Thirteen years ago, at the IMF/World Bank meetings in Washington, the world's financial community first confronted the international debt crisis. Earlier this year, the first victim of that crisis, and perhaps the most successful exemplar of rehabilitation - Mexico - once again suffered a debt crisis, threatening contagion to other countries and stimulating discussion of new institutions and procedures for managing financial crises in heavily indebted countries. A CEPR Report presents a powerful new response to this debt threat. Authors Barry Eichengreen and Richard Portes believe that there are workable alternatives to either `throwing money at the problem' with a bailout from official funds or taking a `hands off' position that runs the risk of chaos and contagion. Eichengreen is Professor of Economics at the University of California, Berkeley and a Research Fellow in CEPR's International Macroeconomics and International Trade programmes; Portes is Professor of Economics at London Business School and Director of CEPR.

Eichengreen and Portes express five concerns about the way financial markets, governments and multilateral institutions respond to `Mexico-style' crises. First, the market's violent reaction to financial difficulties forces governments to adopt drastic monetary and fiscal austerity packages that threaten to destabilize output, employment and economic growth. Over-reaction by investors, who face a problem of collective action, is a market failure from which improved institutions and procedures could offer greater insulation. Second, debts are restructured, if at all, only after protracted discussion and negotiation. This reflects the prevalence of asymmetric information and negotiating costs. Improved institutions and procedures would disseminate information and facilitate negotiations. They would encourage a quicker resolution to crises and reduce the need for public funds where debt restructuring was at issue.

Third, the markets find it difficult to coordinate the provision of new money where this is needed by countries going through liquidity crises. Improved institutions and procedures could help to overcome this coordination failure, facilitating the injection of new funds where an orderly restructuring of existing debts is not enough. Fourth, appropriate management roles for national governments and multilateral institutions have not been defined. The ad hoc response of the IMF and the US government to the Mexican crisis is unlikely to be repeated. G-7 leaders agreed at the June 1995 Halifax Summit to double the General Arrangements to Borrow and to establish a new mechanism for emergency financing to deal with Mexico-like problems, but the procedures themselves are as yet unclear. Fifth and finally, while everyone agrees on the desirability of preventing crises in the first place, there is no consensus on how this might be done.

Several proposals have appeared that address these concerns, variously named orderly workouts, bankruptcy procedures, binding arbitration and debt adjustment facilities. Recommendations include promoting changes in the provisions of loan contracts and bond covenants; government support for the creation of bondholders' steering committees; expanding the signalling and mediation roles of the IMF; creating a venue for negotiations involving bondholders' representatives, the government of the indebted country and the IMF; closing the courts of creditor countries to dissident creditors by statute or treaty or by invoking Article VIII(2)(b) of the IMF Articles of Agreement; and establishing a bankruptcy procedure for sovereign debtors analogous to Chapter 11 of the US bankruptcy code.

The CEPR Report finds problems with each of these proposals. The creation of bondholders' committees would not halt the creditors' rush for the exits. Countries that have been reluctant to suspend debt service payments unilaterally for fear of damaging their reputations would have no incentive to behave differently. Settlements would still take time, and the injection of new money would remain difficult. Measures to strengthen collateralization will be difficult to enforce. Assigning responsibility for debts to quasi-public enterprises rather than the central government is no guarantee against a bailout. Closing the courts to creditors by statute or treaty would prevent a small band of dissident creditors from using legal means to hold up a restructuring but would not address the other problems with current procedures. Using IMF Article VIII(2)(b) to enforce a payments standstill encounters legal obstacles.

An international court or tribunal with powers analogous to those enjoyed by bankruptcy courts in the United States is a non-starter, given the very great legal obstacles to implementation. If such obstacles were to be surmounted, the desirability of such a procedure remains unclear. Even operating under a treaty, such an international court would be unlikely to possess the powers of a national court to enforce seizure of collateral, given sovereign immunity. Nor would it be able to replace the government of a country in the way that bankruptcy courts replace the management of firms. The danger of moral hazard would be great.

Nevertheless, each of these proposals has desirable features. The Report therefore offers an agenda for reform which combines elements of the alternative approaches. A quick initial reaction to a gathering crisis is essential, and the first recommendation is that the IMF should more actively transmit signals about the advisability of temporary unilateral payments standstills. Governments can impose the equivalent of a standstill by suspending debt service payments. But they hesitate to do so for fear that they will jeopardize their future credit market access. Encouraging the IMF to advise the debtor and issue opinions on the justifiability of a stay of payments would give the Fund an important signalling function; a government which received approval for its standstill would suffer relatively little damage to its reputation, while the possibility that the Fund would not approve would discourage governments from utilizing the option strategically. Naturally, the IMF should limit its advice to the debtor government before the fact and share its opinion with the markets only ex post. A definitive reinterpretation of Article VIII(2)(b) would support the IMF in this role even if it did not have legal effect in national courts.

Creating a Bondholders Council would eliminate uncertainty about the locus of authority in negotiations. It would be responsible for restructuring bonded debts, while the London and Paris Clubs would retain their responsibility for bank loans and official credits. Discussions between debtors and the Paris Club, the London Club and the Bondholders Council would rely on a specially constituted conciliation and mediation service designed to minimize the danger of an extended deadlock. Changes in bond covenants to permit a majority of creditors to alter the terms of payment would prevent dissident investors from holding up the settlement. To make this palatable to potential lenders, dissident creditors would have recourse to an arbitral tribunal. To prevent a negotiated agreement or the findings of the arbitral tribunal from being disputed in court, loan agreements would specify that objections by minority creditors be subject to the tribunal's arbitration.

Strengthened IMF monitoring and conditionality would reduce the likelihood that financial problems will recur. The knowledge that any new money that was injected in conjunction with the debt restructuring, and even Fund sanction for a country's unilateral standstill, is predicated on the government's first agreeing to fulfil stringent IMF conditions, would work to minimize the likelihood of such difficulties arising in the first place. Frequent monitoring by the IMF of economic conditions in debtor countries and timely dissemination of information by the Fund would strengthen market discipline. Increased resources available to the Fund would allow, where appropriate, injection of new money on the requisite scale. The CEPR Report concludes that it would be possible to adopt some of the recommendations without also embracing others. But there are important complementarities among the proposed reforms. They would do most to enhance the efficiency of the debt restructuring process if implemented as a package.