International Lending of Last Resort and Moral Hazard: A Model of IMF's Catalytic Finance

Abstract

It is often argued that the provision of liquidity by the international institutions such as the IMF to countries experiencing balance of payment problems can have catalytic effects on the behavior of international financial markets, i.e., it can reduce the scale of liquidity runs by inducing investors to roll over their financial claims to the country. Critics point out that official lending also causes moral hazard distortions: expecting to be bailed out by the IMF, debtor countries have weak incentives to implement good but costly policies, thus raising the probability of a crisis. This paper presents an analytical framework to study the trade-off between official liquidity provision and debtor moral hazard. In our model international financial crises are caused by the interaction of bad fundamentals, self-fulfilling runs and policies by three classes of optimizing agents: international investors, the local government and the IMF. We show how an international financial institution helps prevent liquidity runs via coordination of agents' expectations, by raising the number of investors willing to lend to the country for any given level of the fundamental. We show that the influence of such an institution is increasing in the size of its interventions and the precision of its information: more liquidity support and better information make agents more willing to roll over their debt and reduces the probability of a crisis. Different from the conventional view stressing debtor moral hazard, we show that official lending may actually strengthen a government incentive to implement desirable but costly policies. By worsening the expected return on these policies, destructive liquidity runs may well discourage governments from undertaking them, unless they can count on contingent liquidity assistance.

Catalytic IMF? A Gross Flows Approach

“…Instead, opponents argue that such policies generate moral hazard both for debtors and creditors, and that the Fund's seniority status is detrimental to the debtor-creditor relationship as it might dilute private obligations (Saravia, 2013). In a framework of panic-driven liquidity runs, Zwart (2007) quali…es the results in Corsetti et al (2006) by showing that catalysis may not materialize given that, through its signaling e¤ect, IMF support can trigger capital ‡ight. 3 An extensive literature has studied empirically the signi…cance of the IMF´s catalytic e¤ect, delivering at best mixed evidence.…”

“…A number of theoretical contributions support this positive view. Corsetti et al (2006) and Morris and Shin (2006) contend that IMF lending is able to reduce the incidence of panic-driven liquidity crises. Similarly, Peñalver (2004) shows that subsidized lending can induce the borrowing country to exert e¤ort to avoid default.…”

“…7 In other words, in this aggregation, gross in ‡ows accumulate ‡ows of capital invested in the country by 5 The data set also includes the original (programmed) expiration date. Actual and programmed end dates may di¤er either due to a program extension or an early cancellation.…”

Bulls, bears and excess volatility: can currency intervention help?

“…The presence of large players can nevertheless affect the behaviour of the market as a whole, as shown by Corsetti et al (2004) and Frankel et al (2003). Taking as an example, provision of liquidity support by the IMF to countries under exchange rate pressure, Corsetti et al (2006) conclude that "Limited contingent liquidity support helps to prevent liquidity runs by raising the number of investors willing to lend to the country for any given fundamentals, i.e., it can have catalytic effects. "…”

“…6 Much of the psychological biases associated with how people form expectations were summarised in Barberis and Thaler (2003). 7 In this paper, we take euro as the domestic currency and dollar the foreign currency. 8 The 'observational equivalence' between trend expectation and risk aversion is noted further below.…”