Political risk and moral hazard in international lending: Two essays

In this dissertation we examine, in two essays, the role of political risk and IMF-induced moral hazard in international lending. In the first essay we examine the role of political risk as reflected in contract enforcement and institutional stability. In the second essay we examine the role of IMF lending in inducing moral hazard in international lending.;Contract enforcement and institutional stability play an important role in increasing the level and maturity of international debt. Contract enforcement is modeled as a fixed cost that investors incur to obtain the contracted, gross returns on international investments. Institutional stability is modeled as the probability that the same contract enforcement cost will persist over time. Countries with poor contract enforcement and which are institutionally unstable would therefore impose and increase the uncertainty about costs. The level and maturity of international debt is reduced as a result. Empirical evidence supports this hypothesis. Stronger contract enforcement and institutional stability increase international lending and lengthen its maturity.;In the second essay we examine the moral hazard hypothesis, which International Monetary Fund critics have raised. IMF Critics have argued that IMF lending generates moral hazard in international financial markets. The empirical examination of such conjecture has focused exclusively on distortions in the pricing of credit, in the form of lower spreads. Surprisingly, so far no research has been conducted to examine the impact of IMF lending on the maturity composition of borrowing. In the financial crisis literature, shorter debt maturity increases the probability of financial crisis.;In the second essay we contribute to the ongoing debate on whether IMF lending generates moral hazard in international financial markets in three respects. First, we examine the impact of IMF lending on short-term foreign debt in emerging and developing market economies. The focus on short-term debt evolves from the key role that short-term debt plays in financial crises. Second, we examine the potential differential impact of IMF programs. IMF programs differ in their objectives, conditionality, and their terms of borrowing. Thus the basic question is whether different IMF programs lead to different levels of moral hazard. Third, we separately examine the signaling and commitment effects of IMF programs on moral hazard. Using panel data for 68 emerging and developing economies for the period 1992–97, we find that some IMF programs reduce short-term debt mainly through signaling the availability of liquidity, an empirical finding, which is consistent with the IMF catalytic effects literature. The IMF catalytic literature contends that IMF lending catalyzes additional private lending. Commitment to economic reform seems to play a smaller role. Different IMF programs would appear to reduce short-term debt in different magnitudes. More importantly, we conclude there is no empirical evidence supporting the hypothesis that IMF lending leads to moral hazard.