Financial Sector Returns and Creditor Moral Hazard: Evidence from Indonesia, Korea, and Thailand

Abstract

This paper introduces a framework of investor behavior in which investors form their expectations regarding the credibility of a prospective IMF program in reforming the financial sector characterized by domestic implicit guarantees. We examine the changes in financial sector returns in response to IMF-related news such as announcements of program negotiations and approval to infer investor perception regarding the Fund support associated with the program. We test the implications of our framework based on the East Asian crisis of the late 1990s. Using daily financial sector returns from Indonesia, Korea, and Thailand, we find that news of program negotiations and approval increases financial sector returns in Indonesia and Korea. The findings are consistent with investor perception that negotiated IMF programs are non-credible due to expected continuation of domestic implicit guarantees during the future Fund