FRBSF Economic Letter
2002-18; June 14, 2002
Country Crises and Corporate Failures: Lessons for Prevention and Management?
The recent wave of financial crises in emerging markets—Mexico in
1994-1995, Asia in 1997-1998, Russia in 1998, and Argentina in 2001—has
exacted a considerable toll in terms of lost output and welfare and at
times even posed a threat to the stability of world financial markets.
As a result, many policymakers and economists have focused on the lessons
to be learned from these experiences—lessons both in how better to
prevent crises in the first place and in how to manage crises once they
occur.
These country lessons also have a lot in common with some lessons from
recent high-profile U.S. corporate failures—Long-Term Capital Management
(LTCM), Enron, Global Crossing, and Kmart, to name a few. One common thread
is that, in market-based economies, country crises and corporate failures
are inevitable. The hard truth is that markets impose consequences for
both bad policies and for bad luck. Bad policy at the corporate level
may be anything from misguided plant expansion plans to "crony accounting";
bad policy at the country level may range from inappropriate exchange
rate targets to "crony capitalism." Bad luck at the corporate
level can be a tornado in Texas or an earthquake in California that disrupts
businesses; bad luck at the country level can be a worldwide investor
panic that indiscriminately sucks the capital out of emerging market economies,
punishing the innocent as well as the guilty.
This Economic Letter discusses the lessons that apply to country
crises and corporate failures and illustrates that the lessons on prevention
share many similarities, while the lessons on crisis management have some
interesting and complex differences.
Lessons in prevention
The three basic lessons for preventing problems are pretty similar for
both countries and corporations.
First, improve the quality and transparency of information provided to
markets. At the corporate level, recent concerns about disclosure practices
have led firms, like GE, IBM, and others, to offer clearer information
about balance sheets and earnings in order to bolster their credibility.
At the international level, recent crises have led the International Monetary
Fund (IMF), the Bank for International Settlements, and others to lean
on emerging markets to be more transparent about their policy intentions
and more timely in providing data.
Second, improve the effectiveness of monitoring by regulators. For firms,
the near-meltdown of LTCM prompted the Federal Reserve to look more carefully
at the exposure of U.S. commercial banks to hedge funds. More recently,
concerns about "creative accounting" are likely to affect the
way the Securities and Exchange Commission monitors corporate business
practices. For countries, the IMF and other bodies are developing international
standards, codes, and best practices in such areas as corporate governance
and bank regulation. A good example in the latter case is the latest work
revising the Basel Accord guidelines on bank capital adequacy.
Last, but not least, corporations and countries both have a better chance
of surviving the market's punishment for bad policy and of weathering
spells of bad luck by improving their underlying fundamentals. At the
corporate level, the shake-up among dot-coms has reminded us of the importance
of reliable earnings. At the international level, recent experience has
shown that countries do better if they pursue credible monetary and fiscal
policies, reduce their short-term foreign borrowing, and strengthen their
financial systems. The need to maintain good fundamentals has become particularly
important as countries have liberalized their economies and become more
sensitive to market forces.
Managing crises and failures
When it comes to managing crises and failures, there are more differences
than similarities between countries and corporations. A key similarity
is the set of goals. One goal is to permit the restructuring of debt financing
in times of economic weakness—in other words, to give a firm or a
country an orderly way to reorganize activities and adjust the terms of
debt contracts, so as to avoid the premature liquidation of assets and
also to balance its interests against those of creditors. A second goal
is to limit the possibility of wider contagion effects of individual crises
and failures. Though the goals are similar, the way crises and failures
are managed at the corporate and country levels is very different.
Corporate failures. In dealing with corporations, U.S. bankruptcy
laws—particularly Chapter 11—are designed to achieve the first
goal, namely, permitting debt restructuring so as to balance the interests
of the firm against those of its creditors. Specifically, Chapter 11 allows
firms to apply for breathing room from creditors, obtain infusions of
new working capital, and submit a plan of reorganization to a bankruptcy
judge It also addresses the so-called "collective action" problem
in getting creditors to accept the plan. The collective action problem
arises when a deal that is in the best interests of the creditors as a
group gets blocked by individual creditors who want more for themselves.
Chapter 11 handles this by allowing a deal to go through if it is accepted
by a supermajority—usually two-thirds—of the creditors, or by
the judge.
The second goal—limiting contagion—comes into play in special
cases where the failure of a big firm or bank poses systemic concerns
to the economy. In this case the government may act as a lender of last
resort. The Treasury did this by bailing out Chrysler in the 1970s, and
the Fed has done it occasionally, as in the aftermath of the 1987 stock
market crash and the terror attacks of September 11. In addition, the
government may act as a crisis manager to deal with systemic concerns
in other ways. For example, in 1998, the Fed helped get LTCM's management
and its major creditors to meet and catalyzed the firm's reorganization.
Country crises. Managing a crisis when a debtor country has repayment
problems is very different from the corporate setting, because there is
no equivalent legal procedure to provide breathing room and work out the
problems, nor is there any clear lender of last resort.
In the country crises during most of the 1990s, the IMF and international
development banks served as a quasi lender of last resort by providing
some official financing—so-called "bailout" loans—in
exchange for domestic policy reforms. These actions were accompanied by
the hope that the debtor country and its creditors could work out some
form of debt restructuring.
This approach has met with several criticisms. First, the string of
recent crises has pushed the international system to the limit of funds
available for bailouts. Second, this approach introduces moral hazard
considerations that may reduce the incentive to prevent new crises, as
politicians, borrowers, and investors all expect the IMF always to rescue
them. Lastly, the debt restructuring process typically has been ad hoc,
slow, and cumbersome.
To balance the legitimate need for funds against moral hazard concerns,
some incremental changes have been implemented in recent years. These
include setting up contingency credit lines to qualifying countries in
advance of the possible need for funds and raising the cost of obtaining
bailout loans.
Current efforts to improve the management of crises have focused on trying
to smooth the debt workout procedure. The emphasis of this new approach
is to encourage private creditors to restructure their loans to debt-burdened
countries voluntarily. In other words, it tries to get the private sector
to share more in the costs of resolving country crises. This approach
is called "bailing-in" the private sector, or "involving
the private sector."
Getting this new approach to work is very hard, however, because of the
collective action problem, which itself has become even more complicated
now that countries facing repayment problems typically have many more
creditors to deal with. Back in the 1980s, emerging markets' borrowing
was mainly syndicated loans from a small number of large banks, which
could be easily corralled around a table by the IMF and cajoled into rolling
over the debt and, sometimes reducing it. Even as recently as 1997 this
approach worked when the IMF, the U.S. Treasury, and others got major
foreign banks to roll over their loans to Korea.
During the 1990s, however, countries have come to borrow more by issuing
bonds. For example, Argentina currently has thousands of bond creditors
through more than 120 different bond issues outstanding, which are subject
to multiple jurisdictions and laws. Working out an agreement among such
large numbers of creditors can be a nightmare, since unanimous consent
is generally required. Particularly disruptive have been the so-called
"vulture investors" who buy up cheap, discounted country bonds
in the secondary market and then threaten to hold up deals unless they
get full payment. For example, a hedge firm, Elliott Associates, bought
Peruvian debt at a deep discount for $11 million and successfully got
back $58 million.
Two proposals are now on the table to remedy this collective action problem,
one from the U.S. Treasury and one from the IMF. The Treasury plan involves
modifying international bond contracts and still largely letting the markets
solve the problem. Specifically, borrowers would write clauses into their
bond contracts that would allow restructuring deals to go through if a
supermajority of bondholders, say 75%, agree. This approach raises questions,
though. Might the inclusion of these new bond clauses create the perception
that it is easier for countries to default, resulting in higher costs
of borrowing for emerging countries? What about older issue bonds without
these clauses? What about bank loans that do not involve formal contracts?
The IMF plan relies less on the market and more on legal procedure. It
would create a formal international bankruptcy procedure, sort of a "sovereign
Chapter 11," that would cover all debt contracts. Under this procedure,
a country with debt problems could do the equivalent of filing for bankruptcy
and receive a temporary timeout period—termed a "standstill"—during
which it could stop paying its debts to all of its creditors. The country
would then negotiate the terms of a new payment plan that is conditioned
on domestic policy changes.
The IMF approach also raises a question. Who would play the international
equivalent of a domestic bankruptcy judge? The IMF initially recommended
itself, but creditors were concerned that the IMF might not fully protect
their rights, especially since the IMF is itself a major creditor of many
countries. As a result, the IMF has modified the plan to leave the final
terms of any restructuring deal in the hands of a supermajority of creditors,
with an independent panel of judges handling any loose ends. (Further
details about the IMF and Treasury proposals are provided in the next
issue of the FRBSF Economic Letter.)
Where do things stand now?
While we cannot expect to eliminate crises and failures from market-based
economies, we can learn from experience. In fact, there already is evidence
that progress has been made on learning how to prevent country crises
better. For example, the crises in Brazil in 1999, Turkey in 2000, and
Argentina last year have had relatively few contagion effects across borders.
There is also widespread agreement that we need a new approach to manage
and resolve country crises. The current debt renegotiation process is
generally too cumbersome and costly for all involved. The Treasury and
IMF proposals both draw on the principles of domestic corporate bankruptcy
laws to provide a new approach. And both proposals head in the same direction:
allowing country debtors and creditors to work out mutually beneficial
deals in a more orderly and less costly manner. Though different, the
two proposals are not mutually exclusive. In fact, the G-7 Finance ministers,
including the U.S. Secretary of the Treasury, recently endorsed a two-track
approach towards pursuing both plans.
Reuven Glick
Vice President, International Research, and
Director, Center for Pacific Basin Monetary and Economic Studies
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