Lecture n° 3 - The IMF and the provision of finance

1. International Finance Lecture n° 3 - The IMF and the provision of finance

2. International Monetary Fund • Introduction • Set up in 1944 as part of the Bretton Woods agreements to deal with the exchange rate arrangements in the world economy, and to aid in the financing of balance payments deficits. • US had often been reluctant to provide large funds, fearing that deficit countries would simply delay structural adjustment in case of external financing. • After the oil price shock, the resources of the fund were insufficient to face the large deficit, and private banks financing played an important role. However, private financing is rarely adapted, since banks tend to overlend to certain groups of countries with improper monitoring, partly leading to severe financial crises.

3. International Monetary Fund • Introduction • Goals of the chapter : • Examine what role a public institution like the IMF might take to alleviate the problems of private finance. • Examine the role of the IMF at present in the World Economy. • Arguments developed : • The role of the IMF in the years 1980’s, 1990’s extends far beyond its provision of finance. • The IMF is in need of reform to undertake seriously the mediation role between deficit and surplus countries, as well as adapting the actual conditions usually entailed in an IMF stabilisation program.

4. The role of the IMF • The role of the IMF • Lending to deficit countries • The IMF as a number of facilities which members can draw on. When a members borrows, it purchases foreign currencies for the IMF with its own currency. • Basic facility : General Resources Account. In case of borrowing of higher tranches, more and more conditions are attached to the loan. At the highest level, the IMF requires a “Letter of Intent” which outlines the ‘stabilisation programme’ to be followed by the country.

5. The role of the IMF • The role of the IMF - surprising facts • Rather low amounts involved • At the peak of its lending (period 1963-1993), in the mid 1980’s, the credit outstanding of the IMF was around 37 billion SDR (around 54 billion USD), compared to a total debt of developing countries of around 1,000 billion USD. • This peak has been reached again only 10 years later. • The most recent peak, reached 70 billion SDR, around 110 billion USD.

6. The role of the IMF IMF lending volumes since 1984 (in MM SDR - Source: IMF):

7. The role of the IMF • The role of the IMF - surprising facts • Negative flows of credit • The net credit provision (lending minus repayments) indicates a large positive flow of funds after the second oil crisis and the start of the debt crisis in Latin America. • By contrast, between 1986 and 1992, the flow of funds has been negative : countries on average were repaying more than they were borrowing. • Since 1992, the net credit position has been highly volatile, linked to the international financial crises, with another negative period between 1999 and 2001.

8. The role of the IMF IMF Net Flows of Fund since 1984 (in MM SDR - Source: IMF):

9. IMF stabilisation progammes • The contents of the IMF stabilisation programmes • ‘Letter of Intent’ and pre-conditions • The letter of intent describe the condition attached to the loan of a country, and is kept confidential by the IMF. Next, additional preconditions can be asked before the IMF will actually consider approving the programme itself. • Goals of the IMF programmes : • Main objective of the IMF : a viable balance of payments (current account and capital account altogether). • The country has to show that it has a balance of payments problem before it can access to the financing of the IMF. • Stabilisation programme often include targets for inflation and growth.

10. IMF stabilisation progammes • Identified causes of deficit problems : • The cause of the BOP problems is critical to understand the type of policies followed by the IMF. Causes listed by the IMF are the following (1964 - 1979): • Expansionary demand policies (20 cases) • Cost and price distortions • Related to the exchange rate (11 cases) • Other prices and wages (14 cases) • Exogenous causes • Decline in export volumes (2 cases) • Deterioration in the terms of trade (9 cases) • Non-economic (11 cases) • External debt servicing problems (11 cases)

11. IMF stabilisation progammes • Identified causes of deficit problems : • Expansionary demand policies is seen as a major cause of BOP problems. • This targets the inappropriate policies that expand aggregate demand too rapidly relative to the growth of the productive capacity of the economy. • Price distortions is a second factor that grew in importance during the 1980’s. • BOP deficits might be associated with an overvalued real exchange rate resulting from a policy of fixing the nominal exchange rate whilst inflation is still high. • Other prices and wages distortions usually refer to the structure of subsidies in the economy.

12. IMF stabilisation progammes • Identified causes of deficit problems : • Exogenous causes • Interestingly, these are thought to be of secondary importance. • The tendency to identify causes as being domestic, influence the type of policies asked by the IMF. • However, in large financial debt crises, it appears that developing countries are highly sensitive to conditions in industrial countries, where recessions cause declines in their terms of trade as well as a reduction in the demand for their exports.

13. IMF stabilisation progammes • IMF preconditions : • Main preconditions found in IMF programmes include : • Exchange rate devaluation • Interest rate increase • Changes to pricing policy (like the removal of subsidies) • The targets to be met : • They are known as the performance criteria and determine a country’s continue access to credit. Most common criteria are : • Credit ceilings, with targets for a deceleration of credit expansion to both public and private sector • Restrictions on the accumulation of external debt

14. IMF stabilisation progammes • Remainder of the programme : • Wide-ranging policies aimed at meeting the performance criteria • Fiscal policies recommendations • Pricing policies of both state and private enterprises • Efficiency of the administration of state-owned companies

15. Rationale for IMF progammes • The rationale for the IMF programmes : • General monetarist economic philosophy favouring the free market without state intervention. • Reflected in the focus on inflation control, by use of credit ceilings, pricing policies ad interest rates rise. • Three main areas of policy undertaken by the IMF : • the relationship between credit ceilings and inflation, • the role of devaluation, • the use of other pricing policies, particularly interest rate liberalisation.

16. Rationale for IMF progammes • Anti-inflation policy : • Inflation is seen as the major impediment for growth. • Idea based on the negative correlation between growth and inflation • Theoretical problems : the causality link could be inverse - other factors can jointly affect both values, themselves not linked together. • Weak empirical evidence, but some theoretical support that inflation has a negative effect on growth, like the fall in competitiveness and the reduction of savings and investments. • However, it could be argued that higher growth reduces inflation, by expending the productive capacity and reducing bottlenecks that can be inflationary.

17. Rationale for IMF progammes • Anti-inflation policy : • Inflation is largely the result of expansionary demand policies • Therefore, it can be controlled by credit ceilings on the domestic components of the monetary base, reducing the rate of growth of the money supply and then the prices. • Credit ceilings are applicable both to the private and to the public sector. • Credit ceilings to the public sector limit the fiscal deficit that, in developing countries, are often financed by printing of new money, the market for government bonds being often underdeveloped.

18. Rationale for IMF progammes • Devaluation policy : • Argument is made that devaluation is appropriate to boost the traded goods sector. • Since, in many developing countries, real exchange rate is often overvalued, due to the combination of a fixed nominal FX rate and higher inflation than trading partners. • Devaluation is appropriate to boost the traded goods sector. • Another argument is that, if inflation and the current account deficit is brought under control by demand reduction, then sticky prices and wages may lead to a deterioration in output and unemployment. Devaluation, by changing the relative prices in favour of the country, might moderate the deflationary effect of demand reduction.

19. Rationale for IMF progammes • Financial liberalisation • To allow interest rates to settle at a level that will clear the market for savings and investments. • The argument is made that economic growth is being hampered by low nominal interest rates, where inflation makes that real rates are often negative. • It results that savings are low, and hence investment are credit-rationed. By contrast, a policy rising interest rates will rise savings and thus the investments capacity, and growth. • Note : keynesian ideas would lead to about the opposite of these statements.

20. A critique of the IMF approach • A Critique of the IMF approach • The goal of this section is to briefly review the numerous critiques made to the IMF, as well an discuss the effects of the IMF programmes. • Critiques can be catalogued in the following issues : • (1) The rationale for conditionality of any kind • Most people agree that some conditionality for granting a loan is necessary, and that monitoring is desirable. • However, a reform of the voting structure within the IMF would probably make conditionality more acceptable to countries. At present, the voting structure still represent the balance of power after WW II. The US control 20% of the votes and can veto on any major change requiring 85% of the votes. The Group of 10 have 35% of the votes.

21. A critique of the IMF approach • (2) The total volume of resources available • The real value of resources available to the IMF has steadily decline since Bretton-Woods, from 16% of total imports in 1948, to 3% in 1980. • The scarcity of resources is linked to the rise in high conditionality loans. • (3) The burden of adjustment • According the Bretton-Woods, the IMF should be in charge of insuring the burden of adjustment of the BOP disequilibria is equally shared between deficit and surplus countries. • However, this has never been the case in practice. The scarce currency clause has never been evoked.

22. A critique of the IMF approach • (3) The burden of adjustment • In consequence, adjustment became compulsory for the deficit (debtor) countries, and voluntary for the surplus (creditor) countries. • A deficit in one country might be due to external factors (and not only an excess of domestic demand), like a structural surplus abroad. Why not, then, intervene on the surplus country? In this case, demand reduction reduces the desiquilebria, but at the cost of deflationary effect on the world economy • However, IMF has never imposed conditions on structural surplus countries, that tend to be strong, thanks to the market domination of their producers.

23. A critique of the IMF approach • (4) The objectives of the IMF • Debate on the extent to which IMF see the BOP as a target. • If the target is a “viable” BOP, how is it measured? Which level is acceptable? Which durability, given the volatility of capital flows? Next, at present, developing countries need to run a surplus to finance the net repayment of debt. • The short timescale and limited resources leads to the use of instrument that operates quickly, like demand reduction, contrary to longer-term policies like supply-side structural reforms. • Argument is made for less emphasis on quantitative targets and more on the achievement of a policy consensus, on a need for a public debate on IMF condition within a country before agreement is reached.

24. A critique of the IMF approach • (5) The hypothesised cause of BOP problems • There is a concentration in the IMF programmes on demand deflation and financial market liberalisation. • The structuralist school; however, underlines other cause than those seen by the IMF. • Structuralists argue that developing countries deficits are a structural problem associated with development. They export primary goods with low prices and income elasticity of demand. At the same time, they import manufactured goods with low price elasticity of demand, but high income elasticity. Thus, it is unlikely that growth will be accompanied by balance on current account. • In addition, exogenous factors, like the long-term deteriorating terms of trade on primary commodities, and the export earning instability worsen the picture.

25. A critique of the IMF approach • (5) The hypothesised cause of BOP problems • According to the structuralists the causes of BOP problems are more on the supply-side than demand mismanagement by the domestic authorities. • Then, the IMF programmes should be differently designed and timescale extended. IMF has recognised some of these critics and set up Extended Fund Facilities to this purpose. • However, the conditionality of this programmes, emphasising on market failures, have still few to do with structuralist theories.

26. A critique of the IMF approach • (6) The content of stabilisation programmes • Focus here on three policies common to all IMF programmes : • Credit controls and their link with inflation • Devaluation • Financial liberalisation measures • Credit ceilings is based on a monetary model of the relationship between credit and the BOP. However, this model suffers form several weaknesses : • Strong set of assumptions, like the money demand is stable, and the money supply controllable. • However, control of money supply is notoriously difficult in practice in most developed economies, and even worse in developing economies, due to the large non-monetised sector, and to the narrowness of financial markets, where traditional monetary transmission mechanism does not operate.

27. A critique of the IMF approach • (6) The content of stabilisation programmes • Credit ceilings - weaknesses : • The model ignores any impact of domestic credit ceilings on the rate of growth of output and unemployment. The implicit assumption is the neutrality of money : the rate of growth in money supply only affects inflation, and output remains at its natural rate. However, if the rate does not stay “natural”, the result is a sharp deflation. • Structuralists state that inflation in developing countries is a result of conflict between wage owners and capital owners. If wages increase in wage negotiation, the effect is fully transferred into prices, so that employers protect their mark-up. A reduction on domestic credit has thus very little effect on inflation reduction.

28. A critique of the IMF approach • (6) The content of stabilisation programmes • Devaluation - weaknesses : • The role of devaluation is to make imports more expensive and imports cheaper. • A first critique is that the price elasticities are insufficient to insure that devaluation will improve the current account. • A second critique is that it can be inflationary. • A final side-effect is its impact on the domestic value of foreign debt : the more the domestic currency devaluates, the higher is the burden of public debt, libelled in foreign currency, for the developing country, leading possibly to bankruptcy. The recessionary impact can be quite large. • Next, increased public deficit makes in turn credit ceilings on public sector more and more difficult to meet.

29. A critique of the IMF approach • (6) The content of stabilisation programmes • Financial liberalisation - weaknesses : • The assumed advantages of financial liberalisation conducted at the same time as macroeconomic stabilisation, is that its deflationary impact may be offset by the expansionary effect of the financial liberalisation. • However, limitations pointed are many : in particular, it neglects the importance of market failures present in credit markets, like the information asymmetry between lender and borrowers, leading possibly to excessive credit rationing. • More important is the potential for increased fragility of the financial system following liberalisation. • Bank crises arise in a context of increased competition combined with markets failure that affect credit markets.

30. A critique of the IMF approach • (7) The effects of stabilisation programmes • A main methodological problem of testing the effects of an IMF programme is to what compare the observed situation. Four approaches may be used : • “Before and after”. The problem is here that the economic environment has changed and led to the IMF intervention, so that comparability is far from perfect. • “With and without” : performance of 2 groups of countries are compared, having and having not undergone a stabilisation programme. But there is a selection bias, since the “without” countries are in theory in a better initial situation than the “with”. • “Actual versus targets” : compares the actual performance with the IMF targets. The problem is the definition and the types of targets envisaged. • “Simulation” of effects of other than IMF policies, via econometric models.

31. A critique of the IMF approach • (7) The effects of stabilisation programmes • Second methodological problem of assessing the effects is the time element : over what time period a programme should be evaluated ? • Most studies consider three years from the beginning of the programme. • Results of several impact studies • Most use the “before-after” or “with-without” approaches. • In terms of BOP adjustment, most do not find any statistically significant improvements. • In terms of inflation, some studies find a few cases of reduced inflation by an IMF programme. • In terms of growth, all studies show that countries with IMF programmes have a poorer or a similar growth performance than they had before, or than other countries.

32. A critique of the IMF approach • (7) The effects of stabilisation programmes • Results of several impact studies • Regarding the impact of devaluation, the result of a study including a panel of countries over the period 1965-1985 shows significant and negative effect from real depreciation on output. • This output effect negatively affects investment • Devaluation and increased uncertainty have a negative impact on capital accumulation • Another criticism of the IMF approach is that it worsen income distribution in developing countries, partly because most of the burden is placed on low income groups, via the decline in real wages and a sharp rise in unemployment. Evidence is shown for Latin American countries.

33. Financial Crises • Recent financial crises • The Asian crisis of July 1997 • The Russian rouble’s collapse in August 1998 • The fall of the Brazilian real in January 1999 These crises provide a spectrum of emerging markets economic failures, each with its own complex causes and unknown outlooks. They also illustrate the growing problem of capital flights and short-run international speculation in currency and securities markets.

34. Financial Crises • The Asian crisis • Roots : fundamental change in the economies of the region of many Asian countries, expanding their economies from net exporters to net importers • Starting in 1990 in Thailand, this rapid expansion required major net capital inflows to support their currencies • As long as capital kept flowing in, the currencies were stable, but if this inflow stopped then the governments would not be able to support their fixed currencies • Most visible part : the excesses of capital inflows into Thailand in 1996 and 1997. • Easy access to capital for firms and thai banks to US dollar denominated debt at cheap rates. • Banks continued to extend credits and as long as the capital inflows were still coming.

35. The Asian Crisis • After some time, the Thai Baht came under attack due to the country’s rising debt. • The Thai government tries to support the exchange rate by direct intervention on the markets by selling foreign reserves and indirectly by raising interest rates. • This caused the Thai markets to come to a halt along with massive currency losses and bank failures • On July 2, 1997 the Thai central bank allowed the Baht to float and it fell over 17% against the dollar and 12% against the Japanese Yen • By November 1997, the baht fell 38% against the US dollar, form Baht 25/US to Baht 40/$.

36. The Asian Crisis • Within days, other Asian countries suffered from the contagion effect from Thailand’s devaluation. • Speculators and capital markets turned towards countries with similar economic traits as Thailand and their currencies fell under attack : Indonesia, Korea, Malaysia, Philippines, Taiwan... • The only currencies that were not severely affected were the Hong Kong dollar and the Chinese renminbi. • The causal factors of the crisis were complex : • Corporate socialism • Corporate governance • Banking and liquidity management

37. The Asian Crisis • Corporate socialism • Great stability in Asia in the post-war period, with active government intervention in the economy, and life-long employment in firms. Until the crises, the government was reluctant to allow firms and banks to close, workers to lose their jobs. • Corporate governance • Most firms were controlled by families or groups related to the governing parties. Theses practices could favor exploitation of private benefits of power and conflicts of interest of the management or controlling shareholders not acting in the firm’s best interests.

38. The Asian Crisis • Banking and liquidity management • The government used up its reserves in tentative of direct intervention and could not support banks when large speculative attacks and huge capital outflows cause the failure of many of them. • The liquidity disruption of the banking and financial system profoundly affected the real economy, causing a chain effect of failures among Asian companies, leading to a region-wide recession. • There are interpretation disputes over the role of the IMF in the provision of finance in distressed Asian countries during the crisis.

39. The Russian Crisis • The Russian crisis of 1998 • The Russian crises was the culmination of a continuing deterioration in general economic conditions in Russia. • From 1995 to 1998 Russia extensively borrowed ion international capital markets and the servicing of the debt became soon a preoccupying problem. Although the country run a surplus of $15-$20 billion per year, capital flight was accelerating as hard-currency earnings were leaving the country. • The Ruble operated within a managed float from Rub 5.75/$ to Rub 6.35/$. The government maintained this band by announcing what rate it was willing to buy/sell rubles to the markets. • Even after a $4.3 billion IMF facility, the ruble fell under attack in August of 1998

40. The Russian Crisis • On August 7, 1998 the central bank announced that its hard currency reserves had fallen by $800 million to a level of $18.4 billion as of July 31st • Russia announced that it would issue an additional $3 billion in foreign bonds but the ruble continued to fall • On Monday August 10th, the Russian stocks fell by more than 5% as investors feared a Chinese renminbi devaluation that would aid Chinese exports but would deteriorate Russia’s ability to generate foreign exchange reserves. Russia’s ability to collect taxes was also waited to be proved. • On August 17th, the central bank announced that the Ruble would be allowed to fall by 34% to Ru9.50/$. They postponed $43 billion in short-term debt as well as a 90-day moratorium on all repayment of foreign debt in order to avoid a banking collapse.

41. The Russian Crisis • On August 28th, trading of the Ruble was halted after ten minutes as the Ruble traded around Ru19.0/$. By January, the Ruble had settled at Ru25.0/$ • Russia had defaulted on its foreign denominated debt, mostly dollar debt marking the first time a sovereign issuer defaulted on Eurobonds. • The crisis of the Ruble and the loss of Russia’s access to international capital markets has brought into question the benefits of a free market economy among the Russian society.

42. The Brazilian Crisis • The Brazilian crisis of 1999 • In 1997 and 1998, most analysts did not question the perspective of a devaluation of the Real, but wondered when and how much. • Since 1994, its value had been artificially maintained by the government in the hopes of stabilization of economic condition and financial growth. • But the government’s inability to resolve the persistent current account deficit and the inflationary pressures drove expectations of a devaluation. • Increased volatility on the markets in the second half of 1998, in the context of the Russian crises, pave the way for speculative attacks on the Real. • From January 11th, till 15th, 3.44 billion USD flew out of the country and the Real lost 16% of its value, devalued twice atR$1.43/$

43. The Brazilian Crisis • The Brazilian crisis of 1999 • During the following week, the floating rate was temporarily adopted and the Real continued to fall. • The finance minister rose interest rates from 36% to 41% “to limit inflationary pressures from the devaluation”. • By April of 1999, the real had appreciated against the dollar and was now hovering around R$1.70/$ • After a sharp drop, equity markets steadily recovered in the following weeks and month, based on positive expectations due to the improved competitive position of Brazil compared to its major competitors, and following the renewed confidence brought by the return of foreign investors to the Brazilian markets, signaling the end of the crisis.