IMF Should Act as a Lender of First Resort to Prevent Emerging Market Crises

CEPR DISCUSSION PAPER NO. 4615: TOWARDS A LENDER OF FIRST RESORT

Authors:

Daniel Cohen is Professor of Economics at the University of Paris I (Sorbonne) and Ecole normale supérieure, as well as Director of CEPREMAP.

Richard Portes is President of CEPR, Professor of Economics at London Business School, and Directeur d'Etudes at Ecole des Hautes Etudes en Sciences Sociales (Paris).

In a new CEPR Discussion Paper, Daniel Cohen and Richard Portes propose that emerging market countries commit themselves to an 'indebtedness regime' to prevent the vicious spiral that a confidence crisis can unleash. Confidence crises may lead to crises of the fundamentals: spreads rise, the fiscal position deteriorates, the markets downgrade the country, and spreads rise further. Debt can rapidly undergo a snowball effect, which then becomes self-fulfilling with regard to the fundamentals themselves. Cohen and Portes propose that the country and the IMF should act together before any snowball effect comes into play, since analysis of the debt build-up mechanism shows that it takes time before the situation becomes explosive. This 'indebtedness regime' would be based on the interest rate spreads paid on the debt. If the country spread were to pass a predetermined threshold, to which the country had precommitted as the maximum at which it would borrow, the IMF should act as a substitute for the markets and lend at that rate, while immediately launching an adjustment programme with the country.

The 'indebtedness regime' signifies that the country will take all necessary steps to hold its indebtedness down to a level compatible with the threshold level of interest rates. If the regime is 'credible', so investors are convinced that rates will never go above this level, the 'bad equilibrium' of a vicious spiral is ruled out, in that the mechanism coordinates expectations on a low level. Moreover, this indebtedness regime has the merit of committing the country to a prudent strategy. It would avoid the widespread temptation to allow problems to accumulate before tackling them and in so doing to become vulnerable to a crisis of confidence, which it is then too late to circumvent. This process relies only on market signals (spreads). Spreads both reveal a problem and contribute to creating it. Such confidence crises are preventable, along with the extremely disruptive adjustments and possible defaults they can provoke. This proposal and the use of collective action clauses (CACs) are both supported by a theoretical model and data analysis in the paper. The model shows that self-fulfilling debt crises can happen only when debt restructuring is expected to be inefficient, ex post. The model shows the benefit of a commitment device on debt dynamics in order to avoid confidence crises.

This mechanism could replace the now defunct Contingent Credit Line, although it is quite different both in intent and design. The CCL was created to help 'first-class policy' countries to deal with contagion crises. The reason why no country ever decided to use the CCL was the fear of sending a wrong signal to the market, despite the quasi-pre-qualification clauses that were are attached to it. The mechanism here is constructed to prevent confidence crises, and it relies only on market signals (spreads), so that it would not run into such a risk.