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Sovereign Debt Restructuring Decision Making Under Uncertainty

The Greek debt talks have broken down. The IMF has withdrawn from negotiations and IMF Chief Economist Olivier Blanchard has a blog post, here, explaining the Fund’s position. The outlook is bleak.

The Fund is struggling to strike the right balance in terms of incentives: balancing the desire to promote timely, orderly restructuring with the need to minimize risk of market turbulence. Access to Fund resources is a potential catalyst to restructuring, but also poses a moral hazard threat that frustrates the goal.

It is doing so in a fog of uncertainty, however. Consider the range of situations that it must deal with: there are cases in which it is obvious that a country is insolvent in that the discounted present value of potential current and future resource transfers is less than the value of the debt; cases in which the country is clearly solvent. The decision rule in both of these cases is clear — restructure in the former, finance in the latter. But there is also a range of cases in which it isn’t clear whether the sovereign is solvent or insolvent. In such cases, the Fund is confronted with a dilemma.

If it provides financing and the sovereign is insolvent, it risks undermining the efficiency of financial markets (violating the principle that risk/ex ante return, creating moral hazard and subordinating private claims that remain after footloose capital has fled). If it doesn’t provide financing and the sovereign is actually solvent but illiquid, it creates unnecessary disruption for the sovereign and potential contagion for the global financial system. It is a kind of type I versus type II decision error problem.

The potential for contagion also explains why the systemic contagion exception was built into the Fund’s decision rule: the threat that Greece’s default could pose a systemic threat to financial stability led the Fund to its present dilemma, notwithstanding the fact that the staff couldn’t certify that the debt was sustainable.

So what to do about it?

First, recognize that there is a grey zone, which, realistically, will be quite large, in which it is unclear “beyond reasonable doubt” whether the debt is either sustainable or unsustainable, corresponding to solvency or insolvency. In such situations, allow for Fund support of re-profiling operations. Check.

Second, remove the systemic exemption clause under which the Fund can provide support to countries with debt burdens that can’t be certified as sustainable. The problem the Fund faces in these circumstances is a decline in the value of its preferred creditor status: as the level of Fund exposure rises from de minimus to significant, the implicit value of its preferred creditor status declines. This effect is magnified by the participation of other official creditors also claiming preferential treatment (think: ECB).

Final thought: there is an issue of dynamic inconsistency in all of this. The Fund is charged with guarding international financial stability; it will be difficult for it to eschew lending if there is a chance that doing so will result in global financial instability. What is needed arguably is a framework that puts some confidence bounds on the potential fallout — this is what bankruptcy frameworks do in the domestic context. The outstanding question is whether something similar can be done at the international level.

This need not be done through formal legal frameworks; a soft law approach embodied in the sovereign debt forum proposal might serve global interests equally well.

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