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Yet again the IMF has failed to mitigate financial crisis

London School of Economics
By Professor  

The June 30 deadline has passed and Greece has failed to pay the $ 1.7 million due payment to the International Monetary Fund (IMF). The default is the first by an advanced economy in the IMF’s seven-decade history and the largest single overdue payment. It puts the Athens government on par with a small group of mostly conflict-ravaged debtors that have stiffed the IMF- a short list that includes Afghanistan’s Taliban and coup-stricken Haiti. Zimbabwe was last to default on a major payment in 2001.

Amidst all the hue and cry about the Greek economy, I want to raise a simple yet perplexing question: To what extent is the “Trioka” (European Union, European Central Bank & the IMF) responsible for this? Or, perhaps more importantly, what has the IMF done to prevent this from happening?  It is beyond me how an international financial institution such as the IMF, mandated to surveil, mitigate and end financial crises of such a nature has YET again been unsuccessful. Taking into account crises such as the 1997-98East Asian crisis, 2002 Dot-Com Bubble burst and the 2007 US Sub-Prime crisis, the IMF is developing a rich history of failing to effectively predict and curtail financial crises.

When evaluated in its role as a central institution of global monetary cooperation, the Fund seems ill-prepared to meet the great macroeconomic challenges that lie ahead (for example, in the current Eurozone crisis case, there does not seem to be a clear recovery plan to deal with the impact of a Greek default on the Euro and other similarly debt-ridden countries such as Italy, Spain and Portugal).

Here I briefly highlight two central issues hindering the IMF’s performance on its mandated goals of surveillance and crisis lending.

Surveillance

In a paper written in 2000, Morris Goldstein addressed the structural problems related to a central, but often neglected, issue of the IMF’s role in surveillance, in particular over member’s exchange rate policies.The Bretton Woods conference elaborated a post-World War II international monetary system based on fixed exchange rates that sought to avoid the ‘beggar thy neighbor policies’ that had undermined the interwar global economy. However, time and again the Fund has fallen down on its job assignment as umpire of the exchange rate system. Goldstein cites the case of China, who manipulated exchange rates to prevent global balance of payments adjustment. Similarly, Japan and USA too have been seen doing this time and again with respect to their own currencies.

A fallacy needs to be debunked here with respect to exchange rate manipulation: If a country’s rate is fixed against another country’s currency, the country cannot manipulate that rate; passive intervention in defense of a fixed rate is not manipulation even if it is heavy; a country may be justified in maintaining an undervalued rate for domestic economic reasons, and it is the real exchange rate that matters and in due course inflation will take care of any nominal undervaluation.

To restore the IMF to its proper role in this area, some valuable reform proposals have previously been offered but ignored i.e. 1) The Fund should issue its own semiannual report on exchange rate policies including the identification of cases of potential currency manipulation practices 2) The Fund should use a process system of providing semiannual or quarterly estimates of reference rates that could be reviewed by the IMF Executive Board. The reference rates can then become the basis for IMF surveillance over policies affecting those rates, including intervention policies, until the rates are revised.

Another related problem that has imperiled the trust in IMF has to do with its inability to effectively deal with regional monetary arrangements.  In the 1960s and 70s the Fund had to deal with the G-10 network of swap arrangements and more recently with the European Monetary Union (EMU). In an earlier article, I mentioned how it was a grave mistake to allow for a monetary union to be established in Europe without effectively conceding the members to a fiscal union. The absence of a fiscal union among the EU members has led to the current fiscal mess. This is an example of where one would expect the IMF to play a key role before giving its consent for the Euro to be adopted as a single currency.

Crisis lending and conditionality

The IMF’s crisis lending mechanism is poorly designed to provide effective liquidity assistance or act as a Lender of Last Resort. Liquidity crises – by their nature – happen quickly. There is no time to enter into protracted negotiations, or to demonstrate one is an innocent victim of external shocks (as the IMF’s stillborn contingent credit facility mandated). If the IMF’s crisis liquidity assistance is to be effective, the most logical approach would be to have countries prequalify for lines of credit.  The current IMF formula of taking weeks or months to negotiate terms and conditions for liquidity assistance, and then offering that assistance in stages over a long period of time simply is a non-starter if the goal is to mitigate or prevent liquidity crises (See Schadler’s CIGI paper here).

The Fund has managed to transfer resources to debtor countries during severe economic crises along with other development bank lending (which entails substantial subsidies to borrowing countries). But these transfers also do not seem to improve securities markets or spur growth; rather, they are put to use for less laudable goals-most notoriously, for shady transactions in Russia or Ukraine (see Randall W. StoneLending Credibility: The International Monetary Fund and the Post-Communist pp 179-182).

Argentina

In Latin America, Argentina, perhaps more than any other country, has depended on IMF conditional lending over the past several years to maintain its access to international markets. It is now perceived by some as potentially at risk of a public finance meltdown, which can be blamed in part on the IMF and the US Treasury. IMF support, in retrospect, was counterproductive because it put the cart of cash ahead of the horse of reform. Now Argentina, like Portugal, Italy and Spain is faced with a growing and possibly unsustainable debt servicing burden. Similar to the Greek situation, at the IMF’s behest, Argentina too has been asked to continually raise its tax rates and take austerity measures. Instead, focus should have been more on cutting down government expenditures. The notion that tax hikes are an effective substitute for expenditure cuts as a means of successful fiscal reform is an article of faith at the IMF, but unfortunately, one that is at odds with the evidence.

Bangladesh

In 2012 the IMF approved a loan to Bangladesh worth almost one billion dollars under its Extended Credit Facility, to help the country overcome macroeconomic pressures and build a reserve buffer. The amount represented the largest loan ever offered to a member country under the IMF’s reformed concessional lending architecture, and was staggered across seven equal installments, with a disbursement of $141 million made available immediately.

Enforcing a Contractionary monetary policy was one of the major conditions set for negotiating IMF’s USD one billion loan under its Extended Credit Facility (ECF) programme. Bangladesh was instructed to follow a tight monetary and fiscal policy to control its inflationary pressure. The IMF here fell short in identifying the real phenomenon explaining Bangladesh’s inflationary situation. The Fund advocated Bangladesh to pursue a tight monetary policy assuming that the country is facing demand-led inflation. In reality, the high inflation that takes place in Bangladesh is in most cases due to a supply shock (Read Faiz Chaudhary’s explanation in his paper here).

In Bangladesh, inflation – especially food inflation – has been climbing sharply mainly for the shortage of supply of the basic food items in the local market as well as for supply shock inflation prevailing in the global market. To control supply shock inflation, augmenting the level of production is a more effective step, as was done all along in 2009 when Bangladesh bank imposed the maximum limit of interest rate at 13 percent in an effort to boost investment. On the other hand, tight monetary policies that cater to demand-led inflation create a reverse effect by soaring up inflation further and increasing the balance of payment pressure. Adopting a tight monetary policy also then reduces the availability of credit to the commercial bank. The ultimate effect was the reduction of credit availability, which caused an interest rate increase.

Greece

In case of the current Eurozone crisis too, the economics of austerity behind the program that the Troikafoisted on Greece five years ago appears to have done more harm than good, resulting in a 25% decline in the country’s GDP. Greece’s rate of youth unemployment now exceeds 60%.

Conclusion

In a recent article I argued how because of such reasons, confidence in the older Bretton Woods Institutional framework such as the IMF seems to be rapidly waning (especially when looked from the lens of developing countries) which is now giving rise to new regionally designed multilateral institutional frameworks such as the AIIB by China and the New Development Bank set up by BRICS.

While deciding the process of financial lending, it is prudent to identify goals and take into account factors such as local ownership, private investment, innovation, multi-stakeholder partnerships accompanied with the process of institutional development through mutual accountability and transparency. No single change by itself can restore faith in the IMF. Effective reform must encompass many aspects of the IMF’s activities.

Effective and expedient surveillance mechanisms (members’ exchange rate management, monetary and fiscal policies) and more prompt and reasonable policies in crisis lending (and the conditionality attached) for me must be the two most important and probably the only institutional functions that the Fund should involve itself in if it is to uphold its role as a transnational pecuniary organisation.

Note:  This article gives the views of the author, and not the position of the South Asia @ LSE blog, nor of the London School of Economics. Please read our comments policy before posting.