Balance - of - Payments Rescue Packages : Can They Work ?

This paper generates a typology of balance-of-payments crises under rational expectations, namely liquidity crises and solvency crises. The ex-post application of official financial rescue packages of sufficient size is a perfect cure for liquidity crises but amounts to an ineffective and costly bailout of private investors in the case of solvency crises. The anticipation of the rescue program encourages borrowing offsetting any solvency improvement. Due to likely imperfections in implementation, actual rescue programs entail official financial losses and may be easily counterproductive due to moral hazard. In particular, if liquidity and solvency crises cannot be distinguished, rescue programs heighten the risk of crisis. ___________________ I thank Subir Lall for insightful discussions. I have benefitted from comments by Guillermo Calvo, Mario Blejer, and participants in presentations at the Inter-American Development Bank, Washington DC, and the XIV Latin American Meeting of the Econometric Society, Rio de Janeiro. The views and interpretations in this document are those of the author and should not be attributed to the Inter-American Development Bank or to any individual acting on its behalf. INTRODUCTION The financial difficulties experienced in Mexico in 1994, characterized by abrupt Central Bank reserve losses and the unwillingness of investors to roll over public bonds despite good fiscal indicators, have provoked a reexamination of balance-of-payments crises. The unprecedented and ad-hoc gigantic rescue package put together by the international community (especially the United States Treasury, IMF and BIS) at the beginning of 1995 has spurred intense controversy, as well as deep concern on the part of those who see this kind of emergency as a natural feature of emerging markets. It has been agreed among G-10 countries that a new emergency financing mechanism, based on the IMF=s General Agreement to Borrow, will be established to halt similar crises in the future. This paper analyzes the root causes that may give rise to external capital market crises of the kind observed in Mexico, as well as the efficacy of official financing packages in preventing or overcoming such crises. Most of the debate concerning the Mexican crisis focused on exchange rate policy: whether the Mexican peso should have been devalued before the crisis and, if so, when and by how much. Such a policy focus is based on the implicit