Voicing what has become a widespread concern among emerging market economies, Henrique de Campos Meirelles, Governor of Brazil’s central bank, recently said that his country “would like to see a facility that prevents crises, particularly when they are caused by changes in market sentiment that have nothing to do with emerging markets in general.” With available “insurance” options against runs being limited and costly, is there anything that the international community can do? One possible alternative, a new IMF Working Paper argues, is to create a facility that could extend automatic credit to eligible countries at a predetermined interest rate.
Many recent emerging market financial crises followed a similar script: a sudden increase in the perceived debt rollover risk led to an escalation of interest rates that made otherwise sustainable levels of debt unsustainable. As a result, emerging market economies have started to feel that globalization, for all its potential benefits, opens the door to self-fulfilling runs. In the absence of better insurance alternatives, most such economies have been favoring self-insurance via the accumulation of reserves, either in the central bank or in the banking sector through the imposition of liquid asset requirements. In many cases, however, the cost of holding reserves— that is, the country’s borrowing costs in excess of the returns offered by high-grade liquid assets— can be substantial.
Other options have been explored. Two countries— Argentina and Mexico—have experimented with private insurance in the form of a contingent credit line with a consortium of financial institutions, but with disappointing results. There is little scope to diversify highly correlated emerging market risk, which limits the coverage and increases the cost. And, unlike standard insurers, insuring banks can hedge their exposure by selling the country’s assets, thereby fueling the run.
Another alternative is to insure with the IMF. The problem is that current IMF facilities are more suited to fundamental solvency crises than to nonfundamental self-fulfilling runs. These facilities emphasize corrective actions, and their disbursements are backloaded and conditional, and usually follow arduous negotiations. This combination explains why governments in emerging market economies prefer to pay lofty rates in private markets before turning to the Fund. In any case, the amount and timing of IMF assistance are, a priori, highly unpredictable, and unpredictable assistance is not what is needed to prevent a run.
Yet another option is to have international financial institutions offer a streamlined lending facility in the event of an “exceptionally large” capital account reversal. This idea is not new. It dates back to 1972, was debated by the IMF’s Executive Board in late 1994 right before the Mexican crisis, and it regained momentum after the Asian crises.
Against this background, in 1999, the IMF launched its Contingent Credit Lines (CCL) to help countries with sound fundamentals cope with liquidity crises by qualifying them for IMF financial assistance before the need arose. Eligibility for such assistance, however, remained subject to IMF approval upon the country’s request, and governments may have been disheartened by the possibility that markets might interpret a mere request for prequalification as a signal that something was amiss. For this and possibly other reasons, the facility went unused and was phased out in 2004.
Current IMF facilities are more suited to fundamental solvency crises than to nonfundamental self-fulfilling runs.
Automaticity is key
Since then, there have been extensive discussions about the role of the IMF as international lender of last resort, the advantages of ex ante conditionality, and the lackluster performance of the CCL.
The alternative proposed here—a new country insurance facility (CIF) through which the IMF could address the shortcomings of previous approaches and handle short-lived self-fulfilling liquidity crises—is a natural offspring of that debate. A CIF would entail the creation of a liquidity window, through which eligible countries would have automatic access to a line of credit at a predetermined interest rate to cover short-term financing needs. By offering instant liquidity, the facility would place a ceiling on rollover costs—thus avoiding debt crises triggered by unsustainable refinancing rates, much in the same way as central banks operate in their role of lenders of last resort.
Why would this scheme succeed where the CCL failed? The key is automaticity. It is essential for preempting liquidity runs, and it would distinguish the CIF from other IMF facilities, including the late CCL, which required a prequalification process.
A blueprint for country insurance
The appeal and feasibility of the proposed CIF hinge on the balance between two basic principles: predictability and sus-tainability. The first requires that at each point in time there is certainty regarding a country’s eligibility—that is, no “constructive ambiguity” should be allowed. The second requires that, at the prefixed interest rate and without the need of unrealistic improvements in the fiscal stance, eligible countries should be able to repay their obligations. Maastricht-type criteria on debt-to-GDP ratios and the fiscal deficit are natural candidates for eligibility criteria. In addition, to the extent that foreign currency debt exposes a country to swings in the real exchange rate, foreign-currency-denominated debt could carry greater weight in any debt-to-GDP eligibility threshold.
Following lender-of-last-resort practices, the CIF could charge a penalty rate relative to precrisis levels. Thus, the interest rate of the facility could be set at a premium over the risk-free rate corresponding to the currency and duration of the credit line (as is customary when computing charges in multilateral nonconces-sional loans). The spread should be set low enough so as not to compromise the country’s repayment capacity and high enough to prevent abuse of the facility and to maximize the country’s efforts to regain access to private markets. Something in the range of 300—400 basis points appears to be reasonable.
The idea behind the CIF is to stop and reverse short-lived liquidity runs—and, ideally, to have the facility’s mere existence help prevent them altogether. For this reason, CIF loans should be short term. However, whereas longer maturities may induce undue reliance on the CIF, too short a maturity may leave open the possibility of a new run once the loan comes due. Striking the right balance would inevitably involve some arbitrariness. One possibility would be to set the duration at six months with the option to renew, at a higher rate, for another six. In this way, the CIF would represent a shorter-term alternative to the IMF’s Supplemental Reserve Facility.
Naturally, no set of eligibility criteria is fail-safe. Liquidity crises may not be undone during the life of the loan and may even evolve into a solvency crisis. If so, CIF assistance would need to be phased into an IMF-supported policy program. For this reason, the size of the CIF loan should not exceed the amount of resources commonly available under an IMF-led rescue package. However, the often-made argument that small IMF-supported programs are ultimately counterproductive applies even more starkly to the CIF. A visibly inadequate amount of funds would simply fuel the run. To effectively insure a country against liquidity runs—and, ideally, to preempt liquidity runs altogether—the facility should cover most of the country’s short-term financing requirements. Thus, any limit on the size of the facility automatically imposes a sub-ceiling on the short-term debt-to-GDP ratio (the stock of debt coming to maturity over the life ofa CIF loan), so that the “insurance coverage” is close to 100 percent.
The appeal and feasibility of the proposed country insurance facility hinge on the balance between two basic principles: predictability and sustainability.
Insurance as a reward for good policies
In the past, critics have charged that excessive largesse in the rescue packages of international financial institutions has undermined market discipline and diminished the authorities’ incentives to pursue sound policies. As a result, the debate on how to reform the international financial architecture has centered on how to limit financial assistance rather than on how to make it more accessible. However, the untested presumption that financial assistance reduces the incentive to put in place sustainable policies is not necessarily true, particularly when crises are triggered by factors beyond policymakers’ control.
On the contrary, if countries are provided with some degree of insurance against liquidity runs, long-run efforts would ultimately be rewarded, inducing the right incentives. This argument applies fully to the CIF outlined here. Furthermore, the incentives embedded in the eligibility conditions should make countries more willing to embrace sustainable policies to gain access to the facility. In this way, through the “carrot” of insurance, the CIF would replace the standard ex post conditionality with voluntary ex ante conditionality.
Ultimately, a well-designed CIF that prevents liquidity runs should be used very infrequently, if ever. Its impact should be visible, however, in an increasing number of eligible countries and in lower and less volatile emerging market risk premiums. This is indeed the metric by which the success of a CIF should be measured.
This article is based on IMF Working Paper No. 05/23, A (New) Country Insurance Facility. Copies are available for $15.00 each from IMF Publication Services. See page 80 for ordering information.