International institutional lending arrangements to sovereign borrowers

Abstract

Recent financial crises in east Asia and elsewhere have illustrated the problems that plague emergency liquidity arrangements and the ‘lender of last resort’ role of the International Monetary Fund and other international institutions. In particular, these act under conditions of extreme uncertainty, where potential sovereign borrowers, as well as private financial institutions, are ‘kept in the dark’ regarding the intentions of the emergency lenders and the amounts and terms of emergency liquidity that can be tapped. From April 1999, longer-term credit lines are being offered by the IMF, designed to be awarded to ‘healthy’ countries before they experience contagion or distress. The paper evaluates the advantages of this form of IMF lending and this new trend in IMF operations. It is argued that provision of IMF financing through such long-term lending facilities is better in some senses than shorter-term lending. Long-term contracts reduce the uncertainty with respect to IMF intentions. Moral hazard problems are reduced for the borrowing country and financial markets know the future level and terms of IMF support. Another advantage is that long-term loan contracts improve the allocation of resources within the borrowing country. Much as private-sector facility lending is the dominant mode of finance in many markets, so facility lending has efficiency advantages when it is provided by the IMF. This efficiency advantage is derived formally. It is shown that sovereign borrowers are actually better off when utilizing these as backup lines of credit, instead of emergency borrowing that is conducted after distress occurs. Facility lending by international institutions can lead to a welfare improvement and superior resource allocation for sovereign borrowers. The intuition for this is that when financial distress drives these borrowers to increase their debt, risk premia in borrowing rates would not rise, at least up to the limits established by the size of the facility.