International Financial Architecture and Strategic Default: Can Financial Crises be Less Painful? Michael P. Dooley JEL No. F15, F2, F34 ABSTRACT Recent financial crises in emerging markets have been followed by temporary but substantial losses in output. This paper explores the possibility that threats of such losses are the dominant incentive for repayment of international debt. In this environment private debtors and creditors have strong incentives to design international contracts so that renegotiation is costly. Such contracts generate dead weight losses following crises. Proposals to modify contractual arrangements, or to facilitate or impose renegotiation, can be welfare improving under special circumstances.
However, it is likely that such
proposals would also weaken the incentives that make private international debt possible.
I am grateful to Guillermo Calvo and Ben McCallum for helpful comments. This paper was prepared for the Carnegie-Rochester Conference Series, “Financial Crisis and the Role of the IMF,” November 19-20, 1999. Michael P. Dooley Department of Economics Social Science I University of California, Santa Cruz Santa Cruz, CA 95064 Tel 831 459 3662 Fax 831 459 5900
[email protected]
1. Introduction On September 27, 1999 an IMF press release stated that the Managing Director of the Fund “would be willing to recommend to the Executive Board the approval of Ecuador’s request for financial assistance under a stand-by arrangement once agreed policy measures have been implemented and provided Ecuador is judged to be making good faith efforts to reach a collaborative agreement with its creditors.” How did an institution that was widely viewed as being a bill collector for the commercial banks after the 1982 debt crisis take on a role that appears designed to weaken the bargaining position of bond holders in 1999? Is it possible to set out a framework in which “involving the private sector” following a crisis, and/or modifying private contracts before a crisis, are welfare improving reforms of the international monetary system? The output costs of recent crises in developing countries have been very heavy and the debate on how performance of the international monetary system might be improved has been intense. Recent contributions by Giannini (1998), Meltzer (1998), Eichengreen (1999), Feldstein (1998), Rogoff (1999), Chari and Kehoe (1999), Fischer (1999), Goldstein (1998), and Stiglitz (1999) address the basic issues surrounding government interventions in international capital markets. Bhattacharya and Miller (1999) provide an excellent summary of the recent literature. Policy recommendations drawn from this work range from redesigning bond contracts to the abolition of the IMF or the establishment of a super agency that would oversee bankruptcy proceedings for debtor governments. The debate lacks focus because participants have very different views about the causes of financial crises. A central unresolved issue in this debate is the specification of incentives faced by sovereigns to repay international debt. Since creditors cannot seize assets, threats that have been modeled involve trade sanctions or prohibition of future borrowing. The empirical relevance of these enforcement mechanisms is, however, quite
suspect, the former has never been observed and the latter seems very weak because defaulters are not, in fact, excluded from credit markets for long time periods. As Rogoff (1999) emphasizes, these issues are largely unresolved and are central to an evaluation of proposed reforms of the international monetary system. In this paper we focus on the one punishment for default that has actually been observed in the past twenty years, namely the protracted loss in output in debtor countries that has followed default. Moreover we assume that the loss in output is “caused” by the inability of debtors and creditors to quickly renegotiate contracts. This creates a time interval during which residents of the country in default find it difficult to borrow from one another or from nonresidents. The idea that financial intermediation is an inherently fragile process motivates much of the recent analysis of financial crises (Stiglitz, 1999). In this paper we argue that this fragility is, in part, an endogenous response the incentives present in the current international monetary system. We also assume that the costs of renegotiation cannot be conditioned by the reason for default. In this special circumstance, contracts designed to discourage strategic default will impose unnecessary output losses following unavoidable defaults. In short, there will be too much punishment relative to a first best equilibrium. Moreover, we argue that the frequency of defaults and their associated costs are amplified if output losses fall largely on residents of debtor and creditor countries that do not participate in international credit markets.
An
important
conclusion
is
that
the
structure
of
private
international claims on residents of developing countries is an endogenous response to this incentive structure. It follows that changing the nature of the contracts, or the costs of renegotiating the contracts, will alter the equilibrium level of debt.
Models of sovereign debt based on alternative enforcement mechanisms tend to keep contractual arrangements in the background. In Bulow and Rogoff (1989), for example, default gives the creditor the right to reduce the value of domestic output in the debtor country. In one important sense the punishment mechanism proposed above is similar. In both frameworks the debtor pays because of the threat of lost output following default. But in the more conventional framework the loss in output is independent of the nature of the contracts. Moreover, since both parties know exactly how the other values alternative strategies, renegotiation is immediate and costless. In this paper we assume that creditors and debtors can commit not to renegotiate by designing contracts that are very difficult to renegotiate even if, after default, it would be in both parties interests to do so.i This is a well-known feature of international debt contracts. The “failure” of coordination among creditors following default to deal with a debt overhang has long been recognized as a source of output losses following default. What is less recognized is that international debt contracts are designed to frustrate coordination. Equal sharing clauses allow individual creditors to recover payments to other creditor countries in the creditor countries’ courts if one creditor tries to settle outside a general agreement. In most cases restructuring debt requires unanimous or almost unanimous approval among creditors. Eichengreen and Portes (1995) and Eichengreen (1999) argue that modifying contracts in order to facilitate renegotiation is a promising route for reform of the current system. Three general improvements are suggested. First, contracts could set out collective representation so that it is clear ex ante how bargaining coalitions are formed after default. Second, a qualified majority of each class of creditors should be able to approve binding changes in the contracts. Third, contracts should set out how payments would be shared among creditors. This approach has been endorsed by the G-10 Deputies
(1996) the G-22 (1998) and by Fischer (1999) but criticized strongly by the private sector (Folkerts-Landau and Garber, 1999). The bargaining model set out below suggests that the critics of these proposals are on solid ground.
2. A model of sovereign debt We can explore these ideas in the context of a simple accounting framework.ii Assume a world that lasts for three periods. In the first period a foreign creditor lends the government K to buy assets where K is a dollar amount. The risk-free interest rate is assumed equal to zero. The government uses K to import an asset that in the second period yields x with probability 2 and zero with probability 1-2. This outcome is observed by the creditor but cannot be verified.iii For this reason the payment specified in the financial contract is not conditioned by the outcome and default is triggered by nonpayment. The asset lasts for one more period but depreciates uniformly during the period and yields a certain return y if utilized for the entire third period. The government agrees to pay z in the second period. If the government pays less than z, it is in default and the productivity of the asset is impaired until a new agreement is reached for sharing the residual value of the asset y.
During the third period the asset is not productive if a
negotiation for sharing y is in progress. We assume that debtors and creditors can design contracts that set the duration of the negotiation. The value of the asset declines during the third period from y to zero. This specification of the punishment technology is appealing because it means that the creditors are only able to interfere with the debtor’s ability to utilize the assets for as long as the assets last. This seems consistent with the sharp but temporary declines in output observed following recent crises. The alternative interpretation that the creditors can
punish the debtor forever and without regard to the seriousness of the offence is less appealing. One might think of a subsistence economy lifted temporarily to a higher level of output by an infusion of foreign capital, but once the capital depreciates the creditor has no way to push output below the initial level. An alternative interpretation is that, over time, debtors and new creditors find a way to subordinate existing creditors. If the government can pay, which occurs with probability 2, it will consider a strategic default. The temptation to keep z, the contractual payment in period two, is compared to the value of y that the government expects to capture following a negotiation with the creditors. The incentive constraint for the government to pay z if x occurs is
(1) gyts < y - 2z
where gyts is the expected share of y that goes to the government following a strategic default and a negotiation lasting 0
