The Message In Letting Ecuador Default

In early 1995, over the strong objections of both Democratic and Republican congressional leaders, the Clinton Administration mobilized an international rescue package of $50 billion to prevent a Mexican default. It did so despite great uncertainty that the package would succeed in restoring investor confidence in Mexico and despite polls indicating that most Americans opposed a Mexican "bailout."

Why did the Clinton Administration take the risk? First, the U.S. has strong strategic interests in Mexico's economic and political well-being. A prolonged recession in Mexico threatened to destabilize its politics, undermine its fledgling transition to a market economy, and spawn flows of illegal immigrants across U.S. borders.

Most important, the Mexican crisis threatened the international financial system. The Administration and the Federal Reserve worried that a default might unleash a stampede of private capital out of all emerging-market economies, triggering other defaults, toppling reforms, and undermining global growth. Fear of such "contagion effects" was the primary motivation behind the controversial decision to "bail out" Mexico.

Since the early 1990s, private capital flows to emerging-market economies had surged, dwarfing official capital flows as the dominant source of financing. Private capital had increasingly taken the form of bond and equity instruments in lieu of more traditional bank-syndicated loans. Although the new forms of private lending were plentiful, they were by nature footloose, able to move rapidly anytime.

SOBERING LESSONS. The U.S. bailout worked. Mexico avoided default, reaffirmed reform, and began to recover after a short recession. Foreign investors holding on to risky Mexican bonds survived the temporary crisis unharmed. So why has Washington decided to sit on the sidelines as Ecuador becomes the first country ever to default on so-called Brady bonds, which are dollar-denominated bonds partially backed by U.S. Treasury bonds?

Of course, American economic and security interests are not nearly as great in Ecuador as they are in Mexico. And unlike Mexico, Ecuador has not adopted credible policies to address its economic problems.

But the sobering lessons of the financial disruptions that have rocked global capital markets in the past two years also explain U.S. inaction on Ecuador. Not only did generous rescue packages for Thailand, Indonesia, and South Korea fail to prevent the crises there from spilling over to other countries but they also had the perverse effect of encouraging private investors to take on excessive risk.

Nowhere was this effect more dramatic than in huge purchases of risky Russian government debt by foreign investors who expected to be bailed out in the event of repayment difficulties. This expectation proved unwarranted, and what was revealingly dubbed on Wall Street as the "moral hazard play" in Russian debt sent the first clear signal that private creditors could be forced to share in the pain of their bad decisions.

NO WINNERS. Ecuador's unilateral decision to default and reschedule some of its debt with the acquiescence of both the U.S. and the International Monetary Fund is the second clear signal. True, Ecuador's actions have been ad hoc, lacking in transparency and equal treatment to all investors. But Ecuador has had little choice, since to date no progress has been made on developing multilateral rules requiring or encouraging bondholders to participate in necessary debt restructurings. Indeed, private investors have steadfastly opposed a formal restructuring framework, maintaining that they are automatically "bailed into" the pain of national financial crises when asset values plummet. They prefer, they say, to act individually to get the best deal they can at the expense of an embattled debtor, its other private creditors, and whatever official assistance is mobilized on the debtor's behalf.

But history shows clearly that a long delay in rescheduling an unsustainable debt burden benefits neither a debtor country nor its creditors. And although international guidelines requiring private bondholders to agree to restructuring under certain circumstances could reduce their willingness to lend to emerging-market economies, such guidelines would also encourage more prudent lending, discourage overborrowing by individual countries, and reduce the likelihood and severity of future financial crises.

That's a risk worth taking. And that's a valuable lesson that the U.S. and the IMF may hope to teach private investors by sitting on the sidelines as Ecuador negotiates with its private creditors.