Explaining Michael Tomz’s Theory

Michael Tomz theory can be argued in both positive and negative ways. If a private bondholder or a commercial bank base a country’s reputation on its external image, self-image and additional factors from global market factors, most of the countries are badly reputed.

If we take Iraq as an example, it has been placed as the worst reputed country for almost a decade by the annual country RepTrak reports.

These RepTrak reports are conducted compiled annually based on each country’s external and self-image along with the factors they get from global markets.

Below are the 2017 & 2015 reputation report.

Iraq’s economy has been hit by its civil war, weaker oil prices and political instability. Their economy was badly affected. But when they issued bonds in 2017, investors have rushed to buy Iraq’s first independent bond sale in more than a decade.

6.6 billion USD of orders were placed to buy 1 billion USD bonds, which will mature in 2023. All these bonds were guaranteed 100% by the United States Government.

In fact, the yield was fixed lower than the initial pricing expectations.

Apparently, reputation was not considered by the bondholders who bought bonds from these countries. It might be because Iraq is vastly dominated by the oil sector, and its oil exports have been gradually increasing as a result of its new pipeline and restoration facilities.

Even though, Iraq doesn’t have a good reputation to ensure the repayment, it has its own oil sector and resources, at which world countries eye.

Second country is Greece. Its economy recorded a growth rate of only 0.01% in 2016. It’s also a country which has undergone multiple bailouts by the European Union and the International Monetary Fund.

Greece remains below the European regions and even among world averages. 2008 financial crisis affected the economy of Greece severely. Their unemployment rate still remains high.

But when they issued first Greek bond in three years in 2017, they sold five year government bonds for 3 billion euro, and of course investors and bondholders willingly bought the bonds despite Greece’s awful credit ratings and position as the only country to miss a repayment to the International Monetary fund.

In fact, demand for the debt exceeded by 6.5 million euro, which at last resulted in turning away the investors.

In this line, third country is Argentina. In 2017 June, Argentina borrowed 2.75 billion USD of 100 year bonds at a yield of 8%, despite its lengthy histories of sovereign defaults.

It is highly notable that since its independence in 1816, Argentina has defaulted on its sovereign debts for eight times. Including the world’s largest default was made by Argentina in 2001 on USD 100 billion of bonds.

Taking a look at these three countries all can be said is reputation or repayment records clearly did not matter to the investors, Commercial banks or private bondholders. If they did, all these bonds sales should have taken place. But the notable thing is there are some examples of reputation borrowed lending as well.

There are number of incidents, countries failing to borrow expected amount through the issuance of sovereign bonds.

A United States bond auction in March, 2018 failed to drew the required demand. It was a USD 21 billion bond auction. Bond traders and private bondholders backed away from lending to America as its budget deficit has widened along with the raise in the interest rates by the federal reserves.

Even china has failed to achieve in a bond auction in June 2015, as a result of climb in the yields.

In 2011 German failed on its bond auctions by drawing weakest demands. It sold USD 4.92 billion of 6 billion euro in 10 year auction. The average yield was 1.98%.

Regardless of a country’s reputation these failed bond auctions have taken place just because of the economic instability of the borrowing country.

Explaining Strom Thacker’s Argument

Being established in the 1945, International Monetary Fund is an organization, which works with a primary mission of watching and maintaining the International Monetary systems. It has provided great economic turning points to many countries. It has fostered global economies and stabilized world monetary system.

Even though the IMF claims that it sticks to universalistic criteria when designing an agreement to the borrowing country, in reality individual governments exert their power over IMF’s lending decisions.

Storm Thacker’s argument can hardly be proven wrong as the United States exert its influence for more than to a certain point on IMF’s lending decisions.

IMF is being funded by its member countries, in which United States owns 17.46% of quota with a voting power of 16.52%, apparently a major quota owner.

IMF’s decision making structure provides United States much power than any other member governments.

In May 2009, IMF was pressurized by the United States officials to delay a 1.9 billion USD loan to Sri Lanka, accusing that the country was not in a position to implement strategic implement reforms.

In March 2017, IMF was pressurized by the Donald Trump administration to restrain from Greek’s bailout participation. A bill was also introduced calling the Trump administration to oppose any further IMF participation in a Greek’s bailout. The bill further required the US to oppose any larger IMF reforms until Greece repays all of its debts to the IMF.

In the same time period, the IMF sent a staff team to Athens to negotiate with the government, but IMF was discussing in the hardline and refused to commit any funds as a result of the influence of the new US administration.

Apparently, United States exert influence on IMF.

Why do countries default?

Countries occasionally default on their external debt when the borrower government is in an unable situation to pay off its debts. Defaults can happen due to various reasons. In some cases, the government may have missed a loan payment or it could also be a disbursement delay.

Global capital inflows hold a significant role in debt defaults of a country. In booming times countries borrow money from financial centers or institutions with a higher promise of return. But as a coin, every situation has its two sides. Countries can’t trust on the liability of Positive environments. A simple bank failure can interrupt entire trade of a country. Crisis in the capital flow cycle can lead to a country, default on its debt.

Argentina, Greece, Russia, Pakistan and Venezuela are few among the debt defaulted countries in the recent years.

Taking a look at famous and recent debt defaults, Mexico defaulted on its foreign debts as a result of 1994 Peso crisis. The Mexican government was forced to buy US dollars at devalued peso, with an aim to repay national debts of Mexico. Later on an USD 80 million loan from multiple countries helped Mexico getting bailed out.

In 2001, Argentina defaulted on its debt a USD 132 billion loan, which amount is considered as one-seventh of all the money borrowed by the third world at the time.

The move came after political and economic uncertainty determined to devalue Argentina currency. Argentinian government froze all bank accounts for one year and allowed each person withdraw a very little amount of money per week. Then Argentina borrowed money from the international monetary fund to pay off its debt, but still suffers a greater depression.

During the global financial crisis in 2008, Iceland the country defaulted on USD 85 billion of its international debt. The Central Bank of Iceland later on tried to bailout the nation’s three biggest lenders and ended up bankrupting itself. The value of the Iceland currency plummeted. It took extreme restriction on money moving outside of the country and loans from the IMF to get out Iceland from one of the worst economic defaults in the history.

Various crisis have lead countries to default on their external debts.

What will happen when a country defaults?

Undoubtedly, a debt is a burden for a government but what will happen when a country does not pay back its debt? The results will be worse.

When a country defaults on its debt, the effect on bondholders can be worse. It will effect pension reserves and investors with large amount of holdings.

The borrowed government will lose access to international capital markets when it defaults. Furthermore it won’t be able to issue bonds to commercial banks or private bondholders and borrow money from them. This will eventually force the country to have zero public deficit or create money to pay for deficits. Clearly it will not be able to go through debt or bond maturities and most probably the country won’t be able to repay as no one will provide another loan.

When during a default even private businesses and citizens from the borrowing country cannot obtain any foreign financing as they won’t provide loans to the government nor will they give loans to companies.

Most of all, defaulting on external debt means, closing the economy of that particular government. The government has to rely entirely on its own self.

This will result in pressurizing the Central Bank to create money and produce inflation. When a government is extremely based on external funding, the government go out of money simply like its economy.

Next horrible result is the currency of that particular government will get devalued as a result of lack of confidence. But this won’t cause a direct impact on its economy as it will result in major exporters exporting more an importing less, making the trade deficit narrow.

But indirectly, this will drop the value of the government’s assets such as buildings. They’ll become to a point, being available to everyone and affordable even for outsiders.

The post result after a debt default are extremely horrible and it will take years to get recovered.

Why does International Monetary Fund get privileged treatment?

International Monetary Fund’s aim is to be the lender of the last resort to countries which are going through financial crisis. All the loans of IMF are issued and repaid in dollars and euros most of the time.

The hypothetical example below shows how IMF acts like a lender of the last resort.

Country A is a developing nation with a resource dependent economy and its exports are really valuable and high priced commodity. Because of that Country A has been able to obtain a loan in order to make long term investments. 20% of that borrowed money goes to government spending, while 40% of the government revenue comes from export.

Now due to some unavoidable circumstances those high valued export commodities lost their value and export numbers aren’t that satisfactory. As a result government’s revenue fell by 20%.

The second issue is Country A’s currency was being bought all these time to buy their exports and now as a result of export’s poor performance, the currency has also lost its value relative to the dollar and euro. This indirectly means when during its external debt repayment, this Country A has to spend more of its local currency to equalize the borrowed debt value. The A government is already dealing with lower revenue but now it has to put more money from its shrunken budget, towards debt servicing.

Trade deficit will be widened. Now the A Government has to look into ways. It might head into defaulting its external loans. Then come the worst results. Foreign direct investments will go out from the country, eventually adding a bad reputation to the Country A. now what’s the option that has been left? Yes. They’ll go to the International Monetary Fund, seeking assistance from them.

On the other side International monetary Fund is an organization which is designed to solve such issues. Once the Country A seeks assistance, IMF will step in and provide multiple times of loans to the country under various strict conditions arrangements and agreements. It will also restructure Country A’s debts. Sometimes there are also chances of IMF convincing lenders, to forgive and wave off a certain amount of the debt. It will also structure further plans to stabilize and strengthen the affected country’s economy and its devalued currency.

Summary - Apparently, countries do not want to harm their relationship between International Monetary Fund, by delaying a reimbursement, by defaulting their IMF loan or by not obliging to IMF’s certain conditions. Countries always try to give special treatment to IMF as they do not want to have a bad reputation with the world’s lender of the last resort. When in an economic crisis, when in a state where no countries are willing to lend money, they simply go to the IMF. Even though the country is worst reputed and have a poor economic performance IMF still provides assistance to such countries under certain guidelines. No one wants to treat a person who will lend to you, no matter how worse you are.

Effectiveness of IMF

Since its establishment IMF have been carrying many projects and providing many services and assistance under various criteria. Effectiveness of those programmes vary from one to another. For most of the countries, IMF has been a successful institution to light up their economy during crisis. At the same time IMF has its own failures as well, as an organization which has being criticized widely.

Basically IMF has three main functions. It provides basic economic health checkup for member countries, this is called surveillance. It also provides technical assistance and training, and it lends to member countries in times of trouble.

When countries face economic crisis or want to prevent them they can turn to the IMF for advice and loans to restore their economic stability. A country should have a safe level of reserves but sometimes countries run short of money. This can be caused by internal or external problems and could lead to a crisis. For example crisis can occur if a country has weak financial system or if it keeps buying more financial goods and services from other countries more than its exports. A crisis can also occur if an economy is not growing fast enough to keep up with mounting debts. This can lead to a loss of confidence and foreign investors suddenly taking the money elsewhere. Crisis can also occur when a country spends money wastefully. Crisis can be very dangerous and the IMF can help by providing larger amounts of money to ease the adjustments and help restore confidence. Any member of the IMF, be it rich or middle income or poor can reach the IMF and ask for a loan. These loans come in many sizes and they are cheaper than other sources. They are tailored to specific needs. When a country request a loan, the IMF works with a country to design a flexible and a targeted reform plan to make it easier for the country to engineer its own recovery and address the underline problems. Often the road to recovery means tough choices should be made. In order to the loan to be effective, countries’ have to adopt the right policies and correct the problems that calls the crisis in the first place.

IMF lends loans to countries based on some strict conditions with regards to implementation of economic policies. They suggest the government to spend less and increase taxes, to charge higher interest rates to strengthen the country which eventually allow failing firms to go in bankruptcy. Sometimes these economic policies can make the situation worse.

Taking a look at some of the unsuccessful stories, we can’t simply miss out Greece. Till 2001 Greek’s currency was drachma, 3000 years ago. 1832 Greece became an independent nation and brought back the drachma. But then in 2001 Greek joined the Eurozone and began using the Euro as its currency. The euro had been great so far as it facilitated the trade but 19 countries sharing a currency had its problems. One of the reasons this crisis had been so severe was that Greece’s monetary policy, how much money they can print was controlled by the European Central Bank. But Greece’s fiscal policy, how much money they can spend and where they spend was mostly controlled by the Greek government. Greece and other Eurozone countries were supposed to follow fiscal rules, such as no more than 3% of annual budget deficit for instance, but many Eurozone countries including Greece had been broken the rules. Speaking of which, since the mid-1990s the Greek government had been reporting deficits and debts that were much lower than the actual deficits and debts. In 2009 newly elected government announced for the year, that would be 13.9% of total economic output and the numbers had been fudged with some previous years. Greece’s labor cost was much higher after joining the Eurozone. They had too much of debt to start and also had a huge problem with tax evasion. In 2008 U.S. recession became global. Greece disproportionally affected because two of its big industries are shipping and tourism, neither of them was doing particularly well after recessions.

A loan from the IMF has larger benefits. It encourages other creditors and lenders to provide financing and also sends a positive signal that it is okay to invest in the country. This help to rebuild foreign exchange reserves and boost confidence in the country’s currency and the economy at large.