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Can
the Moral Hazard of IMF Bailouts be Reduced?
Geneva Reports on the World Economy Special Report 1
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a copy
Since
the Asian crisis, policy-makers have been searching for better ways of
managing financial crises. A newly published* supplement to the Geneva
Reports on the World Economy, written by Barry Eichengreen of the
University of California at Berkeley and CEPR, considers two leading
proposals: empowering the IMF to impose or endorse a standstill on
payments to protect countries hit by a financial panic, and using
collective action clauses (CACs) to help resolve crises resulting from
inconsistent policies and disappointing performance. Eichengreen
concludes on both economic and political grounds that ‘collective
action clauses and not internationally sanctioned standstills should
be the priority for those seeking to strengthen the international
financial architecture’.
Both
proposals are designed to help resolve the ‘moral hazard’ created
by IMF bailouts. Bailouts encourage reckless lending, their critics
allege, because lenders are led to believe that if things go wrong the
IMF will rescue them. This has prompted a debate on alternatives to
large-scale financial rescues. A particular focus has been how to
‘bail in’ the private sector – how to see that IMF rescues do
not automatically allow investors to escape all losses.
Eichengreen
is critical of several fashionable approaches to reform. He does not
believe that it is feasible for the IMF to condition its assistance on
case-specific agreements by investors to restructure existing loans,
roll over maturing issues, or provide new money, for the simple reason
that investors understand that the Fund will be compelled to help the
crisis country anyway even if the markets fail to cooperate. He argues
that it is not possible under present institutional arrangements in
financial markets for the IMF to stand aside and let events run their
course: ‘the costs of inaction...have repeatedly been shown to be
too painful for the international community to bear’.
One alternative to large-scale
financial rescues is imposing a standstill on payments. This is
appropriate if the root cause of the crisis is investor panic; a
payments standstill would then impose a cooling off period and allow
panicked investors to collect their wits. New evidence from corporate
bond markets for 24 countries, reported in the study, does not suggest
that such a measure would automatically raise borrowing costs.
Unfortunately, empowering the IMF to impose or endorse a standstill
raises a host of difficult practical issues that will not be easily
overcome.
Eichengreen
argues that most crises are in fact the result of deep problems with
economic policy and performance, not simply investor panic. In these
cases debt restructuring will be required. While there still may be a
case for a standstill provision to provide an umbrella for
restructuring negotiations, the key innovations needed to provide an
alternative to large-scale international rescues are measures designed
to facilitate restructuring, specifically, CACs in loan contracts.
CACs
are already widely used. Bonds governed by English law typically
include provisions enabling the holders of debt securities to call a
bondholder assembly empowered to pass resolutions relating to
defaults, and other aspects of the original agreement, subject to the
consent of the bondholders holding most of the bonds. This contrasts
with American law, which allows so-called ‘vultures’ to hold up
restructuring. Pursuing this alternative requires the official
community to promote their more widespread utilisation. The IMF has
already taken a first step in this direction by citing the use of CACs
as one factor in determining whether countries qualify for its
Contingent Credit Line.
Eichengreen
points out that more than 40% of all international bonds issued
between 1990 and 2000 were subject to English law. If they were even
more widely used, the market would have a mechanism with which to
restructure problem debts. There would then exist an alternative to
relying on the IMF to run to the rescue of the crisis country, a
‘pattern of behaviour [that] creates moral hazard which undermines
market discipline and the stability of the international system’.
The author shows that, contrary to the claims of some market
participants, adding CACs to bond contracts does not necessarily raise
capital costs for emerging market borrowers.
Which
reform should receive priority, Eichengreen concludes, should depend
on the predominant cause of crises. If crises are mainly caused by
investor panic, then an IMF imposed or endorsed standstill is the
appropriate alternative to large-scale IMF rescues. If, on the other
hand, crises reflect inconsistent policies and disappointing economic
performance, CACs should be the priority for strengthening the
international financial architecture.
*Published
by the Centre for Economic Policy Research (CEPR) and The
International Centre for Monetary and Banking Studies (ICMB), Geneva.
Barry Eichengreen
is John L. Simpson Professor of Economics and Political Science at the
University of California at Berkeley and a Research Fellow in CEPR’s
International Macroeconomics and International Trade Programmes.
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