Chapter 35 Moral Hazard and the Role of International Rescue Programs
- International Monetary Fund
- Published Date:
- January 2001
The problem of moral hazard has been at the center of the international financial crises of the past few years, stretching from Mexico via Asia and Russia to Latin America. The trend in the spreads for capital investments in emerging markets and other risky investments up to 1997 shows that the risk spreads declined constantly, even though the magnitude of the risks remained more or less unaltered, and that at the same time the willingness to make risky investments and the respective capital flows increased dramatically.
This trend was due to several factors. For example, attention should be drawn to the preference of many emerging market countries for fixed exchange rates, the intensifying competition among all kinds of institutional investors, an increasing international debate on the function of central banks and international organizations as “lenders of last resort,” and the development of ever more sophisticated instruments for managing and diversifying risks. In the latter case, very often vague definitions of risks and “bold” proxy hedges were in evidence.
But the behaviour of the international financial institutions undoubtedly also played a role. Often encouraged and pressurized by the governments of the afflicted countries, they stepped into the breach with increasingly larger rescue programs whenever a new financial crisis arose, in some cases interpreting the statutes governing lending and the permissible range of operations very liberally.
The financing programs for Thailand, South Korea, Indonesia, and Russia illustrate this clearly. Private investors generally gained the impression that the considerable—if diminishing—spreads were a safe bet since. If things came to a head, international rescue programs would enable them to withdraw in good time from their investments, which had indeed been recognised as being risky from the outset. For example, talks with our German banks held during the Asian crisis showed that the credit analysts of these banks had in fact drawn their management board’s attention to the precarious financial structure in the relevant countries, both regarding the currency denomination of the loans and the pattern of maturities. However, the boards nevertheless continued their expansive lending activities as they were convinced that the international community would not leave these countries, and thus also their creditors, in the lurch. This attitude constitutes the core of the moral hazard problem.
There can be no doubt that the situation has changed fundamentally in the meantime. Since it became clear that even the most extensive rescue programs can no longer cope with the potential for capital flight, which has increased drastically, investors’ risk awareness has been aroused again owing to the painful experience made in Asia and Russia. This is illustrated by the trends in spreads at many levels, for example between industrial countries and emerging markets, between government and private sector bonds, even in interbank trade. In this respect, the moral hazard is receding, which, taken by itself, is a welcome development, even though the pace and the scope of this trend are contributing significantly to the current apprehensions.
Now I wish to deal specifically with the international rescue programs mentioned in the title by addressing three aspects: the role of the IMF in financial crises, the appropriate size of financial packages, and the appropriate conditionality of fund supported programs.
As far as the role of the IMF in managing financial crises is concerned, I would like to make one thing clear at the outset. The first choice should be no intervention in the markets. However, if—but only if—financial intervention is unavoidable, the IMF should be the “lead manager.” The reasons:
1. The IMF has acquired an outstanding level of expertise in dealing with challenges to the international monetary system.
2. No other institution can better express the concerns and deliver policy recommendations. This remains true despite the fact that some of these recommendations are and should be the subject of a lively debate.
3. The past months have demonstrated once again that the fund is a very flexible institution and can act quickly when a crisis occurs.
Let me now turn to the second issue—the size of IMF financial packages. This issue is probably the most controversial one.
First, I do not share the view that extraordinarily large financial packages have automatically calming effects on financial markets.
• Neither in Asia nor in Russia did the announcement of large packages stop the capital outflows, either immediately or later, because—as mentioned—everyone could see that even these large packages were by far not large enough to finance all possible capital outflows.
• I suspect that such announcements may even intensify outflows. It is like “ringing the bell,” thereby promoting the perception of an emergency. It indicates additionally that the exit door may be open only for some time.
• The situation was calmed only after crisis had made credible commitments to implement reforms and after the private sector had participated in finding a solution to the crisis.
• Large financial packages favor inevitably moral hazard and create the basis for the next crisis. Therefore:
• It is crucial for the fund to concentrate on its catalytic role and involve private creditors at an early stage. Concepts for sharing the burden of unavoidable losses are necessary. I know this raises a number of complex issues. The approach taken in Korea and—in a different way—in Indonesia, however, might provide a basis on which we can build.
• While advocating minimal intervention, I strongly prefer voluntary solutions. But if market participants cannot agree, additional means should be taken into consideration, for example a moratorium or a standstill.
I would like to turn now to my third and last issue: the appropriate conditionality of fund supported programs.
• I think the fund’s two-pronged approach of macroeconomic adjustment and structural reforms is fundamentally appropriate.
• The sharp rise in interest rates was necessary—although not sufficient—to stop or at least reduce capital outflows.
• Fiscal austerity is in many cases appropriate to reduce current account deficits, and to finance to some degree the financial sector restructuring. Anticyclical fiscal deficits to avoid or mend recession have to be handled very carefully.
• The IMF is doing well to insist that far-reaching financial sector reforms be carried out in order to correct these flaws.
In the context of the Asian and the Russian crisis, the fund had to act under extremely difficult economic and political circumstances. It found itself on the horns of a dilemma: it had to act quickly enough to prevent a deterioration of the crisis without acting prematurely. Fund-supported programs may be distorted by political shortcomings. To that extent, the outcome may not be optimal from an economic point of view.
Having said this, I conclude with two “footnotes.” Firstly, we should also discuss the criticism from Martin Feldstein, who argued that some structural measures recommended in Asia look like being from the trade agenda of some member countries of the fund. In my view, unnecessary intervention in political sovereignty should be avoided. It may lead to a delay in seeking the help of the IMF in crisis situations. And that is exactly what we want to avoid.
Secondly, the incorporation of second lines of defence in international rescue programs ought to be dispensed with if—when it comes to the crunch—it turns out that they were not really meant seriously and were little more than “window-dressing.” The credibility of international rescue programs is too valuable and too vulnerable to be jeopardized in that manner.