ECONOMYNEXT – The International Monetary Fund and Western lenders should devise a clause to be built into future bilateral loans, instead of delaying programs to countries like Sri Lanka while they try to get China into the international default resolution architecture.

Such a rule, called a collective action clause (CAC), already exists in the case of private creditors where bond holders have to re-structure if a majority agrees.

Such a rule promoted for bi-lateral loans can help at least in the future.

But there are other ways of getting around existing loans under IMF policies, when creditors do not agree to re-structure, like using a Most Favoured Creditor Clause that has been talked about.

An MFCC was used in Ukraine in relation to Russian loans.

G20/Sovereign Roundtable

Western nations and the International Monetary Fund had so far not succeeded in persuading China to agree to re-structure loans of Sri Lanka and other defaulting nations according to Fund requirement despite several discussions.

The most recent was during the G20 meetings in India.

Sri Lanka’s IMF program had been partly delayed pending agreement by China to re-structure debt along the requirement of the Fund, though the IMF has said several prior actions are pending.

Last week President Wickremesinghe said 15 items had been completed. However Sri Lanka still has a surrender

IMF had previously approved programs in several defaulted countries including Suriname and Zambia following so-called ‘soft assurances’ from China. But a re-structuring has not been finalized.

This has led to the demand for a ‘hard assurance’ in the case of Sri Lanka. A Global Sovereign Debt Round Table has also been initiated where Western lenders are trying to bring China to the existing default framework, which is usually followed by the Paris Club of lenders and others.

A more “predictable, timely, and orderly processes are needed” now according to US Treasury Secretary Janet Yellen.

“This is the goal of the new Global Sovereign Debt Roundtable (GSDR): to bring together creditors—official, old and new, and private—and debtor countries to discuss key issues that can facilitate the debt resolution process,” Georgieva said on February 25 after talks at the G20 meeting ended inconclusively.

“We launched the GSDR under the auspices of India’s G20 presidency last week at the deputies’ level, followed by an engaged and constructive principals meeting earlier today. We will further build on this discussion during the World Bank-IMF Spring Meetings in April.”

The US Treasury initiated the IMF in the immediate post World War II era along with the State Department backed by some European and Latin American nations as part of setting up the failed Bretton Woods system of gold linked soft-pegs.

The US has spearheaded debt work outs as Latin American nations started to default from the 1980s as the Fed tightened policy ending a weakened monetary standard that emerged in the aftermath of the Bretton Woods collapse.

If the US Treasury is hoping to persuade China in April IMF World Bank spring meetings, Sri Lanka will have to wait till May to get its deal approved by the IMF.

But what if China doesn’t?

China doubling down calling for IMF, World Bank relief

Recent statements by China’s Foreign Ministry indicates that the country is doubling down on the original debt assurance sent by the Exim Bank to Sri Lanka and it is in no hurry to change its stance.

China has said it is giving a two-year moratorium to Sri Lanka covering 2022 and 2023. As a result Sri Lanka technically has no official arrears to China. China has agreed to re-structure its loans to Sri Lanka this year.

China however has not directly conveyed it to the IMF according to available information. As far as China is concerned, Sri Lanka is the counter-party to its contracts.

Though Sri Lanka is trying to get another letter, China has insisted that it has provided debt assurances.

China is also calling on lenders like the World Bank and ADB to re-structure their debt. These International Financial Institutions, considered senior creditor, do not usually re-structure debt.

It happens rarely for instance during the Highly Indebted Poor Countries (HIPC) initiative involving the IMF, World Bank and the African Development Fund.

Sri Lanka has classified some Chinese lending including syndicated loans given when the country.

According to officials who negotiated with Chinese officials their line of questioning seems to reflect a concern that China was somehow being targeted by Western powers.

It must be noted that the US AID is now mostly give grants unlike in the Marshall Plan days. US money goes through other multilateral agencies like the World Bank which are insulated from debt re-structure.

Lending into to Official Arrears

The IMF does not usually lend to countries which have arrears to IFIs (called the Non-toleration policy). It lends despite arrears to bilateral creditors in some circumstances governed by its lending into official arrears policy.

IMF programs usually have a Performance Criteria barring arrears. However, in the case of default, it has a policy of lending into official arrears.

The requirement include non-objection by the creditor.
However in the case of Sri Lanka there is technically no official arrears to China at least until the end of 2023, so it is moot point whether it applies to Chinese lending.

Sri Lanka is still servicing its debt to the World Bank and other accepted senior creditors.

There is a number of countries with monetary instability and Chinese loans that are likely to default in the coming months.

Many of them have Chinese loans.

The IMF would understandably like to be ready and not get bogged down like in earlier cases.

Most Favoured Creditor Clause

One way out that has been considered is a Most Favoured Creditor Clause.

An MFCC written into say Paris Club or Indian re-structured loans will ensure that if any special treatment is provided to China, the others will also get it.

However it is also expected to serve as a deterrent to anyone from asking for special treatment in the first place.

The IMF lent to Ukraine with an MFCC relating to Russian debt.

Of course with US as the main stakeholder in the IMF anything can happen.

An MFCC clause written into Argentina private re-structured debt failed to deliver due to several shortcomings.

Bi-lateral creditor clause

The IMF and other lenders should devise a clause to be inserted into bilateral loan deals which compels the lender to agree to any default framework under its sanction.

That way when countries borrow from China or any other party they will have to make sure that such a clause in inlcuded.

The IMF could also consider making a bilateral creditor clause a requirement for all re-structured loans.

That way when these countries default again, it will be easier to re-structure them.

Under flexible inflation targeting to which Sri Lanka and other reserve collecting nations are being pushed into, with legalized output gap targeting (stimulus), defaults of re-structured debt will be inevitable, regardless of what their fiscal metrics are, just like Latin American countries with sterilizing central banks.

IMF also Partly Responsible

The IMF itself is partially responsible for sovereign defaults in several ways and should expedite its programs – as long as the soft-pegged/flexible inflation targeting countries that collapse takes reasonable steps to change what is within their control.

The IMF was set up originally because the architects of the Bretton Woods soft-peg system knew that attempts to operate an externally anchored pegged regime with artificially controlled policy rates (so-called monetary policy independence) to achieve objectives other than monetary stability would end up in balance of payments crises unlike the pre-Depression, pre-Keynesian gold standard.

First IMF’s currently peddled ‘flexible inflation targeting’ is much more dangerous than the Bretton Woods itself as the peg is no longer the final backstop against monetary policy errors. Mis-targeted rates can be perpetuated with depreciation or what is now called exchange rate as the first line of defence policy.

As a result, the IMF bears responsibility for peddling an extreme impossible trinity regime to unfortunate third world countries without a doctrinal foundation in sound money.

Second when the IMF declares a country’s debt as being unsustainable it makes default inevitable by stopping all multilateral lending and scaring away other lenders who may help.

As a result, even if the country hikes rates to stop money printing and restore the ability to make external payments, default will be certain. Sri Lanka made no attempt to either hike taxes or rates in 2021 or 2022 when it had some reserves in hand.

Currency crises and external defaults within IMF programs

Pakistan is now trying to fix itself after running down most of its reserves during an IMF program. But Pakistan has no bullet repayment debts this year. Though reserves are down to 3.0 billion dollars and a float has succeeded.

With doubts about external financing it is not clear whether IMF program will continue.

Significantly, Sri Lanka also ran into currency crises in 2012 and 2018 within IMF programs, borrowing heavily aboard all the time during each crisis and not just when the country was running monetary policy on its own.

This is a feature found in several programs of late. Argentina defaulted in 2019 despite entering into an IMF program. Pakistan is on the brink of default within an IMF program.

Sri Lanka managed to avoid sovereign default during 30 years of war where billions of were busted up in a military spending each year, but defaulted in peace time, following a series of quickfire currency crises which ratcheted up foreign debt as the country faced forex shortages.

Third the IMF also and has an obligation to help countries as long as they do the prior actions and whatever is within their own control to hike rates to printing money so that the ability to make foreign payments come back and reducing deficits.

DDR and Problems in Default Framework

There are serious problems with the current default framework. External sovereign defaults proliferated from 1980s in the Latin America and the IMF was unprepared for it at the time. The lender is still not prepared.

Under flexible inflation targeting style extreme impossible trinity regimes, following steep depreciation domestic re-structure is now done even through the currency collapses automatically impose a real hair cut.

It is true that IMF Debt Sustainability Analysis have to be pessimistic. Under flexible inflation targeting and related intermediate regimes, where ‘reserve adequacy’ and fixed policy rates are mentioned in the same breath, a country has no hope of stability and steady growth.

Forex shortages, output shocks and more defaults are the path once market access has been reached. Under unstable reserve collecting intermediate regimes, where monetary stability is denied to an entire population, worsening fiscal metrics and pessimistic DSA forecasts are self-fulfilling prophesies.

The lack of clarity on domestic debt re-structuring and cut off dates on what domestic debt if any is re-structured has pushed -up interest rates to unsustainable levels. In addition to DDR itself the lack of a cut-off date is directly responsible for the elevated rates.

The fear of DDR has pushed Sri Lanka’s interest rates to 30 percent levels and it has persisted for about a year. As a result banks are unwilling to buy government debt.

Domestic creditors are the last resort lenders, especially in countries like Sri Lanka with exchange controls and should be treated as senior lenders, which would keep rates down.

In earlier currency collapse episodes in the midst of the civil war, where Sri Lanka also went to the IMF, rates have risen to over 20 percent, but have come down within a few months of a float and the approval of a program.

Rightly or wrongly external and domestic investors get confidence from an IMF program now, and therefore everyone waits with baited breath for program approval even though external stability has now been restored.

Fiscal Metric Spectrum

A look at recently defaulted nations show that they have varying fiscal indicators. Some have high revenue to GDP ratios, while others had debt ratios of 60 percent of GDP and deficits around 5 percent of GDP before default.

Some of these ratios are better than what is found in some developed nations with floating rates.

What is common to all these countries is monetary instability from flexible intermediate regimes.

In these countries fiscal metrics dramatically worsens with each currency crisis and then the country defaults, especially if it has market access.

Market access Latin American countries defaulted after 1980s, with no war, simply on monetary policy.

A currency crisis comes from trying to control the exchange rate while printing money to suppress rates. In Sri Lanka money was printed until inflation went up to 5 percent, triggering forex shortages.

Under an IMF program which has reserve targets, there is no hope of going into a clean float.

Recent crises in several countries have come from liquidity injections for Covid re-finance and rate cuts as the economies recovered strongly after the pandemic. Pakistan and Bangladesh are examples.

Monetary Instability and Debt</b.

Since the denominator slows down with each currency crisis, the debt to GDP ratio tends expand. When the breaks are put to stop the currency crisis that comes from flexible inflation targeting, tax revenues slow down and budget deficits also widen.

Interest rates also go up, further widening the deficit and overall debt.

At each currency crisis, foreign debt also expands both due to ‘bridging finance’ or monetary instability driven borrowings and depreciation.

As a country runs out of reserves and credit downgrades come, sovereign yields go up, rolling over bonds become impractical and market access is lost.

The IMF then says debt is unsustainable and prevents the World Bank or others from giving loans.

Shortly after the country defaults.

Argentina’s debt to GDP ratio was 57 percent in 2017 when its currency started to collapse in 2018 after US tightened policy. By 2019 it was 85 percent of GDP with the peso falling from 18 to 36 to the US dollar. By 2021 debt to GDP was 101 percent.

It could not pay re-structured debt. And not for the first time. By 2021 Argentina’s debt was up to 167 percent of GDP according to IMF data.

In Sri Lanka the debt to GDP ratio rose from 78 percent in 2015 to over 120 percent as the currency collapsed.

In addition to coming up with a solution to China, the IMF can do itself a favour and the unfortunate countries with monetary instability by recognizing – even at this stage – that flexible inflation targeting with reserve collections is an impossible trinity regime.

The IMF should recognize that the impossible trinity regimes it peddles, involving flexible inflation targeting and other attempts to conduct independent monetary policy with foreign reserve targets are paths to disaster.

The IMF should also take note that countries that defy its advice in East Asia maintains reasonable exchange rate stability and are doing much better at maintaining monetary stability.

Countries like Cambodia and Hong Kong also has the best fiscal metrics in Asia. Dismissing them as outliers is a costly mistake. (Colombo/Feb27/2023)