1 part 1 fundamentals of international finance - lecture n° 6 the imf and the provision of finance...

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Part 1Fundamentals of

International Finance -

Lecture n° 6The IMF and the provision of finance

International Finance

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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.

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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.

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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.

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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.

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The role of the IMF

IMF lending volumes since 1984 (in MM SDR - Source: IMF):

15 000

30 000

45 000

60 000

75 000

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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.

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The role of the IMF

IMF Net Flows of Fund since 1984 (in MM SDR - Source: IMF):

-10 000

-5 000

0

5 000

10 000

15 000

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

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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.

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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)

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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.

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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.

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IMF preconditions : Main preconditions found in IMF programmes include :

Exchange rate devaluationInterest rate increaseChanges 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

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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

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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.

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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.

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Anti-inflation policy : Inflation is largely the result of expansionary

demand policiesTherefore, 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.

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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.

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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.

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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.

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(2) The total volume of resources availableThe 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 adjustmentAccording 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.

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(3) The burden of adjustmentIn 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.

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(4) The objectives of the IMFDebate 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.

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(5) The hypothesised cause of BOP problemsThere 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.

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(5) The hypothesised cause of BOP problemsAccording 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.

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(6) The content of stabilisation programmesFocus 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.

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(6) The content of stabilisation programmesCredit 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.

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(6) The content of stabilisation programmesDevaluation - 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.

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(6) The content of stabilisation programmesFinancial 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.

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(7) The effects of stabilisation programmesA 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.

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(7) The effects of stabilisation programmesSecond 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.

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(7) The effects of stabilisation programmesResults 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 accumulationAnother 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.

1 part 1 fundamentals of international finance - lecture n° 6 the imf and the provision of finance...

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