The Americas: Ecuador’s Brady Bonds Are IMF Guinea Pigs

Late last month debt-strapped Ecuador made history by missing two Brady bond coupon payments totaling $96 million. Although the government says that it may still meet the payments within a 30-day grace period, bondholders are facing the prospect of having to “restructure” the terms of the $6 billion worth of Brady debt.

Brady bonds are named after former Treasury Secretary Nicholas Brady, who led the effort to help Latin American countries reestablish credit by securitizing–in the form of dollar bonds–the bad bank debt that piled up during the 1982 Latin American debt crisis. There has never been a deferred Brady-bond payment, much less a default.

Yet the big story here is not about Ecuador or even about Brady bonds. It is instead about whether the International Monetary Fund, as many investors now vociferously contend, quietly encouraged Ecuador not to pay on time. The suspicion that it did is roiling the once-cozy relationship between the IMF and international bankers, who stand to lose–and who may face an onslaught of legal difficulties–if the Ecuadoran bonds go sour. The IMF’s official position is that it isn’t saying yea or nay.

Until now, the IMF and Wall Street have had a symbiotic relationship in financing emerging nations. The private sector lends and when crisis hits, the IMF steps in. Economists have become increasingly critical of this arrangement, on the grounds that IMF “rescues” encourage investors to take unwise risks, allow reforms to be postponed and leave local taxpayers holding the bag. “Moral hazard” is the term used to describe this.

Of late the IMF has started taking the position that the private sector should be “involved” in “resolving financial crises.” That’s why the bankers suspect that the Fund has not discouraged, at the very least, the Ecuadorans from putting the bondholders’ feet to the fire. But just as Bill Clinton can no longer lecture teenagers on sex, drugs and lying, the investment community is a bit short on moral authority to complain about IMF intervention.

Ecuador’s claim that it needs to restructure its mountainous public external debt–equivalent to more than 90% of gross domestic product–is plausible. The economy is in shambles, having followed a trajectory of destruction since the mid-1970s of inflation, protectionism and over-regulation. President Jamil Mahuad inherited this basket case when he took office in August 1998. History will show that one of his first mistakes was a visit to the IMF’s Washington offices in February. A week later, the sucre was devalued and the new president’s popularity collapsed, along with his lofty goals of reform–including privatization of state industries.

Since then the country has been in a downward spiral, paralyzed by labor strikes, unable to execute a much needed banking reform, and draining international reserves. The economy will contract by 7% this year. The Ecuadoran Congress opposes, and is in no hurry to debate, the president’s fiscal package, which includes the IMF’s prescription for higher taxes.

Even though a “workout” with creditors is in order, investors may well have expected another outcome. If Ecuador had hit bottom in vogue, it probably would have won an IMF financing package to allow the government to honor its Brady-bond contracts. That the struggling government would have had to agree to IMF austerity measures–including punitive tax increases–might have mattered less to the investment community than it would to impoverished Ecuadorans who would be left with few resources to dig themselves out.

But it now looks like the Fund, with U.S. Treasury assistance, privately encouraged Ecuador to default on its private-sector debt as a prerequisite for IMF support. This is not good for Ecuador but it is possible that the Fund hopes to use it to deflect growing criticism of its role in creating moral hazards. Evidence of this was available last March, when in a summary of an executive board meeting the agency’s acting chairman Stanley Fischer wrote that, “…Directors agree that more needs to be done to create incentives and instruments for the private sector to remain involved.”

What Mr. Fischer may have been getting at is that while the cycle of “rescues” encourages U.S. banks and investment companies to lend money in emerging markets, when the crisis hits, investors tend to flee once secret meetings between government, the Fund and the investment community produce the loan. Of course, the bigger the exposure for U.S. banks and investors, the more likely there will be a rescue. One reason tiny Ecuador is being singled out as the IMF’s guinea pig for a Brady default is that it is not too big to fail.

Recall what Treasury Secretary Lawrence Summers likes to call the successful Mexican peso-crisis intervention of 1994, which the banking/investment community strongly supported. After Mexico devalued the peso, holders of dollar-linked Mexican short-term debt, who for several years had been reaping a rich risk premium over U.S. short-term debt, were made whole by the administration’s decision to “rescue” Mexico. Then they fled. Ironically, working Mexicans were just about the only ones not rescued. For them, taxes went up, while savings and wages plummeted.

In October, I asked a high level U.S. banker why Brazil, with no evident appetite for fiscal reform, should not be denied a massive infusion of IMF aid. He responded: “because the markets are expecting it.”

These are but two examples of how creditors have cheered the IMF on in recent years. But they are crying foul on Ecuador. The IMF, we’re now told, is interfering with markets and, more outrageously, with private contracts, i.e. bonds.

The IMF for its part seems also to be thinking hard about how to let the market work while it continues to interfere. It has already recommended that crises be handled on a “case-by-case basis”–sometimes the market, sometimes the Fund, sometimes a little of both. Take a guess. Due to Fund secrecy, the public has no way of knowing if negotiations are going on to save the Ecuadoran Brady bondholders after all. What we do know for sure is that when it comes to saving the world, the IMF’s golden rule is to save itself first. While pressures and criticism about moral hazard abound, the Ecuadors of the world are at risk.

But if the investment community is outraged by the IMF switching sides, it is a welcome development. Now perhaps the outraged will lead the efforts to rein in the off-budget multilateral monster. Millions of Latin Americans will ultimately be better off for the removal of a crutch for bad banking and bad government economic policies.

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