Is Greater Private Sector Burden Sharing Impossible?

• Author: Barry Eichengreen
• Position: John L. Simpson Professor of Economics and Political Science at the University of California, Berkeley

Finding ways to "bail in" the private sector is an important element of crisis prevention and resolution. Yet no mechanisms are universally applicable, and some proposed strategies could precipitate the crises they were meant to forestall.

Finding better ways of compelling investors to share the financial burden when crisis strikes is key to learning to deal with modern financial crises. Recent experience has heightened concerns that international rescue packages have let creditors off the hook and are a source of moral hazard. The IMF has experimented with a variety of methods, including putting direct and informal pressure on international banks to lengthen their credit lines and imposing the renegotiation of the government's bonds as a precondition for official assistance. The official community has encouraged the adoption of new provisions in loan contracts to facilitate orderly restructurings and to create workable alternatives to ever-bigger IMF bailouts. Governments have proposed, and international bodies have contemplated, more far-reaching options, including rules for IMF lending that would impose formulas for bail-ins and amendment of the IMF's Articles of Agreement to provide for an officially sanctioned standstill on payments.

Yet progress on this problem has been slight. The reason, some have suggested, is that bailing in the private sector is immensely complicated. Creditors are heterogeneous; it is not clear that bank creditors and bondholders can or should be treated in identical ways. The logistics of orderly restructurings are formidable in a world of custodial notes, credit derivatives, and cross-default clauses. Above all, it is important to avoid finan-cial and policy innovations with unintended consequences, precipitating the very crises that officials wish to forestall. The gravity of these difficulties has led pessimists to conclude that greater private sector burden sharing may be impossible. Still, the urgency of the problem suggests that the search for the best approach-whether rules-based or discretionary-should continue.

Direct and indirect pressure on banks: Korea and Brazil

Unlike other countries where there were serious problems with economic fundamentals at home, Korea's problem in 1997 was primarily a liquidity crisis. The country had been recovering from a slowdown in 1996, when the prices of semiconductors (its single biggest export item) fell sharply. Slow growth and depreciated currencies elsewhere in Asia were already creating questions about whether the country's progress could be sustained. As business failures mounted, concern spread for the viability of the banks to which the chaebol (industrial conglomerates) were linked. Korean banks thus found it increasingly expensive to fund themselves abroad. Meanwhile, investors suffering losses elsewhere in Asia liquidated their investments in Korea in order to rebalance their portfolios and raise cash, intensifying pressures on the financial system.

The negotiation and approval of an IMF package on December 4, 1997, brought only temporary respite. Revelations that the country's short-term debt was significantly higher than previously thought, combined with the government's reluctance to close troubled banks, undermined confidence among international investors. Foreign creditors refused to renew their maturing short-term loans and withdrew their money even faster than the IMF and Group of Seven governments pumped it in.

In the week between Christmas and the New Year, the foreign commercial banks with credits to Korea held emergency negotiations with the new government of Kim Dae Jung, under the stewardship and with the moral suasion of Group of Seven central banks. European, Japanese, and U.S. banks agreed to roll over their loans through March, allowing the government to negotiate a more comprehensive restructuring package. On January 28...