Mixed Signals: Crisis Lending and Capital Markets

(Joint MZES / SFB 884 talk)

We analyze a formal model of crisis lending that incorporates bargaining, compliance and enforcement, and show that the effect of new crisis lending announcements on capital markets depends on the lender's political motivations. There are conditions under which lending reduces the risk of a deepening crisis and reduces the risk premium demanded by market actors. On the other hand, the political interests that make lenders willing to lend weaken the credibility of commitments to reform, and the act of accepting an agreement reveals unfavorable information about the state of the borrower's economy.  The net "catalytic" effect on the price of private borrowing depends on whether these effects dominate the beneficial effects of the liquidity the loan provides. Decomposing the contradictory effects of crisis lending provides an explanation for the discrepant empirical findings in the literature about market reactions, especially with regard to IMF programs. We test the implications of our theory by examining how sovereign bond yields are affected by IMF program announcements, loan size, the scope of conditions attached to loans, and measures of the geopolitical interests of the United States, a key IMF principal.

Authors: Terrence Chapman, Songying Fang, Xin Li, Randall W. Stone.