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We are grateful to Jim Boughton, Rex Ghosh, Alberto Martin, Jaume Ventura, Xavier Vives, and seminar participants at the IMF, UPF, and IESE for comments and suggestions.
The IMF acts as a delegated monitor for the creditors ex post (in a crisis), which benefits the debtor country ex ante (when the borrowing takes place): “the IMF’s role is to substitute for the missing contracts between the sovereign and individual foreign investors and thereby to help the host country benefit fully from is capital account liberalization. Accordingly, the IMF should act as a delegated monitor and a trustee for foreign interests precisely to facilitate the country’s favorable access to foreign borrowing.” (Tirole, 2003)
See Federico (2001) for an earlier paper that models both ex post and ex ante conditionality within one framework. Ex ante conditionality has also been modeled by Jeanne and Zettelmeyer (2001a) and Weithöner (2006), and is implicit in the analysis of Gale and Vives (2002). See also the survey by Frech (2005).
See Jeanne and Zettelmeyer (2001b) and Zettelmeyer and Joshi (2005) for details. Note that IMF lending to poor countries has been different in this regard, involving both heavily subsidized interest rates, and eventual deft relief. This has not been the case for middle income countries.
Article I (v) of the IMF’s Articles of Agreement. The evolution of IMF lending practices in the 1950s and early 1960s is described, in order of increasing detail, in Fleming (1964), Spitzer (1969), and Horsefield (1969). Boughton (2001, Chapter 13) provides a brief summary.
There are, however, predecessors to IMF conditionality in the context of official lending, particularly lending by the League of Nations: see Santaella (1993), and Khan and Sharma (2001) for an overview.
The main exception is subsidized lending to low income countries, which was ultimately forgiven in many cases following the “highly indebted poor countries” (HIPC) and “multilateral debt relief” (MDRI) initiatives of the last decade (IMF, 2007b).
Polak (1991), p. 54, writes: “Ex ante conditionality would be unlikely to work. It seems too much to hope that a government interested primarily in its own survival would be held back from unwise policies by the mere knowledge that the IMF would not stand ready to mitigate the severity of the eventual adjustment crisis.” Implicit in this sentence is the view that traditional IMF lending was not a cause of unwise policies to begin with. In the context of the 1980s reschedulings, this is indeed a plausible view, since the interest subsidy implicit in IMF lending was “modest” (Polak, p. 55), and it was hard to argue that the IMF was facilitating redistribution from bank creditors to countries.
Barro (1998). See also Wall Street Journal (April 23, 1998); Calomiris (1998a); Meltzer (1998); Willett (1999); Council on Foreign Relations (1999); Nunnenkamp (1999); Mussa (1999, 2004); International Financial Institutions Advisory Commission (2000); and Eichengreen (2000). An extensive empirical literature on moral hazard ensued. Key contributions include: Zhang (1999); Lane and Phillips (2000); Kamin (2002); Brealey and Kaplanis (2004); Haldane and Scheibe (2005); Dell’Ariccia, Schnabel, and Zettelmeyer (2006); and Lee and Shin (2007). Kim (2007) presents a calibrated model to gauge the potential moral hazard effect due the expected subsidy embodied in IMF loans (resulting from the riskiness of IMF lending).
Calomiris (1998b), Council on Foreign Relations (1999), International Financial Institutions Advisory Commission (2000), Jeanne and Zettelmeyer (2001a,b; 2005), Kenen (2001), Cohen and Portes (2004), Cordella and Levy Yeyati (2005) and Ostry and Zettelmeyer (2005).
Recently, there has been an attempt to revive the idea of a large-scale credit window for qualified countries (the “Reserve Augmentation Line”, or RAL, which is currently under discussion by the IMF’s Executive Board; see IMF, 2006, 2007a). Compared to the CCL, the RAL would have a more clearly defined qualification framework while requiring less conditionality ex post.
What follows does not pretend to be a complete survey of models involving the IMF. It leaves out, in particular, a literature on IMF conditionality focused on conflicts of interest between the IMF and the borrowing country and on program compliance (see Mosley, 1987, 1992; White and Morrissey, 1997; Bird, 1998; Killick, 1996, 1997, 1998; Hermes and Schilder, 1997, Drazen and Fischer, 1997, and Joyce, 2003). Similarly, it ignores papers on whether conditionality should be outcome-based rather than policy-based (Ivanova, 2006); and how streamlined conditionality should be (Erbas, 2003). The focus here is on models that rationalize the IMF’s role in terms of correcting particular market or policy failures.
Hence, unlike in the literature decribed as the “second strand” in the discussion above, the rationale for IMF lending is not primarily that it is a large lender relative to the private sector. This said, our model could also be extended, with relatively little change, to encompass this aspect, by introducing the possibility of self-fulfilling runs. This this would not change the main conclusions.
The model also has equilibria with self-fulfilling crises, but we leave this possibility aside in the following.
Thus, there is no moral hazard between the government and the private sector in setting the effort e0. As we will see, there would be no moral hazard even if the government or the private sector were a Stackelberg leader.
Of course, the IMF needs to be large enough to undertake the lending. The difference with respect to the literature is that in our model, there is a role for IMF crisis lending regardless of whether private sector lenders are large and/or coordinated or small and dispersed. In other words, the market failure that generates a role for the IMF is not lack of coordination among private lenders, but rather the inability of the private sector to undertake tranched, conditional lending. As a historical matter, there have been rare attempts by banks to play this role, but they have not been successful (see, for example, Rieffel, 2003, on conditional lending by a group of banks to Peru during Peru’s 1976-78 balance of payments crisis).
Note that the debt overhang problem is still present, in the sense that the government appropriates only θ – (1+ r), rather than the full θ. But if the condition is satisfied, it is nonetheless in the government’s interest to accept the IMF’s conditional lending offer and exercise the crisis resolution effort, even when it would not have wanted to exercise this effort following a private sector rollover. The reason is that that the alternative to accepting the IMF’s offer is receiving nothing, while in the case of the private sector rollover the government could still hope to receive θ – (1+r) with probability 1–π.
This result has been referred to as the “Mussa Theorem,” after the IMF’s former chief economist, Michael Mussa (see Mussa, 1999, 2004; and Jeanne and Zettelmeyer, 2005, for a formal statement). In Mussa’s original formulation, emphasis is put on the fact the IMF cannot be a source of moral hazard provided it is always repaid. The latter is assumed in the setup of our model.
The details of this extension of the model are available upon request to the authors.