Debt Sustainability

The considerations guiding the IMF’s debt sustainability analysis which crucially determines the Fund’s lending policy is explained on an IMF website.

The DSA framework is in place since 2002. It has three objectives: To assess the current state; identify vulnerabilities; and examine alternative debt stabilising policies. Both total public and total external debt are analysed. Market-access countries and low-income countries are distinguished. These charts and tables summarise the DSA indicators for a market-access country. An example of the DSA is at display on page 41 in the September 2014 report on Italy.

Pari Passu and Collective Action Clauses: The New World

An IMF staff report published in September and entitled “Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring” discusses recent legal developments of relevance for sovereign debt markets and implications for the sovereign debt restructuring process.

The New York court decisions (NML Capital, Ltd v. Republic of Argentina) have rendered a holdout strategy more likely to succeed. This tends to exacerbate collective action problems and raises the risk of more protracted debt restructuring processes. Market participants, including the International Capital Markets Association (ICMA) are discussing contractual clarifications and modifications in response to this challenge. The IMF observes these discussions and supports the preliminary results.

The New York court decisions established a broader interpretation of the standard pari passu clause in sovereign debt contracts. Specifically, they extended the standard notion of “protection of a creditor from legal subordination of its claims in favor of another creditor” to the broader notion that a sovereign must pay creditors on a pro rata basis. The court decisions prohibited Argentina from making payments to holders of restructured bonds unless it paid holdout creditors on a pro rata basis, and it prevented banks from making payments on Argentina’s behalf. In this context, the decisions also interpret the U.S. Foreign Sovereign Immunities Act. The scope of the rulings is not clear, not least because the decisions also refer to Argentina’s “course of conduct.” If interpreted broadly, the court decisions change the legal framework and are likely to complicate the restructuring of New York law-governed debt contracts (while probably not affecting London law-governed contracts).

Box 1 of the report discusses in detail the history of the Argentine litigation in the U.S. The report also contains an annex on the history of pari passu clauses in New York law-governed sovereign debt contracts.

Sovereign issuers have already reacted to the court decisions, by modifying the pari passu clauses in debt contracts. Also, ICMA has proposed a new standard pari passu clause, emphasising equal ranking as opposed to pro rata payments.

Collective action clauses enable a qualified majority of bondholders (e.g., 75%) of a specific bond issuance to bind the minority to the terms of a restructuring agreement. If collective action clauses operate on a series-by-series basis rather than on the total stock of debt then a blocking minority can more easily be formed and a strategy of holding out is more likely to succeed, in particular in light of the recent New York court decisions. The possibility to aggregate claims across bond series for voting purposes works in the opposite direction. Some countries have included aggregation clauses in the debt contracts, and the ESM treaty requires standardised aggregation clauses (“Euro CACs”) in Euro area government bonds as well. These clauses feature a “two limb” voting structure, requiring a majority of bondholders in each series and across all series but a lower quorum (e.g., 66%). Currently, “single limb” procedures are being discussed. These would solely require a majority across all series. To prevent abuse, such single limb procedures would have to be accompanied by safeguards that ensure inter-creditor equity, in particular a restriction to offer all affected bondholders the same (menu of) instruments. (Offering the same (menu of) instruments would generally imply that some creditors suffer larger restructuring losses than others, depending on the type of instruments they held initially. But already today, this is common and generally accepted.)

Box 2 of the report discusses the history of collective action clauses. Box 3 of the report discusses disenfranchisement provisions. Their purpose is to limit the risk of a sovereign manipulating voting processes by influencing votes of entities under its control.

Maturity Extension as Precondition for Large-Scale IMF Financing Operations?

An IMF staff report published in May and entitled “The Fund’s Lending Framework and Sovereign Debt—Preliminary Considerations” proposes to drop an exemption related to systemic importance and to give a larger role to debt maturity extensions.

Prior to 2002, when a member state sought funds in excess of established limits, the Fund often waived these limits on the basis of “exceptional circumstances,” and did so in a discretionary manner. Growing concerns over the problems this may create (moral hazard, early exit of private creditors, delays in necessary debt reduction measures, large-scale Fund financing operations) and the Argentinian collapse of 2001 triggered a review that gave rise to the 2002 exceptional access framework.

This required as a precondition for Fund support that debt be sustainable with a high probability. Whenever debt sustainability was clearly not given or remained in doubt, the framework called for debt restructuring with the aim to render the remaining debt sustainable. In retrospect, this restructuring requirement is viewed as too inflexible since it generates restructuring costs even when it turns out ex post that a restructuring was not actually needed.

During the Euro area crises, the Fund did not judge debt sustainability of the most affected countries to be very likely and the exceptional access framework of 2002 therefore would have required a debt restructuring as a precondition for IMF funding. However, pointing to high risks of international systemic spillovers of a debt restructuring, the Fund waived in 2010 the requirement that debt had to be sustainable with a high probability. By now, this modification of the exceptional access framework is also seen as unsatisfactory because systemic exemption structurally favors large member states and does not address the problems that gave rise to the 2002 framework. Against this background, a reform proposal is put forward.

The reform proposal is guided by two objectives: To improve debt service capacity without imposing debt reduction as a prerequisite; and to avoid that private sector claims are fully honored while debt sustainability remains in doubt. According to the proposal, the IMF would require as precondition for funding that measures are taken to improve debt sustainability even if they do not necessarily restore sustainability with high probability. Chief among those measures, the proposal suggests that creditors should be asked to agree on a maturity extension (re-profiling). That is, private creditors would remain exposed to the default risk and would be forced to contribute to the refinancing.

Collective action clauses might be needed to win creditors over. For a majority of them to be voluntarily participating, they must perceive the maturity extension as likely leading to renewed market access of the sovereign. Even in the absence of a payment default, re-profiling would likely trigger a credit event if collective action clauses were activated, and a credit downgrade among rating agencies.

Sovereign Debt Issuance under Domestic Law

In the second of his Munich Lectures in Economics, Kenneth Rogoff discussed financial crises. (His first and third lecture covered a proposal to phase out cash, see my post.)

In addition to reviewing his work with Carmen Reinhart, Rogoff returned to an earlier proposal (Bulow and Rogoff 1990, Journal of Economic Perspectives) according to which sovereigns should issue public debt under domestic law. This would avoid complications in an eventual debt restructuring process but would also make it harder to issue debt in the first place.

Rogoff reminded his audience that not only developing countries are and were subject to IMF programs; advanced economies were too (e.g., the UK in the 1950s).

Phasing out Cash

In the first and third of his Munich Lectures in Economics, Kenneth Rogoff argued in favour of phasing out cash, at least high denominations and in some developed economies. (His second lecture covered financial crises, see my post.)

Rogoff is well aware that cash preserves privacy and he acknowledges that one should have very good reasons to advocate phasing it out. He believes that there are two: Tax evasion and the black economy on the one hand, and the zero lower bound on nominal interest rates on the other.

Based on earlier research (Rogoff 1998) he argues that withdrawing bank notes with high denominations (e.g., USD 100 bills, EUR 500 bills etc.) would increase the cost of evading taxes or engaging in the black economy sufficiently strongly as to raise tax revenues, and that increased tax revenues would more than compensate for any loss of seignorage.

The (close to) zero lower bound on nominal interest rates and the resulting constraints for monetary policy derive from the fact that cash pays a zero nominal interest rate. Rogoff emphasised the seminal contribution of Lebow (1993 Fed working paper) in identifying the problems connected with the zero lower bound as well as possible ways to address them. Rogoff added that earlier writers (e.g., Gesell, Goodfriend, Mankiw or Buiter) who suggested to relax the constraint by subjecting cash to depreciation missed the point. Rather than forcing a negative nominal interest rate upon cash one should eliminate it altogether. He also dismissed shifting to a higher inflation target to avoid the zero lower bound problem, pointing to the huge loss of credibility that central banks would suffer as a consequence. Among factors for the trend towards lower real interest rates, Rogoff emphasised demographics and the asset pricing consequences of rare disasters; he dismissed secular stagnation. He also discussed forward guidance in the form of price level targeting.

Rogoff suggests to replace cash by universal debit cards. He does not expect significant technical difficulties in the process and proposes to subsidise debit cards for low income households.

Corporate Taxation, Profit Shifting and Cross-Border Tax Avoidance and Evasion

Matthew Klein discusses corporate and personal income tax evasion and avoidance in the FT (part 1, part 2), with reference to a JEP article by Gabriel Zucman. Klein makes several points:

  • Profit taxes were introduced as complements to income taxes, in order to make it more difficult to evade taxes by routing profits through fabricated corporate structures rather than distributing them. To avoid double taxation, capital gains and dividends typically are taxed at lower rates than labor income.
  • Whether corporate taxation should be coordinated internationally is not a new question. The League of Nations already debated it. The issue regained importance as international trade and cross-border profit flows rose.
  • Today, a third of US corporate profits are generated outside of the US. Of those, more than half are generated in Ireland, Luxembourg, the Netherlands, Singapore, Switzerland and the Carribean. Both shares have increased over recent decades (see the figure below which is taken from Zucman’s article). This might have contributed towards lowering the effective corporate tax rate of US corporations in the US.
    Zucman-tax-haven-share-of-foreign-profits-590x437
  • If the objective is to (i) avoid double taxation and (ii) render cross-border profit shifting irrelevant, an easy way forward could be to credit a corporation’s taxes paid worldwide against the personal income taxes owed by the corporations shareholders. This would imply that higher corporate taxes abroad could lead to lower domestic income tax revenue, a difficult political sell. It would also imply that unrealised capital gains may go untaxed.
  • Based on discrepancies between national balance of payments statistics, Zucman estimates that 8% of global household financial wealth is not reported to tax authorities (see the table below which is taken from Zucman’s article).
    Zucman-offshore-wealth-propensity-590x432
  • He proposes to impose high tariffs on exports originating from “tax havens” to force these countries to exchange information about bank accounts and, in the medium term, to create an “international financial registry.”

Languages, Specifically English

Dylan Matthews presents interesting facts about the use of languages, their roots and in particular, about the English language, in Vox.

The median number of languages spoken in Denmark, the Netherlands or Slovenia equals 3. In the English language, the letter “b” mostly appears at the beginning of a word, the letter “d” at the end and the letter “u” in the middle. Also in the English language, a “d” or “y” is most often followed by a blank; a “h”, “v” or “z” by an “e”; and a “q” almost always by a “u”. And the most common letter combinations in Google Book archive are

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“Debt Maturity Without Commitment,” JME, 2014

Journal of Monetary Economics 68(S), December 2014. PDF.

How does sovereign risk shape the maturity structure of public debt? We consider a government that balances benefits of default, due to tax savings, and costs, due to output losses. Debt issuance affects subsequent default and rollover decisions and thus, current debt prices. This induces welfare costs beyond the consumption smoothing benefits from the marginal unit of debt. The equilibrium maturity structure minimises these welfare costs. It is interior with positive gross positions and shortens during times of crisis and low output, consistent with empirical evidence.

World War II in 42 Maps

Timothy Lee and collaborators provide a map-based account of World War II in Vox. Short texts and 42 maps cover Germany, China and Japan, Central Europe, Finland, France and the UK, Russia, the Pacific, Africa, the Allies’ invasions, the Holocaust, Israel and Korea, among other aspects. An animated map displays the opponents’ varying spheres of influence during the war years.

Harmless Deflation

John Cochrane argues in the Wall Street Journal that deflation fears are overblown. His main points are:

  • According to the Friedman rule, low deflation is beneficial.
  • Sticky wages only cause problems if the deflation rate exceeds the rate of productivity growth. This is not in the cards.
  • Similarly, the debt burden does not rise dramatically when prices fall by only two percent per annum say.
  • Low deflation limits the flexibility of monetary policy but that’s ok.
  • Implosive deflation spirals of the type feared by commentators have never been observed. They cannot happen because investors who hold government bonds would sell the securities (fearing default) and try to buy goods instead.

Research Productivity of Economics PhDs

In an article in the Journal of Economic Perspectives (data appendix), John Conley and Sina Önder argue that

only the top 10–20  percent of a typical graduating class of economics PhD students are likely to accumulate a research record that might lead to tenure at a medium-level research university. … graduating from a top department is neither necessary nor sufficient for becoming a successful research economist. Top researchers come from across the ranks of PhD-granting institutions, and lower-ranked departments produce stars with some regularity, although with lower frequency than the higher-ranked departments. Most of the graduates of even the very highest-ranked departments produce little, if any, published research.

The Economist discussed the article here.

Single-Point-Of-Entry, Orderly Liquidation Authority and Chapter 14

In the thirteenth, fourteenth, fifteenth and sixteenth chapters of “Across the Great Divide: New Perspectives on the Financial Crisis,” Randall Guynn, Kenneth Scott, David Skeel and Michael Helfer discuss legal strategies to resolve financial institutions, including single-point-of-entry, orderly liquidation authority under the Dodd-Frank act, or proposals for a new chapter in the bankruptcy code.

Proposed in 2012 by the FDIC, the single-point-of-entry strategy has widely been acknowledged as useful, both in the US and internationally (for example in Switzerland by FINMA). Guynn writes:

The key to solving the TBTF problem without taxpayer-funded bailouts is a high-speed recapitalization of the failed financial group that imposes losses on shareholders and other stakeholders but avoids unnecessary value destruction and preserves the group’s going-concern value. …

The SPOE strategy can be implemented under the existing Bankruptcy Code, although a new Chapter 14 could increase the likelihood of its success, particularly if it were coupled with a secured liquidity facility from the government that would be able to provide such liquidity under the most severe economic conditions.

“Financial Market Infrastructure”

In the eleventh chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Darrell Duffie argues that central clearing parties administering tri-party repurchase agreements cannot be resolved under current bankruptcy law, including recent provisions under the Dodd-Frank act. He argues that

a financial institution should not operate key financial market infrastructure backed by the same capital that supports much more discretionary forms of risk-taking, such as speculative trading or general lending.

“Toward a Run-Free Financial System”

In the tenth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Cochrane argues that at its core, the financial crisis was a run and thus, policy responses should focus on mitigating the risk of runs (blog posts by Cochrane on the same topic can be found here and here). Some excerpts:

… demand deposits, fixed-value money-market funds, or overnight debt … [should be] backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. …

Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund … Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, and providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt.

If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour …

Rather than outlawing short-term debt, Cochrane suggests to levy corrective taxes on run-prone liabilities. Moreover:

… technology allows us to overcome the long-standing objections to narrow banking. Most deeply, “liquidity” no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities.

… electronic transactions can easily be made with Treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. … On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets.

Cochrane rejects the claim that the need for money-like assets can only be met by banks that “transform” maturity or liquidity. He argues that current regulation reflects a history of piecemeal responses that triggered the need for additional measures; and he points out that the shadow banking system creates run risks because a “broker-dealer may have used your securities as collateral for borrowing” to fund proprietary trading.

Cochrane debunks crisis lingo and clarifies links between aggregate variables:

The only way to consume less and invest less is to pile up government debt. So a “flight to quality” and a “decline in aggregate demand” are the same thing.

He questions the need for fixed value securities other than short-term government debt as means of payment or savings vehicle; offers a short history of financial regulation; and deplores regulatory discretion.

Do Higher Nominal Interest Rates Raise Inflation?

In several blog posts (here and here), John Cochrane mulls over the Fisher equation and the stability properties of the variables in the equation:

I think I can boil down the issue to this question: If the central bank pegs the nominal rate at a fixed value, is the economy eventually stable, converging to the interest rate peg minus the real rate? Or is it unstable, careening off to hyperinflation or deflationary spiral?

He offers a series of instructive graphs to illustrate the inflation dynamics under the assumption that inflation dynamics are (i) stable (Neo-Fisherian view) or (ii) unstable (standard view):

Slide01

Interest rate increase pushes up inflation, maybe with a delay.

Slide05

Inflation shock eventually dies out even if interest rate does not respond.

Slide03

Interest rate increase pushes down inflation, on an accelerating path …

Slide04

… unless monetary policy steps in and undoes the initial tightening.

Slide07

Inflation shock does not die out …

Slide08

… unless the interest rate responds.

Which model is the right one? The US, Japan and other countries have been at the zero lower bound for a while—without an explosion in inflation. John Cochrane interprets this fact as evidence in favour of stability. And he offers this nice analogy:

Think of holding a broom upside down. That’s the standard view of interest rates (on the broom handle) and inflation (the broom). Anytime the Fed sees inflation moving, it needs to quickly move interest rates even more to keep inflation from toppling over — the Taylor rule. To raise inflation, the Fed needs first to lower interest rates, get the broom to start toppling in the inflation direction, then swiftly raise rates, finally raising them even more to re-stabilize the broom.

The neo-Fisherian view says the Fed is holding the broom right side up, though perhaps in a gale. To move the bottom to the left, move the top to the left, and wait. But alas, the broom sweeper has thought it was unstable all these years, so has been moving the handle around a lot.

“How Is the System Safer? What More Is Needed?”

In the ninth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Martin Baily and Douglas Elliott argue that significant progress has been made in safeguarding financial stability:

  • Due to higher bank capital requirements, the FDIC can intervene before equity is wiped out.
  • Liquidity requirements work in the same direction and render fire sales less likely.
  • Easier resolution of distressed financial institutions helps to shield taxpayers when a bank fails.
  • Better macro prudential oversight helps to manage systemic risks.

The authors discuss these dimensions in much detail.

“Mistakes Made and Lessons (Being) Learned”

In the seventh chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Peter Fisher argues that the Fed’s mandate should be reviewed:

  • The Fed did not address leverage early enough. In the future, monetary policy should weigh financial stability objectives more strongly—at the cost of employment and inflation objectives.
  • Moral hazard should be addressed before, not during the crisis.
  • “Since the end of the financial crisis, the Fed is making the mistake of conceiving of its mandate over too short—and too narrow—a horizon. This permits the Fed to avoid articulating the difficult intertemporal trade-offs that it is making.”
  • The Fed’s mandate is not crystal clear and has been interpreted differently over the years. In light of the new experiences, it should be clarified or adjusted.

“The Federal Reserve’s Role: Actions Before, During, and After the 2008 Panic in the Historical Context of the Great Contraction”

In chapter six of “Across the Great Divide: New Perspectives on the Financial Crisis,” Michael Bordo argues that the Fed misinterpreted the experience of the Great Depression when acting during the financial crisis. Insolvency rather than illiquidity fears were central to the great recession.

“Causes of the Financial Crisis and the Slow Recovery”

In the third chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Taylor argues that monetary policy, regulatory policy, and an ad hoc bailout policy caused the financial crisis:

  • Monetary policy was too loose before the crisis.
  • “[R]egulators permitted violations from existing safety and soundness rules.”
  • An “on-again, off-again bailout policy … created more instability.”

The policy responses during the crisis saw more—counter productive—temporary and discretionary measures. Taylor argues that the Reinhart-Rogoff “weak recovery is normal” and the Summers “secular stagnation” views are inconsistent with the data.