IMF Moves to Get Tough on Private Creditors in Crisis-Hit Economies ; NEWS ANALYSIS: Plans Are Afoot to Ensure Bondholders Carry Some of the Losses When a Country Defaults on Debt

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BY THE end of the annual meetings of the International Monetary Fund and World Bank in Washington last week, it was clear that reform of the "international economic architecture" had made steady progress in all areas but one.

On one issue - how to involve private sector creditors in the resolution of future financial crises - there has been scant progress since Mexico devalued the peso in December 1994.

Stung by the taunt that the IMF's phone number had become 1-800- BAILOUT, the Fund and G7 governments want to ensure that in future private sector bondholders are "bailed in" and suffer their fair share of the losses during a crisis.

For while equity investors lose through a decline in share prices, countries in trouble have to perform somersaults to repay bondholders and bank loans. The alternative, default, is catastrophic because it causes new credit flows to dry up precisely at the moment they are most badly needed.

The crises in Mexico in 1994/95 and in East Asia, Russia and Brazil in 1997/98, however, have brought about the spectacle of the IMF paying billions of dollars into the affected countries so they can repay billions to their private creditors.

The argument is that there is simply too much "moral hazard", or in other words too great an incentive for creditors to act in ways that will make the crisis worse, lending too much in the confidence that it will be repaid thanks to a sort of IMF guarantee.

The scale of the problem is enormous. Between 1996 and 1998, capital flows to the five affected Asian economies - Korea, Thailand, Malaysia, Indonesia and the Philippines - went into reverse by $125bn, or 12 per cent of pre-crisis GDP. About four- fifths of this swing was accounted for by commercial banks.

Recent figures from the Institute for International Finance (IIF), the big banks' international trade association, showed that commercial banks withdrew a net $45bn from all emerging markets in 1998, and predicted these outflows will continue.

The IIF argued that part of the reason for the continuing withdrawal of funds, however, was the fear that the G7 and IMF will impose unfair forms of burden sharing on private sector lenders.

Sir John Bond, chairman of the IIF and of HSBC, said: "There is anxiety that the IMF and other official authorities are supporting involuntary techniques involving the private sector, such as forced rescheduling of Brady bonds or Eurobonds." (These being the two main forms of private lending to emerging market borrowers.)

Not surprisingly, the banks favour voluntary involvement. They also argue strongly for an ad hoc, case-by-case negotiation in every crisis, rather than any sort of general principles of burden sharing.

In this they have the strong support of Lawrence Summers, the US Treasury Secretary, who believes that every crisis is sufficiently different that each needs a new solution. It is his insistence that has essentially stalled progress on bailing in the private sector.

Other members of the G7, including the UK, favour a variety of methods, set out recently in a speech by Mervyn King, deputy governor of the Bank of England.

One suggestion is that the IMF should set a minimum level of foreign exchange reserves for countries to which it is making emergency loans. …