lecture 12 bailouts
TRANSCRIPT
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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 .