International Monetary Fund (IMF) Managing Director Christine Lagarde speaks at IMF/ World Bank Annual Meetings Plenary in Washington.(AP Photo/Jose Luis Magana)
International Monetary Fund (IMF) Managing Director Christine Lagarde speaks at IMF/ World Bank Annual Meetings Plenary in Washington.(AP Photo/Jose Luis Magana)

A previous post argued that agency problems, or the potential for borrower and creditor interests to diverge, have increased over the past thirty years as the role of private capital flows have increased in importance. As a result, it may be more difficult for the IMF to fulfill its role in assisting its members strike a judicious balance between financing and adjustment. And this, in turn, has, arguably, undermined the credibility, legitimacy and effectiveness of the Fund. The question is what role can or should the IMF and other international financial institutions play in a world of global financial integration.

One answer is to strengthen the efficiency of capital markets, so that risk is priced appropriately and capital flows to projects with the highest social and private returns. This entails responsibilities for the Fund, but also for the multi-lateral development banks that help complete the international financial architecture.

Consider the common agency problem. Each individual lender provides capital to the sovereign borrower, pricing in the risk of default. This risk is a function of many factors, including the overall total aggregate exposure of the sovereign (the amount owed to all lenders). Each individual lender would like to limit the amount other lenders provide the sovereign because each loan represents an additional claim on the output of the country.

In the domestic corporate context, of course, lenders can take collateral and enforce negative pledge clauses, which preserve their priority of claim in the event of liquidation. In the sovereign context, however, such contractual measures are not generally available or are potentially unenforceable.

In these circumstances, private lenders face a common challenge: they would like to covenant with the sovereign to ensure sound policies (including limiting total aggregate exposure) are followed and to prevent the possible subordination of their claims. But, given the doctrine of sovereign immunity, Individual lenders can't bind other lenders, while the sovereign's commitment to refrain from excessive borrowing are non enforceable.

Given these difficulties, the common agency problem remains unresolved. That said, one way to think about the IMF, and its surveillance exercise in particular, is as a delegated monitor for heterogenous, atomistic individual lenders in the unique circumstances of international lending, in which sovereign borrowers cannot credibly bind themselves to private agents. in effect, the IMF allows the sovereign to gain access to higher levels of debt on better terms than would otherwise be possible. The IMF, in short, provides the public good of stable, efficient global capital markets.

What about the dual agency problem that arises when an international lender provides capital not to a sovereign borrower, but to a private firm in the foreign country. In this case, the return to the lender is a function both of the actions of the private firm (the loan is used to fund investment that generates a higher profit stream) and the general macroeconomic environment (which determines whether the firm can operate profitably, and whether foreign exchange reserves are available to cover interest and amortization payments to the foreign lender). This dual dependency raises special issues for the international financial institutions that help complete the international financial architecture.

In some respects, the dual agency problem is more complex; more difficult to assuage. It might be argued, however, that IFI lending to private companies shouldn't be "held hostage" to the macroeconomic policies of the government; that as long as the risks of lending are appropriately priced into the loan, those policies are irrelevant. That is too narrow a perspective. The simple fact is that as more foreign capital enters the capital structure of the firm, the more the incentive structures faced by the government change.

Consider the example of a regional development lending to a private sector entity. As foreign claims on the company increase and a larger and larger share of the profit stream flow to outside investors, the greater the incentive the government has (or the lessor the dis-incentive) to follow policies that promote a stable exchange rate or access to foreign exchange that allows the foreign investors to repatriate their claims. In the extreme, the government can expropriate the firm in order to ensure profits remain in the country. Indeed, foreign investors are subject to the "hold up" problem — once capital is invested, host governments have an incentive to change the rules of the game, ex post. The result is uncertainty that depresses capital flows and creates higher risk premia that are paid by all countries seeking access to international.

In this respect, the dual agency problem is particularly pernicious because it potentially generates costs, generated by an irresponsible few, that must be borne by the virtuous. It is, in effect, a public "bad" that harms all.

Moreover, by providing capital in the face of the dual agency problem, the IFI can inadvertently fuel the common agency problem as private sector lenders see the IFI lending as a signal of a sound policy framework. This was obviously not a concern in the halcyon days of the Bretton Woods era when private lending was limited and the IMF and other official lenders (export credit agencies) had far greater leverage than is the case today.

The environment in which the IFIs operate has changed. This evolution creates new opportunities but also new responsibilities and obligations for members of the international architecture.

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