GEI Newsletter Issue No. 2

‘Political Economy, Sovereign Debt and the Role of the IMF’ G E I Workshop, Cambridge, 7/8 July 1995 - by Sylvia Vally

Also in this issue:

Editorial
by David Vines
Global Competition Policy in the International Economic Order
by Peter Holmes
Seminars at Chatham House on Subsidiarity in the Governance of the Global Economy

‘Political Economy, Sovereign Debt and the Role of the IMF’ G E I Workshop, Cambridge, 7/8 July 1995
by Sylvia Vally

Sylvia Vally is a PhD student at Warwick University.

The following article reports on the workshop ‘Political Economy, Sovereign Debt and the Role of the IMF’, held at Sidney Sussex College, Cambridge, 7/8 July 1995. A more formal conference on this subject is planned for the second half of 1996, the proceedings of which are expected to be published as a book. Details will be announced in the next GEI Newsletter .



The workshop was organized by Marcus Miller (University of Warwick and CEPR), William Perraudin (Birkbeck College, London, and CEPR), and Jonathan Thomas (University of Warwick). The event brought together IMF officials, economists from the policy community and academics working in this field both in the UK and elsewhere. It provided an opportunity for the organizers to present their first results in this project, including papers written jointly with Pinar Bagci (University of Cambridge) and Lei Zhang (University of Warwick), both Research Associates funded by the ESRC. An international conference is planned for 1996.



In ‘The IMF and the Latin American Debt Crisis: Seven Common Criticisms’, James Boughton (IMF) discussed various critiques of the IMF’s role in managing debt strategy throughout the 1980s, which became part of the conventional wisdom about the debt crisis. Some reflect a perception that the Fund tended to act on behalf of the interests of creditors and industrial countries more than for the indebted developing countries; others, that the Fund was acting outside the traditional framework established at Bretton Woods and that its technical analysis was inappropriate. Although Boughton argued that much of this criticism is either misplaced or exaggerated, two shortcomings in the IMF’s management of the debt crisis were acknowledged. First, that its forecasts of a resumption of sustained output growth in Latin American countries were too optimistic; and second, that the operational significance of combining macroeconomics adjustment with structural reforms was gained only gradually during the 1980s.

Zanny Minton-Beddoes (The Economist ) agreed that much of the criticism has been overdone, but went on to question the appropriateness of the Fund’s role in overstepping its mandate and in being the handmaiden of commercial banks. She noted that the failure of World Bank/IMF coordination had probably exacerbated the crisis, and faulted the Fund’s technical analysis on three points: the interpretation of the liquidity/solvency situation of the debtor countries, the delay in providing debt relief, and the use of a wrong model of adjustment. Raquel Fernandez (LSE and CEPR) pointed out that the IMF’s role in ‘buying out’ other creditors could make things worse for the debtor countries.



In ‘The Timing of Privatization’, written with William Perraudin, Anne Sibert (Virginia Polytechnic) presented a bargaining model to examine the timing of a particular type of structural reform – privatization. The two parties involved in bargaining over economic reform are a government and foreign lenders. A country approaches an international lender for a loan. The lender wants as much privatization as possible. It proposes a programme yielding economic benefits (a fixed amount of the loan) to the country, including some degree of privatization as a condition. The country may accept the programme, in which case privatization occurs; or it may reject the package, in which case the lender may revise its proposal. The model aims to describe the process of negotiation between debtors and their foreign creditors, where bargaining may be lengthy and occur in several stages, and borrowers are sometimes able to attain less stringent conditions. The surprising results from comparative statics are that either higher costs of postponing the reform or the prospect of a crisis can actually slow the process of privatization.

Jonathan Thomas suggested that in the model there are two sources of inefficiency: the delay in privatization and its limited extent (more privatization would be better). In the equilibrium the fraction of privatization in the country is less than one. Using the same analytical framework he argued that the possibility of a crisis would lead to the fraction of privatization increasing. In Thomas’s opinion the welfare effect of a crisis on efficiency is therefore not clear, implying more delay (greater inefficiency) but also more privatization (greater efficiency). David Newbery (University of Cambridge and CEPR), emphasized the need to incorporate other dynamic aspects of the privatization process, including the role of the domestic lenders. Andrew Powell (Banco Central de Argentina) noted that privatization can be very fast as in Argentina and the Czech Republic.



In ‘Sovereign Debt Buybacks Revisited’, Jonathan Thomas reconsidered the arguments put forward by Bulow and Rogoff (1988, 1991) against sovereign debt buybacks. These authors had argued that buybacks are likely to be a poor deal for debtors. Thomas presented a ‘willingness-to-pay’ model in which the sovereign determines repayments to be the solution to an explicit welfare maximization problem. Including default costs in such a framework reverses Bulow and Rogoff’s conclusions and small market buybacks become beneficial to debtors. In this context buybacks may be a cheap way of avoiding default costs. Emphasis was placed on the repayment strategy of the debtor country. The critical assumption was that default costs depend only on the size of the default, and not explicitly on the circumstances of the country. This can be justified by the asymmetric information which exists concerning the prospects of a sovereign country.

In her discussion Raquel Fernandez argued that it would be desirable to take the model one step further. She suggested that a fully-specified strategic model could be constructed based on the assumption of asymmetric information about country income and sanctions, which are costly to impose. She demonstrated that the argument would still go through with an explicit model of creditor-imposed sanctions.



In ‘The Political Economy of Savings Behaviour and the Role of the International Financial Institution’, Joshua Aizenman (Dartmouth College) and Andrew Powell provided an explanation of why many governments facing volatile revenue streams appear to have woefully inadequate savings. Their explanation stems from a political-economy analysis. Fiscal budgeting decisions are seen as the outcome of a political process which involves many groups competing for scarce funds. If there is no strong centre to impose the cooperative solution, the result can be a very low savings rate and current spending may be determined by the access to capital rather than by any inter-temporal maximization problem. Aizenman and Powell suggested that this result can be mitigated in a repeated game framework, or in a democratic country where governments are judged periodically in national elections. An important role in mitigating opportunistic spending behaviour may also be played by outside agencies, including the IMF, which may provide the necessary coordination to move the non-cooperative to the cooperative savings behaviour.

In his discussion David Newbery questioned the behaviour of commodity prices assumed by the authors, citing empirical evidence of high persistence in commodity prices.



Michael Dooley (University of California, Santa Cruz) in ‘The IMF and the 1982 and 1994 Crises: Who is in Charge?’, examined the role of the IMF as financial intermediary in the ‘political credit market’. Dooley argued that IMF’s influence is derived from its private information about potential sovereign debtors. Private information is captured as a by-product of continuously screening potential borrowers, or is made available to the Fund where it could not credibly or confidentially be provided to other creditor governments. As a consequence of this private information held by the IMF, a Fund seal of approval is necessary for most bilateral official lending. Private information, moreover, permits the Fund to mitigate the ‘adverse selection’ problem. Another familiar part of the Fund’s role is in monitoring the behaviour of the debtor after the loan is made. Clearly the loan itself induces a moral hazard problem, but this can be offset by the nature of the contract, by the conditionality and by periodic performance reviews common to IMF contracts. The conclusion is that to demand greater transparency in the Fund is counterproductive. The analysis also suggests making access to Fund facilities automatic would be inconsistent with the organizations’ basic purpose.

John Williamson (Institute for International Economics, Washington) disagreed, arguing that the source of the Fund’s influence is not private information, but the ‘own money’ it provides to facilitate burden-sharing among other creditor countries. He also referred to other popular views of the Fund’s role – as a macroeconomic policy adviser, and as an organizer of financial rescue packages (attributing these to Stanley Fischer and Jeffrey Sachs respectively).

In ‘Seigniorage, Inflation and IMF Intervention’, Marcus Miller and Lei Zhang use a simple monetary model to show various ways in which the presence of an external agency, such as IMF, might affect rates of government spending and inflation in an economy which relies heavily on seigniorage to finance its deficit. The seigniorage was assumed to follow a geometric random walk subject to intervention barriers for spending cuts (or increases) chosen by the government. Optimal barriers were defined using a political-economy model, where the government faces a trade-off between expected inflation and seigniorage. Miller and Zhang showed that if the government is allowed to intervene actively, seigniorage and inflation will tend to increase significantly. In particular, in a case where both increasing and cutting seigniorage are costless, active government intervention leads to infinite seigniorage and inflation.

Amlan Roy (Queen Mary and Westfield College) welcomed the application of optimal control theory to analyse trigger points for budget cuts. Referring to high expected inflation scenarios, he suggested that the simple demand for money function used in the paper for simulation was more appropriate than Cagan’s original formulation. David Vines (Balliol College, Oxford, and Australian National University) stressed the existence of multiple equilibria, pointing out that for any given seigniorage level the Laffer curve means that there is one good luck (low inflation) and one bad luck (high inflation) solution.

Continued - William Perraudin and Pinar Bagci's ‘Do IMF Programmes Work?’...

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