Lack of a clear policy on emerging-markets bailouts is causing confusion and leading some investors to believe that the International Monetary Fund will cover their bets. The biggest: Argentina.
By Deepak Gopinath
June 2001
Institutional Investor Magazine
Lack of a clear policy on emerging-markets bailouts is causing confusion and leading some investors to believe that the International Monetary Fund will cover their bets. The biggest: Argentina.
Domingo Cavallo returned to power in mid-April to rescue a teetering Argentina from the brink of financial collapse. He nearly pushed it over the edge.
Economy minister from 1991 to 1996 under then-president Carlos Saúl Menem, Cavallo won fame and respect for creating the currency board that tied the peso to the dollar and broke the back of hyperinflation. But in mid-April Cavallo proposed a change to this convertibility plan to help jump-start the economy from a three-year-long recession, which made Argentina’s peso uncompetitive. The peso, Cavallo suggested, should be tied to a basket composed of the dollar and the euro. A week later he announced that Argentina would suspend a planned $750 million bond auction because of high interest rates.
Markets reeled, as investors appeared to take a tough new look at a country with more than $128 billion in debt and a government having trouble servicing it. The price of Argentina’s widely traded floating-rate Brady bonds plunged from the 80s to the mid-70s. Briefly, Argentina became nearly as risky as Ecuador and Nigeria.
Yet within days, remarkably, the crisis eased. Argentina’s benchmark bonds shot back up to the 80s, and the country’s risk premium declined from 13 percentage points over U.S. Treasuries to 10 points over.
What caused the turnabout? First, Cavallo announced plans for a swap to extend the maturity of Argentina’s short-term debt, reducing near-term financing costs. Investors cheered the plan, though it has its own problems: It locks in crisis-level interest rates long term and pressures an ailing banking system that holds much of the debt.
But there is a second factor that has received less attention and carries with it wider-reaching implications for the world’s financial system. That is the decision, made that same week, by the International Monetary Fund to team up with the World Bank to provide Turkey with a $10 billion bailout package.
Turkey had already received a $10.4 billion IMF-led bailout in December to help the government maintain its own inflation-fighting peg to the dollar. But the package failed when a political spat between Prime Minister Blent Ecevit and President Ahmet Necdet Sezer sparked a crisis of confidence that forced the government to devalue the Turkish lira in February.
To emerging-markets investors what matters most is the nature of the new bailout, which is designed to help reform the Turkish banking sector. The package does not involve any bilateral loans from Group of Seven member countries, nor does it attempt to include private sector lenders and investors in a broader restructuring, or “bail-in,” in which they would share in market losses.
“Turkey caught people by surprise. It changes investor perceptions about U.S. and G-7 willingness to work with the IMF and World Bank,” says Paul DeNoon, a portfolio manager at Alliance Capital Management.
“Some people are saying the willingness of the Fund to lend to Turkey means we are returning to the old days of big bailouts,” adds Mohamed El-Erian, a portfolio manager at Pacific Investment Management Co. “It was striking that the second round of the package didn’t have private sector involvement.”
Since the financial crisis of 1997-'98, when countries from South Korea and Thailand to Brazil and Russia received IMF-led bailouts, policymakers have sought to create mechanisms like bail-ins to reduce moral hazard - foolhardy policymaking by developing-country leaders and risky lending by rich-country investors both convinced that they will be protected by multilateral bailouts.
One key proponent of bail-ins: the U.S. Congress, which created a special reform commission, chaired by Carnegie Mellon University political economy professor Allan Meltzer, as a condition of providing more funds to the IMF in 1998. Last year the Meltzer commission recommended that the IMF sharply curtail its mission - and the scope for moral hazard - by lending only during crises and only to preapproved countries.
Wary investors have wrangled with the IMF and other multilateral bodies to protect their rights in the face of efforts to arrange bail-ins. The tension peaked with the IMF’s refusal to lend to Ecuador in 1999, precipitating that country’s default and a subsequent debt restructuring in which bondholders were forced to take a 40 percent haircut.
The lack of bilateral cooperation on the Turkey package sends a signal to investors that the biggest countries, after years of slagging the IMF, might now be ready to let it take up again its role as cop on the beat - and effective lender of last resort. That suggests a return to sweeping bailouts that would make even foolish investors whole. After all, the Turkey bailout appears to indicate a change of heart by the George W. Bush administration. Most observers had expected Bush to adopt a harder line toward bailouts, using the Meltzer report as a blueprint for international financial institution reform. Both Bush economic adviser Lawrence Lindsey and Treasury Secretary Paul O’Neill had expressed distaste for the international financial institutions in general and for mega-bailout packages in particular. But in its first test, in April the new administration decided to make an exception for Turkey.
“The decision to provide Turkey with $10 billion rather than resume the old program does indicate a resumption of huff ‘n’ puff ‘n’ pay,” says Morris Goldstein, an economist at the Institute for International Economics and a former deputy director of research at the IMF. “Those in the administration who favored a sharp change seem to have buckled or were outvoted. It is not an encouraging sign for market discipline.”
The result: Market participants’ expectations of far higher risk of sovereign default associated with the tough talk from an incoming Republican administration has been replaced by too little perception of such risk. And that is what’s at play in Argentina, reeling despite its own $40 billion IMF-led loan package from December but still able to attract money from investors.
So is the stage set for a return to the hot money heyday of the mid-1990s, with the IMF riding to the rescue with big no-fault bailouts and no requirement that private investors take their own hits?
“Don’t bet on it. It is not our intention as an important shareholder of the IMF,” says Caio Koch-Weser, German deputy finance minister and a leading contender last year for the position of IMF managing director, until U.S. opposition scuttled his candidacy. “We believe we have made progress in coming to a common European position,” Koch-Weser adds. “There is an agreement to meet as deputies to move the agenda forward. We have been waiting for the U.S. since the elections and are looking forward to making progress.”
Agrees Canadian Finance Minister Paul Martin: “Private sector involvement is an essential part of crisis resolution and crisis prevention. The private sector needs to know the rules of the game.”
In the second Turkey package, IMF managing director Horst KÓhler, backed by Germany, tried to supplement IMF-World Bank aid with bilateral funds as part of a joint
G-7 effort but was rebuffed by the U.S. Bilateral aid would have reduced the size of the IMF-World Bank package and helped create a distinction between IMF lending for policy reasons and G-7 lending for strategic and political reasons.
“The more the G-7 uses the IMF for strategic reasons, the higher the risk of returning to the old too-large-to-fail doctrine, like that which dominated the market in the run-up to the 1998 Russia default,” says El-Erian. Adds Goldstein, “If there is no bilateral aid, fund lending could well become more politicized - not less.”
But the U.S. firmly opposed bilateral aid, preferring to put the burden of success squarely on KÓhler’s shoulders - and thereby protect the administration from congressional criticism. “If the [IMF and World Bank] are to be of real merit, they should be the instrumentality of world states,” said Treasury Secretary O’Neill following the April G-7 meeting. Bilateral assistance, he added, “calls into question the importance and utility of these institutions.”
G-7 ministers insist that the Turkey bailouts do not mean they have abandoned efforts to limit such interventions and to bail in the private sector. The G-7 has followed a Bill Clinton administration-led discretionary, case-by-case approach to bailouts and private sector involvement. Under this policy, no rules were set defining when a country would get assistance or the process by which private creditors would be bailed in.
But officials at the IMF and in Germany, Turkey’s biggest creditor, see that country’s package as an exception. “We don’t like to see such large packages as we have seen here and would have liked to send a bilateral message from both the burden-sharing and signal-to-markets point of view,” says Koch-Weser.
He and Martin, as well as officials from the U.K., are looking to promote a new rules-based approach to bailouts. Martin says he told O’Neill at the April G-7 meeting that progress on private sector involvement is necessary if the G-7 is not to lose credibility with another bailout. “We have talked to O’Neill about it, KÓhler has spoken out strongly on the Canadian position, the U.K. and France also,” says Martin. “I think we are getting there.”
In the recent past, uncertainty surrounding the criteria for determining when a country should receive official support and about the process for involving the private sector has led to the introduction of increased volatility for the rockiest countries. “International capital markets are completely intertwined with what the official sector will do,” says Amer Bisat, a former IMF economist who is now a portfolio manager at Morgan Stanley Asset Management. “Markets are no longer shielded by the action of policymakers; we are in a continuous guessing game.”
With Argentina, the guessing game is getting serious. Investors also know that time is running out. High interest rates cannot be maintained for long, and Cavallo’s economic measures of tax and tariff hikes and spending cuts are distortionary and will hurt growth in the medium term. Eventually, Argentina will have to go to the official sector for help; the question is whether it gets a package and, if so, under what terms.
Argentina accounts for almost 23 percent of the J.P. Morgan emerging markets bond index - which means most investors in emerging markets have Argentinean exposure. And its crisis is already affecting neighboring Brazil, so many investors see a new bailout as inevitable.
“The Turkish bailout was necessary, correct and good. The same is true for Argentina,” says Ricardo Haussman, a former chief economist at the Inter-American Development Bank and now an economics professor at Harvard University and a consultant for J.P. Morgan Chase & Co., who last month told clients to expect official financial assistance for Argentina.
In fact, Haussman believes that last year’s IMF program for Argentina was underfunded because of policymakers’ concerns at the time about moral hazard. He thinks Turkey represents a shift in policy and a signal that pragmatism is back. “It is political suicide for the U.S. to let Argentina go under, because it will generate enormous political consequences in Latin America. It would be a market-destroying move and would set us back decades,” says Haussman.
Heightening expectations of a bailout are market perceptions that the U.S. State Department took the lead on Turkey as well as the high priority Bush has placed on creating a Free Trade Area of the Americas. “The reality is, if we want free trade in Latin America, we need to be involved in Argentina,” says a senior congressional aide. “Clearly, policy has changed relative to what conservative Republicans were saying last year. Allowing the IMF to take the lead on Argentina and Turkey is practical diplomacy.”
For now, the discount at which Argentina’s benchmark floating-rate bonds trade demonstrates that market has not priced in an official package for Argentina. But Morgan Stanley’s Bisat thinks that will change over time. “Increased financial instability in Argentina may make more market participants expect a package.” He sees Argentina as a bigger test for policymakers than Turkey. “There is a group of people in Washington who feel Argentina is unsustainable and that any assistance would be throwing good money after bad. Another group says we cannot afford to let Argentina fail because of contagion to Brazil,” he says.
The play on Argentina only raises the stakes for policymakers. Time is running short not only for Argentina but also for the G-7 and multilaterals to come up with criteria for bailouts and bail-ins that would reduce market uncertainty and help investors to better price risk. “There is now a broad-based awareness in the market that we receive high spread to compensate for default risk,” says El-Erian. “Market participants need to know the principles governing the process of bailouts and bail-ins.”
