## Overview

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### Context and purpose
- The enormous economic and social costs of financial crises at the turn of the last century underscore the importance of crisis prevention.
- The IMF can assist crisis prevention through surveillance, technical assistance, promotion of standards and codes, and by providing financial support—either disbursed or made available contingently.
- This paper examines possible roles of IMF-supported programs in crisis prevention and provides analytical backdrop for designing a possible new liquidity instrument for market-access countries.

### Analytical framework for capital account crises
- A capital account crisis requires—and is caused by—a combination of balance sheet weaknesses in the economy and a specific crisis trigger.
- Balance sheet weaknesses can take many forms (currency and maturity mismatches in private or public sector balance sheets).
- Crisis triggers can be external (contagion, a terms of trade shock, deterioration in market conditions) or domestic (inconsistent macroeconomic policy stance, political uncertainty, other turmoil).
- Many emerging market countries lack the ability to borrow in their own currencies at long maturities; some currency and maturity mismatches may therefore be unavoidable.
- Crisis prevention should minimize balance sheet vulnerabilities and seek to avoid triggers by pursuing strong policies and differentiating performance.

### Roles of IMF financing in prevention
- In principle, IMF financing can support crisis prevention through at least four channels:
  - Improving policies.
  - Providing conditionality to solve time-inconsistency problems.
  - Signaling to markets the authorities’ commitment to stronger policies and continued ownership.
  - Augmenting foreign exchange reserves, reducing maturity and foreign currency mismatches.

### Evidence from precautionary arrangements (1992–2005)
- Precautionary arrangements: financial arrangements that provide the right, conditional on implementation of specific policies, to draw should the need arise.
- Key empirical findings:
  - Out of some 50 precautionary arrangements over the period 1992–2005, in only 6 cases did the authorities eventually draw, and 4 out of these 6 cases were associated with crises.
  - Precautionary arrangements are typically requested by members whose overall macroeconomic situation is sound but with perceived underlying political and economic uncertainties.
  - Such countries are normally recipients of relatively large capital flows but are experiencing a slowdown in capital inflows at the time of the program request.
  - Precautionary arrangements appear to send a positive market signal: spreads during such programs are no higher than during nonprogram periods and probably lower than the counterfactual of no precautionary program.

### Econometric analysis of high-vulnerability episodes (27 emerging market economies, 1994–2004)
- Sample and outcomes:
  - Panel covers 27 emerging market economies over the period 1994–2004.
  - 32 episodes of heightened vulnerability identified (high exchange market pressures measured by real exchange rate depreciation, loss of foreign exchange reserves, or widening of sovereign bond spreads).
  - Of these 32 episodes, 11 turned into full-blown capital account crises, while 21 cases avoided such a crisis.
- Determinants of crisis conversion:
  - Stronger policies and smaller balance sheet mismatches lower the likelihood that a high market pressure event turns into a crisis.
  - Disbursements of IMF resources (or their immediate availability) are a significant factor in lowering the crisis probability—“money matters.”
  - The liquidity effect matters: it is the disbursement (or availability for drawing under a precautionary arrangement) that matters, not merely having an on-track program or possible future drawings.
  - IMF financing remains significant even controlling for the country’s (gross) foreign exchange reserves, reflecting policy strengthening via conditionality and the “seal of approval” implicit in IMF disbursements.
  - The marginal benefit of IMF resources depends on the quality of a country’s policies:
    - If policies are weak, IMF financing has very limited effects on crisis probability.
    - Strong policies both directly lower crisis likelihood and increase the effectiveness of IMF resources in reducing crisis probability.
  - IMF support and the country’s own efforts are strong complements in crisis prevention.

### Implications for a liquidity/precautionary instrument
- The analysis suggests a possible new liquidity instrument may be useful for countries that:
  - Continue to face balance sheet vulnerabilities but are pursuing strong policies.
  - Would receive positive market signals from IMF backing.
  - Seek to complement the country’s own efforts at avoiding costly financial crises.
- Until such an instrument is operational, definitive determination of its usefulness for subscribing countries is not possible; the analysis suggests potential benefits where strong policies and IMF-backed liquidity are combined.

*Source: _op262*

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_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/262/_op262.pdf_