How not to bail out a country

Emergency bailouts are still creating moral hazard for both debtor and creditor countries. Taxpayers are bearing the long-term cost, while bondholders walk away unscathed.

Lowy Interpreter

One of the many lessons of the 2008 financial crisis is that emergency bailout funding (such as an IMF-orchestrated rescue) seriously distorts the operation of financial markets.

Emergency funding helps both the insolvent country and its foreign creditors, improving their repayment prospects. But this creates moral hazard: in future both debtor and creditor will underestimate funding risks.

With five clear examples from Europe since the 2008 crisis, you might think that such a fundamental problem would have been addressed. In practice, the prospects of a solution are receding.

The clearest examples are the European peripheral countries such as Greece. When these countries joined the euro, financial markets began to treat their debt as if it was as safe as other euro-denominated debt. Greece could borrow almost as cheaply as Germany. With this availability of easy money, Greece ran up large budget deficits.

The euro rules were explicit: an insolvent country would not be bailed out by other euro countries. Financial markets ignored this, and took a chance.

By and large, this turned out to be a good bet. When Greece collapsed in 2010, the initial bailout left the bondholders unscathed. These creditors argued that, if there was default, contagion would spread to Spain, Portugal and Italy (which happened anyway). Many of the creditors were able to redeem their bonds before the second bailout imposed some haircut on the remaining debt.

The outcome has been that Greece's remaining debt burden -- grossly unsustainable and headed for yet another debt rescheduling -- is now almost entirely in the hands of governments, the European Central Bank or the IMF. European taxpayers will bear a cost that should have fallen on the initial investors.

The huge over-borrowing of Ireland's banks was treated the same way. Under pressure from the euro-authorities organising the rescue operation, the Irish government guaranteed all the private bank debt, letting the bondholders off scott free.

The lessons seemed to be learned for the last of the bailouts -- Cyprus in 2013. But the effort to bail-in the creditors (ie. making them take a 'haircut' which writes off some of their debt) was so comprehensively botched by the 'troika' (the ECB, the European Commission and the IMF) that Cyprus is now being used as a case study in why creditors can't be bailed in. The Economist editorialises that Cyprus 'should serve as a warning against strict solutions that smack of puritanism rather than pragmatism.'

Just as religion without some form of hell loses its discipline on behaviour, bailing out creditors leaves them with less reason to exercise care in making future loans. In a normal bankruptcy, the borrowers and lenders can be left to their own devices (within the law) to work out a settlement involving the remaining assets. But where an insolvent country is given the benefit of additional funding through a bailout (such as an IMF rescue), it is totally unacceptable that these new funds should be used to repay the initial creditors.

Thus this issue has been left in a most unsatisfactory state. The IMF has been tentatively exploring solutions, but has to do so without seeming to revive the earlier Sovereign Debt Restructuring Mechanism, which was rejected nearly a decade ago by IMF members, thanks to America's dominant voice.

Wall Street's proxies are busy undermining these efforts to find a better resolution. All the time-worn arguments are being revived by Peterson Institute researchers. Sure, any automatic bail-in process may not be a perfect fit for the specific circumstances of a crisis, but the alternative is inaction.

Of course bail-ins will make lenders more cautious in providing funding in the future; this is the principal objective. To argue as if debt contracts are somehow sacred ignores the universality of bankruptcy processes, which are designed specifically to achieve an equitable bailing-in of creditors when bankruptcy is unavoidable.

It's hard to see how a better resolution will be achieved. While the debate (and the US vote) is in the hands of investment bankers, the prospect is slim for an orderly bail-in (the Peterson Institute researchers are both former investment bankers). Even debtor countries are unenthusiastic about change: it would raise the cost of their borrowing.

This might be an opportunity for Australia to take the initiative, on the side of the Fund staff, based on the firm principle that if our money is to be used in a bailout (as it has been in Greece and elsewhere in Europe), then we require a resolution framework which always ensures adequate bail-in of creditors.

This is not a new issue. When Thailand was bailed out in 1997 with a combined package from the IMF and regional countries, Australia argued that our funds should not be used to bail out careless creditors who had contributed so much to the 1997 Asian crisis. IMF deputy manager Sugisaki, chairing the rescue group meeting, said that if we pursued this line of argument the meeting would fail and he would ensure that Australia would be blamed. That's over fifteen years ago and IMF thinking has progressed.

It's time to fix this problem.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.

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