Working Paper: NBER ID: w10125
Authors: Giancarlo Corsetti; Bernardo Guimaraes; Nouriel Roubini
Abstract: It is often argued that the provision of liquidity by the international institutions such as the IMF to countries experiencing balance of payment problems can have catalytic effects on the behavior of international financial markets, i.e., it can reduce the scale of liquidity runs by inducing investors to roll over their financial claims to the country. Critics point out that official lending also causes moral hazard distortions: expecting to be bailed out by the IMF, debtor countries have weak incentives to implement good but costly policies, thus raising the probability of a crisis. This paper presents an analytical framework to study the trade-off between official liquidity provision and debtor moral hazard. In our model international financial crises are caused by the interaction of bad fundamentals, self-fulfilling runs and policies by three classes of optimizing agents: international investors, the local government and the IMF. We show how an international financial institution helps prevent liquidity runs via coordination of agents' expectations, by raising the number of investors willing to lend to the country for any given level of the fundamental. We show that the influence of such an institution is increasing in the size of its interventions and the precision of its information: more liquidity support and better information make agents more willing to roll over their debt and reduces the probability of a crisis. Different from the conventional view stressing debtor moral hazard, we show that official lending may actually strengthen a government incentive to implement desirable but costly policies. By worsening the expected return on these policies, destructive liquidity runs may well discourage governments from undertaking them, unless they can count on contingent liquidity assistance.
Keywords: No keywords provided
JEL Codes: F33; F34; N20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| IMF lending (F34) | crisis likelihood (H12) |
| larger IMF liquidity provisions (F33) | willingness to roll over debts (G33) |
| willingness to roll over debts (G33) | probability of a crisis (H12) |
| IMF liquidity support (F33) | moral hazard (G52) |
| IMF liquidity support (under certain conditions) (F33) | government behavior (H10) |