Chapter 34 Moral Hazard and the Role of International Rescue Programs
- International Monetary Fund
- Published Date:
- January 2001
I first want to make clear that in everything that follows, there are two very specific assumptions. First, that it is a high priority to maintain capital account convertibility, and second that I will be referring specifically to emerging economies, where emerging is defined as economies that do not have permanent access to international capital markets. This definition is very important to understand the line of reasoning that I will follow.
In my brief remarks, I would like to focus on the role of the IFI’s and the trade-off between on, the one hand, reducing the probability of a liquidity shock, perhaps caused by some contagion effect, and, on the other hand, the problem of moral hazard.
However, before I get to the specifics we need to consider the appropriate overall policy stance of countries since the role of the IFI’s should not substitute for good policies but rather to complement them.
In very broad terms, I would suggest that one precondition for this overall policy stance is of course sound macroeconomic policies where consistency between monetary, exchange rate and fiscal policy is a must. However, secondly I would suggest that to participate in world capital markets, emerging countries also need to have an appropriate financial policy.
This financial policy may consist of a number of elements including strong banking regulations regarding capital, provisioning and risk management. However, for emerging markets I would stress that it must also include a liquidity policy. These policies in the financial sector should be independent of the exchange rate regime in place. The general point is that as emerging economies tend to be subject to higher volatility they need a strong banking sector irrespective of their monetary arrangements.
However, as I mentioned in my definition, emerging markets, for reasons that I think we don’t totally understand, may suddenly be cut off from international credit and government bond markets may simply dry up. This means that an emerging country has less degrees of freedom than say a typical G-10 country. For example, a G-10 country facing a liquidity problem in the banking sector can inject liquidity and at the same time sterilize that injection without jeopardizing monetary or exchange rate targets. An emerging country, whose government bond market has become illiquid does not have that option. Moreover, the monetary injection will not normally be accompanied by an increase in the demand for domestic liabilities and hence the exchange rate will instantly be put under pressure. Note that this also means that emerging countries have significantly less freedom to define their own monetary policy. Take an emerging economy that ostensibly has an independent monetary policy, let’s say a flexible exchange rate, but no liquidity policy. If there is a liquidity shock and the Central Bank feels forced to inject liquidity into the banking sector then for the arguments I have given above this will most likely be reflected directly in the exchange rate so the independent monetary policy is really illusory. To put this another way, whatever macroeconomic rule an emerging economy adopts, whether this be an exchange rate, monetary or inflation target, then this rule may be put in severe jeopardy given a lack of access to international credit and insufficient liquidity. Of course an emerging country, which has no such rule, can claim greater “flexibility.” However, “flexibility” in this context is really “instability.”
Therefore, there is a need for a liquidity policy. I strongly believe that this policy should take into account the liabilities of both the private and public sector both in local and in foreign currency and with residents and nonresidents. In other words, what is required is an overall or Systemic Liquidity Policy. In recent crises, depending on the country context, we have seen liquidity problems in public debt, in bank debt, in other private sector debt and we have seen problems with foreign liabilities and with domestic liabilities. Our experience in Argentina, through with very different monetary and exchange rate arrangements, is that domestic residents run at least as fast as foreigners and that peso liabilities can be just as serious a problem as liabilities in dollars. I therefore would resist making strong distinctions between domestic and foreign or between resident and nonresident. I repeat, emerging countries may need to think about an overall or systemic liquidity policy.
Let me, as an example, refer more specifically to the banking sector where normally there will be an important concentration of liquidity risks. The instruments of a systemic liquidity policy can and probably should include (i) holding a specified proportion of liabilities in internationally liquid assets (i.e., foreign assets); (ii) developing internationally liquid instruments such as standardized mortgages, and securitized products; (iii) facilitating international contingent lines of credit for banks; (iv) holding significant international reserves of the central bank to provide liquidity lender of last resort support, and finally (v) arranging international contingent lines of credits for the central bank, to enhance those reserves.
Holding international reserves to back liabilities is clearly expensive, especially for emerging economies where the banking system is the largest component of the capital market. In economies where loans are a scarce good and where capital markets are underdeveloped there is a strong trade-off between a prudent liquidity policy and domestic credit creation. An extreme liquidity policy means narrow banking, and narrow in the strictest sense, i.e. banks holding only internationally liquid short-term papers (U.S. T-bills, for example). This policy implies no domestic credit in the normal way.
To enhance this trade-off between liquidity and credit formation the standard solution in the domestic context is the creation of a LOLR. This function is usually performed by the central bank, where the trade-off between the potential provision of liquidity, and hence control of the problems of “runs” and “contagion,” versus the creation of a moral hazard has been well-understood since the last century. Indeed, we central bankers know very well the principles proposed by Bagehot in 1873, which try to define explicit rules that would allow an effective lender of last resort to operate but at the same time minimize the moral hazard created.
What I then see is a clear need for an informed debate of these issues but at the international rather than domestic level. We need a set of rules for an effective international lender of last resort to improve the trade-off between liquidity and credit but at the same time controlling the moral hazard.
I think we understand the moral hazard issue reasonably well now. Moral hazard occurs when creditors believe that, irrespective of the soundness of the investment being financed with their money, they are able to get somebody else to absorb the costs of their mistakes. That means that, in some of the recent crises, the mistakes are clearly shared by the borrower as well as by their creditors and also their supervisors. To the extent that private banks assumed that unlimited assistance to countries with problems was available—and to the extent that their supervisors did not require sufficient capital or provisions against those risky investments—then they must share the blame with the local authorities themselves.
I am not sure however that we fully understand the mechanisms, the depth nor the implications of contagion. Economists tend to focus on interesting but complicated explanations of contagion such as the low incentives for diversified fund managers to learn about individual countries, whereas market traders focus on more technical issues such as liquidity effects and the necessity to make margin calls and the effect of dynamic hedging strategies. In any event a serious topic for research is to understand the market microstructure issues which have led to this extremely indiscriminate sell-off of emerging market debt.
I am not sure either that we fully understand the depth nor the implications of this contagion. It is clear that most emerging countries are effectively cut off from world capital markets at current spreads. This obviously has a significant and self-fulfilling negative effect on those very same economies. The liquidity policy that I have described above is extremely important then to buy time. The best place to be when there is a huge storm is safely in the harbor and, with a strong liquidity policy, countries do not need to venture out to sea to place debt in these markets. However, this is only a partial solution. It does not solve the problems in these markets, it just buys time.
To solve the problem and so to preserve open capital accounts—which as I have said is an objective that I think we should keep as a high priority—then the international community needs to develop an international LOLR to protect countries from such storms. Such an institution would have to act with rules similar to those that apply to a central bank in relation to domestic banks. In a domestic context these include (i) strict monitoring so that the solvency of the bank is not in doubt and (ii) plenty of assistance to the financial system in general and especially to those banks that face the risk of contagion from the particular bank that is in difficulties.
Of course, this is easier said than done even in a domestic context. Central banks do not like to be too explicit about which banks would receive assistance and which would not. This policy has become known as constructive ambiguity. Whatever its merits in a domestic context, it is clear that in an international setting something more predetermined, less arbitrary, is needed, so that it is crystal clear that there are no political issues involved. The need for transparency in procedures and practices becomes paramount.
In fact I would advocate a two level approach. Countries that satisfy a set of criteria perhaps including a set of Maastricht type fiscal rules plus a set of financial criteria related to the soundness of their financial system should gain access to virtually unconditional lending to prevent them from being affected from other countries’ problems. The conditionality in other words would be ex ante and not ex post and the idea is that this should then be a preemptive program such that everyone knows that the funds are available if required without conditions. In fact the IMF already does this although not quite in name. Argentina’s EFF arrangement with the fund includes a substantial amount, which Argentina has chosen not to use, but is available just in case. What I am suggesting is in some sense only a formalization of these arrangements.
However, we must also realize that the nature of crises has changed. As stressed in the work of Michael Gavin and Andrew Powell, recent crises have reflected sharp disequilibria in financial stocks rather than the flow disequilibria typical of the 1970’s balance of payments crisis. This has two strong implications. First, it means that the IFI’s, whether they like it or not, are put in a very analogous position to a financial lender of last resort but second, the amounts of assistance required have grown considerably. The total sum committed for the packages to Mexico and Argentina in 1995, plus Thailand, Indonesia, Korea, and Russia amount to a staggering $185 billon dollars. We therefore need an effective lender of last resort which can commit significant quantities to countries that have satisfied a set of ex ante policy targets.
For countries that do not satisfy these policy targets but have some fundamental problems a different approach is then required corresponding closely to the more traditional operations of the IMF. In these cases, a substantial amount of policy dialogue and conditionality needs to be applied at the time of disbursement. Which countries are in the first group and which countries are in the second group obviously needs considerable research and may involve difficult political decisions. However, such an approach would clearly give a strong message to countries to get their houses in order.
In any event, I think we must also recognize that at some point we will reach the political limits of the amounts of official financing available. It is then both beneficial and necessary to “bail in” the private sector when it comes to crisis prevention and crisis resolution. My own view is that the IMF should probably focus on the arrangements I have just described but an entirely appropriate and complementary role for the MDB’s (World Bank and IDB) would be to assist countries to set up private sector LOLR type facilities. As many of you know, in Argentina we have set up a private contingent liquidity rep. facility. We have also proposed that the unique status of the IDB and the World Bank implies that they have an extremely important role in complementing the private capital in this facility and that the presence of the multilaterals will significantly enhance the quality of this private lender of last resort arrangement.
This facility has a very important role in Argentina in helping to ensure that credit still flows to enterprises, and especially small and medium sized firms, in situations where banks suffer a liquidity problem from some totally external event. Anyone who thinks that this facility does not have a “productive purpose” should analyze the Tequila period in Argentina carefully, where a sharp liquidity crunch caused a severe recession and increased unemployment and poverty significantly. These ideas are general, they do not depend on our particular monetary arrangements and indeed several other countries have requested detailed information regarding the structure of our facility.
To conclude, I want to leave you with two main ideas. The first is that I still do not think that we understand well how contagion effects really occur. We also urgently need a much better understanding of the microstructure of international capital markets and specifically we need to analyze the behavior of hedge funds and mutual funds. For this we need information. As a first step I recommend that we gather position data on these funds and we analyze carefully the motivations for their actions. Just as the world has developed complex regulations for banks, which protect against systemic banking risk, it may be that their are particular characteristics of these markets which imply that we need regulations on world capital market players to protect the integrity of these markets. Having studied in Chicago, I am a firm believer in market processes but I think we must recognize that markets may function well or badly depending on the institutional settings. We need to be much better informed on how international markets actually function if we are to rely on these markets for countries’ financing needs.
Second, we need to develop an effective lender of last resort. I know that there is resistance to these ideas, but it is very important to analyze the costs and benefits of action and inaction. The risk of action is that we might not get it exactly right from the beginning. However the question is whether action will improve on the current overall arrangements. The risk of inaction would be to leave the world as a very dangerous place in particular for emerging countries. Indeed it would run the enormous risk of going back in the process of opening of the capital account. Many may decide that the degree of volatility in capital markets is just too high to keep the capital account open.
Acknowledgment: I would like to thank the Federal Reserve Bank of Chicago for allowing me to comment on these very important topics in this excellent conference at this very opportune time.