A leap of faith for sovereign default: from IMF judgment calls to automatic incentives.

• Author: Lerrick, Adam

Official policy, whether national or global, always lags behind the realities of the marketplace. In times of major transition, it lags behind real policy, informal and unstated, as it responds to crisis on the ground. Formal codification follows.

More than three years of default in Argentina since December 2001 have proved that current events cannot be forced into the mold of past experience. The good old ways from the good old days are no longer relevant to a modern settlement of troubled sovereign debt.

Lenders have changed. A fraternity of regulated commercial banks with homogeneous holdings has morphed into an impersonal and fluid array of investors with divergent claims--all in competition for the biggest slice of the pie. Small individual bondholders that have entrusted retirement savings at 100 cents on the dollar must vie with hedge funds and holdouts that accumulate bonds at distressed prices and measure time horizons in months.

Borrowers have changed. Financial debt is no longer seen as a fixed obligation but must be weighed against the government's "social debt" to provide a better quality of life for its people. Emerging nation leaders are seeking emancipation from the dictates of IMF policies even at the price of a loss of official monies.

International banks have changed. The industry has consolidated into fewer and larger universal financial institutions. Behind the fictitious Chinese Walls hides a mass of conflicts: responsibility to investors to whom bonds were sold; a role as investment banker and adviser to borrowers; proprietary trading positions; and protection of assets and subsidiaries held captive. All are interactions with the same defaulted government. No longer major lenders, for all their size and past authority, the large banks have lost their voice in the settlement of debt.

Technology has changed. Negotiations need not consist of years of stale sandwiches and warm Coca-Cola around a centralized conference table. Instead, decentralized mechanisms can collect and transmit information from a larger universe to permit the debtor to "discover the price" of restructuring in a matter of months.

The balance of power has changed. With the demise of bailouts, the International Monetary Fund no longer dominates the discussion between sovereign borrowers and their private sector lenders. A single anachronism lingers. An IMF judgment call on "good faith efforts" controls the flow of official funding and obstructs a "good resolution" of default. It means uncertainty for the markets, false hopes and confusion for creditors, resentment among debtors, and delay in settlement.

Amid a revolution in the way debt restructuring can be handled in "real time," process must keep pace with substance.

A Fading Role for the IMF

In the 1980s and 1990s, the IMF was a hands-on arbiter and banker that controlled the debt restructuring process. This was welcome to borrowers and to their private sector creditors alike. An outsider with a chariot-load of money would magically descend upon the stage. Investor losses would be lessened. Debtor costs of adjustment would be mitigated. In short, the deus ex machina of a bailout.

An IMF adjustment program was underwritten with large-scale IMF loans. These highly subsidized official sector funds freed up cash to pay the nation's private creditors. A fiscal surplus decreed by the IMF fixed the level...