Lecture 12 Bailouts

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Bailouts

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• In previous lectures, we have seen how acountry’s willingness to pay determinesrepayment, long before its ability to repay actsas a binding constraint.

• Threat of creditor punishment helps supportdebt contracts – ex post penalties provide exante incentives for good behaviour

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• We can regard coordination failure as apenalty of sorts.

– The threat of a run could induce good behaviour – Vulture creditors can “hold out” in debt

restructuring deals

• Are financial crises a “market solution” to theproblem of debtor moral hazard?

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A model of “IMF” bailouts

• Three periods, t=0,1, 2.

•

A debtor faces a continuum of small creditors(eg bond holders).

•

Country produces only if able to procureforeign loans.

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• At t=1 – If the debtor repays in full, the project is allowed

to mature to fruition by creditors.

– But if there is a shortfall in the amount repaid,they can force costly liquidation commensurate

with the size of the shortfall.

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• Let x be the amount repaid at t=1. Then the(proportional) discretionary shortfall as afraction of the amount owed is

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• Output at t=2 depends on the level of the initialloan and the extent of costly liquidation. Assume

• If interim cashflows are sufficient, then the

debtor can either repay in full or default. But ifthey are insufficient, the debtor has no choice butto default on some/all of its debts.

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Optimum loan contract

• Let the interim cashflow of the debtor be therandom variable x~:

• Is the payment shortfall bad luck or strategicdefault? The creditors cannot verify.

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• Let the (proportional) natural shortfall at t=1be z

• The optimum loan contract maximisesexpected output net repayment costs, takinginto account possible disruption cost ofpremature liquidation by creditors

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• So we seek the loan size that maximises

• Subject to an incentive compatibility constraint: – If there is no resource shortage (z=0), the debtor has

incentive to repay in full and – If there is a resource shortage, it has incentives to give

over whatever it has

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•

And a participation constraint – the debtormust be better off with the contract thanwithout

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• First consider the unconstrained maximisationproblem

•

FOC:

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• Now consider the decision about thediscretionary shortfall, given the realisedshortfall (z):

– If the cost of crisis exceeds the cost of repayment,then repayment is preferred. Otherwise default.

– So the loan must be such that

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• From equations (8), (9), the incentive compatibilityconstraint fails to bind if

• So the model suggests that threat of prematureliquidation disciplines the borrower into repaying asmuch as possible

• But what if the debtor is genuinely unlucky??

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The IMF as whistle-blower and fireman

• Could IMF scrutiny substitute for market discipline,helping distinguish between bad luck and strategicdefault?

– A whistle-blowing role

• And can official sector funds mitigate the costs ofcrisis?

– A fire-fighting role

• Does public sector involvement reduce equilibriumlevel of international lending by weakening penaltystructures?

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• If IMF intervenes, final output given shortfall s is:

• The IMF can (a) correctly intervene; (b) incorrectlyintervene; (c) mistakenly fail to intervene; (d) correctlynot intervene.

• By reducing costs of crisis, output losses are mitigatedwhen fundamentals are poor. But there is a reduceddisciplining effect, so there is lower credit.

– Which of these forces is dominant?

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• First, suppose that the debtor has sufficientresources (z=0)

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• Incentive compatibility tells us that the initialloan must satisfy

•

Again, contrast with earlier result.

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• Now consider the case where z>0. The onlycase where the debtor’s choice of s matters iswhen the IMF fails to intervene when z>0.

• Expected output is

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• Now the debtor repays if

which is the same as before. This second

constraint does not bind.

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Welfare

• Welfare consequences depend on IMF judgment of fundamentals and extent of thebailout.

– If IMF judgment is sound, it can compensate formarket discipline

– If the bailout is not effective, then the less

relevant is the IMF in influencing the calculusbetween debtor and creditor

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Reading

• Chui and Gai (2005), Chapter 9.• Gai, Hayes, Shin (2004), Journal of

International Economics .