Rescue packages

Rescue packages

When a financial crisis hits a country, that country’s government usually seeks a rescue package of loan commitments to assist it in getting through the crisis.As indicated in the discussion of the history of lending to developing countries, the sizes of these rescue packages have been large since the mid 1990s, for example, $17 billion for Thailand and $58 billion for Republic of Korea.The lenders generally included the IMF, the World Bank, and some national governments.

A rescue package can have several purposes.Firstly, the loans in the rescue package compensate for the lack of private lending during the crisis.The money allows the country to meet its needs for foreign exchange, to provide some financing for new domestic investments, and to cushion the decline in aggregate demand and domestic production.Secondly, the package can restore investor confidence by replenishing official reserve holdings and by signaling official international support for the country and its government.This can stem the capital outflow, even if it does not immediately restart new private foreign lending to the country.Thirdly, the IMF and the other official lenders in the rescue package hope that the package will limit contagion effects that could spread the crisis to other countries.As the leader in most of these efforts, the IMF is organizing an international safety net, in a way similar to national efforts to prevent problems at one bank from spreading to other banks in the national financial system.Fourthly, the IMF imposes conditions as part of its lending, to require the government of the crisis country to make policy changes that should speed the end of the financial crisis.These policy reforms usually include tighter monetary policy and tighter fiscal policy, and they may include other structural reforms like liberalizing restrictions on international trade or improving regulation of the banking system.

One major question about these rescue packages is how effective they actually are.The rescue package for Mexico in 1995 seemed to be very successful in helping Mexico to resolve its financial crisis.The packages for the Asian countries in 1997 were at best moderately successful.The economies went into surprisingly deep and long recessions, and the exchange rate values of the countries’ currencies declined greatly before stabilizing.Russia was a non-test—Russia did not abide by the IMF conditions, so the package never took hold.The package for Brazil did not prevent a currency fall, probably largely because the Brazilian government did not enact the fiscal reforms that it promised.But the package appeared to be helpful in heading off a full financial crisis.The package for Turkey again seemed successful mainly in preventing much contagion.The package for Argentina did not succeed in heading off a crisis, but it also was withdrawn before the crisis because the Argentinean government did not meet the IMF’s conditions.

The other major question about the rescue packages is whether they actually increase the likelihood of financial crises because they encourage over-lending and over-borrowing.A large rescue package provides a bailout for lenders and borrowers when a crisis hits.But if lenders and borrowers expect to be bailed out, then they should worry less about the risk of a financial crisis.This leads them to lend and borrow more than is prudent—an example of moral hazard, in which insurance leads the insured to be less careful because the insurance offers compensation if bad things happen.Given the costs that the borrowers incur when a crisis hits, it seems that the moral hazard for them is probably not too large.Borrowers still lose a lot even with a rescue package.

The rescue package can create moral hazard for lenders.In the Mexican crisis of 1994-1995, the rescue package was used to pay off foreign investors, including full payment to the holders of the tesobonos.The lack of large losses to rescued creditors in the Mexican crisis probably encouraged too much international lending during 1996-1997 because the lenders worried too little about the risks of the lending.

In the Asian crisis, lenders to banks in the crisis countries were generally repaid in full, using money from the rescue packages.Still, the scope for moral hazard had its limits.Foreign investors in private bonds and stocks suffered large losses as the market price of these securities declined, and foreign banks suffered large losses on loans to private non-financial borrowers.

The failure of the rescue package for Russia led to large losses for all foreign creditors.Many of these lenders were specifically relying on a rescue to limit their downside risk, so they received quite a surprise.Some of the caution in lending to developing countries after the Russian crisis is probably the result of a reappraisal of the risks of this lending.This message was reinforced when Argentina defaulted in 2002 without any bailout appearing.Moral hazard has declined because lenders realize that rescue packages may not provide a bailout.