What lessons have the International Monetary Fund and the international financial community learned from last year’s debacle in Ecuador and Brazil’s currency devaluation in January 1999?
In 1998, multilateral lenders and developed country governments assembled a rescue package to help Brazil support the real. They feared that a crisis in one of the world’s 10 largest economies would have a dangerous effect on the global financial system. Despite this support, Brazil caved in, letting its currency slide by 30% in 1999. Soon after, the Fund renegotiated terms. Brazil quickly resumed growth with low inflation and is borrowing again on increasingly favorable terms. In the end, almost nobody got seriously hurt in Brazil.
In Ecuador it was quite different. Many people believe that Jamil Mahuad, president at the time, made the decision to default on $6.65 billion in Brady bond debt and Eurobonds with the encouragement of the IMF. The idea was that this would force private lenders to share the risk of lending to emerging-market countries. Sharing the pain with the official sector would discourage moral hazard.
Lenders had to accept cuts of 40.6% in debt principal after long and sometimes belligerent negotiations. It will probably take Ecuador many years to regain access to the non-official debt markets. The Ecuadorian people have suffered through the worst economic crisis in recent history. In January, the military toppled Mahuad. Vice President Gustavo Noboa took over and moved ahead with his predecessor’s dollarization plan. However, Congress and the government still disagree on basic economic reforms needed to make dollarization work.
Of course, there are huge differences between the two countries. Brazil is a large, relatively sophisticated economy with functioning institutions, solvent banks and an excellent economic team. Western governments think that there are countries that are too big to fail, and this helped Brazil.
This still leaves us with the problem of moral hazard. This issue has received little attention since last year. Maybe there is time to devise a new, improved intervention model before the next Latin American economy crashes. What should the IMF, the G-8 governments and private-sector creditors do if and when a borrower needs help?
These days it is Argentina and Venezuela that keep lenders awake at night. Venezuela has plenty of oil and relatively few debts, although the deterioration in its public finances is worrisome. When oil prices slip, Venezuela may need help. In August, it was a flubbed bond deal by Argentina that got alarm bells ringing. The government is asking the IMF to waive its fiscal targets. José Luis Machinea, the economy minister, has asked the Fund to draw $11 billion from its contingent credit line.
Neither country is doomed to restructure its debts, but it only makes sense to brace for the worst. We can either return to the traditional IMF-led rescue mission, or we could force private-sector creditors to take a hit when governments run into trouble.
If sovereigns begin restructuring their debts to private-sector lenders more frequently, the markets need mechanisms to deal with these events in a less traumatic way than in the Ecuadorian crisis. Bailing-in would force markets to price risk more precisely; the prospect of a bail-out by the IMF merely encourages moral hazard. Capital would probably become even more expensive, but this might encourage governments to use resources less wastefully.
There are some problems with this approach. Governments now borrow heavily on the bond markets, making it difficult to negotiate with this dispersed investor base. Seventy percent of Argentina’s foreign debt in 1999 was in bonds. Once a deal is struck and creditors take a haircut, it may take a long time for reformed sovereign and non-sovereign borrowers to return to the market. This could starve countries of voluntary funding, making them depend even more on the official sector’s limited resources.
However, the logic of making private-sector lenders pay for their mistakes is compelling. The Fund and the markets have allowed Argentina to go on a spending binge in recent years, which it is having difficulty paying for now. Would private lenders have been so forthcoming if they knew their money really was on the line?