Financial Post G7 Record

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Financial Post, Weekly edition, Fri 23 Jun 95, page 10

Keywords: International finance Economic summits Economic policy Taxation Foreign investment World International Monetary Fund

Are taxpayers on the hook for G-7's plans for reform

Greg Ip

Coming out of their summit last weekend, G-7 leaders spoke grandly of their new commitment to preventing the financial disasters of the 21st century.

But behind their promise is a controversial reality - their taxpayers could be on the hook toabsorb the losses of private investors who gamble on unstable economies.

The G-7 has asked the International Monetary Fund to create an ''Emergency Financing Mechanism'' for countries facing massive capital outflows. It would work much like the U.S.-IMF bailout of Mexico did last winter.

If a country is at risk of defaulting on payments to investors who are pulling out en masse, the IMF will quickly step in with extra credit to prevent a default and the risk of a crisis spreading to other countries (the ''contagion'' factor).

This appears not so different from what the IMF has done in the past. When the developing country debt crisis began in 1982, bank lenders to those countries asked the IMF to negotiate debt restructurings.

The G-7 leaders say the new mechanism differs principally by offering more money faster. As in the 1980s restructurings, loans would be contingent on the recipient reforming the policies that led to the crisis.

But there would be a big difference in how the new mechanism would work, one that could hitthe taxpayers of countries that finance the IMF (including Canada).

In the 1980s, creditor banks had to write down their loans in return for the IMF extending new money to prevent total loss. Those writedowns were the price the banks paid for poor lending judgment.

But private investors who pour money into countries the IMF might rescue will not have to make similar sacrifices for their mistakes. In effect, the IMF will assume the risk of default by supplying money to pay off these private creditors.

This seems unfair, and is likely to provoke political opposition, just as Congress opposed the U.S. bailout of Mexico on the grounds it was a taxpayer financed bailout of foolish mutual funds.

''There's certainly a recognition it is a problem,'' in the G-7, a Canadian official said. The question of how to force private creditors to share in the pain occupied a lot of discussion among G-7 leaders. But, he said, ''nobody has come up with any suggestions about how to deal with it.''

Nobody knows how to deal with it because debt crises have changed so much. In the 1980s, the creditors were several dozen large banks whose officers could be collected in a single room to negotiate with their debtors. Now, the creditors are thousands of individual mutual funds, pension funds, investment banks and individuals who simply cannot be gathered together for a coordinated rescheduling operation.

Mexico's problems last year were rooted in the huge amounts of money foreign investors poured into the country to grab high rates of interest with little currency risk. They did this by buying tesobonos, high-yielding short-term securities indexed to the US$.

But investors' appetite diminished as Mexico's current account deficit grew and monetary policy remained too loose. Mexico depleted its foreign exchange reserves redeeming tesobonos, and needed a US$50 billion bailout to refinance maturing issues. It managed to avoid defaulting, and investors did not write down loans.

Presumably, in future uses of the emergency financing mechanism, the IMF will similarly not extract concessions from private investors.

This problem promises to be an area of fierce debate within the G-7 in coming years. Their comminque last week papered over their differences, mumbling about the need, given ''the complex legal ...issues'' to explore ''other procedures'' for bringing other creditors into the rescue process.

In the view of some, what the world needs is ''Chapter 11'' bankrupty protection for countries. Jeffrey Sachs, a prominent Harvard University economist, has called for an international bankruptcy court. The IMF would be permitted to essentially place countries in receivership and stop paying its private creditors until a restructuring could be arranged.

But anything like that is years away, and will be subject to ongoing argument among the G-7.

In the meantime, the lack of penalties for private investors means the new IMF powers could create ''moral hazard'' - the risk governments will follow reckless policies knowing the IMF stands ready to bail them out, and the risk investors will finance those policies for the same reason.

The G-7 has tried to combat moral hazard in two ways. First, there will be no automatic triggering of the mechanism - the IMF will only lend the money when its board of directors feels there's a risk of contagion. Second, recipient countries will have to adhere to severe conditions designed to correct the problem that led to the disaster.

To get its money, Mexico had to promise a budget surplus, a sharp cut in credit growth, and to bring its economic and financial statistics up to first-world standards of accountability and frequency. Conditions would vary from case to case, said Lawrence Summers, U.S. undersecretary of treasury for international affairs: ''Fnancial emergencies differ and each financial emergency .. comes with a different set of problems.''

Yet it is impossible to create a bailout device without moral hazard. Just as deposit insurance lowers the incentive for bank customers to scrutinize where they put their money, IMF emergency financing, regardless of its conditions, reduces the risk in the mind of an investor contemplating investing in an emerging market.

Will taxpayers end up on the hook? Supposedly, no. The IMF will get the money through a US$56 billion line of credit with 11 industrialized nations plus Saudi Arabia. Canada's share has been 5.25% (it may change).

Even if the recipient country defaults on its loan from the IMF, the IMF still has to pay back Canada. But its own loss will take away from its capital base, part of which belongs to Canada. Officials emphasize that the IMF almost always gets its money back; the fund in fact is profitable. But on the other hand, it has never lent such large amounts before - or dealt with such large crises.

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Revised: June 3, 1995

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