By Martin Khor
Third World NetworkOctober, 1998
Summary: A country with high external debt and facing a currency
attack can theoretically defend itself through four methods. But
three of the methods (high interest rates, keeping high foreign
reserves, lender of last resort) are inadequate or non-existent.
The UNCTAD Report, released in mid-September 1998, advocates the
fourth option: a standstill in debt servicing, accompanied by
exchange restrictions and followed by an orderly debt workout. An
international system for debt workout, similar to Chapter 11 of the
US bankruptcy code, is urgently needed.
Countries coming under speculative attack and who want to avoid an uncertain economic recession or collapse may have little choice but to resort to two presently unconventional measures -- capital controls and a "debt standstill" (or temporary stop in servicing external loans).
This message is part of a set of analyses and proposals put forward by the United Nations Conference on Trade and Development (UNCTAD) in its Trade and Development Report 1998 released last week.
In a chapter on "the management and prevention of financial crises", the Report says that theoretically there are four lines of defence an indebted country can take if faced with a massive attack on its currency:
** Domestic policies (especially monetary and interest rate policy) to restore market confidence and halt the run;
** Maintain sufficient foreign reserves and credit lines;
** Use of an international lender-of-last resort facility to obtain the liquidity needed;
** A unilateral debt standstill accompanied by foreign exchange restrictions, and initiation of negotiations for an orderly debt workout.
Examining each of these options, UNCTAD finds that although the first three are theoretically possible, in reality they either don't work or are not in existence. Therefore, in the present crisis, the fourth option should be considered seriously.
The first option (tight monetary policy and high interest rates), favoured by the International Monetary Fund, has not worked for ailing Asian countries. On the contrary, says UNCTAD, higher domestic interest rates increase the financial difficulties of the debtors and reduce their incomes and net worth, increasing the likelihood of default. "Thus, they provide no incentive for foreign lenders to roll over their existing loans or extend new credits."
The second option (maintaining high reserves) might work if the reserves are large enough and have been built up through trade surpluses, as a few countries have. But there are many problems if reserves are increased through borrowing: the cost for carrying such reserves would be very high, the reserves may not be enough to stem a big attack or large fund withdrawals, and moreover the borrowed funds in the reserves are also vulnerable to withdrawals.
On the third option, there has not been an international lender of last resort to provide liquidity to stabilise currencies in developing countries facing currency crises. Instead, after the currency has collapsed, there have been IMF-coordinated bailouts.
These bailouts are however designed to meet the demands of creditors and to prevent default, says UNCTAD, and they pose three problems: they protect creditors from bearing the costs of poor lending decisions, putting the burden entirely on debtors; they create "moral hazard" for international lenders, encouraging imprudent lending practices; and the funds needed are increasingly large and difficult to raise.
UNCTAD thus proposes the fourth option: setting up an international insolvency procedure whereby a country unable to service its foreign debts can declare a standstill on payment and be allowed time to work out a restructuring of its loans, whilst creditors would agree to this "breathing space" instead of trying to enforce payment.
What UNCTAD is proposing is actually an extension of national bankruptcy procedures (similar to Chapter 11 of the US Bankruptcy Code) to the international level for countries facing debt difficulties.
Bankruptcy procedures are especially relevant to international debt crises resulting from liquidity problems as they are designed to address financial restructuring rather than liquidation.
In the US Code, no receiver or trustee is appointed to manage the debtors' business and debtors are left in possession of their property. The procedure is to facilitate a three-stage orderly workout.
In stage one, the debtor files a petition and there is an automatic standstill on debt servicing, giving debtors-in-possession a breathing space from their creditors, who are not allowed to pursue lawsuits or enforce debt payment. This prevents a "grab race" by creditors, and the debtor can formulate a reorganisation plan.
In stage two, the Code provides the debtor with access to working capital to carry out its operations, by granting a seniority status to debt contracted after the petition is filed. This debtor-in- possession financing can be granted if approved by the court and does not depend on the existing creditors' agreement.
Stage three sees the reorganisation of the debtor's assets and liabilities and its operations. The plan does not need unanimous support by creditors (acceptance by 50 percent of the creditors in number and two thirds in amount of claims is sufficient) and the debtor can get court approval of the plan.
These procedures are used not only for private debt. Chapter 9 of the US Code deals with public debtors (municipal authorities), applying the same principles as Chapter 11. The recent successful workout of the Orange County debt was under Chapter 9. There are similar arrangements in most other industrial countries.
UNCTAD proposes an international mechanism using the same principles. One suggestion, by K. Raffer in a 1990 academic article, is an international bankruptcy court that applies an international Chapter 11 drawn up in a United Nations treaty.
The court would have powers to impose automatic stay, allow debtor- in-possession financial status and also restructure debt and grant debt relief.
UNCTAD says a less ambitious and perhaps more feasible option is to set up a framework to apply key insolvency principles (debt standstill and debtor-in-possession financing) combined with established debt-restructuring practices, with the IMF playing a major role.
However, there are many objections to giving so much power to the IMF, on grounds of conflict of interest (as the IMF is also a creditor, imposes conditionality, and its shareholders are countries affected by its decisions).
An alternative, which UNCTAD seems to favour, is to set up an independent panel to determine if a country is justified in imposing exchange restrictions with the effect of debt standstills according with the IMF's article VIII, section 2(b).
The decision for standstill could be taken unilaterally by the debtor country, then submitted to the panel for approval within a period. This would avoid "inciting a panic" and be similar to safeguard provisions in the World Trade organisation allowing countries to take emergency actions.
These debt standstills should be combined with debtor-in-possession financing so the debtor country can replenish its reserves and get working capital. This would mean the IMF "lending into arrears."
UNCTAD argues that the IMF funds for such emergency lending would be much less than the scale of bailout operations. The IMF can also help arrange for private-sector loans with seniority status.
As regards government debt to private creditors, reorganisation can be carried out through negotiations with creditors, with the IMF continuing to play an important role of bringing all creditors to meet with the debtor government.
For private sector debt, negotiations could be launched with private creditors immediately after the imposition of debt standstill.
The above proposal by UNCTAD has been badly needed. In the absence of such an international system, developing countries have been at the mercy of their foreign creditors and investors, who can suddenly pull out their funds in herd-like manner.
Without protection, these countries first face a liquidity crisis which in turn produces a solvency crisis and then an economic crisis.
If a Chapter 11 type of international bankruptcy procedure is in place, a country facing the imminent prospect of default can declare a debt standstill, get court clearance for protection from creditors, obtain fresh working capital, restructure its debts, and plan for economic recovery which in turn can eventually service the debts adequately.
With such procedures, countries facing a "cashflow problem" can nip it before it worsens and thus prevent a major crisis. Both the debtor country and its creditors gain.
Contrast this with the present messy situation, where in the absence of a fair system, all creditors rush to exit the country, each hoping to recoup its loan before other creditors take out their loans.
And then when the debtor country has its back to the wall, the creditors as a group usually demand, in a restructuring plan, that the government not only pay higher interest on its loans, but also take over or guarantee the payment of the loans contracted by private banks and firms.
It might be argued that a country already near default could unilaterally declare a debt moratorium and then dictate its own terms for debt restructuring. However, few countries have the courage to do so, as the foreign banks may probably gang up and deny any new credit, thus threatening the countries' capacity to pay for essential imports.
Last month, however, a rapidly ailing Russia did declare a moratorium not only on its foreign debt but also on its domestic government bonds (most of which are held by foreign investors), at the same time as floating the rouble, which has since devalued sharply. It is also stating the terms of debt restructuring.
The foreign banks have expressed outrage at these terms and are clamoring to negotiate with the government, even threatening to seize the assets of Russian banks located abroad.
By taking unilateral action, Russia was trying to preempt an even greater crisis for itself, and is forcing the foreign investors and creditors to take their share of the loss.
This on-going drama also shows how necessary it is to have an internationally agreed debt workout procedure. In its absence, the situation is bound to be messy, whether in the case of a country unilaterally declaring a default and moratorium (as Russia did), or in the case of countries that helplessly watch as the foreign creditors pull their money out.
If the rich creditor countries are serious about reforming the global financial system, then the international bankruptcy procedures put forward by UNCTAD (and also by others in the past) should be urgently considered.
For there are many more countries that presently face the threat of capital flight and could be on the brink of debt default. Action should be taken before the financial bleeding spreads to these many other countries.
Article One: UNCTAD's Wide-ranging Analysis of Financial Crises
Article Three: Using Capital Controls to Deal With a Financial Crisis
More Information on UNCTAD
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