Catalytic IMF? A Gross Flows Approach

Aitor Erce

European Stability Mechanism

Daniel Riera-Crichton

Bates College


Globalization and Monetary Policy Institute Working Paper No. 254


The financial assistance the International Monetary Fund (IMF) provides is assumed to catalyze fresh investment. Such a catalytic effect has, however, proven empirically elusive. This paper deviates from the standard approach based on the net capital inflow to study instead the IMF’s catalytic role in the context of gross capital flows. Using fixed-effects regressions, instrumental variables and local projection methods, we find significant differences in how resident and foreign investors react to IMF programs as well as in inward and outward flows. While IMF lending does not catalyze foreign capital, it does affect the behavior of resident investors, who are both less likely to place their savings abroad and more likely to repatriate their foreign assets. As domestic banks’ flows drive this effect, we conclude that IMF catalysis is “a banking story”?. In comparing the effects across crisis types, we find that the effect of the IMF on resident investors is strongest during sovereign defaults, and that it exerts the least effect on foreign investors during bank crises.

Catalytic IMF? A Gross Flows Approach – Introduction

Many crises feature, as part of the resolution strategy, the involvement of the International Monetary Fund (IMF). In such cases, the Fund takes on the role of an international lender of last resort and provides crisis-hit economies with subsidized funding, provided those countries implement a macroeconomic adjustment program. The financial assistance is designed to give the economies breathing space in which to solve their temporary financing problems.

This approach has both critics and supporters. The Fund itself defends this strategy by arguing that it reassures private creditors that the exit from the crisis will be orderly, reducing the potential for a drastic reaction (Cottarelli and Giannini, 2002). An extensive literature has assessed the importance of the so-called catalytic effect of official financing by looking at the net flow of capital entering/exiting countries under an IMF program. On the theoretical front, Corsetti et al., (2006) and others have shown that IMF lending has the potential to catalyze foreign capital inflows But disconcertingly, from an empirical perspective, many studies cast doubt on the existence of any such positive effect. Critics have seized upon this lack of empirical evidence to argue that Fund policies are too restrictive and generate moral hazard on both debtors and creditors (Birds and Rowlands, 2002).

In parallel, the literature on capital flows has recently turned its focus to the gross components of the financial account. According to this literature, the gross flows composing a country´s net capital inflow react dissimilarly to different factors. Along these lines, Forbes and Warnock (2012) and Broner et al. (2013) show that resident and foreign investors’ reaction functions are distinct.2 These papers demonstrate that gross capital flows are very large and volatile, especially relative to net capital flows. They also shed light on the sources of fluctuations driving capital flows by proving that crises can affect domestic and foreign agents asymmetrically.

IMF programs

In this paper, we bridge these two literature strands by looking at the catalytic effect of IMF lending through the lenses of the gross flows composing the current account. We distinguish varieties of capital flows entering and exiting an economy and study how they react to the signing of an IMF program. We follow Broner et al. (2013) and separate flows according to the investors’ residence. Additionally, as in Janus and Riera-Crichton (2015), we study the effect of official funding on a breakdown of capital flows into and out of an economy, regardless of the nationality of investors. The contrasting experiences of Uruguay (2002) and Turkey (2005) after their respective IMF programs were signed exemplify the relevance of our approach. As shown in Graph 1, resident and foreign investors reacted markedly differently in these two instances. In Turkey, after the IMF agreement was signed, the foreign inflow continued unabated and residents retrenched only briefly. In contrast, in Uruguay, after the signing, significant foreign capital took flight. Fortunately, residents’ investment pattern also changed and cushioned in part the effects of that flight; after the program signing, they started repatriating a significant amount of their savings placed abroad.

To obtain more systematic and robust evidence regarding the role of IMF lending on gross capital flows, we have compiled a detailed dataset of IMF interventions and quarterly gross capital flows for over 50 economies. We use it to analyze whether IMF program signings have distinct effects on gross flows. Non-random selection into official support obscures the interpretation of the relation between official credit and gross capital flows. We tackle this concern by employing an instrumental variables approach. We follow Barro and Lee (2005) and a large literature on the political and geo-strategic determinants of IMF lending. This literature provides us with an easy and powerful way of instrumenting official support programs. Additionally, we use a linear local projections method (Jorda, 2005) to gauge the dynamic reaction of the various types of capital flows to the enactment of IMF programs.

IMF programs

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