Download Cours 6 - Solvay Brussels School

International Finance
Part 1
Fundamentals of
International Finance
Lecture n° 6
The IMF and the provision of finance
1
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.
2
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.
3
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.
4
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.
5
The role of the IMF
IMF lending volumes since 1984
(in MM SDR - Source: IMF):
75 000
60 000
45 000
30 000
15 000
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
6
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.
7
The role of the IMF
IMF Net Flows of Fund since 1984
(in MM SDR - Source: IMF):
15 000
10 000
5 000
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
0
-5 000
8
-10 000
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.
9
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)
10
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.
11
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.
12
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
13
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
14
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.
15
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.
16
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.
17
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. 18
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.
19
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.
20
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.
21
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.
22
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.
23
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
24
export earning instability worsen the picture.
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.
25
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
26
monetary transmission mechanism does not operate.
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.
27
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.
28
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.
29
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
30
econometric models.
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
31
they had before, or than other countries.
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.
32