25 March 2019

IMF working paper: Costs of sovereign defaults: restructuring strategies, bank distress and the capital inflow-credit channel

In this paper, authors shed new light on the growing empirical literature on the costs of sovereign debt restructurings, by exploring output and banking sector costs, and linking them to the restructuring strategies chosen by the sovereign.

They show that the transmission channels and associated output and banking sector costs depend on whether the restructuring takes place preemptively (without missing payments to creditors), or after a default has occurred (and payments are unilaterally missed). Their local projection estimates show a large decline in GDP and investment, amplified by severe sudden stops and transmitted through a “capital flow-credit channel”—supported by both an increase in lending interest rates and declines in credit and capital inflows.

Their key finding suggests that countries that succeed in a restructuring without missing payments to creditors are largely able to avoid, or at least mitigate both output and banking sector costs associated with restructuring. Though that approach can lead to better outcomes, in practice countries can face several constraints on the choice of how to restructure. For instance, they may be hit by the sudden realization of a large shock or they may find themselves in the “bad equilibrium” in a multiple-equilibria context. Depending on their situation, they might have no choice but to stop servicing their debt without some immediate debt relief. But even then, instances where the suspension of payments is decided quickly in collaboration with creditors are still associated with better outcomes than when payments are suspended unilaterally by the debtor. Smaller haircuts i.e., creditor-friendly terms also tend to be associated with better outcomes. But the haircut offered should be large enough to restore solvency (offering a small haircut which eventually requires another restructuring is likely to be counter-productive, and lead to even higher costs).

Their findings have implications for the ongoing discussion on how to best resolve sovereign debt crises. The real economy, the financial sector and the government are all interconnected. When designing a debt restructuring strategy, it is crucial to understand the spillover and feedback channels that the restructuring can have on the domestic financial system. Much of the output costs hinge on whether a severe sudden stop can be avoided, which is more likely in a preemptive restructuring.

Moreover, their results show that, even if sovereign’s debt has fallen into arrears, a sovereign can still minimize the output costs of the default by reaching a restructuring agreement rapidly. Relatedly, their findings also have implications for the design of official financing, suggesting that where feasible, long-run costs can be attenuated if official financing and creditor cooperation allow countries to restructure without missing payments. It also highlights the costs that countries can face for trying to delay adjustment (and requests for official support) until a default becomes inevitable. These should be important considerations in the design of future debt restructuring strategies.

Working paper

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