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Chapter 4: The Global Financial Crisis and the Euro-Area Crisis

Author(s):
Julianne Ams, Tamon Asonuma, Wolfgang Bergthaler, Chanda DeLong, Nouria El Mehdi, Mark Flanagan, Sean Hagan, Yan Liu, Charlotte Lundgren, Martin Mühleisen, Alex Pienkowski, Gustavo Pinto, and Eric Robert
Published Date:
September 2018
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1. In the aftermath of the Argentine crisis, IMF members experienced a relatively calm period. There were few IMF-supported programs (Brazil, Turkey, Uruguay) under the Exceptional Access Policy (EAP—see chapter 3), largely due to balance of payments problems in the current account, and relatively few sovereign debt restructurings (e.g., Uruguay, Dominican Republic, Grenada, and Belize). However, imbalances and vulnerabilities were growing and subsequently erupted in 2007 [58].

The Global Financial Crisis (2007-2012)

2. The Global Financial Crisis (GFC)—beginning in 2007 with the collapse of the U.S. sub-prime mortgage market and escalating with the failure of Lehman Brothers in 2008—led to the deepest global recession since the Great Depression. The ensuing global credit crunch required a swift and decisive policy response from the IMF, including through numerous IMF-supported programs under the EAP for members having lost market access. In 2008, the IMF modified its EAP to cover current account crises, as well as capital ones.

3. The GFC first affected Eastern Europe (Latvia, Hungary, Romania) and then Iceland and other emerging markets (Seychelles, Mongolia, St. Kitts), all of which requested IMF-supported programs, most under the EAP [59]. Balance of payments problems stemmed from misaligned fixed exchange rates (Latvia), fiscal imbalances (Romania, Hungary), financial sector problems (Iceland), and debt sustainability issues (Seychelles, Jamaica, St. Kitts).

4. The GFC deepened and spilled over to euro-area members (Greece, Ireland, Portugal, and Cyprus). Balance of payments problems stemmed from fiscal and current account deficits (Portugal), fiscal and debt sustainability concerns (Greece), or financial sector crisis (Ireland, Cyprus). This stage of the crisis was marked by unprecedented concerns over contagion given the close economic and financial linkages within the currency union. Risk aversion also shot up for many emerging markets.

5. It was during this confluence of events in 2010 that Greece requested an exceptional access stand-by arrangement. The EAP required that debt be sustainable with “high probability”; staff was unable to determine that Greece’s debt met this standard. Concerned about the systemic consequences of a failure to provide financing, the IMF amended the EAP to allow the IMF to provide exceptional access financing to members, even if debt was not sustainable with high probability, if there was a high risk of international systemic spillovers [60]. This policy change essentially bought time for the euro-area to reorganize its crisis response architecture, but the change was controversial and recognized as imperfect.

Taking stock in the aftermath (2013-18)

6. Given the significant problems in the global architecture for preventing and resolving sovereign debt crisis exposed during the GFC, the IMF conduced a comprehensive review of its legal and policy framework to tackle these deficiencies in 2013 [58]. The following areas were highlighted:

Supporting bail-in

7. An assessment of recent sovereign debt restructurings (e.g., Jamaica, Belize, Grenada) found that debt restructurings often did not adequately resolve debt problems. The conclusion was that debt restructuring often need to happen earlier and involve deeper debt reductions—private sector involvement (PSI) was often “too-little and too-late.” Furthermore, it was concluded that while the “systemic exemption” in the IMF’s EAP was necessary to tackle the euro-area crisis, it ultimately did not prevent contagion, and allowed some private creditors to avoid a “bail-in” [58].

8. The IMF policy response was to reform the EAP in 2016 by removing the systemic exemption and making the EAP more flexible. Importantly, it recognized that when debt sustainability is uncertain (i.e., debt is assessed to be sustainable but not with a high probability), the IMF could grant exceptional access if financing from other sources improves debt sustainability and sufficiently enhances the safeguards for IMF resources. In such cases, there would be a range of options that could meet such requirements, depending on the circumstances of the individual case. For example, in situations where the member retains market access, or where the volume of private claims falling due during the program is small, sufficient private exposure could be maintained without the need for a restructuring of their claims. In other cases, a reprofiling of existing claims (i.e., a short extension of maturities falling due during the program) would typically be appropriate [61, 62].

Strengthening risk assessment

9. Prior to the crisis, the IMF’s debt sustainability analyses (DSAs) were often overly optimistic and did not focus enough on risks to market access and funding sources. This arguably contributed to the failure to anticipate debt sustainability crises and then to recognize their magnitude once they had begun (contributing to the “too-little, too-late” problem) [58].

10. This led to a wholesale redesign of DSA toolkit in 2013, which was rolled out to all advanced and emerging markets (“market access countries”). The revamped DSA moved to a more multifaceted framework for assessing sovereign debt risks, explicitly assessing market access and financing risks, recognizing the inherent uncertainty of debt projections, and scrutinizing the realism of assumptions underpinning the debt projections [63, 64].

Growing role and changing composition of official lending

11. The IMF’s legal and policy framework for financing assurances and on arrears (see Chapters 1 and 3) long depended on Paris Club practices, given its historic importance in representing the majority of official bilateral creditors. However, following debt relief efforts under Heavily Indebted Poor Countries (HIPC) and Multilateral Debt Relief Initiative (MDRI), the stock of Paris Club debt declined significantly and was replaced by the rapid emergence of new non-Paris Club official creditors. The 2013 paper also recognized that the IMF’s non-toleration of arrears to official bilateral creditors posed a risk of holdouts by official bilateral creditors [58].

12. In response to this, and the case of Ukraine which brought this issue to the fore, in 2015, the IMF sought to better align its arrears policy for official bilateral creditors with that for private creditors (i.e., the Lending-Into-Arrears (LIA) policy—see Chapters 2 and 3). The Lending Into Official Arrears (LIOA) policy allowed the IMF to provide financing in the presence of sovereign external arrears to official bilateral creditors in narrowly circumscribed circumstances. The reform was designed to strengthen incentives for collective action when official sector support is required, and to prevent non-contributing official bilateral creditors from blocking IMF-supported programs [65, 66].

Improving contract design to address collective action problems

13. The contractual approach to addressing collective action problems described in Chapter 3—i.e., the adoption of collective action clauses enabling a qualified majority of creditors to take a decision regarding the terms of the restructuring that is then binding on the minority—worked reasonably well after the widescale adoption of traditional collective action CACs in the 2000s. However, in the aftermath of the GFC, two weaknesses were exposed. First, the case of Argentina, where the interpretation by New York courts that the pari passu clause in Argentina’s international sovereign bonds required ratable payment to all creditors, raised concerns about the potential leverage for holdout creditors in future cases. Second, traditional CACs only enabled a restructuring of bonds series by series and thus allowed holdout creditors to impede a restructuring of one series if they could acquire a blocking position in that series [58].

14. In response, in 2014, the IMF reaffirmed its commitment to the contractual approach and endorsed key features of enhanced CACs and modified pari passu clauses for international bonds. Enhanced CACs enable decisions to be taken by a majority of creditors across all bond issuances, without the need for an issuance-by-issuance vote, subject to important safeguards to ensure inter-creditor equity across different issuances. A key advantage of having a single vote is that either no one is in or everybody is in, and enhanced CACs transfer legal leverage from individual creditors to the creditor group as a whole. The modified pari passu clause clarified that this clause does not require ratable payment to all creditors but only equal legal ranking [67]. Both clauses have since been very well accepted by the market and included in most bond issuances. However, a large outstanding stock with traditional CACs will remain for some time [68].

15. The IMF also took a fresh look at state contingent debt instruments, examining the case for instruments that link a sovereign’s repayment obligations to the underlying state of its economy. The paper highlighted the benefits of this type of instruments (e.g., for natural disaster risk and commodity price fluctuations) and suggesting practical steps to overcome some of the costs and constraints with their issuance [69].

Papers

[58] Sovereign Debt Restructuring - Recent Developments and Implications for the IMF’s Legal and Policy Framework, SM/13/100, April 29, 2013; The Chairman’s Summing Up, BUFF/13/42, May 22, 2013 (as reflected in the Public Information Notice).

[59] Review of Access Policy in the Credit Tranches and Under the Extended IMF Facility and the Poverty Reduction and Growth Facility, and Exceptional Access Policy, EBS/08/15, February 1, 2008; Acting Chair’s Summing Up, BUFF/08/30, February 29, 2008 (as reflected in the Public Information Notice).

[60] The Acting Chair’s Summing Up - Greece - Request for Stand-By Arrangement; Rule K-1 Report on Breach of Obligations Under Article VIII, Section 5 of the Articles of Agreement, BUFF/10/56, May 9, 2010.

[61] The IMF’s Lending Framework and Sovereign Debt - Preliminary Considerations, SM/14/133, May, 23, 2014; Chairman’s Summing Up, BUFF/14/54, June 18, 2014 (as reflected in the Public Information Notice).

[62] The IMF’s Lending Framework and Sovereign Debt-Further Considerations, SM/15/84, April 13, 2015; Annexes, SM/15/84, Sup. 1, April 13, 2015; SM/15/84, Sup. 2, January 6, 2016; Acting Chair’s Summing Up, BUFF/16/9, January 27, 2016 (as reflected in the Public Information Notice).

[63] Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis, SM/11/211, August 5, 2011.

[64] Staff Guidance Note for Public Debt Sustainability Analysis in Market-Access Countries, May 9, 2013.

[65] Reforming the IMF’s Policy on Non-Toleration of Arrears to Official Creditors, SM/15/261, October, 15, 2015; SM/15/261, Sup. 1, November 25, 2015; SM/15/261, Sup. 2, December 7, 2015; Chairman’s Summing Up, BUFF/15/107, December 9, 2015 (as reflected in the Public Information Notice).

[66] Status of Ukraine’s Eurobond Held by the Russian Federation, EBS/15/149, December 11, 2015.

[67] Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring, SM/14/265, September 2, 2014; The Chairman’s Summing Up, BUFF/14/95, October 3, 2014 (as reflected in the Public Information Notice).

[68] Progress Report on Inclusion of Enhanced Contractual Provisions in International Sovereign Bond Contracts, FO/Dis/15/148, September 18, 2015; Second Progress Report on Inclusion of Enhanced Contractual Provisions in International Sovereign Bond Contracts, FO/Dis/16/192, December 27, 2016; Third Progress Report on Inclusion of Enhanced Contractual Provisions in International Sovereign Bond Contracts, FO/Dis/17/205, November 30, 2017.

[69] State-Contingent Debt Instruments for Sovereigns, SM/17/61, March 23, 2017; Acting Chair’s Summing Up, BUFF/17/21, April 17, 2017 (as reflected in the Public Information Notice).

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