Markets Insight: IMF Greek apology shows need for bankruptcy code
Jun 26, 2013
Publisher: Financial Times

IMF admission of error will be positive if a new crisis management structure limits decline

The International Monetary Fund has admitted serious errors in the way it handled Greece's bailout in May 2010. Its mea culpa this month said that, in providing funds in exchange for austerity, it had underestimated the damage to Greece's economy. The debt should have been restructured earlier, and reduced to a level that would have been serviceable over the longer term.

The IMF should not be surprised. A deep recession in Greece and worsening debt ratios were predictable outcomes. I made a case in this column in December 2010 for debt reduction instead of the liquidity infusion by the troika of the IMF, European Commission and European Central Bank.

But this is not the first time the IMF has made this error. It took seven years, from 1982 when the Mexican crisis began, to 1989 when the Brady Plan was implemented, before Latin America was given the benefit of debt reduction, lower interest rates, and debt-equity conversions. The delay resulted in a "lost decade" for the region in terms of economic growth and employment.

And in January 1999, the IMF said that, in its response to the Asian crisis, it had misgauged the severity of the downturn in Thailand, South Korea and Indonesia. The statement was similar in tone and substance to this month's apology.

There is a common thread to these errors. The IMF typically concludes that the problem is a shortage of liquidity, while the crises eventually involve a loss of solvency. Mexico in the 1970s, Russia and Asia in the mid-1990s, and Greece in the years before the 2009 crisis, borrowed large sums they could not repay. In the case of Greece, the IMF's forecast that the debt-GDP ratio would be more than 120 per cent in 2020 -- still a dangerously high level -- despite the troika's financial package should have set off alarm bells. The IMF proceeded with the programme anyway.

The troika's financial support allowed foreign private banks to continue valuing loans at par, and to escape losses on their holdings. Also, the objectives of the banks and of Greek residents diverged. While real GDP was 17 per cent lower in 2012 than in 2009, compared with the 5.5 per cent decline the IMF had forecast, official bailout funds enabled private lenders to receive payments from the Greek government.

At the same time, the bailout procedure discouraged new private investors from making up the funding gap, since they knew the loans were not worth their face value. The market was artificially boosted by troika support, depriving Greece of an important funding source in private investors.

On the domestic front, the Greek economy fell into a vicious downward cycle. With private credit markets not functioning, cutbacks in government spending and reductions in employment had to be larger than if the debt had been reduced. GDP fell by more than forecast, and debt ratios were worse.

Could Greece have avoided this sequence of events? If existing lenders had been forced to take losses promptly on their loans, the story may well have ended differently. New investors would have provided capital at better valuations, and haircuts on existing credits would have lowered debt ratios. Just as important, Greece's capital structure would have improved as equity-related inflows replaced a falling level of debt. The growing dependence on debt since Greece became a member of the eurozone in 2001 was a key cause of the crisis.

More broadly, the IMF's experience with debt restructurings over the past three decades points to the need for a sovereign debt reduction procedure comparable to the US Chapter 11 corporate bankruptcy code. The proposed code would replace the current system, under which lenders escape loss, while residents take a hit in living standards.

Then, as indicators worsened -- a rise in the debt-to-GDP ratio, persistently large current account deficits, a sharply weakening currency -- the debt would start trading at discounts to face value. Creditors and debtor governments would discuss procedures for a debt workout. It should be this market mechanism, rather than an all-powerful troika, that determines the economic reforms governments pursue to attract funds.

As in corporate bankruptcies, the proposed procedure would create a coincidence of interest between lenders and debtor governments. Some lenders might choose to convert loans to equity while others might hold on to them hoping they will rise in value. All parties would benefit from a quicker resumption of economic growth.

In sum, the IMF's admission of error will turn out to have a positive effect if a new crisis management structure limits the economic decline, and aligns various parties' objectives better through a faster introduction of the market mechanism.

Komal Sri-Kumar is a Milken Institute senior fellow and president of Sri-Kumar Global Strategies

A version of this article appeared in the Financial Times here.