Big bailouts, bigger problems
The IMF’s exceptional access policy is not working
Sovereign debt crises tend to follow a pattern as recognisable as the stripes of a zebra. Every one is subtly different, but the fundamental features are the same.
A struggling country unable to refinance its debts approaches the IMF for a loan to avoid default. The IMF obliges, provided the country adopts an economic adjustment program that addresses its problems. For the IMF, the objective is to be a catalyst: its loan, coupled with the adjustment program, is designed to help the country regain the confidence of markets.
Unsurprisingly, the IMF has to exercise greater scrutiny as the size of the loan grows. And since the county’s capacity to repay the IMF depends on the success of the economic adjustment, bigger programs require stricter scrutiny
In a recently published report examining how the IMF has been applying its policy on large loans — the “Exceptional Access Policy” — the IMF’s independent watchdog found that this strict scrutiny has been, well, not so strict. The Independent Evaluation Office’s own emphasis below:
While the EAP has improved upon the Fund’s previous more discretionary approach, it has not enhanced the standards of IMF lending as envisaged. The EAP has provided guardrails by obliging the institution — including the staff, management, and the Board — to consider in a structured manner key aspects of EA programs.
It has enhanced decision-making procedures through greater Executive Board engagement and provided a vehicle for learning lessons and enhancing accountability through the EPEs.
However, the EAP has not provided a substantively higher standard for EA programs compared with NA programs, and it has not fully settled expectations about the Fund’s lending and assumption of risk nor addressed concerns about uniformity of treatment. EA programs have generally been ineffective in catalyzing private capital inflows, and they rarely involved debt restructuring.
Given that the intention was to replace excessive optimism with analytical rigour and realism, it’s ironic that the IEO found that over-optimism was greater in exceptional access programs than in normal (ie smaller) programs.
Why did the envisaged realism and scrutiny not materialise?
Taking into account interviews with both IMF staff and outside observers, the IEO concluded that, at least in a number of “high profile cases”, there was considerable pressure for the IMF to lend, even when it was questionable as to whether the proposed program satisfied the requirements under the policy. Alphaville’s emphasis below:
Outside the Fund, there is a strong perception of political pressures in some high-profile cases affecting the assessment of (Exceptional Access Criteria]. Internally, this perception is shared by many and the analysis for this evaluation confirms that pressures on staff and management, exerted directly or indirectly, were strong in high-stakes cases. The majority view among staff is that the EACs have not sufficed to shield the Fund from the pressure in favor of lending when the fulfillment of the criteria is questionable and, therefore, the effectiveness of the framework hinges on staff and management’s determination to apply it rigorously. These perceptions affect the credibility and reputation of the Fund, which is seen as being more flexible in some cases depending on the pressure exerted.
For anyone who has been involved in the resolution of sovereign debt crises, the existence of this “pressure” is hardly surprising.
Although the IMF generally relies on the catalytic approach — which allows for creditors to be paid under the original contractual terms — the IMF cannot do so if it determines that the member’s debt is unsustainable. In other words, when the debt burden is so high that there is no feasible adjustment that would enable the country to repay its debt without some form of debt reduction.
At that point, the IMF is required to ensure that any program be accompanied by a debt restructuring that restores sustainability. Since failure to do so would undermine the interests of the country, it would also be contrary to the IMF’s mandate.
The problem is — and this is where the pressure comes in — there is often an alignment of interests against a debt restructuring.
Even though it may be in the interests of the country in the medium term, a debt workout will probably create short term economic dislocation and, accordingly, domestic political instability — indeed, it may cost the minister of finance his or her job. Unsurprisingly, creditors whose claims are falling due would also prefer to be paid under the original terms. And finally, as was illustrated in the case of Greece, concerns regarding contagion may cause other countries to exert pressure on the IMF to lend without a restructuring.
This pressure will often translate into over-optimistic assumptions regarding the IMF’s Debt Sustainability Analysis (DSA), the analytical tool developed by the IMF to assess sustainability. And, as noted by the IEO:
IMF programs entail finding the correct combination of policy adjustment, financing, and (if needed) debt restructuring. If macroeconomic projections and DSAs are optimistic, Fund access effectively becomes a substitute for necessary restructuring.
Given this tendency, the IEO’s finding that debt restructurings were rare under exceptional access cases is hardly surprising.
The IEO’s recommendations are somewhat schizophrenic, however. On the one hand, it focuses on reforms that would give stronger guidance on what is required by the policy, thereby effectively giving the IMF less wriggle room to replace realism with optimism. One the other hand, it proposes the creation of an “exceptional circumstances” clause that would enable the IMF to lend in “rare” cases where the standards under the policy have not been met.
While more specific guidance would be helpful, the creation of an exceptional circumstances clause would not be. Given the general pressure to avoid a debt restructuring, the “tightening” of the policy to be achieved through more specific guidance would almost certainly simply result in the frequent use of the exceptional circumstances clause.
But more fundamentally, it’s unlikely to help the country — which is the IMF’s central mission.
While it would introduce transparency and make life easier for staff (they would no long have to try to justify the unjustifiable), it will undermine the success of the program. After all, a central objective of IMF financing is to nurture a return of market confidence, and investors will not view the use of the exceptional circumstances clause as a vote of confidence by the IMF in the strength of the country’s program.
Moreover, an additional reform feature is needed: the introduction of hard access limits, at least in certain circumstances (see this report for more details of this proposal).
One of the assumptions underpinning the catalytic approach is that a larger loan can be more effective since it signals to the market a greater degree of IMF confidence in the program. That is why there are no ex ante limits under the exceptional access policy. However, one of the striking findings of the IEO is that exceptional access programs have actually been less catalytic than normal programs:
EA programs have generally been ineffective in catalyzing private capital inflows, and they rarely involved debt restructuring. While they have sometimes resolved members’ BOP problems, in a number of cases problems have remained, as reflected in members’ repeated use of Fund resources and continued debt vulnerabilities.
We shouldn’t be surprised, particularly given that a number of exceptional access programs were found to be excessively optimistic regarding debt sustainability.
When there is continued uncertainty regarding the sustainability of a country’s debt, a large amount of financing by the IMF will actually deter private inflows. Because of the IMF’s preferred creditor status, creditors will naturally fear that in any future debt restructuring they will need to bear a larger burden of the required debt relief, because IMF’s own claims are shielded from the restructuring process.
Not only did the IEO make this observation, it was also one of the lessons learned in an ex post evaluation of the IMF’s unsuccessful program with Argentina, where even the IMF itself didn’t have full confidence in the country’s debt sustainability.
To address this problem, there should be hard upper limits on the amount of IMF financing a country can receive when the Fund’s staff reckon that the country’s debt are sustainable — but not with high probability (often referred to as the “grey zone” category).
In contrast, there would be no ex ante limits when the IMF has full confidence that the c debt is sustainable. Consistent with the policy on “normal” access limits, these limits would be expressed as a percentage of a country’s quota in the IMF, and would be reviewed regularly to take into account the IMF’s financial firepower relative to the size of global capital flows.
The IMF’s failure to address the problems that have arisen with its exceptional access policy creates substantial risks. Delays in addressing debt sustainability problems undermine both the welfare of the country and the mandate of the IMF.
It also threatens to undermine the IMF’s preferred creditor status. When a restructuring of unsustainable debt has been unnecessarily delayed, pressure from the private sector will grow for the IMF to participate in the debt restructuring process — particularly if its claims have become a large portion of the debt stock . . .