Making IMF Support More Palatable

Posted by on 30 January 2009

While the attention of most economists and policy makers has been focused on the short term priority of forestalling a global depression through public stimulus packages, we should not lose sight of the need to restore stability to international capital markets. International capital flows have been a major transmission mechanism for both asset bubbles and financial crises, and any reforms of the international monetary and regulatory institutions should focus on enhancing the stability of international financial markets and monetary regimes.

Like any financial crisis, the sources of the current one are complex and multifaceted, but at its root was a credit bubble that led to a massive mispricing of risk. An over-simplified account of the events leading up to the crisis should begin with an examination of how the credit bubble developed: After 9/11, the Fed erred in keeping interest rates too low for too long. This mistake was compounded by what Ben Bernanke has referred to as the ‘global savings glut,’ which emerged after the Asian financial crisis of 1997. Excess savings in East Asia and the oil exporting nations found their way back to America and contributed to low interest rates, which in turn encouraged individuals, financial institutions and governments to borrow too much money.

Prior to the 1997 crisis, many Asian borrowers, unable to raise capital in domestic financial markets, had gone abroad to issue short term dollar denominated debt that then depended on domestic operations to be paid off. This resulted in a ‘double mismatch’ – borrowers were using short term, dollar denominated debt that depended on long term domestic currency revenue streams. When the crisis hit, triggered by the forced devaluation of the Thai baht, borrowers were unable to roll over their loans, and a wave of defaults and devaluations swept the region.

At this point, the IMF stepped in, and offered what were construed as onerous terms as a condition of its rescue packages. Countries that participated in IMF rescue packages learned a lesson: Never again would they be forced to go cap-in-hand to the IMF and submit their fiscal and monetary policies to foreign vetting. Instead, they would build up large foreign exchange reserves as insurance against the vicissitudes of international financial flows. These reserves would provide the financial firepower developing states needed to fight off speculative attacks on their currencies and forego an IMF rescue.

It was this very effort to build up large foreign exchange reserves that caused the ‘global savings glut’ and so unbalanced the global economy. In order to raise foreign exchange reserves, many countries ran sustained current account surpluses. They did so by selling commodities and manufactured goods to the US and receiving dollars in return. These dollars eventually found their way back to the US as they were invested in Treasury bonds and other US securities, which then in turn pushed down interest rates in the US, fuelling the credit bubble that has now popped.

Then an interesting thing happened. Many economists and financial analysts have been warning of the unsustainability of these savings imbalances. They mostly expected the imbalances to end with the short, sharp shock of a dollar crisis, where demand for dollar assets suddenly dried up as foreign investors began to doubt the ability of the US to repay its debts. Instead, the developed world’s financial sector blew itself up before that could happen.

And then the contagion spread around the globe. With banks failing and capital markets collapsing in America and Europe, investors fled to the relative safety of dollar, euro and yen denominated government securities. Even countries with relatively large foreign exchange reserves, like South Korea, faced a dollar shortage as corporate borrowers were unable to refinance their credit lines abroad.

Thus, the current crisis has brought home the importance of hard currencies and credible lenders of last resort to small and emerging market nations. Iceland’s sorry example is a case in point. As financial contagion spread from American banks across the Atlantic, Iceland’s big three banks faced a liquidity crisis as they were unable to roll over their short term lending facilities. Soon, it dawned on investors that the banks’ balance sheets dwarfed the GDP of Iceland, a country of only 300,000 people outside of the Eurozone. Even though these banks may have been solvent (no one really knows), a bank run proved unstoppable because Iceland’s central bank did not have the resources to bail them out.

The sell-off currently afflicting emerging markets points to the need for a more stable international financial system, and in particular a new and enhanced role for the IMF. As currently structured, the IMF is ill-suited to be the lender of last resort for sovereign nations. For starters, the IMF simply lacks enough money to rescue all the sovereign countries potentially in trouble. So it will need to raise more cash. Next, the voting structure of the IMF concentrates control of the Fund in the US and Europe and does not reflect the growth of emerging markets over the last couple of decades. So IMF voting rights too need to be changed to bring in the BRIC’s. More fundamentally, the IMF’s bungled management of past crises – most notably the Asian financial crisis of 1997, has hurt the Fund’s credibility and contributed in no small part to the predicament we currently find ourselves in.

Ideally, the IMF would encourage countries to be responsible members of the global economy, even as it protects them in the event of a crisis. Without coordinated action to discourage emerging markets from further increasing their foreign exchange reserves, global aggregate demand will fall, and the recession will be deeper and longer lived than necessary. Middle income emerging markets in particular, which have gone through the initial stages of industrialization and have robust manufacturing sectors, but whose financial development has not yet reached the sophistication (sic) of fully developed economies, need special help. An enhanced IMF lending facility that provided unlimited (or nearly so) liquidity to member countries in the event of a financial crisis could provide just the sort of insurance small and emerging market countries are looking for.

Such a special IMF facility might have the following characteristics: To start, membership would not be open to all comers, but would be limited to countries that conformed to a few basic rules of responsible citizenship in the global economy – think of them as a sort of ‘Maastricht Criteria’ for membership in the club. Basic fiscal and monetary targets would apply, like limiting the total debt to GDP ratio, controlling inflation and so on. More importantly, countries that gained access to the club would agree not to run current account imbalances of greater than +/- 3% of GDP. Other features, like a Tobin tax to slow down speculative flows of hot money into and out of emerging markets, could also be considered as conditions of joining.

Qualifying countries would then contribute a portion of their foreign exchange reserves to the club, in exchange for enhanced voting rights. This new capital would be augmented by extra capital from the US and the EU, and perhaps by allowing the IMF to borrow in private capital markets, as suggested by Edwin Truman.

In the event of a crisis, these funds could be pledged as collateral against direct swap lines to the Federal Reserve, European Central Bank and the Bank of Japan. Thus, in exchange for abiding by these rules governing monetary policy and good global citizenship, member countries would receive access to IMF lender of last resort facilities in a financial crisis with no strings attached. Countries that do not conform to the new ‘good global citizenship’ rules set out by the enhanced IMF package would still be eligible for IMF help in the event of a crisis, but the help would come with strings attached – in other words, they would have to make structural reforms.

If we do not help emerging markets by providing them access to unlimited (or nearly so) access to hard currency in the event of a financial crisis, they will conclude that the only way to insure themselves from catastrophic collapse will be to rack up ever greater levels of foreign exchange reserves. If that happens, global imbalances will increase to a level that will threaten the very fabric of our global trading and financial systems. Protectionist tariffs and public subsidies of uncompetitive companies will soon follow.

By Ben Carliner
Director of Research
Economic Strategy Institute
[email protected]