Sean Hagan was general counsel of the IMF from 2005-2018; he is currently professor from practice at Georgetown Law
Over the years, efforts to improve the sovereign debt restructuring process have focused primarily on addressing collective action among private creditors. That has changed.
There is now a consensus that a key obstacle to this process — including the process launched by the so-called “Common Framework” — is securing co-operation among official creditors, with much of the focus being on the largest among them, China.
Opinions vary as to the changes to the international architecture that are needed to address this problem. But I think that greater attention should be placed on a consistent application of the existing framework.
The relevance of the IMF to this debate is not surprising. The IMF has always played a central role (for better or for worse) in guiding the debt restructuring process. A country will typically only initiate a debt restructuring if and when the IMF determines that it is no longer prepared to provide financing in the absence of a restructuring.
Moreover, when a restructuring is needed, the financial parameters of an IMF-supported program determine the overall amount of debt relief needed to restore debt sustainability. A key challenge has always been the next step: ensuring adequate creditor co-operation.
On the one hand, the IMF is reluctant to postpone approval of financial support until the ink is dry on the restructuring agreement. On the other hand, it cannot approve a program until it has adequate assurances that creditors will, in fact, provide relief consistent with the program’s assumptions.
The IMF’s approach to obtaining these assurances from creditors (generally referred to as its “financing assurances” policy) has evolved. During much of the 1980s debt crisis, IMF would not approve a program unless a critical mass of private creditors signalled their willingness to provide the necessary debt relief. However, over time, creditors began to drag their feet and, as a consequence, the IMF found its financial support for countries being unduly delayed.
The IMF therefore introduced one of its most consequential policies — the “lending into arrears” policy: in the absence of creditor support, the IMF obtained financing assurances by assuming that if — during the period of the program — the debtor failed to reach an agreement with its creditors, the necessary financing for the program would be obtained through the accumulation of arrears.
A key aspect of this policy is that it can be relied upon even when arrears do not exist — in other words, in a pre-default context. In these situations, the financial parameters of the program assume that payments will no longer be made in accordance with the original contractual terms. While the first best scenario is that these parameters will be observed through a consensual restructuring that avoids a default, the IMF can proceed on the basis of an assumption that, even in a worst-case scenario, these parameters would be observed through the accumulation of arrears. In essence, the policy can be used as a backstop.
Unsurprisingly, the introduction of this policy was unpopular with private creditors: they no longer had the leverage to hold up an IMF program. Moreover, in order to avoid a default, they had no choice but to provide debt relief on terms consistent with the IMF’s program.
As originally conceived, this muscular approach was limited to private creditors. Through the Paris Club process, bilateral government creditors continued to provide early assurances to the IMF regarding their willingness to provide the necessary debt relief on a consensual basis.
However, over time, exclusive reliance in this consensual approach broke down with the emergence of new official bilateral creditors who were unwilling to join the Paris Club, including China. Faced with this challenge, the IMF decided in 2015 to adopt a policy enabling it to lend into arrears to official bilateral creditors.
Importantly, the policy on official arrears is less flexible than the one applicable to private arrears. Although two of the criteria that must be satisfied also apply to private arrears (namely, the urgency of IMF support and the existence of good faith efforts by the sovereign), the third criterion is specific to official claims: the policy cannot be applied if it would have an “undue negative effect on the Fund’s ability to mobilise official financing packages in future cases”.
Because arrears on a particularly large creditor — or group of creditors — increases this risk, the policy provides that the Fund would “normally” not be willing to lend into the arrears when the total value of claims held by the official creditor(s) in question represented a “majority of total financing contributions required from official bilateral creditors over the program period”.
Notwithstanding these constraints, the 2015 policy remains an important policy tool, both in the pre-default and post-default context. In particular, the term “normally” provides flexibility and could, consistent with the policy, enable the IMF to lend into the arrears of a large creditor that does not have a proven record of providing debt relief.
Unfortunately, the IMF has generally been reluctant to apply this aspect of the policy. This reluctance no doubt reflects concerns at the IMF Executive Board, where the interests of traditional Paris Club creditors are represented.
There may be a worry that even if a country accumulates arrears to a large official creditor during the program period, the creditor in question will be able to use its influence to restore the full value of the claim upon the expiration of the program, raising both sustainability and inter-creditor equity issues. While this is no doubt a risk, there may be ways to mitigate it, including through the type of “Most Favoured Creditor” provision recently suggested by Lee Buchheit and Mitu Gulati.
In any event, this reinstatement risk must be weighed against another one: giving a creditor a veto over the approval of an IMF program. This is precisely the risk the lending into arrears policy was designed to address.