by Sean Hagan, Former General Counsel, International Monetary Fund, Professor of Practice, Georgetown University Law Center

Mark Twain once quipped that, although history does not repeat itself, it often rhymes. He could have been talking about financial crises. When the IMF is frenetically performing its financial fire-fighting role, a key objective is to distinguish those features of an ongoing crisis that are typical from those that are unique. The IMF wants to be able to apply lessons that it has learned from previous episodes but, at the same time, does not want to be the general fighting the last war.

This brief note provides an overview of what may described as the common patterns of previous financial crises, while also briefly identifying those that do not fit these patterns. It also discusses the trade-offs that policy makers confront as they seek to mitigate their impact.

The Nature of Debt: Not All Borrowing is Problematic

At the outset, it should be recognized that, when we talk about financial crises, we are talking about crises involving debt. Not that debt – in and of itself – is a bad thing. For policy makers in low income and emerging market countries, it may make complete sense to access the savings of wealthier countries in the form of debt as a means of financing their own development objectives. While foreign direct investment is more stable, it is often harder to come by. Moreover, governments may be reluctant to surrender control of key sectors to nonresidents for strategic and national security reasons.

For creditors in advanced economies, lending to developing countries can also be sensible. It provides an opportunity to obtain a higher rate of return that would otherwise available if they invested domestically. While the risks are greater, these are typically mitigated by lending in a currency other than that of the borrower (to protect against devaluation) and to subject the loan agreement to the law other than that of the borrower (to protect against default).

The problem arises not from indebtedness, but from overindebtedness.i.e. when the amount of debt incurred, coupled with the features of the debtor’s economy and the prevailing external environment, raises questions amongst creditors as to the debtor’s capacity to repay.

Often, a key part of the underlying problem is that the policy stance has undermined competitiveness. Loose fiscal and monetary policies, while popular, can create inflation and asset bubbles.An overly valued exchange rate, while it may make imports cheaper and ease debt servicing costs, will also serve to undermine competitiveness.

In some cases, adverse developments in the external environment – which are completely outside of the control of the sovereign debtor – put added pressure on the economy. This was certainly the case with respect to the crisis of the 1980s, which was the perhaps the most systemic debt crisis we have ever experienced. While there were a number of domestic policy shortcomings in many of the Latin American economies, a key ingredient to the crisis was rising oil prices, a significant increase in US interest rates (which increased debt servicing costs) and a global recession that undermined the exports of these countries.

From Confidence to Collapse

Whether it is a result of domestic policy shortcomings or adverse external developments or – as is typically the case – a combination of the two, at some point external creditors begin to have doubts as to the sovereign’s capacity to generate the foreign exchange needed to repay its external debt. And, in response, they begin to manage their risk by lending to the sovereign at higher interest rates and at shorter maturities.

It is at the stage where things become particularly unstable. When maturities shorten – when the debt becomes “runnable” – the government is generally not borrowing to fund development projects but, rather, to simply repay the debt that is continuously coming due. And its ability to continue to refinance this debt is dependent on market confidence, which will continue to erode as the increased cost of borrowing further undermines the country’s capacity to repay. Moreover, the loss of confidence among external creditors is exacerbated by capital flight: residents of the country begin to transfer scarce foreign exchange abroad as they anticipate a collapse in the value of their currency. At this point the country can no longer finance its deficit in foreign exchange through spontaneous borrowing in the market and is experiencing what is referred to as a balance of payments crisis.

As indicated at the outset, there are important variations to this pattern. For example, the Asian Financial Crisis was a balance of payments crisis that was not fueled by debt incurred by the government but by external borrowing of the banking and corporate sector. And one of the reasons why the global effects of the 2008 Financial Crisis were so severe is that it effected the balance sheets of all sectors: the government, banks, corporations – and even household debt. Importantly, however, the crisis in the US itself during this period was not a balance of payments crisis. There was no erosion of confidence in the dollar. Indeed, the value of the dollar as a reserve currency and safe haven asset appreciated. Rather, it was a banking crisis triggered by excessive leverage within the financial system.

A final point on causes. The breadth and depth of international financial crises is often affected by contagion, which can take a number of forms. In some cases, financial institutions in one country become insolvent because they hold the debt of another country that is in distress. This occurred in the context of both the 1980s debt crisis (which almost brought down the US financial system) and the Eurozone crisis. In other cases, contagion is driven by raw fear. Having ignored risks in emerging markets for an extended period of time, a crisis in one country will ignite fear among creditors who suddenly see risk everywhere and cut credit lines to all of these countries. It is remarkable how quickly the market narrative can shift – and often in a somewhat binary way: risk “on” and risk “off”.

The Response Dilemma

So, how to respond to these crises when they arise?

When the market runs from a country, the immediate objective is, well, to stop the run. And one way to stop the run is to stop it by force:  if the debt is owed by the government – the government can simply stop paying. And, if the debt is owed by companies or banks, governments can simply impose exchange controls which results in a default by the banks and the companies. Exchange controls can also stop residents from converting their currency and transferring them abroad.

In some respects, this rather muscular approach to conserve foreign currency also has another advantage.To the extent that crises are caused – in whole or in part – by imprudent lending, it may seem entirely appropriate that creditors should be forced to bear the risk of this imprudence through a default. Failing to do so create what economists call “moral hazard”; i.e. if creditors are shielded from the risks that they incur this will simply invite future crises.

The problem with this approach is that it entails considerable costs. First, from the perspective of the government of the borrowing country, a default will undermine its hard fought creditworthiness in the market. Second, to the extent to which the government’s debt is also held by domestic banks – which is often the case – a default can result in the insolvency of the banking system. Finally, for international policy makers, a default by the government of one country can result in the type of contagion and international instability mentioned above.

The IMF’s Catalytic Approach and Beyond

In light of the above, the challenge is to stop the run through a restoration of market confidence. And this is where the IMF comes in, whose mandate is to “provide [countries] with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity”. Consistent with this mandate, the IMF has played a central role in resolving debt crises since the 1980s, relying where possible on what is referred to as the “catalytic” approach. This approach involves two elements: financing and adjustment. Specifically, in exchange for the IMF’s provision of financing that contribute to filling the balance of payments deficit, a member country commits to undertake economic policy adjustments designed to address the underlying cause of its balance of payments problem, including, in particular, a restoration of competitiveness. The implementation of these two elements is designed to enable the country to regain market access and to continue to service its debt as it falls due.

Over the years, the IMF has recognized that the catalytic approach is not always feasible. There are circumstances where the IMF concludes that the size of the debt owed by the country is so high that it is “unsustainable”; i.e. where there is simply no amount of financing by the IMF (which takes the form of loan) and no amount of feasible adjustment by the country that will enable it to repay its creditors on the original terms. A determination of sustainability is a tricky one since it has to take into account a number of factors, including the effect of economic adjustment program on growth. Specifically, while the economic program may call for fiscal consolidation (cutting expenditures and raising taxes) as a means of obtaining more resources to repay the external debt, at some point this will have an adverse effect on the country’s growth trajectory and, accordingly, result in lower tax revenues. A judgement regarding sustainability also has to take into account an assessment as to whether the country in question has the political capacity to implement the adjustment measures. Indeed, a tricky determination.

In those cases where the IMF makes the determination that the debt is unsustainable, it will only provide financing to support an adjustment program if a third element is introduced: the restructuring of the country’s debt. The restructuring of the country’s debt ultimately requires the agreement of country’s creditors and, over the years, this has also become increasingly complicated as the composition of the creditor community has become more fragmented. While, in the 1980s, sovereign creditors consisted primarily of a relatively small number of commercial banks and official creditors (the latter meeting as the “Paris Club”), over the years, both private creditors and official creditors have become more numerous and have a greater diversity of interests. As a result, the IMF has had to constantly review its policies and upgrade its tools to enable it to address these creditor coordination challenges in an effective and timely manner. 

Of course, these challenges are not unusual for the IMF. Although its overall mandate – the promotion of international monetary and financial stability – has not changed, all of its activities – whether it be the provision of financing or the exercise of surveillance – have undergone continuous reform so as to enable it to effectively implement its mandate in a global economy that has undergone considerable transformation since its establishment 80 years ago. Reform is a necessary part of the IMF’s DNA.

Featured Author:

Sean Hagan, Former General Counsel, International Monetary Fund, Professor of Practice, Georgetown University Law Center