Moral Hazard of increased IMF funding

2009/04/03 in credit crisis, moral hazard

Today, Im going to take a look at the issue of “moral hazard” and how it pertains to the current economic crisis.  Of particular importance is the issue of whether or not government guarantees encourage private investors to take excessive risks which might inturn increase the chance of future crises.  With profit privatized and risk socialized, is it any wonder that investors are willing to take on more and more risk in search of higher returns?

While resisting the temptation to look back to the origins of this crisis, I prefer to look forward to wonder if we are laying the foundation for future moral hazard (while at the very same time attempting to regulate away the risks of future crises).

Its interesting that the same week the IMF announces $1 trillion in new funding (loans, mostly) to help emerging markets through the crisis (with fewer conditions attached)…we also see a boom in new lending to emerging markets from private investors.  On the surface this may appear to be a good thing, right?  Dont we want new lending to emerging markets?  Yes, but…

What is interesting is that private lenders increased lending because their perceived level of risk has decreased.  Think about it like this… if you knew that the IMF was going to be there to back-stop default from the countries that were borrowing, wouldnt you be more willing to take risks to lend money to countries that might default?  (especially if you thought emerging markets could borrow from the IMF in the future without all of the tough conditions normally attached to IMF money).

While the policy decision to allocate extra money to the IMF (with less conditions attached) may achieve the objective of increased global liquidity, and by encouraging private capital flows it might help reduce the impact and spread of the economic crisis of today, I wonder if this might just be another example of socializing risks and encouraging private investors into the assumption of government guarantees (as they did with Freddie / Fannie, etc).

This latest news article (shown in italics below) caught my attention:  Emerging-Market Bond Sales Surge to Two-Year High

“Investor confidence has been buoyed by a pledge from theGroup of 20 nations yesterday to triple the resources of the International Monetary Fund to $750 billion. The Washington-based fund has allocated more than $70 billion to help developing countries avoid defaults as the economic crisis reduces demand for exports, cuts lending from Western banks and triggers a slide in currencies”

My comments:  Increased IMF protection leads emerging markets to borrow more because the risk of default is being transferred from private lender to public institution.

“Risk appetite is returning and people are looking to invest in more established emerging markets with better liquidity,” said Beat Siegenthaler, chief emerging-markets strategist at TD Securities in London.

My thoughts:  Sure, the “risk appetite” is returning…but that’s because private investors know that the IMF will be there to take some of that risk away.  But, is the risk really being reduced, or just transferred?   It appears as if moral hazard is leading to more risky behavior.

Consider this… most of the countries that are taking in new borrowing are doing so in foreign currencies (such as dollar-denominated, or euro-denominated bonds).  This clearly adds riskto the system rather than reduces it… by borrowing in foreign funds, if the local currency were to depreciate, the repayment burden would skyrocket.

“Turkey’s Treasury may sell bonds in euros or dollars depending on the outcome of the G-20 summit in London, a spokesman for the Treasury said yesterday. And in other news…The Central Bank of Bahrain plans to issue bonds in U.S.dollars this year to help meet the country’s budget deficit…”

My thoughts:  While markets around the globe rally to the news of IMF funding (and eased conditions attached to loans), Im left to wonder if it may just be a short term gain at the expense of long term pain?

I welcome your comments / thoughts…

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4 responses to Moral Hazard of increased IMF funding

  1. Hi Brian,
    I agree with your concern about the moral hazard of increased IMF funding. The increase funding will not benefit the poorest nations because only a small portion of the special drawing rights (the $250 billion) will be allocated to the nations that need it the most. I see your concern about shifting the risk from private to public and it is scary to think that this could actually happen. Take a read of this news article,, it makes a good point that these monies being pumped into the IMF and the World Bank will not benefit the poorest nations is Africa.

  2. Casey said on 2009/04/19

    This article, though I agree whole heartedly with it, is in direct contradiction to Brian’s article posted on the previous day. The April 2nd article states, don’t screw up today to look out for tomorrow, however, this article advises against that. My only point is the illustrate how difficult of a position the entire world is in. Both articles are right in my opinion. Which poison is worse? Letting today’s crisis linger indefinitely; or setting up for a crisis that dwarfs our current problems down the road. To this I do not know the answer.

  3. Hi Casey, Thank you for your comments. I was wondering if anyone was going to call me out on that one :-)

    My position is: If your house is burning, first put out the fire, then look at how it started, then set up preventative measures to ensure it doesnt happen again. My position is that when action is needed, we need to put aside our differences of opinion about how the house caught fire, pick up a hose, and start working together to put it out.

    So, with this analogy in mind, I said in my first piece that the leaders of G20 should focus on todays problem, and not on new regulations to prevent it from happening again. This is my opinion for all things crisis-related. First fix the problem.

    Now, for my second article (on IMF and moral hazard)…I can see how you think this is contradictory. But… that assumes that you first believed that extra IMF funding was critical to solving todays problem (and not intended to prepare for future troubles, nor to restructure the role of the IMF in global finance). If that were true that the “new” money for the IMF were going to fix deleveraging, or housing, or banking, then I would revert to my fist argument… and ignore “moral hazard” issues, and throw money at the problem. Case closed.

    But I disagree with that position. Question: is the “new” funding for the IMF necessary to solve todays crisis? Or, more likely, is it to help bailout countries in the future that might need help if the crisis gets worse? From what I understand, its the latter… but with an additional spice of global institution restructuring laid on top.

    Not only does the IMF get “new” money, but more importantly they hope that the IMF might play a central role in fixing “global imbalances” (i.e. structural current account surpluses as a means of self-insuring against crisis). I don’t see where new IMF money is intended to fix the current banking / housing / deleveraging crisis (please correct me if Im wrong)

    As I said in the first piece: “A general theme that I see arising from the G20 leaders is a desire to “restructure and regulate”. Great. But, first, please do what you can to stop the current crisis, even if those actions are not the best long-term solutions, and even if those solutions dont fit with the new “structure or regulation”.

    I stand by that recommendation, and think that advice applies to the IMF as well as the G20 ministers.

    My understanding is that the IMF talks (ongoing) are more to do with preventing and re-structuring than with fixing the problem of today. They are more about making sure money is available to bailout future countries that get into trouble than to help the US / European banking sectors. They are more focued on redefining the role and structure of the IMF in governance than in stabilizing the housing markets.

    My concerns with “moral hazard” only come into play after I first saw that the IMF’s actions were more long-term (structural) focused, and less about short-term fixes for todays troubles. Once the conversation shifts away from today, and onto tomorrow…then, I think its right to consider the “moral hazard” issues associated with the IMF actions. The critical step is to differentiate between the focus of the discussion (either crisis management or long term planning).

    I will have more articles coming soon about the changing IMF and their new role in global finance..

  4. Casey said on 2009/04/20

    You have successfully made your point clear with me and I couldn’t agree more. I look forward to ready more of your posts regarding the IMF as I am nervous what this entity may morph into, in the future. Thanks for taking the time to clarify your points.

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