What If Ireland Defaults? (27 page)

Capital requirements could be weighted on the risk levels held by type and by size – this would be a far more dynamic and counter-cyclical approach, which would need some tweaking to stop an appearance of ‘de-risking' during a property boom but that isn't insurmountable. Remuneration in lending is also a mess: brokers took a 50 per cent pay cut on loan origination, which used to be 1 per cent of the loan amount, and it got worse recently because there is a ‘cap' on earnings with many lenders now, but this move to slash pay completely misses the point. The idea of ‘money today' for a 25-year loan is insane. I even wrote a paper to the Central Bank about this (for which I got back a nice email). Payment should be aligned with the term of the product undertaken. If you write a 25-year loan then something like 0.2 per cent per year for every year the loan is performing is far more sensible and pragmatic, and, most importantly, it aligns the incentives of the seller with the principle; a non-performing loan offsets a performing loan, meaning banks and all of their sellers alike want to see the loan succeed. Quite frankly, it matters not to a person within the system if a loan goes bang two years down the line, and it should matter.

Many problems in this space will be resolved by the Personal Insolvency Act – at time of writing we have only seen the draft proposal, not the final version that becomes law. Outside of that however, debt will still be an issue and you can't fix one side of the equation (debt solutions) and avoid the other side (how the actual debt functions) or it's only a partial fix.

We have a view of what could happen and what could be beneficial if it were to happen, but what is actually likely to happen?

1. Credit will remain ‘off the cliff', or widely unavailable, until our banks are either bought over by well-capitalised foreign banks or after several years of being competed against by new entrants. Banks, despite the number of smart individuals in them, collectively act pro-cyclically or ‘with the cycle', and lend a lot in booms and don't lend enough in busts; that trend will continue.
   
2. Government regulation will in hindsight be seen as a cause of protraction of credit contraction via higher capital requirements/stricter regulation, pricing control (recent Financial Regulator intervention)/increased rights for borrowers. The Regulator will also take a more prominent role in our history books for doing its job terribly in both boom and bust alike.
   
3. Changes to our bankruptcy and insolvency laws are long overdue; this may reduce the value of bank mortgage books – in particular their value if sold off if the underlying rights of the mortgage holders change significantly. This will affect both existing lending and future lending prospects.
   
4. Central banks are the last line of defence, and I believe they are fit for that purpose but it is not a mantle they necessary want to evoke; eventually a liquidity wall will need to be offered or uncertainty will remain.
   
5. Mortgage lending may eventually be a highly profitable and sought-after business in the future, but we need margins, money to finance lending and confidence in prices as well as the future or people will stay afraid.
   
6. The two aspects missing in the Irish market are a site value tax and a property database; without them we lack insight and the most important property-related fiscal tool available – this has to change.
   
7. Changing fiscal policy may also cause further issues, what about ending tax relief at source? And if we bring in a property tax (albeit needed) what effect will that have?
   

For now, banks must deleverage, lend to SMEs and lower their loan to deposit ratios. How? Easy, it's like trying to drink a glass of water, burp and sing a song all at once. In theory you may say it could be done; in reality you won't find a person who can do it. Our banks are bunched and will remain so for some time. Will this all happen again? You bet it will; that there are property and credit cycles is a given. Fred Harrison in the UK has traced the boom–bust back to the early 1700s, and it goes back further in many other countries. Eventually disaster myopia will set in and we'll forget about the time we are in; things will be different. The Reinhart and Rogoff book
This Time Is Different: Eight Centuries of Financial Folly
has an important hint in the title: it would seem that in almost a millennium (with the restriction on going back further likely being reliable data more than anything) we haven't learned to stop bubbles from forming, which is far more effective than fixing the aftermath.

Somehow I can't shake the feeling that we are merely on the line of track between two stations on the bubble express, a reflation (at least in this analyst's opinion) is not an ‘if' event, just a ‘when' and ‘where' one.

At the same time I am hopeful, the natural tendency or inclination for the world and world economies is expansion; nobody wakes up hoping that their children have a fate or future worse than they do and that alone is a powerful positive force for an increased standard of living over time. What we call ‘bad' now is not nearly as bad as many of the issues our ancestors faced, and, like a broken heart, with time, we'll all get over it and move on. A brighter future will also entail a lot of change, some of which you will see first as you read through this book. For my own part I don't know if there will be a ‘mortgage broker' of the future, perhaps the biggest change in this industry will be to reinvent ourselves in some other space. Time will tell – the key is time – and time does fix everything (eventually). In Ireland it is just a question of ensuring we don't make it a longer process than necessary.

14

The IMF and the Dilemmas of Sovereign Default

Gary O'Callaghan

Gary is professor of Economics at Dubrovnik International University. He was formerly a member of the staff of the International Monetary Fund and, in that capacity, participated in negotiating a number of requests for sovereign debt reduction and rescheduling.

Introduction

‘Sovereign default' is an intimidating term and conjures up images of riots in the streets, guards at the granary and gunboats in the harbour. Thankfully, any recourse to military methods of debt recovery is now frowned upon, but there is always a danger that aggrieved creditors could become forceful and that matters could get out of hand. As recently as 2008, the United Kingdom used its anti-terrorism legislation to seize the assets of an Icelandic bank that had frozen the accounts of British depositors. Iceland was outraged at what it considered an ‘unfriendly act'.

The International Monetary Fund (IMF) represents many things to many people but its main purpose is to help sovereign member states run their economic and financial affairs in a proper manner and make the most of their own potential. The IMF is in the business of promoting stable growth so that a country's opportunities are maximised and its poverty is minimised. This also means that member countries are less likely to run into the sort of difficulties that lead to credit problems. In fact, the IMF strives for a quiet life where violent adjustments are avoided and trade and credit flow smoothly.
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Sometimes, however, member countries need help to repay their existing debts so that their access to international markets and financing is preserved for the future. And the IMF will often agree to bridge the financing gap, by lending its own resources, until solvency is restored. Unfortunately, this often requires recourse to a difficult path of adjustment for the country involved and it is these corrective measures that get most publicity. In these circumstances, the IMF is often portrayed as an enforcer for the great powers and their wealthy lenders – a surrogate for the gunboats of the past.

But, even in these situations, the IMF is more properly regarded as a credit resolution agency than as a debt collector. Some of the IMF's more recent attempts at credit resolution will be examined in this chapter and it will become clear that the IMF often proposes creditor contributions to an amicable debt restructuring in order to avoid either outright default or the imposition of repayment terms that are overly harsh. There is always the difficult issue of how much the country can repay, of course, and of how much debt might be ‘forgiven' by creditors in order to make the solution more durable, but the intention is always to achieve a viable resolution to a difficult problem.

The word ‘default' is uttered as a last resort at the IMF because the staff will always try to achieve an amicable accommodation between debtor and creditor – terms such as ‘debt forgiveness' and ‘debt restructuring' are used to imply creditor acquiescence to any necessary deal. And unilateral default is to be avoided at all costs because all parties lose out badly in such an event.
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When a government does decide to proceed with a unilateral decision to default, the IMF will try to open negotiations as soon as possible with a view to resolving and normalising creditor relations.

As background, it is worth recalling that the IMF is an institution in the United Nations system and was established, at an international conference toward the end of the Second World War, to provide a framework for economic cooperation and development that would lead to a more stable and prosperous global economy. John Maynard Keynes was one of the main contributors to this conference; the same man who warned in 1920 that the harsh financial terms imposed on a defeated Germany after the First World War would foster resentment and lead to further bloodshed.
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The IMF was founded, then, in a spirit of ensuring that punitive and unreasonable financial terms would never again lead to unfairness, instability and self-defeat on such a scale. The aftermath of the Second World War was marked more by the generosity of the Marshall Plan than the vindictiveness of reparations.
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The Default Dilemma: Time Inconsistency and Moral Hazard

Sovereign debt can lead to some very difficult issues but, at the core of any debt dilemma, there are two situations in social choice theory that present incentives for agents to act inefficiently. They are simple concepts but are often not fully understood:

• The first is
  time inconsistency
  , where one party to a transaction has an incentive to break its word and go back on a promise made at an earlier time. This danger clearly applies to debtors, who will always have an incentive to renege on debts once they are due. And the solution, of course, is to ensure that default carries such significant costs into the further future – including exclusion from future trade and finance – that the option will not be taken. Default must be a very costly choice.
  
• The problem of
  moral hazard
  , on the other hand, refers to a situation where a party who is insulated from risk behaves differently from how it would behave if it were fully exposed to it. If a creditor is fully isolated from risk, for example, there is a greater incentive to lend without appropriate diligence to potentially bad debtors. And, clearly, if default were never an option for a debtor, creditors would always be faced with moral hazard. The solution to this second problem is to allow the possibility of default in some circumstances – especially where the creditor may have been negligent and overly eager to lend – and encourage careful lending from the start.
  

So, the option of default can create a problem of time inconsistency but can also resolve a problem of moral hazard. And there needs to be a careful balancing act between the two consequences of default.

To make matters worse, these issues usually arise when some external shock has undermined the economic outlook that was shared when the loan was made. And it is often difficult – especially for opposing parties – to agree on whether, under the changed circumstances, the creditor is trying to take the easy way out or the debtor is trying to extract blood from a turnip. It is especially difficult when the turnip is a sovereign state and the IMF will try to assess what happened and what the debtor might reasonably be expected to pay in the circumstances. This requires a great deal of judgement.

The IMF's original mandate was to help countries overcome balance of payments problems in the context of a system of currencies with a fixed exchange rate to the dollar. Under that system, difficulties with debt repayment would first become obvious when central bank reserves began to drop. But, as time went on, the financial structure of the world changed radically and the IMF had to adapt and to expand its mandate in order to resolve the same basic set of problems. In fact, the IMF is constantly adapting to a changing world and there can be no IMF ‘manual' on how to handle potential default. Rather, the IMF approach is inherent in how its financial instruments and conditionality have evolved over time; IMF principles are best observed in their application.

Complications have multiplied in recent years as private financial markets expanded and became more global in nature. And this gets to a third problem in social choice theory that the IMF must confront:

• The
  free-rider
  problem refers to a situation where a party tries to reap the benefits of a resource without having to pay for it. This concept can be applied to the benefits that ensue when a country returns to financial health: all market participants can benefit from this – especially any creditors that will be repaid – but each will have an incentive to avoid making a contribution to the recovery.
  

Increasingly, then, the IMF has to ensure that, where appropriate, all beneficiaries make an adequate contribution to the resolution of a debt problem. This can be difficult with very disparate lenders.

It is worth noting at this stage that the IMF is never an endangered creditor when it is trying to resolve a debt problem.
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The money is always due to somebody else and the IMF tries to act as an honest broker. In such circumstances, it is very difficult to create an
ex ante
rulebook for creditors. As will be seen below, there were attempts to create a code of conduct a decade ago, but this was rejected by creditors who wanted to retain flexibility. It is also difficult to impose universal rules in advance because the financial world is changing so quickly and any rule book could quickly become out-dated.

Instead, the evolving IMF approach is set out below. It should become obvious that the IMF always tries to achieve a balance between attaching sufficient costs to default, on the one hand, and imposing a meaningful duty of care on a complete group of international creditors, on the other. This is never easy and, sometimes, the IMF will get it wrong and will have to review its approach. However, the evolving nature of the IMF approach also allows one to speculate on how it might apply to the Eurozone crisis, and this exercise is undertaken in a concluding section.

An Evolving Approach to Debt Resolution

The IMF consults with member states every year on how their economies have progressed, where problems have emerged and what policies or corrective measures will be pursued. A ‘surveillance' report is prepared and discussed at the IMF Board so that all member countries know what is going on with one another and can make comments. This process aims to impart good advice to members and to create an open and collegial environment in which countries can discuss their common problems.

This most basic function of the IMF already sets the stage to resolve any difficulties that might emerge. If a country has been honest and open in its discussions with the IMF, and has followed any advice that was offered, it is immediately in a better position to appeal for help should something go wrong. Any adverse events or shocks will more easily be recognised as something beyond the control of the country that is in trouble. After all, any country can encounter unexpected and adverse events.

Then, if necessary, the IMF can make a loan to the afflicted country to allow it to repay its debts while it makes the necessary corrections to the economy; the country will be given room to breathe while it adjusts to its new situation. Loans are approved by other member states and are sometimes offered at cheaper rates and better terms when the country is particularly badly afflicted, like Haiti in 2010. However, in most cases, the country will have to make difficult corrections so that its public finances and balance of external payments will be put on a stable footing into the future. An IMF ‘programme' will establish a medium-term schedule of loans and corrective actions and policies to be adopted.

Very soon after the IMF was established (in 1946), and its basic surveillance and lending practices were set up (as described above), Argentina got into serious financial difficulty. It could not repay its debts, even with assistance from the IMF, and arranged to meet its assembled sovereign creditors in Paris in 1956. The debt was rescheduled and led to the setting-up of the Paris Club: an informal group of countries that ‘seeks coordinated and sustainable solutions for debtor nations facing payment difficulties.' The Club has no formal legal basis but adheres to an evolving set of principles and has reached 422 agreements covering 88 debtor countries since its inauguration.
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It is chaired by the head of the Treasury section at the French Ministry of Finance.

The Paris Club normally requires that countries have an IMF programme in place in order to qualify for a debt rescheduling agreement. The IMF monitors the capacity of the debtor to make repayments and, as a result, the Paris Club became the IMF's forum for the rescheduling of debt between countries. Until the mid-1970s, private commercial lending to non-industrialised nations was not common – most non-industrialised countries borrowed from richer nations only – so the Paris Club was the main venue for resolving debt problems. With a few exceptions, debt rescheduling during this early period was short-term and did not involve significant write-offs or relief.

From 1956 to 1980, the number of Paris Club agreements signed with debtor countries never exceeded four per year. But, during this period, procedures were put in place and the notion of ‘burden-sharing' became an important element of any rescheduling. According to this concept, the creditor countries, the IMF and the debtor country would
all
share the ‘cost' of resolving a debt problem. In practice, the IMF calculated a debtor's ‘financing gap' and proposed a level of burden sharing – involving IMF loans, debt rescheduling and adjustment policies – that would bridge the gap into the future.

The Paris Club played a very important part in the transition of communist and socialist states to market economies in the early 1990s and this marked an important episode in the evolution of attitudes to debt restructuring. It was clear from the outset that these countries would have to undergo a very difficult period of adjustment and it was also true, of course, that the old debts had been accumulated by non-democratic regimes. Therefore, the problem of time inconsistency was somewhat diminished. Moreover, Western countries would benefit greatly from new markets. In these circumstances, very generous terms were offered, with Poland getting half its debt written off, for example, and most of the republics of the former Yugoslavia having two-thirds of their debt forgiven.
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During the 1970s, global finance began to change. Commercial banks took large deposits from oil exporters and lent these recycled ‘petrodollars' to oil-importing and developing countries, usually at floating interest rates. When interest rates soared in 1979, and the price of commodities from developing countries slumped because of the associated recession, a serious crisis broke out and the IMF led the global response, actively engaging with commercial banks for the first time in Mexico in 1982.
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In 1976, the London Club – an informal group of private creditors – had been assembled in response to Zaire's payment problems and this became the IMF's main private sector interlocutor as it confronted an increasing number of crises involving significant private sector lending.
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