Sovereign debt crises that required weeks to leap national borders in 1931 took only days to do so in 1982 and hours in 1995. Markets should not be left to deal with the consequences of these traumas. Instead, new institutional vehicles are needed to contend with the enormous international capital flows of the 1990s, Barry Eichengreen told a London lunchtime meeting on 7 May. He outlined a new mechanism to restructure defaulted debt in times of emergency. Eichengreen is Professor of Economics at the University of California at Berkeley and is a Research Fellow in CEPR’s International Macroeconomics and International Trade Programmes. His talk was based on the CEPR book ‘Crisis? What Crisis? Orderly Workouts for Sovereign Debtors’ written jointly with Richard Portes and with Francesca Cornelli, Leonardo Felli, Julian Franks, Christopher Greenwood, Hugh Mercer and Giovanni Vitale. The meeting was made possible through the support of the Global Economic Institutions ESRC Research Programme.

Foreign lending to sovereigns and companies has a long and colourful history. Each time difficulties arise in international capital markets, observers invoke the precedent of history. At the same time, the repetition of events suggests that each additional burst of lending reflects decisions by investors who, if they are not ignorant of history, fail to use it to inform their actions.

There have been important shifts in the structure and organization of lending since the large-scale lending of the 1920s. The most prominent is the evolution of intermediation: the rise and retreat of the New York market in international bonds in the 1920s and 1930s, the triumph and tragedy of bank lending in the 1970s and 1980s, and the growth of emerging equity markets in the last ten years. In addition, the IMF and the Group of Ten have evolved as mechanisms for crisis management. Lending has been shaped not just by economic and political conditions in the debtor countries but by monetary policies in the creditors' markets. Prerequisites include brightening growth and investment prospects in the recipient regions and low interest rates in the major financial centres. A corollary is that a rise in world interest rates, by heightening debt servicing burdens, can interrupt the flow of funds even in the absence of policy problems in the borrowing countries.

Large-scale lending has repeatedly posed problems of economic management for sovereign borrowers. The countries most dependent on external finance have also been most vulnerable to shocks in capital flows and domestic economic stability. Once debt crises have struck, it has repeatedly proved difficult to negotiate an orderly resolution of debt servicing problems. The creation of the London and Paris Clubs has provided new institutional vehicles for restructuring bank and intergovernmental debts. The IMF's involvement in the debt crisis of the 1980s created a mechanism for signaling creditworthiness and injecting new money. But these institutions and their functions, however valuable, appear increasingly underfunded and powerless in the face of enormous, highly liquid markets.

With securitization, a debt crisis no longer threatens the solvency of banks in the major financial centres but rather that of banks in the borrowing country, which serve as conduits for foreign funds. As a consequence, to quote Ted Truman, the days are gone ‘when the G–10 central banks could assemble a bridge loan in a few days that would serve to stabilize expectations about a major borrowing country's situation. Also gone are the days when the Managing Director of the IMF and the Chairman of the Board of Governors of the Federal Reserve System could get representatives of 15 major private international financial institutions into a room and easily convince them that a systemic crisis is, first and foremost, a crisis for their own institutions.

Some observers have argued that the markets should be left to deal with the consequences. But this would be inefficient, according to Eichengreen. Investors facing a problem whose resolution requires collective action have an incentive to ‘rush for the exits’, aggravating any liquidity crisis. Asymmetric information and negotiating costs render voluntary restructuring exceedingly difficult. And coordinating the provision of new money is impossible. Under these circumstances, the ‘market solution’ is suboptimal. Nor is it likely that more Mexico-style bailouts will be forthcoming. ‘Institutional reform is the only game in town’, said Eichengreen.

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 outlined an agenda for reform of the debt restructuring process which combines the desirable features of a variety of existing proposals.

The agenda for reform includes: the provision for an immediate payments standstill, where justified; the creation of a Bondholders’ Council, a mediation and conciliation service, and an arbitral tribunal; contractual innovations in bond covenants; and a significant strengthening of the IMF’s role in signalling, monitoring, imposing conditionality and disseminating information.

Rapid action could halt the creditors’ rush for the exits, preventing the panic from destabilizing the country’s banking system and severely dislocating its economy. The quick conclusion of debt restructuring negotiations between bondholders, banks, official creditors and the indebted government would be facilitated.

Where an injection of funds was essential to prevent the crisis from spilling over into the banking system or spreading to other markets, the pump could be primed by the limited provision of funds by the IMF, conditional on policy reforms to encourage the market to supplement official funds. Crisis management measures would be administered in an incentive-compatible way that encouraged governments to release information on economic conditions in a timely fashion.