Should the IMF ever take a haircut?

Before Argentina’s default, Adam Lerrick thought the IMF (or the G-7) should offer to buy Argentina’s bonds at 60 cents on the dollar. Argentina is now offering bondholders an exchange that will be worth a little more than 30 cents on the dollar.

We are lucky that policy makers did not take Lerrick’s advice back in 2001 -- it would have amounted to a $54 billion (think $90 billion in bonds * 60 cents) bondholder bailout. As it is, the IMF only blew roughly $10 billion (net) in a vain effort to try to let Argentina avoid devaluing the peso and forcibly restructuring its debt.

One little known fact: since bondholders hold long-term claims, the IMF typically does not bailout them out directly. IMF funds typically are used to let short-term creditors get out. In Argentina’s case, the biggest drain on its reserves in 2001 was a domestic bank run, not payments on international bonds.

In today’s FT, Lerrick (who represents a group of Europeans holding Argentina’s defaulted bonds) argues that either the IMF should pony up more money to help Argentina make a better offer to bondholders, or the IMF should take a haircut on its loan. That too would make it easier for Argentina to pay its bondholders more. His views are shared by some -- though certainly not all -- participants in the market for emerging market sovereign bonds.

Does his argument hold together? My answer is no.Lerrick argues the IMF lends at "subsidized interest rates 5 to 10% below what the private sector charges." He also argues that the IMF gets paid back when the private sector does not. If that’s the case, the IMF CAN lend at a lower interest rate without lending a subsidized rate. Senior creditors (or preferred creditors: the IMF is paid when other are not as matter of custom, not law) do not have to charge the same rate as junior creditors.

By the way, right now the private sector is certainly not charging 5-10% points above what the IMF charges to lend to emerging markets. Large IMF loans given out through the IMF’s main facility for lending to big emerging economies in trouble (the SRF) carry a 300-500 bp surcharge over the IMF’s base rate (now around 3.15), and even large loans given on standard terms (SBAs) carry a surcharge of 200 bp. Right now, the EMBI (the leading emerging market bond index) spread over risk free treasuries is 375 bp, Brazil trades at a bit more than 400 bp. And that is for junior, not senior money ...

But the bigger question is whether the IMF should continue to be treated, de facto, as a senior lender. The IMF currently has a portfolio of loans to some of the world’s most indebted emerging economies -- think Turkey, Brazil, Argentina and Indonesia (all the details are in here). All these countries have very high levels of domestic debt, even if some are in better shape than others. The IMF lends its funds -- funds that ultimately come from contributions from the rich countries, notably the G-7 countries -- when private creditors are withdrawing their credit from emerging economies. Without seniority, the IMF would be forced to lend less, and also be forced to charge much higher rates --rates that could contribute to a country’s crisis.

I’ll put it more starkly: without the IMF’s seniority, it would have not made a big loan to Brazil in the summer of 2002, and without that big loan, Brazil almost certainly would have been forced into default before Lula proved himself. Emerging market debt would not have enjoyed a stellar 2003 and 2004. The IMF’s bailout of Argentina did not work out for anyone, but IMF lending to Brazil in 2002 worked out well for Brazil, well for the markets and if Brazil is able to repay the IMF during the course of 2005, the IMF too.

I agree with Lerrick on one point though. The IMF has not played its (weak) hand well after Argentina’s default. The IMF spent too much time and effort fighting Argentina on peripheral issues, and was never able to reach agreement with Argentina on a macroeconomic policy path that "set the fiscal surplus that determines the cash for debt payments."

On the other hand, it is not clear that there was a deal to be done between Argentina and the IMF. Argentina’s current President, Nestor Kirchner, has placed a very high premium on the appearance of independence from IMF. To avoid financial dependence on the IMF, Argentina is now running a huge fiscal surplus. If countries are willing to adopt stricter policies than the IMF demands to avoid the IMF, then the IMF’s direct influence is going to be limited, no matter how well or poorly the IMF plays its hand.