A Model of the IMF as a Coinsurance Arrangement

1. A Model of the IMF as a Coinsurance Arrangement Ralph Chami, Sunil Sharma & Ilhyock Shim Conference on “Dollars, Debt and Deficits—60 Years After Bretton Woods” Banco de España, Madrid, June 14-15, 2004

2. Introduction • IMF has seen a sharp increase in demand for financial support from emerging market countries • Recent IMF programs have been large, breaching “normal” access limits • Role of the IMF—emergency lender, crisis manager • Analyze the dilemmas created for the IMF by its mandate, and the incentives created for member countries by IMF lending operations

5. I. Rationale for a Coinsurance Arrangement • Is it mutually advantageous for countries to coinsure each other—yes. • Providing coinsurance creates moral hazard • Interdependence and the mitigation of moral hazard • Peer monitoring • Centralized monitoring and provision of resources

7. II. Operating the Coinsurance Arrangement. • Objectives • Provide appropriate incentives to member countries • Should IMF precommit to a loan contract? • Or should the loan contract be formulated after the country falls into a crisis.

9. The IMF’s Choice of Contract • Objective Function: (i) Safeguarding its resources; (ii) Country welfare and safeguarding its resources. • IMF’s information set: cannot perfectly observe the crisis prevention and crisis resolution efforts of member countries. • Problem: Choose a loan contract to maximize its objective function taking into account the incentive effects on borrowing countries. • Model is solved by backward induction

10. IMF Objective: Safeguarding Resources • IMF demands payment in full • Irrespective of country effort to prevent or resolve crises • Country still exerts a positive effort to insure itself optimally

11. IMF Objective: Country Welfare and Safeguarding Resources • Trade-off • Resources available to the IMF matter • Issues faced by the IMF: • Samaritan’s dilemma • King Lear’s dilemma • Time inconsistency • Timing of IMF intervention matters

12. Timing of Loan Contracts

13. Implications for Country Policy Effort • Under ex post loan contracts, the repayment scheme is compensatory • Comparison of crisis resolution efforts: Ex ante contract > Ex post contract > “last word” contract • Similar statement can be made for crisis prevention efforts • Ex ante contract involves smaller transfers compared to the ex post contract • Raises issue of precommitment to an ex ante contract.

14. Precommitment & Time Inconsistency • In sequential decision problems, we have time inconsistency problems even under complete and perfect information • For the IMF, this problem is exacerbated by: • Concern for country welfare • Information asymmetries • Verifiability issues • Highlights the value of precommitment

15. Concluding Remarks • Other advantages of an ex ante contract: • Help gauge level of self-insurance needed • Mitigate creditor moral hazard • Self-disciplining device for the IMF • Defining the ex ante contract—normal access limits, loan maturity, interest rate charged, conditionality. • Need to address the issue of what are appropriate country quota levels and access limits.