Mishkin, Frederic S. Global Financial Instability: Framework, Events, Issues. Journal of
Economic Perspectives, Vol. 13, No. 4, Fall 1999, p. 12.
Table 1. Growth Rate of Major Crisis Countries
(Annual Percent Change in Real (Inflation-Adjusted) GDP)
Country 1994 1995 1996 1997 1998 1999 2000 2001
Mexico 4.4 -6.2 5.2 6.8 5.0 3.6 6.6-0.3
Thailand 9.0 9.2 5.9-1.4-10.5 4.4 4.6 1.8
Indonesia 7.5 8.2 8.0 4.5-13.1 0.8 4.8 3.3
S. Korea 8.3 8.9 6.8 5.0 -6.710.9 9.3 3.0
Brazil 5.9 4.2 2.6 3.3 0.2 0.8 4.4 1.5
Russia-13.5 -4.2-3.4 0.9 -4.9 5.4 9.0 5.0
Argentina 5.8 -2.8 5.5 8.1 3.8 -3.4-0.8-3.7
Source: IMF World Economic Outlook, April 2002, pp. 158, 165-167.
In almost all cases, though, growth resumed the year after the crisis. Mexico’s
economic activity declined 6% percent in 1995 but grew 5 percent in 1996. In
Thailand and Indonesia, where real GDP fell more than 10 percent in 1998, growth
resumed the next year. South Korea was able to recover substantially in 1999 after
a decline of almost 7 percent in real GDP in 1998. Brazil appeared to avoid a serious
recession, and Russia recovered fairly rapidly from the 1998 recession. In Argentina
the financial crises began in late 2001, although it was preceded by a recession.
Response of the International Monetary Fund
The immediate response of the IMF was to coordinate a package of loans for
each crisis country. In addition to the IMF, other contributors were the multilateral
development banks and individual countries. For example, loan commitments to
Indonesia totaled $42 billion, of which the IMF share was $11 billion, the World
Bank and Asian Development Bank share $10 billion, and the bilateral loan share
A major purpose of the loans was to prevent the crisis from spreading to other
countries. Contagion can occur in one of several ways. Investor confidence can be
shaken by real or perceived similarities between the crisis country and other
countries. For example, if the crisis country’s short-term debt is greater than its
foreign-currency reserves, investors may withdraw funds from other countries that
are in the same situation. Crises can also spread though the trade account of affected
countries, especially among major trading partners. If the crisis country imports less,
the exports of its trading partners decline, raising their current account deficit. There
is considerable debate over the extent to which contagion actually occurs.
Nevertheless, officials of governments and multilateral institutions tend to be risk
averse, and when a crisis occurs, they are likely to take steps to contain it.
Figure 2. IMF Credit Outstanding
19 91 19 92 19 9 5 19 97 19 99 20 01
19 90 19 92 19 94 19 96 19 98 20 0 0
Source: Website: imf.org
Note: The special drawing right (SDR) is an international
reserve asset created by the IMF in 1969 which serves as the unit
of account of the IMF. Its value is based on a basket of key
national currencies and fluctuates over time. At the end of 2001,
1 SDR= $1.26.
The increasing number and size of IMF loans raise the question whether IMF
resources are adequate to meet future demands for funds. As a result of the Asian
crises, the IMF’s lending capacity dropped dramatically. As measured by a liquidity
ratio,7 the lending capacity declined from 104 percent in 1996 to 48 percent in 1998
and to 32 percent in 1999.8 Since then it has increased and was 115 percent at the
end of 2001.
7 The liquidity ratio is the ratio of the IMF’s net uncommitted resources to its liquid
8 Website: imf.org
Over the past five years, several
IMF Resourcessteps have been taken to increase IMF
resources. In 1997, the Supplemental
The principal source of funds for theReserve Facility (SRF) was created to
IMF are quota subscriptions. Each IMFprovide additional financial assistance to
member country is assigned a quota (basedmembers facing a sudden capital
on its economic size) which determines its
maximum financial contribution to the IMF,outflow. In 1998, IMF quotas were
its voting power, and is the basis forincreased by $89 billion (of which the
determining access to IMF loans. U.S. share was $14.5 billion). Also, in
In addition, the IMF can borrow under1998, the New Arrangements to Borrow
two supplemental credit arrangements.(NAB), a backup source of financing,
Eleven countries make funds available underwas established (the U.S. share was $3.5
the General Arrangements to Borrowbillion).
(GAB), established in 1962 and renewed
periodically. Twenty-five member countries
make funds available under the NewCriticisms of the IMF
Arrangements to Borrow (NAB) established
in 1998.A major criticism of IMF loans is
Currently, total IMF resources arethat they contribute to moral hazard ofcreditors and debtors. Moral hazard, in
$307 billion, of which quotas account for
$265 billion, the GAB $21 billion and thethe international context, occurs when a
NAB $21 billion. creditor takes excessive risks when
lending to developing countries because
of the likelihood of an IMF “bailout.”
The lender has come to believe that, in the event of the debtor’s inability to pay, the
IMF (or another institution or group of countries) will come to the aid of the debtor
and the creditor will not lose his investment. In other words, the creditor stands to
gain if the investment is successful, but losses will be mitigated if the investment
fails. Thus, the creditor may more easily take imprudent risks, since he is not
bearing the full cost of the risks. Some argue that the IMF loan to Mexico in 1995
reduced the incentives of creditors to properly evaluate the economic conditions of
other countries before making loans, and thus it contributed to the financial crises of
countries in the late 1990s.
The debtor countries themselves can also be subject to moral hazard. If they
perceive that IMF or other loans will be forthcoming in the event of difficulty
servicing their debt, they might borrow more than is justified by their potential
economic conditions. Furthermore, debtor countries might be less inclined to pursue
responsible economic policies if they rely on the IMF to come to their aid if their
To the extent that moral hazard does occur, the perceived availability of
“bailouts” leads to making decisions that contribute to crises, and are not in the long-
run interest of either the creditor or the debtor. Although moral hazard has been
widely discussed, both by academics and the media, there are no actual data to
suggest that it plays a large or small role in the behavior of creditors or debtors.
Nevertheless, it is important in the debate over the future role of the IMF in making
large loans to developing countries.
Another criticism concerns the “conditionality” attached to IMF loans.
Typically, when a loan is negotiated, the borrowing country agrees to certain
conditions, which may specify limits on budget deficits or limits on increases in the
money supply. Conditions are generally aimed at strengthening the debtor country’s
economic and financial situation. The IMF maintains that conditionality is necessary
to ensure that IMF loans will be repaid. Unlike domestic lenders, the IMF cannot
attach the assets of a defaulting borrower.
In the late 1990s, some critics thought that the macroeconomic conditions,
especially for countries that did not have huge fiscal deficits, were too severe. It was
argued that requirements for tighter budgets and high interest rates worsened the
economies of the debtor countries far more than was necessary. Furthermore, some
suggested that lower-income people in the debtor country bore most of the brunt of
IMF conditionality was also criticized for going beyond macroeconomic and
financial conditions to include structural conditions. For example, the conditions in
the Indonesian case included elimination of the Clove Marketing Board and changes
in the structure of the sugar, flour and cement markets. Some argue that the World
Bank is better qualified to suggest structural changes. Others maintain that
coordination of structural and stabilization policies is needed, and it may be more
effective to put them in the same package.
Finally, the IMF was criticized for not providing the private sector with
sufficient information to evaluate the potential risks of investment. Some also argue
that the IMF kept information confidential or did not provide reliable information in
a timely way.
IMF Reforms to Prevent Future Crises
Preventing financial crises is part of the process of “reforming the international
financial architecture.” The IMF and other institutions have taken a number of steps
in recent years, although implementation and enforcement of some of the measures
remain weak. These measures include:9
!Improved transparency by providing timely, reliable data and
information about countries’ policies to the financial markets and the
!Developed internationally accepted standards and codes of good
practice in areas such as accounting, auditing, and monetary and
!Strengthened the financial sector by enhancing assessment of
financial systems and addressing gaps in regulatory standards;
!Involved the private sector in the prevention and management of
crises by establishing a dialogue with private creditors and
9 For more information on these reforms, see CRS Report RL30272, Global Financial
Turmoil, the IMF, and the New Financial Architecture, by Dick K. Nanto.
encouraging mechanisms that might facilitate the orderly resolution
of crises; and
!Created the Contingent Credit Line (CCL) at the IMF which makes
funds available to countries with strong economic policies where
problems might arise from international financial contagion.10 (To
date, the CCL has not been used by any country, possibly because of
the perception that such use would damage the country’s reputation
as a responsible borrower).
Managing Financial Crises
Although improved crisis prevention may reduce the number of future crises,
many argue that better procedures to manage crises are still needed. At present, there
is no clear alternative to loans by the IMF and other lending institutions. This raises
the question of moral hazard, on the one hand, and letting the debtor country fend for
itself, on the other hand, which poses a hardship on the borrowing country and may
allow the crises to spread to other countries. Moreover, as described earlier, IMF
resources are not unlimited.
Collective Action Problem and Clauses
The collective action problem is at the heart of the IMF and Treasury proposals
for managing financial crises. In fact, the economic rationale for both international
bankruptcy procedures and the use of collective action clauses in bond contracts is
to deal with the collective action problem. Consequently, it is explained in this
Why can’t a country facing an unsustainable debt problem simply initiate
negotiations with creditors itself? It can, but it runs the risk that a few creditors will
immediately withdraw their funds to get their money before the other creditors do
(since there is not enough to go around for all creditors). Also, a holdout creditor
could initiate a lawsuit in order to get full payment, thereby disrupting the
This is just what happened in the case of Elliot Associates versus Peru.11 In
1995, Peru announced that, under the Brady Plan, it would restructure loans to two
Peruvian banks that had been guaranteed by the government. In 1996, 180 creditors
agreed to exchange the old debt for a combination of Brady bonds and cash. Elliot
Associates, a firm that specialized in purchasing securities of distressed debtors,
bought Peruvian bank bonds at a price significantly below face value. Elliot did not
participate in the Brady exchange, but instead filed suit in New York State’s
10 International Monetary Fund. Progress in Strengthening the Architecture of the
International Financial System, a Factsheet. July 31, 2000.
11 For a fuller description of the Elliot Associates versus Peru case, see Economic Report of
the President. March 2002, p. 296.
Supreme Court seeking payment for the face value. Ultimately, after several rulings
and appeals, Peru was close to defaulting on its restructured debt, and chose to settle
by paying Elliot $56.3 million. Since the case was not litigated to conclusion, no
precedent was established. Thus, there is concern that in future cases, holdout
creditors could block a country from restructuring its debt. This case is widely cited
as evidence that a more formal process is needed to restructure debt.
Generally, creditors as a whole are better off in a debt restructuring if they
cooperate in resolving the debt problem. The assets of the debtor are usually worth
more if held together, and creditors gain by negotiating together. At the same time,
an individual creditor can gain more by pulling his money out first. Moreover, if one
creditor is not sure the others will cooperate, he is likely to “run for the exit” and get
his money out safely. If all creditors feel this way, however, a creditor panic ensues.
Bonds issued in the United Kingdom include collective action clauses (CACs).
A key provision of such clauses is that changes in the terms of payment of a bond
(restructuring) accepted by a substantial or super majority (perhaps 70-75%) of the
creditors is binding on all creditors. Bonds issued in the United Kingdom must also
have a procedure for appointing a representative of the creditors to negotiate with the
debtor. This effectively prevents holdout creditors from blocking a restructuring
agreement which benefits the majority of creditors. Holdout creditors cannot sue to
block payment under the restructuring agreement. Under U.K. law, bond covenants
can prohibit individual creditors from pursuing litigation against the debtor and
require that proceeds of litigation be shared equally with all the creditors.
In contrast, collective action clauses are not used in bonds issued in the United
States. Changes in the terms of payment of a bond must be approved by all the
bondholders. Thus, a restructuring agreement must have unanimous approval, which
is generally impossible to obtain. Since much of the emerging market debt is
denominated in dollars, the U.S. practice has a large effect on sovereign debt.
Collective action clauses were, however, included in many corporate U.S. bonds
until passage of the Trust Indenture Act of 1939 (15 U.S.C. 77ppp.(b)) made them
illegal. Section 316(b) of this Act prohibits any change in the principal amount of
a corporate bond without the consent of all bondholders. The rationale for ending
collective action clauses was to prevent insiders from gaining control of a bond issue
and then destroying it for their own benefit.12 Although the prohibition does not
apply to sovereign debt, by tradition sovereign bonds issued in the United States do
not include CACs. Presumably this means that CACs could be included in sovereign
bonds issued in the United States without a change in U.S. law.
The IMF Proposal for a Sovereign Debt Restructuring
On November 26, 2001, Anne Krueger, First Deputy Managing Director of the
IMF, proposed consideration of an international bankruptcy procedure for sovereign
12 Roe, Mark J. The Voting Prohibition in Bond Workouts. Yale Law Journal, December
debt.13 The goal is to provide a statutory basis for debtors and creditors to
restructure unsustainable debt in an orderly, predictable way. The proposal, called
a sovereign debt restructuring mechanism or SDRM, was endorsed by the
International Monetary and Financial Committee (IMFC) which represents the
interests of the IMF’s 184 member countries at the IMF’s annual meeting in
September 2002. The SDRM is based on and similar in many respects to Chapter 11
of U.S. bankruptcy law. Key principles of the SDRM are:
!The debtor is given access to working capital while the
reorganization plan is being devised. The working capital would
have priority over old debt in repayment. Access to working capital
by debtors is important to help preserve the debtor’s ability to
generate resources to meet its obligation to service debt. Working
capital can also mitigate the hardship faced by the debtor. To
encourage private creditors to provide such capital, they need to be
given priority in repayment so the new loans do not get caught up in
!The completed reorganization plan is voted on by a qualified
majority of the creditors, and is binding on all creditors. According
to Anne Krueger,14 the use of a qualified majority of creditors to
bind a dissenting minority to the terms of the restructuring
agreement is the most important element of the SDRM. It prevents
free riders from insisting on full payment after an agreement is
reached, which is unfair to other creditors and reduces the ability of
the debtor to service the restructured debt. Majority voting also
speeds up the debt restructuring process.
In the original proposal for an SDRM, the IMF included clauses requiring an
automatic stay on litigation during the stand-still on debt-servicing in order to allow
the debtor time to formulate a reorganization plan in which all creditors are treated
equally.15 This was considered one of the most important components of the SDRM,
protecting the debtor nation as domestic debtors are protected under Chapter 11
rules. It also proved to be the one of the most highly contested issues concerning the
SDRM and was eventually removed.16
It should be emphasized that the IMF proposal applies only to sovereign or
country debt owed to private creditors, including bank loans and bonds. The
proposal applies only when the debt burden is clearly unsustainable (when there is
13 Krueger, Anne. International Financial Architecture for 2002: A New Approach to
Sovereign Debt Restructuring. Speech, November 26, 2001. Website: [http://www.imf.org]
14 Ibid., p. 14.
15 Krueger, Anne O. A New Approach to Sovereign Debt Restructuring. International
Monetary Fund 2002. 40 pp. Website: [http://www.imf.org]
16 Blustein, Paul, IMF Cuts Disputed Clause from Debt Plan, Washington Post, January 8,
no feasible way the debtor could resolve the crisis unless the value of the debt were
The rationale given for the IMF proposal is twofold. First, lending to
developing countries has increasingly taken the form of bond issues, not commercial
bank loans. Emerging market bond issues have grown four times as quickly as
syndicated bank loans since 1980.17 This means that it is now much more difficult
to coordinate debt restructuring than in the past because bondholders are far more
numerous and diverse than banks. Moreover, bondholders have fewer incentives to
cooperate in restructuring and are less likely to have common interests than banks.
Second, as discussed earlier, IMF resources may not be adequate to provide
loans if multiple crises occur simultaneously in the future. Unlike domestic central
banks, the IMF cannot print money. Its resources are limited to the quotas paid in by
its members and the funds it can borrow from the industrial countries through the
General Arrangements to Borrow and a wider group of countries in the New
Arrangements to Borrow. Furthermore, the widespread moral hazard concern that
IMF loans would bail out private creditors puts some limits on the use of IMF
resources in a crisis.
The IMF proposal would, according to Dr. Krueger, reduce the cost of
restructuring and would encourage debtor countries to restructure sooner than they
do now, perhaps avoiding some of the economic dislocations that occur with a
disorderly restructuring. Creditors also would benefit since the value of their loans
would decline less than in a disorderly restructuring.
The proposal would also encourage sovereign debtors and private creditors to
negotiate a restructuring agreement outside of bankruptcy. The threat of using the
bankruptcy procedure in case negotiations fail may lead to unofficial bankruptcy
workouts which are quicker and less costly. For this to happen, however, a formal
bankruptcy procedure needs to be in place.
The role of the IMF in the SDRM is one of the issues to be worked out in future
discussions of the proposal. Initially, Anne Krueger proposed that the IMF would
approve a debtor country’s request for a temporary standstill, and would review the
debtor country’s policies to ensure that they were appropriate during the standstill.
A qualified majority of the creditors would approve the restructuring agreement
based on a determination by the IMF that the remaining debt is sustainable.
In the discussions that followed Anne Krueger’s November 26, 2001 speech,
some objected to the increased power that would be given to the IMF in the proposal.
It was argued that IMF “mission creep” would arise from the its role in deciding
whether or not a country could impose a standstill and in determining the
sustainability of the restructured debt. Moreover, since the IMF itself is a creditor
and the member countries of the IMF include both debtors and bilateral official
17 Krueger, Anne. New Approaches to Sovereign Debt Restructuring: An Update on Our
Thinking. Speech, April 1, 2002, p. 4. Website: [http://www.imf.org].
creditors, some are concerned that the IMF would not be impartial in approving a
standstill or judging whether restructured debt was sustainable.
Subsequently, a revised SDRM proposal was announced in a speech by Dr.
Krueger on April 1, 2002.18 It differs from the original proposal in two main ways.
First, it supports wider use of collective action clauses, but suggests that they alone
are not enough. Second, while it retains the general procedures of the SDRM, the
role of the IMF is reduced. A qualified majority of creditors would approve the
initial standstill and the final restructuring agreement.
At the September IMF meetings, the IMFC requested the IMF to present a
concrete proposal for an SDRM at the Spring IMF meetings on April 12, 2002. The
most complete and recent proposal, The Design of the Sovereign Debt Restructuring
Mechanism-Further Considerations, was discussed by the IMF Executive Board in
December 2002 and released to January 7, 2003.19
Implementation of the IMF proposal could be through an international treaty
or by national legislation, which could be circumvented if all countries did not enact
appropriate legislation. Anne Krueger proposes using the treaty option to implement
the SDRM. The easiest way to establish a treaty would be through an amendment
to the IMF’s Articles of Agreement, which could provide the legal basis for the
SDRM. An amendment would be binding on all IMF members once it is accepted
by three-fifths of the members with 85 percent of the total voting power. With more
than 17 percent of the voting power, U.S. approval would be necessary. It should be
noted that this would only gives the SDRM a statutory basis, it would not by itself
give the IMF any additional authority.
One criticism of the IMF proposal is that an SDRM is not needed for several
reasons. First, governments already can unilaterally declare a standstill. Second,
even though some creditors might initiate lawsuits, it is not easy to attach the assets
of sovereign borrowers, which are often in a different jurisdiction. Since creditors
are unlikely to sue, it is argued, the stay on legal action is not really necessary. Third,
provision of working capital during a restructuring process can be done by the IMF
which, for the past several years, has been “lending into arrears” (providing loans to
sovereign borrowers who have not yet completed negotiations with private creditors,
but who are negotiating in good faith).
Another criticism is that the SDRM could lead to moral hazard for the debtor
country. In a corporate bankruptcy procedure, the judge can seize control of a firm’s
financial affairs and replace its management. In an international bankruptcy
procedure, seizing control of a sovereign country or replacing its leaders would not
be possible. Thus, a debtor country, knowing that it would be protected by a
standstill, might be more likely to declare bankruptcy. The counter argument is that
countries avoid bankruptcy primarily because they don’t want to be cut off from
international financial markets for a period of time. Since countries have more to
19 See The Design of the Sovereign Debt Restructuring Mechanism-Further Considerations,
International Monetary Fund, November 27, 2002, 76 pp. Website: [http://www.imf.org].
lose than gain from filing for bankruptcy, the moral hazard of the SDRM is
considered small by some observers.
The U.S. Treasury Proposal for Collective Action Clauses
In a speech on April 2, 2000, John B. Taylor, Under Secretary of Treasury for
International Affairs, proposed a decentralized market-oriented approach for
sovereign debt restructuring.20 Under this plan, creditors and sovereign borrowers
would include clauses in their debt contracts which would describe the procedure to
be used when a country decides it has to restructure its debt. Guidelines for the
clauses would include the following:
!A majority action clause. This clause would allow a super-majority
(perhaps 75 percent) of creditors to change the terms of the contract,
which is then binding on the minority. In this way, a small minority
of creditors could not delay or disrupt a restructuring agreement.
!A clause describing the process through which debtors and creditors
come together to negotiate a restructuring. This clause would
specify how the creditors would be represented and the data that the
debtor must provide to the creditors’ representative. The creditors’
representative would negotiate with the debtor and would have
authority to initiate litigation (on instructions of a certain proportion
of the creditors).
!A clause describing how the sovereign country would initiate the
restructuring This clause would allow for a suspension of
payments between the time the sovereign requests a restructuring
and the time the creditors’ representative is chosen. A fixed limit of
perhaps 60 days is suggested, and during this time no creditor could
One criticism of the Treasury proposal is that it might be difficult to get
bondholders and debtors to incorporate CACs in bond covenants. Several proposals
to include CACs have been made by the G-7 and G-10 countries in the past few
years, with very little success.21 Thus, the Treasury proposal suggests that incentives
may be necessary to encourage countries to adopt CACs. One incentive might be to
make CACs a prerequisite for a country to have an IMF program. Another might be
to lower charges on IMF loans for countries with CACs.
20 Taylor, John B. Sovereign Debt Restructuring: A U.S. Perspective. Speech, April 2,
21 The G-7 countries are Canada, France, Germany, Italy, Japan, the United Kingdom and
the United States. The G-10 countries include, in addition to the G-7 countries, Belgium,
the Netherlands, Sweden, and Switzerland (11 countries, but the name G-10 remains
Another criticism of the Treasury proposal is that collective action clauses
would only be included in new bonds, not existing bonds. Without complete
coverage, it is not clear how effective collective action clauses would be. Others
maintain that since much debt is short-term, after a few years CACs would be
included in most bonds. Also, bondholders and debtors might be given incentives
to swap old bonds for new ones that included CACs; however, it is not clear how
successful this would be.
Finally, if CAC’s are included in loans or bonds on an issue-by-issue basis, as
the Treasury proposal suggests, aggregation of different types of debt issued in
various jurisdictions may be difficult. The Treasury proposal suggests that any
inconsistencies could be handled in an arbitration process for which the contracts
Analysis of the IMF and Treasury Proposals
The goal of both proposals is to reduce the uncertainty surrounding the debt
restructuring process. If the procedure is more predictable, sovereign borrowers
will be better able to resolve debt problems in a timely way. Moreover, either
proposal, if successfully implemented, would likely reduce the need for large IMF
loans, and thus reduce moral hazard. Both proposals address the collective action
problem. Generally, the IMF and Treasury proposals are in agreement that
something needs to be done, and that the private sector should be involved in debt
restructuring, but there is disagreement about how to do it.
The IMF proposal has been described as a more centralized, structured
approach, while the Treasury proposal is considered a decentralized, market-oriented
approach. Looked at another way, the IMF proposal is statutory, while the Treasury
proposal is contractual.
Even though the revised IMF proposal reduces the role of the IMF in the
SDRM, it still requires some involvement of the IMF or some other not yet created
institution to make decisions along the way. Some institutional involvement would
probably also be necessary in the Treasury proposal, especially in establishing
incentives for countries and in aggregating claims of different types of debt. Still, the
Treasury proposal is clearly more decentralized than the IMF proposal.
The concept of an international bankruptcy court has never been tried. The only
precedents are domestic bankruptcy procedures, especially Chapter 11 in U.S. law
on which an international bankruptcy court would be modeled. There are a number
of differences between a corporate bankruptcy and sovereign bankruptcy procedure,
so that the two are not directly comparable. Thus, it is difficult to know in advance
what the possibilities and problems might be. In contrast, as discussed earlier,
collective action clauses were in use in the United States until 1939. In this respect,
then, CACs would involve less risk than the SDRM.
Both proposals are relatively broad
Solvency Versus Liquidity Crisesand only provide a general outline of
how the procedures would work. A
A liquidity crises occurs when anumber of important issues would need
debtor temporarily cannot pay some of histo be worked out. For example, the
debts, but has good long-term prospects.proposals apply only to sovereign debt.
In a solvency crisis, it is unlikely theWhat about debt owed by the private
debtor will ever be able to pay his debts.sector to foreign creditors (which was
The appropriate remedy for a liquidityimportant in the Asian crises)? Could
problem is usually to rollover the debt, orthe IMF and Treasury proposals apply to
to provide additional funds to tide thesuch debt? Should the SDRM and/or
debtor over until the temporary problemsCACs be used only for solvency crises,
end. For a solvency situation, however,
the discharging of some or all of the debtor for both solvency and liquidity crises?
is the most useful approach. In U.S.
domestic law, a firm facing a liquidityPerhaps the most important issue is
crisis would file a Chapter 11 bankruptcythe implementation of each proposal.
petition, while one facing a solvencyAlthough it appears that the Treasury
crisis would be dissolved under Chapterproposal would be easier to implement,
7.many obstacles remain. As discussed
earlier, getting creditors and debtors to
In one sense, countries do notinclude CACs in new bond covenants
become insolvent because, over time, theycould be difficult. The likelihood that an
have important assets in the productivity
of their people and in their naturalamendment to the IMF’s Articles of
resources. To the extent that countriesAgreement is necessary to implement the
cannot, however, tax their populationsSDRM is also a major hurdle. It usually
enough to pay their debts, they may betakes a long time to get agreement that
considered insolvent. It should be notedan amendment is necessary, and the
that it may be difficult to know whetheractual amendment process is also
a country is illiquid or insolvent in thelengthy.
midst of a financial crisis.
Perspectives of Economists, Private Creditors, Emerging
Market Countries and Industrial Countries
Some economists support an international bankruptcy court and others support
adding collective action clauses to debt contracts. The views of a few well-known
economists are discussed below.
Many of the issues involved in an international bankruptcy court were identified
and discussed in proposals made since the late 1970s.22 A speech by Jeffrey Sachs,
Professor of International Trade and Director, Center for International Development
at Harvard University, gave new impetus to the concept of an international
22 See Rogoff, Kenneth and Jeromin Zettelmeyer. Early Ideas on Sovereign Bankruptcy
Reorganization: A Survey. IMF Working Paper WP/02/57. 18 pp. Website:
bankruptcy court based on Chapter 11 of U.S. bankruptcy law.23 In Dr. Sachs’ plan,
the IMF would play a central role in resolving both liquidity and solvency crises.
V.V. Chari, Professor of Economics at the University of Minnesota, and Patrick J.
Kehoe, Professor of Economics at the University of Pennsylvania, in a recent article,
also support a bankruptcy court.24 They argue that it would have been useful to
Mexico in 1995, where the country’s economy was fundamentally sound but facing
a creditor panic, as well as for countries whose debt is unsustainable.
In a study by Barry Eichengreen, Professor of Economics and Political Science
at the University of California, Berkeley, and Richard Portes, Professor of Economics
at the London Business School, and Director of the Center for Economic Policy
Research, the authors suggested, among other things, that “loan contracts and bond
covenants should specify that a majority of creditors be entitled to alter the terms of
the debt agreement....”25 More recent studies by Eichengreen have continued to
support the use of collective action clauses.26 Peter Kenen, Professor of Economics
and International Finance at Princeton University, advocates the inclusion of
collective action clauses in all of the countries’ debt contracts, both public and
private.27 In addition, Professor Kenen suggests that all such debt contracts should
include a 90-day rollover option, which each debtor country would be required to
utilize if its government found that the country was in a financial emergency. This
would eliminate the possibility of litigation because the creditors would already have
agreed to the rollover option.
A majority of private creditors discouraged the use of the SDRM after it was
announced in November 2001. Some of the concerns of the Institute for International
Finance (IIF), a global association of financial institutions, were that an international
bankruptcy court could inhibit investor confidence, delay renewed access of debtor
countries to capital markets that use the SDRM, and might lead to contagion of other
emerging markets.28 According to the IIF, the SDRM also might encourage moral
hazard by sovereign borrowers who believe they would be protected by a standstill
if payment problems arose.
Instead, the IIF, in an action plan announced in April 2002, recommended a
three-pronged approach, which includes, but is not limited to, collective action
23 Sachs Jeffrey. Do We Need an International Lender of Last Resort. Frank D. Graham
Lecture, Princeton University, April 20, 1995. 26 pp.
24 Chari, V. V. and Patrick J. Kehoe. Asking the Right Questions About the IMF. Federal
Reserve Bank of Minneapolis, 1998 Annual Report Special Issue. pp. 1-21.
25 Eichengreen, Barry and Richard Portes. Crisis, What Crisis? Orderly Workouts for
Sovereign Debtors,” Center for Economic Policy Research, London, 1995, p. 56.
26 See, for example, Eichengreen, Barry. Toward a New International Financial
Architecture: A Practical Post-Asia Agenda. Institute for International Economics, p. 15.
27 Kenen, Peter B. New Strategies for Dealing with Debt Crisis in Emerging Market
Countries. January 31, 2002.
28 Action Plan of the IIF Special Committee on Crisis Prevention and Resolution in
Emerging Markets, April 2002, p. 36. Website: [http://iif.com].
clauses.29 The IIF plan involves establishing a Private Sector Advisory Group to
sustain investor confidence and facilitate orderly debt restructuring, developing a
number of market incentives (including collective action clauses), and designing a
legal strategy to address disruptive litigation by holdout creditors.
Many emerging market countries are reluctant to include CACs in bond
covenants. One argument is that borrowing countries are being singled out and that
the wealthier developed countries should lead the way by using CACs. In fact,
Canada did include clauses in its foreign currency debt beginning two years ago.30
Only two countries — the United Kingdom and Canada - to date do so.
Borrowing countries also maintain that the inclusion of CACs would suggest
to creditors that they may have difficulty repaying their loans. As a result, creditors
would only loan to them at a higher interest rate than borrowers who did not include
CACs in the contracts. However, one recent study compared interest rates on bonds
issued in the United States (where CACs are not used) to the United Kingdom
(where CACs are used). It found that, for the most credit-worthy borrowers, CACs
lead to lower interest rates, while less credit-worthy borrowers find their interest rates
higher than without CACs.31 Although the less credit-worthy countries would be
dissatisfied with higher interest rates, from the perspective of avoiding financial
crises, such a distinction might be beneficial. Higher interest rates might discourage
lending to countries whose economies are less than healthy and whose payment
prospects are uncertain.
The finance ministers and central bank governors of the G-7 countries have, in
statements issued over the past several years, supported the use of collective action
clauses in bond covenants in order to better manage international financial crises. On
April 20, 2002, the G-7 countries announced an Action Plan in which they support
both the Treasury and IMF proposals for debt resolution, stating that the two
proposals complement each other. The G-7 countries focus more on the Treasury
plan, however, in the short run, since the IMF plan will take more time to work out.
More specifically, the G-7 Action Plan supports a market-oriented approach of
incorporating contingency clauses in debt contracts (the Treasury plan) which would
describe what happens in the event of a sovereign debt restructuring. They suggest
that clauses should include super-majority decision-making by creditors, the process
by which a restructuring would be initiated (including a standstill) and a description
of how creditors would engage with borrowers. The Action Plan, however, also
supports further work by the IMF on proposed approaches to sovereign debt
restructuring (the IMF plan) that may require new international treaties, changes in
national legislation, or amendments of the IMF’s Articles of Agreement. Since this
30 Martin, Paul. There’s a Better Way. The Globe and Mail, May 8, 2002, Website:
[ h t t p : / / www.gl obe a ndma i l . c a ] .
31 Eichengreen, Barry and Ashoka Mody. Would Collective Action Clauses Raise
Borrowing Costs? Website: elsa.berkeley.edu, p. 4.
work is expected to take longer, in the immediate future the contingency clause
approach should be pursued expeditiously, according to the G-7 statement.
Two other provisions of the G-7 Action Plan are also significant. In crisis
prevention, the G-7 countries will work with the IMF to improve the quality,
transparency and predictability of official decision-making. Regarding future IMF
loans, the G-7 countries want to limit lending to normal access levels (usually 100
percent of each member state’s quota) except in emergencies.
Implications for Congress
If the IMF and/or Treasury proposal were effectively implemented, it might
reduce the need for crisis lending by the IMF and G-7 countries, which has been
substantial at times. For example, the United States contributed $12 billion to the
rescue package for Mexico in 1995, and contributed contingent financing of $3
billion to Indonesia and South Korea in 1997 and $5 billion to Brazil in 1999.
Mexico repaid the loans, usually ahead of schedule, and none of the contingent funds
was drawn on. Increases in IMF quotas, which require a vote by the U.S. Congress,
might also be less likely.
Under the IMF proposal, it is likely the IMF’s Articles of Agreement would
need to be amended. As mentioned earlier, the United States, with more than 17
percent of the voting power in the IMF, would need to approve the amendment. To
approve an amendment, the Congress would have to amend the Bretton Woods
Agreement Act of 1944, which would require approval by a majority of both houses
of Congress (in contrast to a treaty which requires a two-thirds vote of the Senate).
The entire process of amending the IMF Articles of Agreement could be quite
lengthy, contentious, and politically difficult, both among countries and within the
It appears that no U.S. legislative action may be necessary for sovereign debtors
to issue bonds in the United States that include collective action clauses.
Neither the IMF nor the Treasury plan provides a quick or easy solution to the
management of international financial crises, primarily because of the difficulties in
getting agreement among and within countries over the most appropriate plan,
working out the details of the plan, and beginning to implement it. Still, the
proposals do offer guidelines for dealing with crises that, in combination with
measures such as strengthening the economies of the emerging market countries,
might prove beneficial. Perhaps the main contribution of these proposals is to
stimulate debate and discussion on an important issue.
In some ways the two proposals are more similar than different. Both address
the collective action problem and involve the private sector in debt resolution. In
fact, it could be argued that the two proposals are complementary.32 Anne Krueger
suggests that a bankruptcy procedure could be used for solvency crises, and collective
action clauses for liquidity crises. The major difference is in the way each would be
implemented. The IMF plan would likely need to amend the Articles of Agreement
to achieve a statutory basis for the sovereign debt restructuring mechanism while the
Treasury plan would need to amend contracts.
Moreover, the two plans are not mutually exclusive. The current administration
and the G-7 have yet to endorse either a purely SDRM or CACs approach and are
urging the IMF and the private sector community to pursue research on both
proposals as well as looking at a two-track approach utilizing both strategies.
The two proposals are part of a broad effort to reform the architecture of the
international financial system. There is much agreement on the importance of
preventing and managing international financial crises, involving the private sector
in debt resolution, and avoiding large loans by the IMF to debtor countries.
Although there has been considerable progress on crisis prevention, no major
measures to manage crises have been adopted to date. Each of the two proposals
discussed in this report aim to do that. If successfully implemented, either one of
them would involve the private sector in debt restructuring and would likely reduce
the need for IMF loans to emerging market borrowers.
32 See Miller, Marcus. Sovereign Debt Restructuring: New Articles, New Contracts — or
No Change? International Economics Policy Briefs. Institute for International Economics.
April 2002. 12 pp. Website: [http://www.iie.org].