This channel reinforces the bargaining power of troubled countries within the euro area and with respect to the regional mechanisms. 4 In addition, the IMF has the capacity and ability to pool risks together among different countries globally. 2 3 A potential explanation is that the threat of contagion perceived by the average euro area member, which is internalized by the ESM, is larger than the one of the average IMF member country due to closer financial and trade linkages within the former group. Help Latvia in a way that sets good precedent for others & helps the stability of neighboursĮnsure stability in the Euro-Area (fear of contagion), address the Greek debt laterĮnsure stability in the Euro-Area (fear of contagion)Īt the peak of the sovereign debt crisis, starting in 2011, the ESM provided loans with a longer maturity and at a lower interest rate than the IMF ( Corsetti et al., 2017) ( Table 2). Priorities of the IMF and the European institutions involved in lending programs (source: Darvas (2017)) Subsequently, we test and validate our theoretical predictions by assessing the effect of spillovers on loan disbursements to programme-countries and by juxtaposing lending conditions imposed by the IMF and the European mechanisms. When accounting for spillover costs, arising from the borrower to the creditor, we find that it is in the lender's best interest to back-load consumption by giving more weight to future transfers in order to reduce contagion cost. In addition, we study the design of lending arrangements within a recursive contract between a lender and a sovereign country. This database allows us to assess the defining role that announcements of future actions have in mitigating spillover costs. We build and present a new database that records both the dates on which official meetings took place, relevant statements were released and the timing of the announcements regarding loan disbursements. We focus on the role of spillovers as a channel of bargaining power that a country might have when asking for financial support from regional lending institutions. This paper analyses how the risk of contagion, an essential characteristic of interlinked economies, shapes borrowing conditions. For the first time, European mechanisms were called to design financing programmes for member countries in trouble. The recent European sovereign debt crisis highlighted the critical role of regional lending arrangements.
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