Moral Hazard of increased IMF funding

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…

Originally published at Globo Trends and reproduced here with the author’s permission.

3 Responses to "Moral Hazard of increased IMF funding"

  1. Guest   April 7, 2009 at 9:39 am

    It is time to seriously consider moving from the monetary system to a new one.The eternal growing debt is to be considered. You should be working in the bases for a new world trading system, instead of putting so much effort on the already proved uneven and far from reality system. Please stop justifying this “flat earth” system and face the roundness of the real world, made of real people with real needs.It is time to build a real economic system, far from the “air money” that sustains the present one. Please.

  2. bose headphones   July 3, 2009 at 1:01 am

    I like very much the writings and pictures and explanations in your adress so I look forward to see your next writings.