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How Easy Should
Debt Restructuring Be?
B
orrowers sometimes can’t pay what they owe, and most borrowers and lenders know this. As a result, debt contracts are usually more complicated, and the considerations that underlie debt arrangements are more subtle, than would be the case if all that mattered were the time value of money. Two specific distinctions are of particular importance for this purpose: Some borrowers don’t pay what they owe because they can’t, while others can pay but seek not to. And among those borrowers who can’t pay what they owe when they owe it, some can pay later but others can’t pay ever. What to do when borrowers don’t meet their obligations is therefore not merely a matter of set principles but also of information, inference, and judgment. Although these basic truths and the practical questions they raise are relevant to all debt markets, the events of the past few years have especially highlighted their importance in the context of borrowers in developing economies and in economies in transition from central planning to reliance on private initiative and incentives—“emerging markets,” as they
I am grateful to Richard Cooper, Howell Jackson, Edward Ladd, John Olcay, Dwight Perkins, Michael Pomerleano, Hal Scott, Elizabeth Warren, and numerous other colleagues and friends for helpful discussions, although I alone assume responsibility for the ideas expressed here. I am also grate- ful for research support from the Harvard Program for Financial Research.
are typically called. From the summer of 1997 until well into 1999, a series of countries, first in Asia and then in Latin America, experienced debt problems severe enough to be widely regarded as crises, typically in conjunction with currency crises. But even in the setting of economic development, such problems were by no means new in 1997. There is a long history of just this kind of event. The Asian crisis in 1997 was not the first such major problem but merely the first since Mexico in 1994–95. Placing the questions that arise from debtors’ actual or potential non- performance in the specific setting of emerging markets adds several important dimensions to the basic considerations that are already present when the borrower and the lender are both resident in a country like, say, the United States. To begin, when the source of the saving flow that finances the credit is outside the borrower’s country—as is often the case for developing economies, which normally rely heavily on foreign capital inflows—then relative currency values become part of the story. Next, many emerging market countries lack the legal or other institutional frameworks that provide standard and well-understood remedies when problems of borrower nonperformance occur in the industrialized coun- tries. Sometimes the requisite legal institutions exist but enforcement is problematic. Many emerging market countries similarly lack the auditing and accounting practices that facilitate monitoring the financial condition of private borrowers in the industrialized world. Finally, in some emerging market countries the borrowers, although nominally private, are often de facto extensions of the government. Sometimes the borrower whose ability to perform is in question is the government itself. The issue addressed in this paper is what to do when borrowers in emerging markets can’t pay what they owe to foreign lenders. The specific question asked is what difference it makes, and for whom, whether the debts of nonperforming borrowers are restructured. Although the pre- sumption here is that the nonperforming debt is owed abroad, the chain from ultimate lender to ultimate borrower may have several steps, and so the nonperforming debts in question are not necessarily owed to foreign lenders directly. But for purposes of this discussion, the fact that it is for- eign saving that ultimately stands behind the credit chain is what matters. In order to pose meaningfully a question like what difference some action or some process makes, it is ordinarily necessary to specify “com- pared to what?” In the case of debt restructuring, however, specifying a clear-cut alternative is problematic. The logically most obvious alternative
the situation of borrower nonperformance considered here almost always results in at least some loss of present value to the lenders, lenders some- times do but often do not recognize that loss for purposes of accounting, regulatory requirements, and the like. Part of what is wrong about the position of current practice on this continuum between restructuring and repudiation is that lenders recognize such losses too infrequently. In terms of a concept that figures importantly in this analysis, the “fiction” of no loss of value is too much a part of current market practice. To state the argument more fully, the chief conclusions of this paper’s inquiry into what difference debt restructuring makes are as follows: (1) The conventional wisdom that in cases of debt-service difficulties rescheduling and other forms of restructuring help to keep new money flowing to the borrowers is correct. (2) That said, however, not all nonperforming debts should be restruc- tured. Some frequency of “defaults” (to the extent that default can be con- sidered the alternative to restructuring), arguably greater than that reflected in current practice, is healthy. (3) With a greater frequency of default, some credit flows to emerging market countries that would take place in a lower-default-rate regime pre- sumably would not happen. This outcome too is not necessarily bad. Judged from the perspective of why debt markets exist in the first place, the highest aim of borrowing and lending arrangements is not simply to maxi- mize the volume of credit flows. (4) Although maximizing economic output and economic development is a plausible objective in choosing borrowing and lending arrangements, avoiding lost output and temporarily interrupted development in every case is not. Real costs consequent on borrowers’ nonperformance, costs that accrue to debtors as well as creditors, serve an economic function too. The goal of output growth and economic development, construed broadly over time and space, is plausibly enhanced when specific borrowers at spe- cific times suffer real costs, just as it is when specific lenders at specific times sustain losses. As the discussion throughout the paper makes clear (if it is not apparent already), an important force driving this argument is the problem of “moral hazard” that arises from the differing incentives of borrowers and lenders.^2
- For a general discussion of moral hazard in this context, see Eaton and Gersovitz (1981). See also Obstfeld and Rogoff (1996, chap. 6), and the many references cited there.
Especially in the context of much of the public debate that has ensued from the emerging markets debt crisis of the past few years, it is worth pointing out explicitly that the moral hazard on which the argument here depends arises from the ordinary conflict of borrowers’ and lenders’ inter- ests inherent in any debt transaction, rather than any consequence specifi- cally attributable to the role of the International Monetary Fund (IMF) or other official lenders. The actual or potential availability of credit from the IMF or other official sources may exacerbate the moral hazard problem that already exists, and hence may make financial problems of the kind many emerging market countries have recently experienced more likely or, when a problem does occur, more severe. That question is a subject for a different paper. But it is wrong as a matter of history to think that there were no such crises in the past before there was an IMF, and it is therefore wrong as a matter of political economy to believe that simply abolishing the IMF, as some of the institution’s recent critics have suggested, would be sufficient to prevent such crises in the future. 3 The more fundamental moral hazard issue that constitutes the heart of the analysis here, and the questions that this paper raises about the “no-loss-of-value fiction,” would remain in any case. The first section briefly sets the stage for the paper’s main line of argu- ment by positing a set of patently counterfactual conditions under which it would not matter whether a nonperforming loan were rescheduled or otherwise restructured. The second section shows how several ways in which the actual world of international lending to emerging market bor- rowers departs from these counterfactual conditions give both lenders and borrowers ample reason to care whether nonperforming debts are restructured. The third section shows that one implication of the way in which restructuring matters is that although restructuring is useful to both lenders and borrowers, it nonetheless should not be “too” easy. The fourth section then examines how this line of reasoning leads to the sequence of conclusions stated above: that some nonperforming debts should default, that some credits should not be extended in the first place, and that under some circumstances debt arrangements should impose real economic costs on defaulting borrowers as well as on the holders of defaulted debt. While no ready metric exists (and this paper doesn’t develop one) for saying how far current practice should optimally
- See DeLong (1999) for a useful historical review.
ket participants about their worth. The only question facing each lender is whether to hold or sell the securities (or buy more) at whatever new, pre- sumably lower, market price emerges. Further, regardless of whether a lender sells its position in the borrower’s securities or not, the lender will have to take the reduction in value into account on its balance sheet. If the lender is a bank, or some other finan- cial institution facing regulation similar to that applicable to banks, the reduced asset value passes through to its equity in a way that bears on the lender’s ability to meet its capital requirements. If the lender is a mutual fund, the reduced valuation is directly reflected in the fund’s quoted net asset value. In either case, no action by the lender can avoid or mitigate these consequences. The borrower’s incentive to meet its obligations is to avoid seizure of its collateral, unless the present value of the debt service owed is greater than the value of the collateral, in which case the borrower would prefer to sac- rifice the collateral and stop paying altogether. The lenders’ incentive, how- ever, is to receive as much value as possible from the remaining debt obli- gation under the new circumstances. From the perspective of an individual lender—that is, any one holder of the borrower’s debt securities—the pres- ent value of the borrower’s future payments or the proceeds of seizure and liquidation of the collateral is simply priced into the market value of the securities. By contrast, the lenders collectively retain an interest in steering the outcome toward whatever course of action will give them greater value, and therefore in whatever process enables them best to achieve this end. But, importantly, under these circumstances lenders do not have an interest in formal restructuring of the debt per se. The borrower’s difficulty in meeting the obligation has already resulted in a reduced price of the securities, and each holder of those securities has immediately taken that reduced value on its balance sheet. Although whoever is empowered to act as agent for the lenders will presumably try to persuade the borrower to perform to the greatest extent possible, using the threat of seizing the col- lateral as its means of compulsion, once the borrower’s future performance or failure to pay is taken as given, a formal restructuring would change nothing. At the same time, the borrower’s only incentive in this regard is to prevent seizure of the collateral. Moreover, because the lenders have no rea- son to seek a formal restructuring, the borrower’s offering to enter into one would not represent a concession of any value. In short, restructuring sim- ply would not matter.
Why Restructuring Does Matter
None of the four counterfactual conditions listed above corresponds to the actual world in which either sovereign or private emerging market bor- rowers obtain credit. Focusing on how each of these stated conditions departs from the “real world” makes clear just why restructuring a debt once a borrower has failed to meet its commitments, or even in advance of an actual event of nonperformance, can be important and normally is.
The Role of Banks
Although the bond market now plays a far greater role in funneling credit to emerging market countries than was the case not long ago (though per- haps not any more so than before World War I), it remains true that much of the debt of both public and private borrowers in these countries takes the form of bank loans. Moreover, most borrowers have traditionally attached high priority to staying current on their security obligations. (Among sov- ereign borrowers, Russia and Ecuador are the only two recent examples of clear nonperformance on the government’s bonds, although what would happen to Mexico’s dollar-linked tesobonos was a major question during the 1994–95 crisis.) Hence most of the emerging market debt that has been the focus of attention in discussions of restructuring is in fact owed to banks, and much of that is in the form of loans rather than securities. One reason this matters is that banks, unlike many lenders in the bond market, can and often do maintain ongoing relationships with particular borrowers. The heart of such relationships is that some lenders have information—perhaps privately disclosed data, perhaps specialized knowl- edge of a country or its banks or its operating businesses, perhaps person- to-person experience with the individuals responsible for the borrower’s affairs—that other lenders do not. The enhanced information content of borrower-lender relationships in turn has value to both sides. From the lender’s perspective, more information means less risk. To the borrower, the fact of being perceived by some lender as less risky means a lower cost of credit. In extreme cases it may mean the difference between having access to credit and finding none available at any price. Another reason why the role of banks in lending to emerging market borrowers is important is that banks normally face capital requirements. Loss of sufficient asset value can therefore force a bank into a disadvantaged
fluctuation that would take place in liquid security markets in a situation of anticipated or actual borrower nonperformance.^5 The fact that the lenders are banks and that banks do not immediately mark loans to market (and, moreover, that knowing the market price is problematic anyway) produces one straightforward reason why reschedul- ing or other formal restructuring can make a difference when a borrower encounters difficulties: Restructuring enhances the lenders’ control over the value that they assign to a loan on their balance sheets. This control itself has value. Replacing an old loan with a new one, stretching out pay- ment schedules, adjusting the interest rate and even forgiving missed inter- est payments (or relegating them to “memo interest”) are all ways of main- taining the fiction—for accounting purposes—that a loan is still an asset worth what it was worth before, even though the appropriately risk- adjusted present value of the probable stream of payments to flow from that asset may be diminished. Such accounting fictions have no direct bearing on the economic value of a lender’s business, but they do affect a lender’s business if they affect its ability to meet its capital requirements. The ability to maintain the fiction of no loss in value is therefore valuable. Hence lenders have a reason to pre- fer formal restructuring to either default or mere nonperformance. And because restructuring has value to lenders but requires the agreement of both parties, lenders in turn have an incentive to induce borrowers to want (or at least agree) to restructure their problem obligations as well.
Multiple Debts
Few borrowers have only one consolidated debt. Most, including most bor- rowers in emerging markets, owe different amounts to different lenders or groups of lenders. Often these debts are also of different form: some secu- rities, some loans (of which some are collateralized and some are not), some self-liquidating trade credits, and so on. Often the same lenders participate in providing financing to the same borrower, or group of related borrow- ers, in several different forms. A bank, for example, might own a country’s
- The fact that banks can set aside a reserve against prospective decline in the value of loan assets complicates this story somewhat but represents no fundamental change. The reserve is a counter-asset against the loan, reducing the net (loan minus reserve) value on the asset side of the bank’s balance sheet. Reserving against a loan therefore reduces the bank’s stated equity just as if the bank had written down the value of the loan itself. For purposes that matter to this discussion, the two are equivalent.
sovereign bonds, extend what amount to uncollateralized loans to the country’s government or its banks, and also provide trade credit to operat- ing companies conducting import-export business there. The multiplicity of debts would not matter if all of a borrower’s obliga- tions were strictly independent of one another. In fact they are not. Cross- default and acceleration clauses give lenders in one transaction the ability to demand full and immediate payment if the borrower defaults on an obligation resulting from a separate transaction. To the extent that bor- rowers prefer not to have their other debts called—after all, there was a rea- son to borrow the funds in the first place—under these arrangements bor- rowers therefore have a reason to prefer formal restructuring to default. Borrowers may likewise have reason to prefer formal restructuring to merely creating an event, such as a missed payment, that would qualify as default even if they were confident that the lender on that particular trans- action would not declare a default. What matters in this case is whether the lenders on the borrowers’ other transactions would exercise the right to demand payment of their claims.^6 The fact of multiplicity of debts and multiplicity of lenders matters in yet further ways in the emerging markets context because of the connec- tion between a country’s foreign borrowing, which is the focus of discus- sion here, and what happens in its domestic credit markets. In the case of sovereign credits, governments typically borrow both abroad and at home, sometimes via the same securities. Hence nonperformance on obligations to foreign lenders can trigger a collapse of the country’s domestic credit market.^7 Moreover, because nonperformance by governments on foreign debt often leads to exchange controls that both block domestic residents’ capital mobility and impede debt service payments by private sector bor- rowers, the most immediate result is often capital flight—which in turn either worsens the crisis or creates a crisis if there was not one already.
- It is useful to distinguish this reason for borrowers to seek debt restructuring from the reason given above for lenders to do so. The lenders’ reason for preferring restructuring to default grows out of forces external to the direct borrower-lender relationship: specifically, the capital requirements and accounting practices that are a part of the relationship between lenders and their regulators. By contrast, the borrowers’ reason for preferring restructuring to default or mere nonpayment grows directly out of an aspect of the borrower-lender relationship, albeit a relationship between the borrower and its lenders other than those on whose claim the borrower is not performing.
- During the 1994–95 Mexican crisis, for example, many tesobono-holders were domiciled in Mexico. Default would almost certainly have made it impossible for the government to borrow from do- mestic Mexican lenders, and probably would have shut down the country’s credit markets more generally.
for lenders to align borrowers’ interests with their own. To the extent that the lenders want to see a nonperforming loan restructured, these terms give the borrowers a reason for seeking a restructuring also. (It is useful to distinguish this line of argument from that made above, based on bor- rowers’ own incentive to maintain knowledge-enhanced relationships with specific lenders. There, borrowers’ incentive to restructure derives from the possibility of obtaining further credit from the same lenders. Here the incentive to restructure arises from a potential desire to borrow from other lenders.) In settings in which well-established bankruptcy procedures prevail, the need for new credit is a well-recognized motivation for how such matters are normally handled. In the United States, for example, a private bor- rower that has sought protection under the bankruptcy code can continue in operation by obtaining debtor-in-possession financing, which takes precedence over pre-bankruptcy obligations. But the ability to do so fol- lows only as a consequence of the bankruptcy proceeding, and even then only with authorization from the court, which takes into account (but need not accede to) objections raised by the existing creditors. Such procedures are inoperative or unenforceable in many emerging market countries. Moreover, it is hard to see what the analogue to a formal bankruptcy pro- ceeding (and hence to debtor-in-possession financing) would be for sover- eign borrowers. Finally, it is important to acknowledge explicitly that borrowers’ non- performance often takes on a further, inherently political dimension in the context of debts owed by emerging market borrowers to foreign lenders. Given the importance of trade to most countries’ economic exis- tence, maintaining orderly international financial relationships has become recognized almost everywhere as a major element of government responsibility, comparable to (albeit not quite on a par with) maintaining public safety, national security, and so on. Hence any situation that threatens a country’s ability to obtain ordinary trade credit, for example, is necessarily not just an economic crisis but a political crisis as well, regardless of whether the initial problem has arisen from the govern- ment’s debts or those of private borrowers. Governments of emerging market countries facing such a crisis therefore have a political incentive to put it behind them, and normalizing relationships with foreign credi- tors is a key part of doing so. Hence borrowers facing difficulty in ser- vicing their debts have all the more reason to agree to a restructuring if that is what the lenders seek.
How Easy Should Restructuring Be?
One of the great paradoxes of banking is that repudiating one’s debts makes a borrower more creditworthy. The standard explanation is that as long as the borrower has some remaining assets, or even just some prospect of a stream of future income, under the usual me-first rules the bottom tranche of debt is always the least risky. Getting rid of all existing debts gives some new creditor the opportunity to hold what will amount to the first tranche. (The analogy to debtor-in-possession financing, and hence the value of establishing workable bankruptcy standards such that this can be done, should be self-evident.) Examples of the working of this paradox are not hard to find. In the United States the surest way for an individual to find his or her mailbox overflowing with new credit card offers is to declare personal bankruptcy. In a context closer to the focus of this discussion, global investors in the early 1990s raced to buy bonds issued by sovereign credits that had just written down the principal on their outstanding debt under the Brady Plan. One of the chief motivations underlying the current proposal for organized forgiveness of the debts of the world’s fifty or so poorest coun- tries is the hope that once the existing debt is expunged, lenders will promptly extend new credit. What makes this behavior paradoxical is the commonsense notion that actions follow a pattern, and so reputation matters. If a borrower has defaulted before, why not again? The answer—at least in principle—is that abandoning debts enhances a debtor’s creditworthiness only in circum- stances that preclude repetition and therefore circumstances that nullify the adverse reputation effect. In the United States personal (as opposed to corporate) bankruptcy is permitted at most once every seven years. 9 Lenders had reason to assume that countries that had restructured their debts under the Brady Plan would not seek another such restructuring any time soon. (The Brady Plan also enabled sovereign credits to put up what amounted to collateral by using U.S. Treasury debt, placed in escrow accounts, to secure the principal and near-term interest payments on what then became bonds.) The current call for debt forgiveness for extremely low-income countries similarly assumes that there will be no repetition of this action within the foreseeable future.
- An interesting empirical question is whether individuals who have gone bankrupt find their ability to gain credit beginning to erode again after, say, five or six years.
New York law require unanimous consent of the holders to amend any of the terms of payment, including the interest rate and the schedule for repayment of principal. The sheer mechanics of notifying hundreds or even thousands of bond holders and obtaining consent from each are daunting enough (and all the more so if the bonds are issued in bearer form), but the unanimous consent requirement also creates an obvious incentive for some lenders to game against the others by withholding their consent. Moreover, New York bond contracts typically include no proce- dure for establishing collective representation of the holders, so that it is difficult to determine how to go about structuring a proposal with at least some claim of procedural legitimacy to present to holders for their con- sent. 11 Bond contracts also typically do not include the equal sharing clauses conventionally used in bank loan contracts to help maintain a united position among the lenders and especially to discourage dissident members of the lender group from initiating litigation on their own. 12 Although these specific contract features make bonds significantly harder to restructure than bank loans, loans as well are not always easy to reschedule or otherwise amend. In the case of loans advanced by large syn- dicates, banks with only a small participation, which poses no threat to their essential business prospects, have less interest in maintaining the no- loss-of-value fiction. When restructuring involves commitment of new money, these banks often prefer simply to write off their loss and drop out. When a borrower owes money to banks in different countries—as was the case, for example, in the 1997–98 Korean crisis—the fact that lenders in different countries face differing regulation and also differing conditions in their respective home economies can be a significant stumbling block. In the Korean example a key part of the story, which was clear at the time, was that the G-10 central banks were pressuring their countries’ commercial banks to agree on a restructuring plan that would prevent a situation of broad-scale default. 13 What would have happened if market forces had been left to function on their own remains (and will remain) an un- answered question.
- By contrast, bonds issued under U.K. law usually include provisions for convening a bond- holder assembly as well as provisions for majority voting.
- See Buchheit (1998a, 1998b, 1998c) for a detailed discussion of sharing clauses, majority action clauses, and collective representation clauses. See also Eichengreen and Portes (1995) and Eichengreen and Mody (2000).
- For an account of the Korean restructuring, see “Korea Stares into the Abyss,” Euromoney (March 1998), pp. 32–37.
The contrast between the readily identifiable interest that both borrow- ers and lenders often have in achieving a restructuring and the prevalence of these systematic impediments to doing so provides the motivation for much of the interest shown in international debt resolution mechanisms during the past few years. At the grand conceptual level, economists and others have offered various proposals for a “new financial architecture,” typically centered around the creation of either an international bank- ruptcy mechanism or an international lender of last resort, or both.^14 At the level of everyday financial practice, bankers have become more adept at handling London Club negotiations, the bondholder community has begun to make progress in addressing its more complicated representation problem, sovereign borrowers such as Pakistan and Ukraine have shown how to use exchange offers to overcome the impediment posed by the unanimous consent requirement, and other as-yet-untried ideas such as exit consents are receiving widespread attention. Yet all these proposals and actual innovations notwithstanding, debt restructuring in the international arena remains far from easy or straightforward. Perhaps there is a reason why this is so. As is well known, the conflict- ing incentives of borrowers and lenders and the asymmetry of information that a borrower and its lenders have about the borrower’s financial condi- tion and prospects create a classic moral hazard situation and hence the need for mechanisms to commit borrowers to meet their obligation. The need for such mechanisms is all the greater when the absence of strong auditing and accounting practices and other forms of transparency make a borrower’s condition and prospects especially difficult for outsiders to monitor—as is often the case in emerging markets. Transaction by trans- action, therefore, lenders always seek ways of committing borrowers to pay what they owe. But from a perspective that is broader than just one transaction at a time, it is also useful to lenders to have mechanisms that commit themselves to press the borrower for payment and even to exercise their rights under whatever mechanisms are in place should the borrower fail to perform. Lenders (and, as developed in the discussion below, borrowers too) have an interest that extends over time to future transactions. That continuing interest may sometimes conflict with a lender’s interest in simply gaining the greatest value, net of fully allocated expense, from any one transaction.
- Prominent examples include Eichengreen (1999); Folkerts-Landau and Lindgren (1998); Goldstein (1998); Rogoff (1999); and Council on Foreign Relations (1999).
broadly, including those that are part of the specific credit in question and those that are not. More generally, conditioning private credits on a coun- try’s receiving IMF loans, or even on its merely entering into an IMF agree- ment, is also a means of solving lenders’ collective action problem. In such circumstances the IMF in effect serves as a cartel coordinator for the lenders. Hence impediments to debt restructuring have their purpose too. But the straightforward implication of this line of argument is that not all non- performing debts should be restructured, even when it is in the interest of the borrower and also in the (narrowly construed) interest of the lenders to do so. Because the practical alternative to restructuring is hard to specify, whether this means more outright defaults or merely more instances of “muddling on” with debts nonperforming but not in default is ambiguous. But it does mean that failure to restructure a nonperforming debt is not necessarily a failure. And given the role that restructuring normally plays in facilitating the extension of new credit to a nonperforming borrower, it also means that some new loans will probably not be granted. Indeed, the deeper implication is that in a regime in which restructuring is systemati- cally not so “easy,” some old credits would not have been extended in the first place.
Real Counterparts of Financial Flows and Accounting Losses
The place to start in assessing whether a regime in which some specific loans are not made is good or bad is to recall that the purpose of credit flows is normally to fund some kind of real economic activity. Hence debt prob- lems, when they occur, are not merely a financial phenomenon. For every financial loss not fully offset by somebody else’s gain, there is somewhere a real economic loss. Since the fundamental rationale for having competitive financial markets to begin with is to support the production and use of real goods and services, what it means to do without any given debt transaction is ultimately a matter of real, rather than financial, outcomes. Thinking about nonperforming debt problems in this way leads to what can sometimes be an awkward question: When things go sour, where did the money go? In cases of ordinary business debt problems, the answer is sometimes straightforward and sometimes not, but rarely interesting in a general way: a firm’s product market is unexpectedly weak, its labor or its suppliers become unexpectedly expensive, its production is disappointingly
inefficient, its competitors are surprisingly strong, its new technology fails, and so on. Life in a competitive market economy is full of idiosyncratic reverses. But the focus of interest here, spurred by the problems suffered by one emerging market country after another in just the past few years, is not isolated business failure. The issue is instead systemic debt problems that affect a country’s borrowers more generally, often to an extent that ulti- mately threatens the government’s own credit as well. Hence asking where the money went is more interesting, but also more difficult. An example from outside the emerging markets context can perhaps best illustrate the point. The collapse of the savings and loan (S&L) industry in the United States in the late 1980s resulted in a direct cost to U.S. taxpayers of $126 billion. 16 This loss was not just a financial phe- nomenon. Much of it represented the dissipation of the American econ- omy’s resources in constructing office buildings, energy extraction facili- ties, and other tangible investments that in the end the market did not value. Much of the rest represented the transfer of resources to corrupt and self-dealing S&L operators, some of whom ultimately faced criminal sanctions. In retrospect, it would clearly have been better if many of the credits that led to the U.S. S&Ls’ demise had never been extended in the first place. Turning then to the case at hand, where did the money go in Korea? In Indonesia? In Thailand? In Brazil? The answer is more complex in these cases, not least because of the role of changing currency valuations in what went wrong. Projects that may have looked economically viable at one exchange rate no longer did at another. But even this plain fact is properly part of the story, not an excuse for ducking the issue, and it opens in turn yet further questions: Why were countries’ exchange rates supported where they initially were? Given the well-known role of capital flight in initiating most countries’ currency crises (not just in this latest round but more gen- erally), were exchange rate policies a thinly disguised mechanism for effect- ing what amounted to transfer payments? Who ultimately bore the risk arising from the use of unhedged foreign currency obligations to finance investments, the viability of which depended on stable or appreciating cur- rency values? And how did the allocation of that risk-bearing correspond to
- This sum included $42 billion in costs that the government reimbursed to the Federal Savings and Loan Insurance Corporation before putting that entity out of business, $79 billion in costs (net of liquidation proceeds) borne by the Resolution Trust Corporation, and $6 billion in contractual tax benefits awarded to private acquirers of failed S&Ls.
