How can emerging bond markets be made more efficient so as to avoid
excessive financial crises? New research by Sayantan Ghosal and Marcus
Miller, published in the latest Economic Journal, examines the two principal
proposals for improving the international financial architecture currently under
active consideration – the Sovereign Debt Restructuring Mechanism (SDRM)
advocated by the International Monetary Fund (IMF) and the ‘collective action
clauses’ recommended by the US Treasury.
The central focus of their analysis is on how problems of creditor co-ordination
interact with debtors’ incentives to generate excessive financial crises. The
researchers conclude that the preferable solution is a sovereign bankruptcy
procedure involving a temporary stay on creditor litigation and a discovery
process for determining the underlying causes of default.
A key element of the procedure would be that when the sovereign debtor in
default is found to have made little or no effort, its private payoffs will be
reduced ex post. To provide the right incentives, it is crucial that the
mechanism for doing this should have been agreed ex ante, as would be true
if a rules-governed public agency were involved. Moreover, the researchers
argue, privately issued bond contracts are unlikely to achieve the same result.
The mechanism that Ghosal and Miller describe incorporates features of the
bankruptcy procedures advocated by the IMF – the SDRM – though, unlike
the IMF's proposal, it is not restricted to cases of ‘insolvency’. They conclude,
therefore, that the institutional approach to sovereign debt restructuring
proposed by the IMF is, in principle, capable of increasing bond market
efficiency. What the rules should be – and whether the IMF as currently
constituted is the appropriate public agency to implement them – are policy
issues that remain to be discussed.
The researchers note that the consensus that capital account liberalisation is
unambiguously good has been shattered in recent years. A number of capital
account liberalisations have been followed by spectacular foreign exchange
and banking crises. Following Russia’s partial foreign debt repudiation in
August 1998, for example, generous inflows to Latin America came to a
standstill; and sovereign interest rate spreads rose to over 1600 basis points
on the Emerging Market Bond index.
These developments – together with the collapsing currencies and soaring
sovereign spreads facing many Latin American countries in 2001/2 – have put
in question traditional explanations for financial crises, based on current
account and fiscal deficits. They suggest the need to analyse the intrinsic
behaviour of capital markets.
A convincing treatment of sovereign debt crises and their resolution needs to
combine creditor co-ordination and debtor incentives in a consistent
framework. This paper develops such a framework. The analysis implies that
bail-outs alone will not solve the underlying causes of a sovereign debt crises;
and that the market equilibrium needed to provide the right incentives is
excessively prone to financial crisis, that is, to ‘sudden stops’ in capital flows.
ENDS
Notes for Editors: ‘Co-ordination Failure, Moral Hazard and Sovereign
Bankruptcy Procedures’ by Sayantan Ghosal and Marcus Miller is published
in the April 2003 issue of the Economic Journal.
The authors are at the University of Warwick.
For Further Information: contact Marcus Miller on 024-7652-3048 (email:
marcus.miller@warwick.ac.uk); or RES Media Consultant Romesh Vaitilingam
on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).