Catalytic Finance: When Does It Work?

1. Catalytic Finance: When Does It Work? Stephen Morris Hyun Song Shin

2. Catalytic Finance Rationale: Partial filling of funding gap by IMF assistance galvanizes other interested parties to fill the rest.

3. An idea born out of necessity? • Huge size of funding gap in 1990s crises • Mexico • Asia • Russia • …

4. Prague Framework, Sept 2000 “the combination of catalytic official finance and policy adjustment should allow the country to regain full market access quickly.”

5. It won’t work: argument 1Powell doctrine • Selection of cases for IMF assistance should be selected rigorously, but the size of package should be large enough to meet funding gap in full. • Anything less will be undermined by coordination on “bad equilibrium”.

6. It won’t work: argument 2Debtor moral hazard • IMF funding will merely substitute for (and postpone) inevitable adjustment effort by the borrower.

7. It won’t work: argument 3Creditor moral hazard • IMF funding merely bails out private creditors who got into trouble. • IMF funding merely substitutes for (and displaces) private lending.

8. On Powell Doctrine • Full funding is sufficient to avert default, but is it also necessary? • Arguments based on multiple equilibria prejudge the issue of whether shoring up of confidence can stave off crisis.

9. Global Game methods • Even when fundamentals are consistent with both good and bad outcomes, better fundamentals are more likely to lead to the good outcome. • IMF funding can alter the terms of the trade-off in the coordination game, tipping the outcome towards the good outcome.

10. Carlsson and van Damme (1993) • Morris and Shin (1998) • Corsetti, Dasgupta, Morris and Shin (2000) • Angeletos, Hellwig and Pavan (2002) • Corsetti, Guimaraes and Roubini (2003)

11. A more sanguine scenario IMF It is only the anticipation of IMF assistance that makes painful domestic adjustment possible Creditors Debtor

12. A more sanguine scenario IMF Creditors Debtor Creditors are induced to roll over if they believe debtor and IMF effort will stave off default

13. A more sanguine scenario Anticipating its pivotal role, IMF provides funds meeting part of funding gap. IMF Creditors Debtor

14. Liquidity Crises • Crisis country may be solvent, but illiquid. • Diverse nature of interested parties lead to coordination failure – inefficient outcome. • Distinguish from workouts after default • Problem closer to bargaining under incomplete information.

15. Funding gap Weak fundamentals Strong fundamentals

16. Funding gap when fewer short term creditors roll over Weak fundamentals Strong fundamentals

17. fundamental solvency insolvent solvent but illiquid

18. Model resources to pay creditors fundamentals adjustment effort short term creditors pull out or roll over

19. Outcome and Payoffs • Default, if short run funding need is greater than resources to pay. • Short run creditors would stay if probability of default is small enough. • IMF aims to minimize probability of default, subject to fundamental solvency.

20. Equilibrium • Unique, dominance solvable equilibrium if creditors have slightly noisy signals of true resources of debtor. • In general, some dead weight loss. • There is a region where the debtor is fundamentally solvent, but defaults.

21. Debtor’s Adjustment effort Weak Fundamentals Strong fundamentals Default point

22. fundamental solvency Debtor’s Adjustment effort IMF assistance Weak Fundamentals Strong fundamentals Default point

23. Debtor’s Adjustment effort Weak Fundamentals Strong fundamentals Old default point

24. Debtor’s Adjustment effort with IMF Debtor’s Adjustment effort without IMF Debtor moral hazard induced by IMF Catalytic effect on debtor effort

25. Narrow Window Creditor moral hazard Debtor moral hazard Steering a narrow course between two rocks

26. Theoretical Issues • Debtor effort and IMF assistance are both non-monotonic functions of the fundamentals. • Low for very good and very bad fundamentals • High for intermediate fundamentals • Signalling issues (Angeletos, Hellwig and Pavan (2002)).

27. Qualifications • Conditionality • Bargaining and enforcement over time • Signalling • IMF, private information.

28. Conclusions • Yes, catalytic finance can work • But its window of effectiveness is narrow • Liquidity crises are best candidates for intervention • Argument rests on solvent but illiquid borrower