the imf and the challenges it faces

WORLD ECONOMICS • Vol. 11 • no. 4 • october–december 2010� 131

The IMF and the Challenges it Faces


Graham Bird and Dane Rowlands

Introduction

In early 2008 many commentators were writing off the International monetary Fund (ImF) as an irrelevant global institution. ImF lending was at a historically low level, with the implication that the ImF’s influ-ence over economic policy reform through the conditionality attached to its loans was minimal. many countries had opted to build up their own international reserves rather than run the risk of having to borrow from the ImF. Furthermore, studies suggested that conditionality was frequently not even fully implemented in countries where ImF programmes had been put in place. on top of this, the ImF had proved largely impotent in resolving the global economic imbalances that threatened the stability of the international financial system. Finally, there were criticisms of the ImF’s governance in terms of the under-representation of emerging and developing countries and the over-representation of Europe, highlighting its underlying lack of legitimacy, and re-enforcing the claim that the ImF was an institution in decline and in need of reform.

Attempts by the ImF to come up with an overall medium-term strat-egy for institutional reform had been received with little enthusiasm (see, for example, Bird 2006b; Truman 2006) and specific reform initiatives, in particular the streamlining of conditionality, met with only limited

Graham Bird is Professor of Economics at the University of Surrey, Visiting Professor at Claremont mcKenna College and The Fletcher School, Tufts University. He is also a Clinical Professor at Claremont Graduate University.

Dane Rowlands has been teaching at The norman Paterson School of International Affairs since receiving his Phd in economics in 1994, and is currently Associate director.

132� WORLD ECONOMICS • Vol. 11 • no. 4 • october–december 2010


success. other reforms, such as the setting up of the Contingent Credit line to deal with emergencies resulting from crisis contagion had been ill thought out and proved ineffective, while proposals for a Sovereign debt restructuring mechanism (Sdrm) to help overcome debt crises had not even made it off the drawing board.

A slightly different interpretation of its situation in early 2008 put less emphasis on institutional failure and sought to place the ImF’s pre-dicament in a historical context. This approach pointed out that, over the years, the ImF had been shaped by events that were difficult to predict (Boughton 2004). In large measure these events took the form of crises of one type or another. There had been the oil crisis of the 1970s, the Third World debt crisis of the 1980s, the fall of Communism and the crisis of transition at the beginning of the 1990s, as well as the currency crises in emerging economies in the later 1990s and early 2000s. According to this approach, the period after 2002 had simply exhibited a low incidence of global economic crises. This was the era of the ‘great moderation’.

A largely benign global economic environment allowed emerging and developing economies to achieve significant economic success and to avoid the circumstances that would previously have driven them to the ImF. By analogy, so it was suggested, it would be unwise to close down the

coastguard service just because there had been a few years of mild weather with no major storms.

If, from 2002–08, most of the world was enjoying favourable economic weather, and an absence of economic and financial turbulence, a perfect storm was of course forming on the horizon. Events in the period since mid-2008 have served to thrust the ImF back into the limelight. This reversal of fortunes is reflected in the enhanced lending activity shown in Table 1. rather than being perceived as irrelevant, it is now often pre-sented as being essential to the resolution of the world’s economic prob-lems. does the evidence support this favourable portrait? What reforms have been instituted? Is the ImF rising like a phoenix from the ashes? And what issues need to be addressed if the ImF is to meet the challenges that currently confront it? These are the questions with which this paper deals.

By analogy, so it was suggested, it would be unwise to close down the coastguard

service just because there had been a few years of

mild weather with no major storms.



The following layout is adopted. We first briefly summarise and dis-cuss the institutional reforms that have been made since 2008, and the background to them. After that, we systematically analyse the issues that need to be addressed in future reform, following which we assess the probability that these issues will be satisfactorily dealt with, by consider-ing the impediments in the way of reform. The final section offers a few concluding remarks concerning the future of the ImF in the medium to longer term.

Reform of the IMF in 2008/09

The financial crisis in late 2008 initially had little impact on the ImF’s pro-file. The crisis emanated from the financial sectors of advanced economies and in particular the United States. If anything, further questions were raised concerning the ImF’s inability to anticipate and avert financial cri-ses. After all, in the wake of the East Asian crisis, it had set up a Financial Sector Assessment Program to examine the stability of the financial sec-

Table 1: IMF arrangements approved and augmented during financial years ended 30 April 2000–2009

Financial year

Number of arrangementsAmounts committed under arrangements*

(in millions of SDRs)Stand-by EFF FCL PRGF ESF Total Stand-by EFF FCL PRGF ESF Total

2000 11 4 – 10 25 15,706 6,582 – 641 22,9292001 11 1 – 14 26 13,093 –9 – 1,249 14,3332002 9 – – 9 18 39,439 – – 1,848 41,2872003 10 2 – 10 22 28,597 794 – 1,180 30,5712004 5 – – 10 15 14,519 – – 967 15,4862005 6 – – 8 14 1,188 – – 525 1,7132006 5 1 – 7 13 8,336 9 – 129 8,4742007 2 – – 10 12 237 – – 363 6002008 3 1 – 4 8 556 343 – 434 1,3332009 14 1 13 28 34,249 – 31,528 959 66,736

EFF�=�extended�fund�facilityESF�=�exogenous�shocks�facilityFCL�=�flexible�credit�linePGRF�=�poverty�reduction�and�growth�facilityNote:�Components�may�not�sum�exactly�to�totals�because�of�rounding.�*�Includes�augmentations�and�reductions



tors of member countries. However, the programme was not mandatory and the US had opted not to participate in it.

Two developments were the keys to a change. First, the economic con-sequences of the financial crisis began to manifest themselves in slower economic growth and the prospect of recession. Advanced economies had reverted to Keynesian policies of fiscal stimulus and monetary relaxation, but potential problems were perceived if these policies were not globally coordinated. It seemed to the G20 leaders that the ImF could play a role in this context, although in practice it was downplayed at the April 2009 G20 summit (see Bird 2009a). more important was the concern that many emerging economies, and even some of the less economically significant advanced ones (Iceland being the most eye-catching example at the time), would need financial assistance from the ImF. The G20 included the leaders of important emerging economies who had a direct interest in and influence on the design of policy relating to the ImF. Even power-ful advanced economies were concerned that, without ImF assistance, emerging economies might default on debt, and might be forced to pur-sue contractionary economic policies that would then reduce their own exports and worsen the economic downturns that they were encountering. There was therefore a unanimity of view across advanced and emerging economies that the ImF needed greater lending capacity, and the April 2009 summit focused on providing it, as well as on reforming the ImF in other ways.

The summit advocated a tripling of the ImF’s lending capacity. Some of this was to be financed in the short term by bilateral borrowing from member countries including Japan and China but, in the longer term, the additional resources were to be incorporated into extended new Arrangements to Borrow. An increase in quotas was also envisaged that would increase the ImF’s resources. on top of this, the G20 leaders sup-ported an additional allocation of Special drawing rights (Sdrs). Apart from injecting more resources into the ImF and increasing its ability to lend, the G20 also endorsed institutional changes that had already been taking place in the ImF to modify the range of facilities under which it could lend and the conditionality attached to such loans.

As noted earlier, the streamlining initiative had been at best only a muted success and had failed to achieve some of its primary objectives (see Bird 2009b for further discussion). There had been no significant decline



in the number of conditions, and structural conditionality remained a key element in ImF programmes. Although the new conditionality guidelines introduced at the beginning of the 2000s had begun to focus attention on the processes through which conditionality was negotiated, something upon which earlier guidelines had been silent, there was little to suggest that this had transformed the record on implementation. many ImF staff and executive directors had remained unenthusiastic about streamlining, and there is little doubt that this impeded progress in fully putting the initiative into effect.

Changes to conditionality were considerably more pronounced between late 2008 and early 2009 with events driving the evolution of conditional-ity in a way and at a speed that the streamlining initiative had not. For example, in September 2008 the ImF modified its Exogenous Shocks Facility (ESF) – originally introduced in 2006 – in order to generate quicker access to finance for those low-income countries without a Poverty reduction and Growth Facility (PrGF) programme in place. The modi-fied ESF incorporates a ‘rapid access’ component, which allows a country to quickly draw up to 25% of its quota without having to undertake ‘up front’ measures in other than ‘exceptional circumstances’.

For emerging market-access economies, the Short Term liquidity Facility (STlF) was launched by the ImF in october 2008. When introducing the facility, dominique Strauss Kahn, the ImF’s managing director, pointed out that conditions under the STlF would be based ‘only on measures absolutely necessary to get past the crisis and restore a viable external position’ (ImF press release reported in ImF Survey, october 2008; emphasis added). Assuming that countries had a ‘track record of sound policies’, as assessed by the most recent Article IV dis-cussions, financing was to be made available ‘without the standard phas-ing, performance criteria, monitoring and other conditionality of a Fund arrangement’ (ibid.).

By march 2009, further institutional reform was in train. The STlF was replaced by a new facility: the Flexible Credit line (FCl). Alongside the discontinuation of the Compensatory Financing Facility, whose role had now been superseded by the ESF, the ImF presented these changes as representing a ‘major overhaul’ and ‘modernisation’ of conditionality. In the case of the FCl, and in the spirit of the STlF, the modernisation was in the form of relying more on pre-set qualification criteria (ex ante con-



ditionality) rather than traditional (ex post) conditionality based on policy targets. Countries merely had to exhibit a ‘strong macroeconomic frame-work’ that could be demonstrated during regular Article IV consultations. moreover, the ImF announced that structural performance criteria were being abandoned, with structural reforms instead being monitored in the context of programme reviews.

Further institutional changes were announced by the ImF in July 2009 in terms of its dealings with low-income countries. While in part these involved an increase in the ImF’s lending capacity and the degree of con-cessionality, they also involved a reformed set of financial instruments to replace the PrGF. These are: an extended credit facility to provide flex-ible medium-term support; a stand-by credit facility to address short-term and precautionary needs; and a rapid credit facility offering emergency support with limited conditionality. The ImF’s stated intention was to adopt a ‘more flexible’ approach to conditionality in arrangements with poor countries.

Potentially, and taken as a portfolio of reforms, these changes to con-ditionality appear to be significant. low conditionality access is now embodied in the rapid access component of the ESF, and even for the high access component adjustment is seen as needing to focus on the underlying shock and not longer-term structural problems. other lend-ing to low-income countries has moved away from structural perform-ance criteria. For emerging economies the FCl potentially fills what has been perceived to be a gap in the range of ImF lending windows and allows ImF resources to be disbursed quickly and without the need to negotiate detailed additional policy reform. The ImF heralded these reforms as representing a ‘new lending framework’, which doubled member countries’ access to ImF resources, provided a ‘streamlined approach’ aimed at removing the ‘stigma of borrowing’, gave flexibility and did away with ‘hard’ structural conditionality, as well as placing a ‘new focus on objectives rather than specific actions’ (quotes taken from ImF press releases).

on top of these developments, further reforms to ImF quotas, approved by the ImF’s Board of Governors in April 2008, sought to modify the quota formula to adjust for differences in purchasing power across member countries, to increase quotas for ‘all 54 countries that were underrepre-sented under the new quota formula’, and to triple the number of basic



votes ‘to increase the voice of low income countries’ (quotes taken from ImF Factsheet on ImF Quotas). Finally, and at least symbolically quite important, the G20 leaders in April 2009 recorded their intent to select the ImF’s managing director purely on merit.

In June 2010, and following the G20 summit in Toronto, the ImF’s managing director (md) pledged that the institution would consider fur-ther reforms designed to fill gaps in the ‘global financial safety net’. Under consideration are plans to enhance the FCl by expanding its duration and removing the cap on access to the facility, to introduce a precautionary credit line for countries that do not meet the qualification criteria for the FCl, to introduce a new mechanism for proactively channelling large-scale liquidity to countries that might be of systemic importance, and to foster closer cooperation with regional financing arrangements based on experience in Europe in association with the Greek crisis. He also stated that the ImF needed to improve its oversight of the world economy and strengthen its capacity to identify early warning signs of crisis. To this end, the md argued that macro-financial stability should be ‘front and centre of ImF surveillance’, but without it becoming a global financial regulator. He announced plans to introduce ‘spill-over reports’ designed to assess how policies in China, the Euro Area, Japan, the United Kingdom and the US might affect regional and global stability, as well as other ‘thematic multi-country’ reports.

It is easy to see how the reforms and proposals catalogued above might appear to be reasonably fundamental and as preparing the ground for the ImF to take on a more significant role in the world economy. First, they could be seen as strengthening the ImF as an adjustment agency, not only by allowing it to respond quickly to countries with balance of payments problems and on the basis of policies more closely aligned to the problems that are being encountered, but also by playing a significant supporting role in the design of policy in countries that do not need to use the ImF for direct financial assistance. Second, and as a financing institution, the ImF’s enhanced lending capacity might enable it to operate more fully as an international lender of last resort and might allow it to indirectly exert more influence over policy reform. Third, and in part as a consequence of these changes, the ImF’s role as a forum for international monetary cooperation and reform might be enhanced; something that would be reinforced by the governance reforms undertaken.



But such a conclusion may be premature. Global economic crises have historically generated institutional responses from the ImF in the form of some combination of modifying the range of facilities under which loans are made, the amount of liquidity provided by them and the conditionality that is attached to them. This was the case in the aftermath of the oil cri-sis in the 1970s, the Third World debt crisis in the 1980s, the transition crisis in the early to mid-1990s and the East Asian crisis in the late 1990s. The response to the 2008/09 crisis might therefore be seen as following a well-established pattern and one that does not necessarily represent fun-damental and underlying reform of the ImF. The ImF’s future depends more significantly on its ability to resolve a number of outstanding issues.

Issues and challenges confronting the IMF

The design of macroeconomic policy

The ImF makes an input into the design of macroeconomic policy via the Article IV consultations that it holds with all member countries, through the Policy Support Instrument, and more particularly via the conditional-ity that is attached to its loans. A common caricature of the ImF’s con-ventional approach to macro policy involves fiscal austerity, monetary tightness and exchange rate devaluation. In the nature of caricature, this is not an entirely accurate representation. For example, the Independent Evaluation office has shown that fiscal contraction is by no means a universal component of ImF-supported programmes (IEo 2003). Even so, the caricature remains influential since it is the view popularised by

many of the ImF’s critics. These same critics have often presented the ImF’s top priorities as being to reduce inflation by eliminating fis-cal and monetary excesses, and to restore international competitive-ness by eliminating currency over-

valuation. Where the ImF has supported a pegged exchange rate regime, it has usually been as a counter-inflationary device. The critics go on to argue that such priorities carry with them adverse consequences for eco-nomic growth and development. It is claimed that fiscal austerity leads to economic recession, that high interest rates erode the confidence of inter-

A common caricature of the IMF’s conventional approach

to macro policy involves fiscal austerity, monetary

tightness and exchange rate devaluation.



national capital markets and lead to capital outflows, and that exchange rate depreciation leads to economic contraction via balance sheet effects.

The ImF’s approach to macro policy came under particularly sharp attack during the East Asian crisis in 1997/98 (see, for instance, Feldstein 1998; Stiglitz 2002), and the ImF acknowledged its mistake in underes-timating the impact of the crisis on domestic investment and therefore in aiming for excessive fiscal correction. But, while accepting that mis-takes have sometimes been made, the ImF has also strongly defended its approach to the design of macroeconomic policy on the grounds that macroeconomic stability is a precondition for sustainable economic growth and development.

recent developments in macroeconomics have, however, made life much more complicated for the ImF and for policymakers in general, cre-ating significant challenges and uncertainties for the design of appropriate macro policy and again calling into question the ImF’s conventional wis-dom. What combination of fiscal and monetary policies should the ImF be advocating where recession or slow economic growth along with high levels of unemployment coincide with large fiscal deficits and high levels of debt? Just how undesirable is inflation, and at what rate of inflation might the successful anchoring of inflationary expectations be threatened? What levels of public debt are sustainable and at what levels do structural fiscal deficits therefore become undesirable? Is it better to close an output gap now and risk higher inflation in the future, and at what point should the stance of fiscal policy be altered? How does exchange rate policy fit into the mix? Exchange rate depreciation may threaten inflation, while appreciation may carry dutch disease. These remain largely unresolved questions.

For some countries, such as those belonging to the Eurozone, the chal-lenge may be even greater since monetary policy and exchange rate policy are not available options and this puts even further pressure on fiscal policy as the principal means of fostering economic adjustment. Is fiscal adjust-ment up to the task, especially where it involves its own contradictions?

It is clear that the ImF is actively considering these issues. For example, Blanchard et al. (2010), in a Staff Position note, address the questions of whether monetary policy has incorporated inflation targets that have been set too low, and whether there is scope for a different overall approach to the design of macroeconomic policy using a wider range of instruments.



recent ImF-supported programmes have accentuated the need for fiscal policy to promote economic growth in circumstances where there is fiscal space (ImF 2010b). moreover, the ImF’s attitude towards exchange rate policy, which in the early 2000s appeared to favour the bipolar approach, seems to have softened, now accommodating a broader array of exchange rate regimes.

The ImF’s contribution to resolving global macroeconomic problems will depend on its institutional judgement on these complex issues. A departure from what has been perceived as its conventional wisdom does not however guarantee the arrival of support for a new improved form of macroeconomic policy. Problems observed with the ‘old’ macroeconomic policy solution do not imply the existence of a clearly superior alternative. Indeed they may merely reflect a more difficult and ambiguous macroeco-nomic environment that is full of inter-temporal contradictions. The ImF will face a serious challenge in addressing them.

The dilemma is nicely captured by an ImF report on Europe reported in the ImF Survey in mid-2010, which argued that while radical fiscal action had to be avoided because it risked a ‘relapse into recession’, warn-ing signs over public debt meant that sizeable fiscal consolidation was needed in the medium term. The report went on to point out that, for those countries with ‘low fiscal credibility … immediate consolidation is a must’. The challenge is in defining more precisely what constitutes ‘radi-cal fiscal action’, delineating at what point public debt transmits ‘warning signs’ and explaining what determines ‘fiscal credibility’.

Conditionality

The challenge facing the ImF over the design of macroeconomic policy spills over into the design of its conditionality in general. much of the ImF’s history reveals a search for the optimum amount and nature of con-ditionality that is attached to its loans. At the outset in the 1950s and 1960s ImF conditionality was quite parsimonious, focusing on a narrow range of macroeconomic targets and policies. during the 1980s and 1990s it expanded rapidly to include many aspects of structural reform. However, a concern was that this expansion resulted in a decline in country ownership and a deteriorating record of implementation, with conditionality becom-ing generally more time consuming to negotiate and less effective. The policy of ‘streamlining’ was introduced in the early 2000s in an attempt



to overcome these perceived weaknesses and, as noted above, the ‘major overhaul’ of conditionality in 2008 and 2009 was a further move in this direction (see Bird 2009b for further discussion).

The issue is whether the ImF has now got the balance right. Two ques-tions need to be answered, or at least kept under close review by the ImF. First, and as discussed in the previous sub-section, it has become more challenging in the aftermath of the global financial and economic crisis to identify appropriate policies even in the ImF’s core areas of exper-tise. Will the ImF be able to select appropriate policies in these areas? Second, problems of structural inefficiency that are no longer covered by performance criteria in the context of ImF conditionality will still often remain important and continue to exert an influence over fiscal balances and international competitiveness. Fiscal policy is less easily modified if elements of government expenditure are politically difficult to alter and if tax administration is inefficient. labour market inefficiency can affect international competitiveness as well as exchange rates. Perhaps most importantly, even countries exhibiting traditional macro policy virtue now seem vulnerable in the face of inadequately supervised financial markets. If the ImF stands back from incorporating such structural reforms in its conditionality, what guarantee is there that they will be pursued? might there be an inconsistency for example between the ImF’s withdrawal from structural conditionality and its recent emphasis on macro financial risks? For some of the ImF’s clients there is the chance that structural conditions may be included in World Bank programmes (although the evidence suggests that this has not tended to happen), but for other cli-ent countries that do not have programmes with the World Bank, it is dif-ficult to see how structural reform will be encouraged. While the ImF’s track record with structural conditionality has not been particularly suc-cessful according to some observers (see, for example, Easterly 2005), this does not necessarily imply that structural reform is unimportant. The issue remains that of identifying and encouraging appropriate structural reform.

It may yet be that at the aggregate level the tendency for conditional-ity either to be deficient or excessive has not come to an end. moreover the challenge is to find the correct design and amount of conditionality in different sets of country circumstances. This implies finding the correct blend of high- and low-conditionality lending, and this is a challenge that the ImF has faced since its inception.



Global economic imbalances and the international coordination of macroeconomic policy

The ImF correctly diagnosed the potential problems associated with large global macroeconomic imbalances in the mid-2000s. It has also pointed to the need for closer coordination of macroeconomic policy interna-tionally as a way of reducing such imbalances in the future. What it has been unable to do up until now is to devise an effective mechanism for encouraging such coordination (on this, see Bird & Willett 2007). Article IV consultations seem unable to exercise discernible influence over the countries concerned, and the round of multilateral consultations that the ImF held in the mid-2000s that were specifically aimed at reducing global imbalances were largely ineffective. There is therefore a stark disconnect between what the ImF as a global financial institution recognises it should be doing and what it is able to do. The challenge is to make the connec-tion between the two.

The size of the challenge should not be underestimated. It requires the ImF to possess a set of incentives that can be used to influence countries with balance of payments surpluses that have been able to build up their international reserves and are most unlikely to need assist-ance from the ImF, as well as countries with current account deficits that retain easy access to private international capital markets. moral suasion seems to be inadequate to the task and more dramatic reform may be needed. In principle, and controversially, this could involve penalis-ing countries with excessive surpluses by some form of international taxation or requiring them to make enhanced contributions to the ImF. Alternatively, but also controversially, it could involve allowing deficit countries more discretion in the design of commercial policy, maybe under the auspices of the World Trade organization (see mattoo & Subramaniam 2009 for a more detailed discussion), or allowing countries experiencing a sudden inflow of international capital to introduce con-trols to minimise the effect on the value of their currencies and thereby avoid the implied loss of competitiveness. There are clear suggestions that the ImF’s unwavering opposition to capital controls may be weak-ening, with a recent Staff Position note (ostry et al. 2010) examining the circumstances in which the use of such controls might be beneficial. But it is also the case that some of the policies mentioned above would be politically unpalatable to many ImF members.



A slightly different approach to global imbalances presents the pursuit of current account surpluses as being motivated by a desire to accumulate international reserves as a precautionary balance against future crises (see more on this below). From this angle, attempts by the ImF to make its conditionality less unattractive to potential users of ImF credits, and to reduce the ‘stigma of borrowing from the ImF’, could also contribute to reducing global economic imbalances. These issues are being debated within the ImF (ImF 2010a), and the ImF’s Asian conference in July 2010 represented an attempt by the ImF to engage with its Asian members. The future of the ImF will depend to some extent on the success of this strategy.

However, it may be that the ImF is simply not very well equipped to deal with the issue of global economic imbalances and that it can do no more than draw attention to the dangers that they carry with them. It may have to go along with delegating the policy response to other institutions such as the G20, although there can be no assurance that the G20 will be any better able to reduce global economic imbalances than the ImF has been. The G20’s mutual Assessment Process (mAP) is yet to prove itself, but the initial commitments made at the Toronto summit appear to sug-gest that the scope for coordination under the umbrella of the G20 will be strictly limited. If macro coordination is taken on by the G20, the ImF could then concentrate on improving the policies over which it does have more control, which focus on providing support to countries experiencing the economic and financial difficulties that are themselves the conse-quence of global imbalances. Such a strategy would not be unhelpful but it would imply an acceptance of the fact that there are binding constraints on the global role that the ImF is able to perform.

Capital account liberalisation and capital controls

The issue of capital account liberalisation is intrinsically difficult (see Edison et al. 2004 for a review of the theory and evidence) and the ImF’s approach to it has changed over the years as the balance of the arguments has shifted. In the Bretton Woods era, capital controls were common and the balance of payments was largely analysed using models that focused on the current account. Although trade shocks did occur, current accounts tended to change reasonably slowly and could be expected to respond to alterations in exchange rates. In such a world things were relatively



straightforward. Since the demise of the Bretton Woods system, however, things have become progressively more complicated, with increasing financial globalisation often exposing emerging economies to large and sudden capital account shocks. Increased international capital mobility has significant global benefits but it also increases countries’ vulnerability to sudden surges or sudden stops of international capital. In a world of flexible exchange rates, volatile capital flows also make the values of cur-rencies more unstable and this in turn makes the task of macroeconomic management more daunting.

For individual countries that experience sudden surges of capital inflow, as for example has been witnessed in latin America in early 2010, the problem is that the related appreciation in exchange rates will lead to an erosion of international competitiveness in conventional dutch disease fashion. So it is not just a matter of financial globalisation causing prob-lems for the individual countries into which or out of which the capital moves. There may be externalities that a global institution such as the ImF should be factoring into its deliberations. A significant question is therefore whether ImF plans to pay closer attention to spill-over effects as part of enhanced multilateral surveillance will generate meaningful results.

The policy challenge is, as it has always been, to retain the benefits asso-ciated with financial globalisation while avoiding the potential costs. This implies that policy needs to be nuanced and dependent on the particular circumstances found at the time. It means that it is unsafe to assume either that unfettered capital account liberalisation is necessarily a good thing or that capital controls are always desirable. Increasing understanding of capital movements allows progress to be made, so that it is now widely accepted that controls should try to avoid discouraging long-term foreign investment, and that sterilised intervention in the foreign exchange mar-ket may make more sense over the short term than over the long term. But it remains difficult to translate these advances in knowledge into clear policy prescriptions. How, for example, can one unambiguously determine whether capital inflows are permanent or temporary?

From a situation in the early 1990s when the ImF seemed to be an advocate, or at least a supporter, of capital account liberalisation, it now appears that it has become much more agnostic. While unbiased analysis of the underlying issues suggests that this change is well founded, it also



means that the related policy prescription is less clear-cut. The challenge facing the ImF is to more precisely delineate the circumstances under which capital account liberalisation or the retention (and even extension) of controls is a superior strategy. Beyond this, in what way should capital controls be designed if they are to be used?

International lender of last resort

The debate over its role as an international lender of last resort remains an enduring theme concerning the ImF, with the reforms in 2008/09 giving the discussions renewed vigour. The reforms substantially increased the ImF’s lending capacity and therefore the incentive for countries to turn to it for financial assistance. Previously, the ImF’s limited budget relative to the size of international capital flows had been seen as severely constrain-ing its ability to fulfil the functions of an international lender of last resort. moreover, there is some preliminary empirical evidence to suggest that the demand for owned reserves is negatively associated with the size of quota-based access to ImF resources (Joyce & raul-Garcia 2010), imply-ing that member countries have not had confidence in the ImF’s ability to supply them with the amount of resources they might need.

As noted earlier, the reforms in 2008/09 also softened the conditionality attached to ImF loans. Conditionality has conventionally been presented by the ImF as a way of policing the potential moral hazard associated with its lending. do these changes therefore mean that moral hazard has become a more significant problem and that this now needs to be addressed in some other way?

The moral hazard argument against ImF lending was popularised by the meltzer Commission at the end of the 1990s (IFIAC 2000) and stimu-lated a number of responses. The issues involved are in one sense fairly straightforward. An international lender of last resort will help create con-fidence in international capital markets and will therefore reduce the inci-dence of crises, provided it possesses adequate capacity to lend. Against this, the availability of ImF resources may encourage countries to pursue over-expansionary policies and foreign investors to underestimate the risks of lending, and may therefore make crises more likely. dealing with this dilemma hinges on recognising the potential moral hazard problem, estimating how important it is and devising mechanisms for neutralising it, without at the same time sacrificing the benefits of ImF lending that allow



countries to minimise the economic and social costs of crisis resolution. The difficult thing is not in identifying the relevant issues but in selecting an appropriately balanced response to them.

The problem here is that there is as yet no entirely satisfactory sci-entific foundation upon which to construct such a balanced response. There remains disagreement about the past significance of moral hazard (for a review of the evidence see Bird 2007) and there is no clearly speci-fied model that allows the demand for ImF credit to be explained and predicted with confidence (see, for example, Ghosh et al. 2007; Bird & rowlands 2010). The challenge facing the ImF is therefore to find a satis-factory outcome by a process of trial and error, and in the light of changing circumstances. The global financial and economic crisis was just such a change in circumstances and led to the broad consensus that the ImF’s lending capacity should be expanded to enable it to fulfil a beneficial role in seeking to overcome the crisis. But the question remains ‘By how much?’ Even answering this question does not end the debate over the ImF as an international lender of last resort, since there is then the ques-tion of how the ImF will generate the resources necessary to fulfil this role.

The ImF’s resources currently come from quota-based subscriptions made by members, and funds borrowed under various arrangements with its wealthier members or members in a strong economic position. Is this method of financing the ImF’s operations ideal or can it be improved? As will be discussed later, quotas are part of the ImF’s organisational struc-ture that could be beneficially reformed, and borrowing from members exposes the ImF to delays and to potential political influence, when it has been claimed that such influence is already excessive. A challenge facing the ImF is to find preferable options.

International reserves and the reserve system

In the aftermath of the crises during the 1990s, the ImF encouraged affected countries to build up their own international reserves. However, after the East Asian crisis in 1997/98 many countries seemed to do this to an extent that was excessive in relation to conventional models of reserve adequacy. A key factor seems to have been a desire not only to avoid future crises but also to avoid the need to borrow from the ImF. Bird and mandilaras (2010) provide evidence to suggest that reserve accumulation



has been positively associated with previous ImF programmes. There is little point in the ImF existing if there are only very limited circumstances in which countries will turn to it for financial assistance. Indeed one of the purposes of the ImF is to pool international reserves at the global level and help avoid the inefficiencies associated with individual countries amassing their own reserves. The desire to accumulate owned reserves also implies that countries will be running current account balance of pay-ments surpluses, and as noted earlier this contributes to global economic imbalances which can then make future crises more likely.

The issue is therefore how to modify the preferences of countries in such a way that they reconsider their attitude to borrowing from the ImF. reforms to conditionality that make it appear softer and more flexible, along with the availability of larger amounts of finance, may be expected to help (though potentially at the risk of magnifying any moral hazard problems). Also helpful might be the creation of additional Sdrs that will enable countries to accumu-late reserves without having to earn them through balance of payments surpluses (for a further discussion of Sdrs see Bird 2007, 2010). But how far should such reforms be taken? To what extent will political factors constrain more radical reform?

In circumstances where crises have created conditions of global illiquid-ity, the more purposeful management of international reserves may also be a theme that could be explored in more detail by the ImF. In addition, the use of national currencies, in particular US dollars and euros, as inter-national reserve assets creates instabilities for the international monetary system as reserve holders are tempted to switch the currency composition of their reserve portfolio in anticipation of gyrations in currency values. Having an international reserve asset that is more stable in value would be an improvement, and working towards such a system could be an item on the reform agenda of the ImF. The ImF may be judged in the future on the effectiveness of it reforms aimed at reducing the accumulation of reserves and modifying the extent to which the reserve system contributes to international financial instability.

There is little point in the IMF existing if there are only very limited circumstances in which countries will turn to it for financial assistance.



Involvement with low-income countries

For a long time the ImF’s dealings with low-income countries (lICs) have reflected a rather uneasy compromise between two views. one view is that these countries are members of the ImF that encounter balance of payments problems and therefore warrant ImF assistance. The other view is that while poor countries need long-term development assist-ance, the ImF is not a development agency; it is not well equipped to deal with the problems that lICs face. The compromise has been that the ImF has continued to lend to lICs but has attempted to modify its conditionality to reflect the longer-term supply-side difficulties that need to be addressed. By the end of the 1990s a number of influential reports were arguing strongly that there ought to be a clearer institutional division of labour between the ImF and the World Bank, and that the ImF should reduce its lending role in poor countries. This was an opinion shared by some of the ImF’s own senior management, who were comfortable with the ImF offering advice on the design of macroeconomic policy but not with its input into structural reform. Aid fatigue during the 1990s made the situation more awkward for the ImF, since it made its somewhat reluctant involvement in lICs relatively more important.

during the first half of the 2000s, circumstances seemed to be changing. Aid flows were increasing and an improving global economic environment was allowing many poor countries to improve their economic performance. The ImF was able to present itself as more of a facilitator than a financier in lICs, and it shifted its emphasis to the provision of adjustment moni-toring and advice under the umbrella of the Policy Support Instrument (Bird & rowlands 2009). If finance was to be provided, it was more likely to be in the form of a short-term cushion against exogenous shocks that would otherwise blow economic reform off course.

However, the global economic and financial crisis of 2008/09 has changed things once again. With aid flows falling, and perhaps likely to fall further, and private capital flows (particularly in the form of foreign direct investment) also declining sharply, the need for the ImF to play a direct financing role has been enhanced. But this has happened at a time when a more parsimonious approach to structural conditionality has also been adopted. The challenge facing the ImF with regard to its dealings with lICs involves determining the extent to which it should focus on providing a complement to conventional bilateral foreign aid by assisting



with the design of macroeconomic policy, or providing a substitute for bilateral aid in the form of external financing. There is then the question of whether the recently redesigned portfolio of facilities within which the ImF assists lICs will be better suited to meeting their needs than the Poverty reduction and Growth Facility they replace.

Governance and organisational structure

The big issue here is the extent to which the ImF’s current governance and organisational structure contributes to or detracts from its effective-ness as a global institution. The issue is complicated. The ImF may be expected to be more effective if it is seen as carrying legitimacy. It may carry more legitimacy if its governance is representative of its member-ship. However, if the effective representation of emerging and developing countries within the decision-making processes of the ImF is increased, there is the risk that the wealthier countries may disengage from it, and weaken its effectiveness and capacity.

Again the challenge is to find the appropriate balance. recent reforms have modified quota shares and have increased basic votes; these reforms have been presented as attempts to change the balance of power in favour of emerging and developing countries, but have they gone far enough? Commitments by the G20 to choose the ImF’s managing director on merit rather than stay with the convention of having a European as md and a US national as First deputy managing director may also demon-strate a willingness to do something about dealing with the perception that there is a political bias in favour of advanced economies. But how much further does this willingness go? Would it go as far as granting the ImF independence? (See Bird 2006a for a fuller discussion.) And, if so, how could an independent ImF be made more transparent and accountable? Could senior management be given more discretion in the running of the ImF by modifying the role of the Executive Board so that it focuses more on global and systemic issues rather than individual programmes? Would it be more feasible to have modest changes based on modifying the compo-sition of the constituencies represented by some Executive directors (see Woods & lombardi 2006 for a discussion of this idea).

In terms of organisational structure, the efficiency of the ImF might be improved by moving away from using quotas as a fundamental organi-sational building block (see Bird & rowlands 2006). It is no coincidence



that quotas have proved to be highly resistant to fundamental reform since they are trying to serve mutually inconsistent purposes. Improving their design in terms of serving one purpose, such as determining the distribu-tion of voting rights, makes them less well equipped to serve another, such as the allocation of subscriptions. The basic problem is that the ImF was initially envisaged as being a credit union with member countries making subscriptions but also occasionally drawing resources from it. For such an institution quotas might be appropriate. But its nature has changed. despite the recent crisis and the travails of smaller, wealthier nations (such as Iceland and Greece), there remains a clear bifurcation between the countries that provide resources to the ImF and those that draw resources from it, and the quota system simply does not deal with this well. There is therefore an argument for stepping away from using one instrument to achieve multiple purposes and designing different formulas for the deter-mination of voting rights, drawing rights and subscriptions.

There may also be an argument for further reviewing the range of facili-ties under which the ImF makes resources available to its member coun-tries. After the early 1950s, when all ImF lending was conducted under stand-by arrangements, there was a rapid proliferation of lending windows designed supposedly to meet different country needs. The ImF seemed to exhibit a greater proclivity to introduce new ones than to abandon old ones, such that the stock of facilities increased. It is unclear whether the facilities have always been operationally distinct. For example, Bird and rowlands (2007) discovered that any pronounced and statistically sig-nificant distinction between the economic circumstances in which stand-bys and extended credits have been used has, over the years, been lost. Although the reforms to the ImF in 2008/09 seem to represent an attempt to tidy up and clarify the functions of different facilities, the issue still remains as to whether the new portfolio of lending facilities is optimal and whether, in practice, they will be used in the way their rubrics suggest. do extended arrangements, for example, continue to make sense if the ImF is simultaneously abandoning structural conditionality? By the end of the 2009/10 fiscal year there were only two extended arrangements in place (in moldova and the Seychelles) against a total of 55 programmes. Announcements by the ImF’s managing director in July 2010 to further modify and extend the range of lending facilities suggest that the ImF believes that additional reforms are needed.



Generic difficulties in resolving the issues and meeting the challenges

There are a number of things that will get in the way of a speedy resolu-tion of the issues that the ImF currently faces. First, for many of them there is no secure theoretical or empirical basis upon which to build and upon which reforms can be founded. This deficiency applies to, for exam-ple, the design of macroeconomic policy and conditionality, the effects of capital account liberalisation and the desirable amount of ImF lending. The implication is that ‘best judgement’ needs to be made drawing on what analysis and evidence is available, while efforts are simultaneously made to gain a better understanding of the underlying issues. A ‘learning by doing’ approach to reform may clearly mean that mistakes are going to be made, so it becomes important for the ImF to be willing to acknowl-edge them when they occur, and to try to rectify them.

Second, experience suggests that there can be a significant gulf between rhetoric and reality. This was, for example, apparent in the pursuit of the streamlining initiative which did not fully deliver on its promises. Where reforms are introduced, they will be more effective if there is strong insti-tutional commitment to them, and this may be difficult to garner where the issues are themselves complex and where there are legitimate grounds for debate. Another way of making a similar point is to note that it is often difficult to modify institutional psychology in anything other than the long term.

Third, although a crisis may create an environment in which change can occur, it may be difficult to sustain the motivation for reform once the crisis has passed. There may be only so much reform that can be achieved before the window of opportunity closes or before reform fatigue sets in. The temptation will always be to carry out the reforms that are relatively easy to put in place, and to leave the reforms that are more fundamental and more difficult to get agreement on.

Fourth, since reform is likely to be piecemeal and incremental, it is helpful to have a broader blueprint of reform so that individual elements can move the institution in the desired direction overall. But it will be dif-ficult to gain agreement on what that blueprint is. disagreement may then make it less easy to bring about even modest reform. The ImF’s attempt to come up with a blueprint in the form of a medium-term strategy in 2005



was regarded by many influential critics as disappointing, casting doubt upon the chances of constructing a new one that is both ambitious and carries wide support among the ImF’s membership.

Fifth, since the ImF is only one of a number of important global institu-tions, and since the issues with which it is dealing do not always fall neatly into particular institutional domains, it is important to ensure institutional coordination based on comparative advantage. Will the G20 provide a better institutional framework for achieving international macroeconomic policy coordination? Would the WTo be an appropriate agency for for-malising measures to encourage surplus countries to alter policies that are perceived by the rest of the world as globally antisocial? And what should be the division of labour between the ImF and the new Financial Stability Board? In terms of appropriate financial sector reform, the contribution of the ImF will be constrained by what the FSB achieves. These questions become more difficult to resolve if institutions exhibit the characteristics that public choice theory attributes to them, and where they are keen to maximise their own areas of responsibility and power.

Finally, the process of reforming any global institution will be heavily influenced by politics. This might be expected to create particular diffi-culties where one of the purposes of reform is to try to relax the political constraints within which the institution operates. In designing a reform agenda for the ImF, is it better to show an awareness of what is easiest to achieve politically and to aim for more modest and less contentious reforms, or to try to overcome political resistance to reforms that are more far reaching? We leave this as a rhetorical question.

Concluding remarks

The basic case for having the ImF is that the world economy is better with it than without it. The justification for its existence hinges on its ability to help deal with the sources of market failure in the form of externali-ties, public goods and coordination failures. Given this justification, it has both an adjustment and financing role in individual countries as well as a systemic role. At the beginning of 2008 many of these roles were not very apparent and reforms in 2008/09 were aimed at strengthening the ImF in each capacity. But have the reforms gone far enough? The future of the ImF depends on how well it deals with a number of fundamental issues



and contemporary challenges that it confronts. In this paper we have sought to identify what these issues and challenges are, and to consider some of the impediments that may get in the way of future reform.

What does the future hold for the ImF? We sidestep this question on the grounds that the history of the ImF’s evolution is characterised by responding to events that were difficult to foresee. We may be in safer ter-ritory in contemplating what will not happen. It is unlikely that there will be rapid and fundamental reform of the ImF. The aim of reform spread over the years ahead should however be to construct an international financial institution that carries legitimacy by adequately representing the interests of all member countries but without threatening its effectiveness by enticing powerful advanced countries to disengage from it. It should seek to establish a more effective and efficient organisational structure. It should also enhance the ImF’s adjustment role by enabling it to exercise effective pressure on member countries to undertake globally appropri-ate economic policies, and it should facilitate a significant financing role by allowing the ImF to provide adequate emergency resources and help fill (under adequate safeguards) the financing gaps left by international capital markets. Beyond these objectives, the ImF should become a more outspoken advocate of desirable systemic international monetary reform. How might it achieve these objectives?

Here we offer our own medium- and long-term reform strategies for the ImF based on our interpretation of the available research. In the medium term – say, over the next five years – it should seek to reduce still further the perception of political bias. This will require bigger changes to quotas than have currently been adopted. It should select its managing director and First deputy managing director solely on merit. It should be prepared to borrow from international capital markets to finance its operations rather than rely on borrowing from member countries. It should be prepared to continue to modify its conditionality on the basis of experi-ence, and it needs to accumulate more knowledge and understanding of the difficulties relating to the design of fiscal policy, monetary policy and exchange rate policy. It should seek to improve its ability to effectively deliver policy advice in the absence of lending, while improving its rapid lending facilities that operate in the absence of ex post conditionality. It should undertake organisational reform to reassess the roles of senior management and the Executive Board, to allow the former to play a more



independent role in the day-to-day running of the ImF and the latter to focus more on global and systemic issues. It should reassess its lending role in low-income countries and consider how the Sdr might be used to facilitate enhanced real resource transfers to them with appropriate condi-tionality. It should ensure that its organisational design allows it to offer a flexible response to economic events as they occur.

In the longer term the ImF should be granted more independence, but with checks and balances that deal with the potential public choice critique. It should seek to move away from the system based on quotas, and replace it with a different set of criteria for determining subscriptions, drawing rights and voting rights. It should seek to construct an effective set of incentives to encourage the international coordination of macro-economic policy in liaison with other international organisations such as the WTo and G20. It should aim to establish a reserve system based on Special drawing rights. Finally, it should retain flexibility and a rapid response capability.

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