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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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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.

Can the Moral Hazard Caused by
IMF Bailouts be Reduced?

Geneva Reports on the World Economy Special Report 1

£10 (Approx. €15 / $15)

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