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Mr. Francisco Roch and Francisco Roldán
We analyze how concerns for model misspecification on the part of international lenders affect the desirability of issuing state-contingent debt instruments in a standard sovereign default model à la Eaton and Gersovitz (1981). We show that for the commonly used threshold state-contingent bond structure (e.g., the GDP-linked bond issued by Argentina in 2005), the model with robustness generates ambiguity premia in bond spreads that can explain most of what the literature has labeled as novelty premium. While the government would be better off with this bond when facing rational expectations lenders, this additional source of premia leads to welfare losses when facing robust lenders. Finally, we characterize the optimal design of the state-contingent bond and show how it varies with the level of robustness. Our findings rationalize the little use of these instruments in practice and shed light on their optimal design.
Luis Franjo, Nathalie Pouokam, and Francesco Turino
In this paper we build a model of occupational choice with informal production and progressive income taxation. We calibrate the model to the Brazilian economy to evaluate the impact of removing financial frictions on informality. We find that financial deepening leads to a drop in the size of the informal sector (from 37 percent to 22 percent of official GDP), to an increase in measured TFP (by 4 percent), to an increase in official GDP (by 27 percent), to a decrease in tax evasion (by 17 percent) and to an increase in fiscal revenues (by 15 percent). When assessing the response of this policy at different levels of financial development, we find a non-linear relationship between the credit-to-GDP ratio on the one hand, and either the size of the informal economy, or GDP per capita on the other hand. We test these features with cross-country data and find evidence in favor of both types of non-linearity. We also investigate changes in the income tax progressitivity as an alternative policy and find it to be more effective in countries with a medium to high level of financial markets development.
International Monetary Fund. Strategy, Policy, &, Review Department, and International Monetary Fund. Statistics Dept.
This note provides guidance on use of third-party indicators (TPIs) in Fund reports, in line with the policy endorsed by the Board in November 2017.
Galen Sher
Over the last two decades, cash holdings in nonfinancial firms around the world have increased. This phenomenon is particularly concerning in Japan, where the success of Abenomics depends on a transition from stimulus-driven to self-sustaining growth based on private consumption and investment. This paper finds that Japanese nonfinancial firms have accumulated cash at the expense of investment and dividends, hampering this transition. The evidence suggests that cash accumulation is due to financial imperfections combined with rising corporate profitability and uncertainty, while corporate governance plays only a limited role. These firms have cash holdings available for investment of about 5 percent of GDP. Policy options for encouraging the use of these cash holdings include improving firms’ access to market-based financing and discouraging CEO duality.
Mr. Damiano Sandri and Mr. Fabian Valencia
We develop a dynamic stochastic general equilibrium model with financial frictions on both financial intermediaries and goods-producing firms. In this context, due to high leverage of financial intermediaries, balance sheet disruptions in the financial sector are particularly detrimental for aggregate output. We show that the welfare gains from recapitalizing the financial sector in response to large but rare net worth losses are as large as those from eliminating business cycle fluctuations. We also find that these gains are increasing in the size of the net worth loss, are larger when recapitalization funds are raised from the household rather than the real sector, and may increase with a reduction in financial intermediaries idiosyncratic risk.
Yishay Yafeh, Mr. Kenichi Ueda, and Mr. Stijn Claessens
Financial frictions have been identified as key factors affecting economic fluctuations and growth. But, can institutional reforms reduce financial frictions? Based on a canonical investment model, we consider two potential channels: (i) financial transaction costs at the firm level; and (ii) required return at the country level. We empirically investigate the effects of institutions on these financial frictions using a panel of 75,000 firm-years across 48 countries for the period 1990 - 2007. We find that improved corporate governance (e.g., less informational problems) and enhanced contractual enforcement reduce financial frictions, while stronger creditor rights (e.g., lower collateral constraints) are less important.
International Monetary Fund
This Selected Issues paper and Statistical Appendix on Bhutan underlie the macroeconomic impact of Tala, rapid private sector credit growth, and macroeconomic risks. In Bhutan, as the bulk of Tala-related flows go through the government accounts, this requires an appropriate fiscal stance and skillful expenditure management. Strong economic growth will require and lead to a deepening and further development of the financial system in Bhutan. The financial sector seems to be relatively shielded from adverse events, although risks remain.
Mr. Ales Bulir, Mrs. Marianne Schulze-Gattas, Mr. Atish R. Ghosh, Mr. Alex Mourmouras, Mr. A. J Hamann, and Mr. Timothy D. Lane


This paper reviews the design of and experience with IMF-supported programs formulated in response to capital account crises in the 1990s, focusing on the experiences of eight countries: Turkey (1994), Mexico (1995), Argentina (1995), Thailand (1997), Indonesia (1997), Korea (1997), the Philippines (1997), and Brazil (1998). The capital account crises in emerging markets confronted both the affected countries and the IMF with a new set of challenges. The central feature of all these crises was the rapid reversal of capital inflows, bringing about a large and abrupt current account adjustment with pervasive macroeconomic consequences. The crises were characterized by an over-adjustment of external current accounts in relation to what was needed for any reasonable means of sustainability. This over-adjustment was associated with severe macroeconomic disruptions. Beyond the importance of crisis prevention, the experience of these countries suggests a number of lessons for program design in the context of high capital mobility—such as the appropriate roles for monetary, fiscal, and structural policies.

Ms. Ling H Tan, Ms. Kala Krishna, and Mr. Ram Ranjan
This paper models investment/entry decisions in a competitive industry that is subject to a quantity control on an input for production. The quantity control is implemented by auctioning licenses for the restricted input (e.g., a pollution permit or a production license). The paper shows that liberalizing the quantity control could reduce investment in the industry under certain circumstances. Furthermore, the level of investment is quite different when licenses are tradable than when they are not. Key factors in the comparison include the elasticity of demand for the final good and the degree of input substitutability. Two examples are computed to illustrate the results.