Tito Cordelia

The recent wave of financial crises has fueled a heated debate on the effectiveness of rescue packages provided by the international financial institutions (IFIs). Do the IFIs fail to provide distressed countries with enough resources to mitigate the impact of adverse real shocks (“real hazard”)? Or do the IFIs undermine market discipline through their excessive largesse (thus creating “moral hazard”)? These somewhat conflicting possibilities reflect the relative weight of “real hazard” versus “moral hazard” considerations. A number of recent studies address this issue and provide insights into a trade-off that is relevant for designing and implementing rescue packages.

Does IMF lending make borrowers and lenders much more imprudent? In other words, are the moral hazard costs associated with IMF interventions so large that “the IMF might consider changing its name to IMH—the Institute for Moral Hazard” (Barro, 1998)? Or are they so small that “Argentina’s difficulty in obtaining IMF lending has to do with an overstating of the problem of moral hazard” (Griffith-Jones, 2003)?

Ultimately these are empirical questions. Although no study has provided a complete cost-benefit analysis of rescue packages along these lines, a number of IMF researchers have gathered substantial empirical evidence on these questions. Several studies have looked at the real cost associated with financial crises, others have provided estimates of the likely moral hazard implications of rescue packages.

The cost of real hazard, that is, of sharp declines in member countries’ economic performance, has been documented by several authors. With respect to the social costs, Baldacci, De Mello, and Inchauste (2002) show that financial crises are associated with an increase in poverty and, in some cases, income inequality. Their view is that such negative effects call for the provision of targeted safety nets. Corbacho, Garcia-Escribano, and Inchauste (2003) look at the effects of the Argentine macroeconomic crisis using urban household surveys. This allows them to identify the most vulnerable households, to investigate whether employment in the public sector and government spending served to decrease vulnerability, and to shed light on the mechanisms used by households to smooth the effects of the crisis.

Other studies focus on the output costs of financial crises. Gupta, Mishra, and Sahay (2003) use a broad sample of 195 currency crises in 91 countries from 1970 to 1998 to examine the output response to the crises. They show that, while the majority of crises have been contractionary, more than 40 percent of them turned out to be expansionary. Moreover, output contraction was greater in large and advanced economies than it was in small and developing countries. This finding contrasts with Disyatat’s (2001) view that developing countries are more exposed to output collapses because of the vulnerability of their banking sector. Finally, Cerra and Saxena (2003) study output recovery in the aftermath of the Asian crisis and decompose the permanent and transitory components of recessions. Their main finding is that while growth recovered fairly quickly after the crisis, there is evidence of permanent losses in the levels of output in all the six countries considered in the study.

To better understand the positive and negative consequences of financial crises on the industrial structure of a country, Borensztein and Lee (2002) evaluate the differential impact of the Korean financial crisis on various industrial sectors. Their main finding is that, after the crisis, credit appears to have been reallocated from the chaebol-affiliated firms to more efficient and less connected ones. Along similar lines, Haksar and Kongsamut (2003) examine the performance of the Thai corporate sector, and show substantial heterogeneity across firms in their pattern of recovery from the crisis.

Estimating the moral hazard costs of IFIs’ interventions is an even more difficult exercise. Indeed, while real costs are observable, moral hazard is not. To test for the existence of moral hazard associated with international lending, Lane and Philips (2000) look at how emerging market bond spreads reacted to a number of IMF-related news items between 1995 and 1999. They only find two out of 22 episodes in which interest rate spread behavior was consistent with the moral hazard hypothesis. One of these two episodes was the increase in emerging market spreads in the aftermath of the Russian 1998 default. This event is analyzed by Dell’Ariccia, Schnabel, and Zettelmeyer (2002), who look at the level and cross-country dispersion of spreads across relatively tranquil periods before and after the August 1998 Russian crisis. They find that, consistent with the moral hazard hypothesis, the failure to provide Russia with a generous rescue package increased emerging market spread levels, sensitivity to fundamentals, and cross-country dispersion.

Even if one accepts that international bailouts may create investor moral hazard, the question remains of who pays for such excessive risk taking. Is such moral hazard financed by global taxpayers? Jeanne and Zettelmeyer (2001) address this critical issue. Looking at the IMF’s repayment record, they argue that official crisis lending de facto involves virtually no cost to the rest of the world. Along similar lines, Joshi and Zettelmeyer (2004) estimate the IMF’s realized transfers to emerging and developing countries for the period 1973–2003. On the basis of their estimates, they suggest that it is implausible that such transfers could have been a source of significant moral hazard in lending to emerging market countries.

If countries (almost) always repay the IMF, then IMF rescue packages should not be considered as state-contingent transfers but as state-contingent loans, that is, as fairly priced country insurance policies. The effect of such contracts has recently been studied by Cordelia and Levy Yeyati (2004). They identify the conditions under which the positive insurance effect of a rescue package more than offsets its moral hazard consequences. In particular, they show that insurance, especially when made contingent on the occurrence of adverse external macroeconomic shocks, is more likely to foster reforms in crisis-prone volatile economies. This effect is similar to the value effect created by a bank bailout (Cordelia and Levy Yeyati, 2003).

The implication of this body of research is that one should carefully weigh moral and real hazard considerations in the design of IMF rescue packages. Although the real hazard costs are quite well documented, the evidence on moral hazard is more shaky, in part, because it is more difficult to gather. On the basis of the existing evidence, Rogoff (2002) rules out the possibility that the moral hazard element associated with IMF lending is as large as some of the IMF critics have suggested. His view is somehow similar to that of his predecessor, Michael Mussa. Indeed, Mussa (1999) argued that the problem of moral hazard arising from international financial support has been greatly exaggerated, and that the main cause of financial crises may not be moral hazard but rather the real hazard that results from lack of proper hedging on the part of the country authorities and the international financial system.