Credibility in Macroeconomic Policy

1. Credibility in Macroeconomic Policy Commitments and signaling September 15th, 2014

2. Incentives matter all around • Liquidity and adjustment: 4 distinct incentive problems required different solutions. • Time consistency: Country “hungry”-need to commit that liquidity will be (partly) inversed in reforms. Role of IFIs conditionality. • Time consistency: repayment is an ex-post bargain(Country cannot commit to repay banks more than a Y in future) Need larger loans by IFIs to repay banks upfront. DDSR needed for Fair burden sharing wt IFIs • Banks coordination: Defensive lending and debt reduction benefit the group, but incentives to free ride Deal conditional on voluntary participation of most lenders.

3. The policy question • Think of a new Government, facing reform opportunities, but with credibility challenges. • Think of ways to commit/signal in ways that can enhance policy reforms • Eg. Egypt, Tunisia, Liberia, Ghana, China, Spain, • Greece … other • Or should the WB get involved in natural resource deals in poor countries? Pros, cons, and thoughtful recommendation

4. Agenda • The issue: credibility matters for policy • Commitment – Chad, debt • Signaling – Brazil • What type of WB? • Leveraged approaches in Chad and South Sudan • Other instruments for signaling and commitment • Conditional lending and HIPC • The policy question

5. The issue: strategic interactions between government • and the private sector • Government pursues policy reform – but there is policy noise • Private sector reacts based on expected future policy. Policy may not be credible. • Government takes this reaction into account – may not implement reform when not credible, expecting failure • Or may want to influence expectations, at a cost, to make reforms work.

6. examples • Costly adjustment in Greece: need liquidity but cannot commit to reform • => conditionality • Pension reforms in China: Need to attract workers in formal sector • => more state funding/credible rules for individual accounts • Big push on infrastructure in Ethiopia: Need PSD response • => complementary policy to support PSD • Trade liberalization: PSD to invest in export sector • => join WTO, NAFAFTA • Inflation stabilization: labor to stop indexing to inflation • => independ. CB, Fiscal rules, Currency board • Anti-corruption: Need credibility to jump to good equilibrium • => arrest a big fish

7. Sources of lack of credibility • Policy Inconsistency – Dynamic inconsistency (Possible with complete information). • Different types with imperfect information • Deep policy uncertainty about support base of regime and implied constraints/incentives of ruling group

8. Example 1: Expropriation risk The game between government and private investors Stylized payoffs for strategic interactions Without commitment, NE is PD: (predate, don’t invest) With commitment, NE is (protect, Invest).

9. Solution: selective protection of property rights • Limited government • Checks and balances on abuse of power of government and elites • Involves an array of specific institutions • • Great, but in poor countries, you won’t go to nirvana over night • An alternative: a combination of • Higher returns(rents) • Selective protection of property rights • Effective by specific third-party enforcers, that have an interest in punishing the government (private sector) on reneging.

10. Chad – a complicated game • Poor, conflict-ridden, unstable region, but new leader • Mutual enforcers • Oil com.: security to invest • WB: a new anti-curse model • Deal in 2002 • Early problems: capacity, oil prices, insecurity rises • 2006 showdown: the companies flinch • 2008 WBG out

11. Example 2: Signaling – uncertainty about type High ability workers signals through costly education. Firms update their beliefs, with the possibility of a separating equilibrium, if they know that low ability workers would find this signal too costly. A prudent government signals through costly measures that are associated with prudence. Lenders update their beliefs, with the possibility of a separating equilibrium, if they know that profligate governments would find this signal too costly. Whether there is a signal that supports a separating equilibrium depends (inter alia) on the shape of the utility functions of the two different types, with respect to the costly actions

12. Different preferences can support a separating equilibrium UG (d', rL ) ≥UG (dG* , rH ) Separating equilibrium if there is a deficit and d’ of the prudent government such that:

13. Signaling in Brazil Incoming President Lula faces a squeeze between social demands from his core constituency and market fears of profligacy and default. He develops a policy program that signals prudency and gets lower interest rates.

14. Signaling: Chad vs Brazil • Range of actions that support COM(policy) vs signaling(politics) different: • Chad: signalingneeded to convince Bank to become 3rd party enforcer • Cut army in halfand survive demonstratesthat Deby candepend on citizensratherthanarmy for survival. • Brazil-by showing the fiscal restraintdoes not elicitnegativereactionfromhis supporters, Lula shows thathedoes not depend on populist part of the party. • Able to avoidtyinghis hands like Argentina wtCurrencyBoard, and manages to retainsomeflexibilityagainstunforseenevents.

15. Signaling vs committing • How different are two mechanisms? • formally different, but in reality, not that different – Commitments imperfect, default can occur in some states of nature (cost of reneging: internal, external COM) • Cost/benefit of default depends on “type” • (gravity of time inconsistency also depends on type – • “serious” governments care for their reputation) • B default more often, so COM discounted • Signals can have additional information value • (complementary) as in Chad • Signals can also be a (partial) substitute to COM wt overall lower costs for credibility – as in Brazil

16. Example 3: debt under imperfect commitment and uncertainly Can have incomplete information on benefits of trade for Government core constituency

17. Examples of (imperfect) commitment – or are these signals? • Why useful? cost? when default? who default more G or B? • Independent central banks, Fiscal responsibility laws, currency board • Procurement laws, FM reforms/independent audits – Anti corruption: agency, indep. Regulators (competition, pricing), Anti-Corruption agency, • IFIs conditionality • Trade agreement, supranational treaties (WTO, Nafta, EU) • Types: myopic/LT horizon; exporters/domestic demand; landed elite/farmers group; labor/capital; N/S; corrupt/principled; …

18. WBG as 3rd party enforcer in Chad • In Chad, WBG had several instruments-- but usefulness depended on oil prices (and oil company cooperation), regime type/security situation, outside options • Mechanism reflect WBG’s preferences (not only no expropriation, but also environment, oil curse). What does each accomplish? • WBG Loan for oil, CB • Whole IDA portfolio [connected to Wolfowitz clause] – IFC loan for oil • Escrow for oil revenues • Halo effect

19. WBG intervention: a failure? • Pipeline was built, some capacity delivered • But could not avoid oil curse • High oil price affected regime type • Mechanism would have worked wt low oil price, no rise of China – Deby became contested from within! Had to broaden coalition and spend on security. Darfur influence too. • Could failure be avoided? – pipeline would have be built anyway, a bit later – there were gains relative to proper comparator • Improvements would have been possible: • Focus more on CB • Should deal be less tight in high states? • Unintended consequences: companies not affected! Shielded, they got a good deal!

20. Similar story in South Sudan • WBG: MDTF, not IDA • Emergency needs: can disburse through UN • SS wanted CB – trade-off depends on political strength (myopia vs LT interests) • GoSS matching funds: to shield oil revenues from corruption and focus on state building • Low spending, low CB, corruption pressures (2007 mis-procurement case) leads to rising tensions • Oil became more important that ODA, affected internal equilibrium of GoSS – led to power fragmentation, less matching funds (2009) • Donors did not help – they pushed WBG for quicker disbursements, irrespective of quality and/or LT impact, closing of MDTF (2010)

21. Future of WBG leveraged mechanisms • Pros/cons: brings in more ODA/PSD but punishes the poor twice • Bank has low appetite now for high leverage instruments – too political and hard to sustain ex-post; standards pushed by NGOs are too high for the poor • So missing on big games, for example in West • Africa – Liberia, SL mining; or in DRC and • Ethiopia (Dams: Bujigali, GG3)

22. A range of WBG mechanisms • Enforcer of contracts (several instruments) • Adjustment lending and conditionality • Performance based allocations (PBA) based on CPIA – principle that ODA better wt good policies. • Anti-corruption: the W clause. • In all cases above – halo effect wt rest of ODA, private sector too • Projects • The Bank of Ngozi vs that of Dr. Kim …

24. conditionality” again • Much IMF and World Bank conditionality is “ex ante”: a government promises to do stuff, and the IMF/World Bank agrees to a loan. • An “insincere” government has incentives to pretend it will cut spending/increase the share of social spending etc. in order to get the loan. The issue is whether there are actions that the sincere government can take that are too costly for the insincere government • IMF/World Bank disbursement in tranches, when conditions satisfied • But ex post, the IMF/World Bank may not like loans to fail so can modify conditions => there is scope for renegotiation when government has some bargaining power

25. Why HIPC Initiative? • Recall Greek debt – DDSR needed to bring in IFIs • But then, why do IFIs provide DDSR? Main case was HIPC • There was no negative transfers! So no tax. • IFIS were refinancing their loans to prevent default, against adjustment promises. • Increasingly, less new new money and more refinancing – bargaining power to get good policies were waning – IFIs were most concerned abt avoiding default!! • As a result, link between disbursement and performance (CPIA) decline (and reversed!), and halo effect disappeared. • Birdsall et al: link between quality of policies and adjustment lending turned around in lead to HIPC – but link re-instated after HIPC. • – Effect of HIPC: WBG regains credibility as a 3rd party enforcer!

26. Takeaways • Diagnostic • Focus has been on credibility of policy – seriousness, reversals, possible predation. • Word of policy is noisy and opaque – private sector has healthy doubts unless governments invest in credibility • Credibility resolution requires analysis of underlying structure – common analysis of time inconsistency and signaling games helps structure thinking about challenges of strategic interaction • But then context-specific working through is needed – In Chad, influence of oil prices, dynamics within ruling group and regional insecurity, possible investments by China were crucial • Policy • Limited government nirvana irrelevant, so need to look specific commitments; • Prudent governments may need to overshoot optimal choices to give a signal that supports a separating equilibrium • – This has social and political costs, thus search for more efficient ways of solving the information problem • Often third party enforcers part of this. – In Chad: World Bank and Exxon-Mobil started as mutual enforcers but companies chose to defect • World Bank had to make a choice as to how much of an enforcer it wants to be in the future