Quarter 2, 1998
by Jane Little

Throughout the current Asian crisis, the International Monetary Fund has been under attack from all sides—right, left, creditor, borrower, and academic. It has been accused of failing to warn the world that a serious crisis was brewing and of yelling "Fire!" in a crowded theater; of using taxpayer funds to "bail out" rash investors, undemocratic governments, and firms competing with U.S. producers; of making matters worse, especially for the poor, by imposing excessively harsh reform programs as a condition of its help; of trying to do what private markets do better; of being too big; of being too small to have adequate expertise; of being arrogant; and of being insensitive. With criticism from all corners, could the Fund be doing something right?

World leaders created the IMF in 1944 to oversee international exchange rates and prevent a return to the disastrous economic conditions of the 1930s that paved the way, as they saw it, to World War II. But the international financial system they envisioned is long gone and, with it, the IMF's original focus. Of course, institutions, once created, rarely disappear. So, almost from the start, the IMF has evolved to reflect its members' changing priorities and the crises that have punctuated the years. Now, as the IMF stands shrouded in criticism for its role in the Asian crisis, its harshest critics argue for its demise. Supporters counter that the virulence of Asia's financial contagion and the costs of the ensuing downturn illustrate precisely why the world needs an international lender of last resort like—or almost like—the IMF. They offer reform proposals to strengthen the IMF and mitigate the tensions facing any supranational lender of last resort.

THE WORLD ACCORDING TO BRETTON WOODS

In July 1944, three weeks after the Allies landed in Normandy, representatives of 45 countries gathered in the spectacular peace of New Hampshire's White Mountains to establish the international monetary system for the postwar world. Working from plans drawn up by Great Britain's Lord Keynes and America's Harry Dexter White, the Bretton Woods conference sought to create an international financial environment supporting sustained, widespread economic growth. Convinced that the chaotic economic conditions and "competitive" devaluations of the 1930s had led to war, the delegates adopted a system of generally fixed/occasionally adjustable exchange rates. Under this plan, the United States became the pole star, standing ready to exchange U.S. dollars for gold at $35 per ounce; other countries, with little gold, fixed their currency in terms of the U.S. dollar, which became the world's reserve and major transactions currency.

To oversee the new system, the conference created two multilateral institutions. The International Bank for Reconstruction and Development (World Bank) was to finance postwar reconstruction and development. The IMF was given responsibility for overseeing the international monetary system; through its "surveillance" of members' exchange rate and other economic policies, its primary mandate was fostering full employment and orderly economic growth. In those early years, surveillance emphasized nudging members to set the value of their currency in terms of the U.S. dollar (and gold) and to end currency and trade controls. Surveillance also meant ensuring that nations maintained their currency peg, once established, except in cases of "fundamental disequilibrium." While this state was not defined, it was presumably recognizable since a change in the peg required IMF review. When payments problems were deemed temporary, member governments were expected to use always printable domestic funds to "purchase" (borrow) dollars or other desirable currencies from the IMF to tide them over; they were not to resort to currency depreciation and export slow growth. Members financed the Fund by providing gold and domestic currency in accord with their economic strength. Their "quotas" defined their voting rights as well as their ability to borrow. (The distribution of voting rights mirrors the belief that multilateral institutions can act only when their most powerful members agree.) Members facing exchange rate pressures could draw dollars in amounts measured in fractions of their quotas. Permission for the first drawing, equal to the member's gold contribution, was automatic; each additional drawing came with increasingly stringent conditions.

By the early 1970s, however, the world according to Bretton Woods had vanished. A series of balance of payments deficits had forced the United States to cut the dollar's link to gold; shortly thereafter, market forces were allowed to determine the major (dollar/yen and dollar/mark) exchange rates with only an occasional prod from government intervention. The Bretton Woods system crumbled because it contained internal inconsistencies. In a fixed-rate system, debtors with dwindling reserves generally feel more pressure to take corrective contractionary action than surplus countries, gaining reserves, feel to expand. Because the Bretton Woods delegates had failed to agree on a way to allow international liquidity to grow with world trade and investment, the system had a built-in contractionary bias. In fact, the only reliable source of international liquidity was a growing U.S. balance-of-payments deficit which provided other nations with "good-as-gold" (thus widely acceptable) dollar reserves. But, as surplus countries used their dollars to buy gold from the United States' dwindling stock, they destroyed the credibility of the U.S. commitment to redeem dollars for gold at a set price—the pledge that anchored the Bretton Woods fixed-rate system.

The emergence of an eclectic new financial system (with clean floats, managed floats, firm pegs, crawling pegs, and no role for gold) led to major changes at the IMF, but the Fund's form and focus had been evolving almost from the start. In response to early needs for added liquidity, members first increased quotas in 1959 (and have done so 10 times since). They also set up new ways to finance IMF operations—like the General Arrangements to Borrow, a G-10 pledge to provide extra funds for a G-10 drawing. (The GAB's descendant, the New Arrangements to Borrow, adds contributors, doubles the funding, can be used for noncontributor drawings, and awaits approval by the U.S. Congress.) Members also established special purpose lending facilities for the most vulnerable countries. And in 1970, in a case of too little, too late, the member governments created a synthetic reserve asset, the Special Drawing Right (SDR), which is defined in terms of a basket of currencies and issued whenever a majority of members sees fit. The move to a more flexible "system" has limited its role.

Post Bretton Woods, the IMF has continued to evolve in response to new threats to world stability—the oil shocks of the 1970s; the 1980s' debt crisis in the developing countries; the breakup of the Soviet empire, which required Central and East European countries to negotiate the transition from planned to market-based economies; and the Mexican peso crisis of 1994-95. When these shocks produced serious payments problems in developing countries, they turned, perforce, to the IMF for its conditional help. In its joint role of advisor and taskmaster, the IMF has, also perforce, racked up considerable experience with exchange rate crises and adjustment programs. Over time, with hindsight, it has gained some sense of what works and what doesn't in a variety of settings. To carry out its responsibilities, the IMF collects and publishes quantities of data (never enough, of course) and conducts and shares its analyses of these crises and their aftermath. Its role as conditional lender/de facto creditor with a stake in the outcome gives these efforts a persuasiveness they might otherwise lack. And since the IMF is a multilateral institution, the benefits of these costly activities are widely shared. By contrast, the private sector has less incentive to perform these tasks since individual firms could not reap all the benefits. For domestic political and foreign policy reasons, industrial country governments have also been glad to curtail their bilateral efforts and let the IMF play the heavy.

THE IMF AS SCAPEGOAT

Today, much of Asia is suffering a sharp downturn as a result of the fierce financial crisis that erupted in Thailand last year. The contagion proved to be virulent, destabilizing weak banking systems and curbing growth throughout East Asia and beyond. Exchange rates in the afflicted countries remain as much as 75 percent below their early 1997 levels, and industrial output has plunged over 10 percent, year-over-year, in Korea, Thailand, and the Philippines. The extent of the contagion, which was not widely expected, has been a good deal worse than occurred during the Mexican peso crisis. (See sidebar on Mexico.) What went wrong? And is the IMF to blame?

IMF Myopia. Some critics ask why the IMF didn't see the Asian crisis coming and issue clear warnings. They complain that as the institution charged with collecting data and overseeing members' economic policies, the IMF was remiss. In fact, however, the IMF did issue public alerts, albeit carefully worded, about the large-scale capital flows flooding into Southeast Asia, particularly Thailand. (And some bankers seem to have got the message, since bank flows to Thailand actually slowed in 1996. If others did not, is the IMF to blame for their failure to perform adequate risk analysis?) In private, the IMF also warned Thai officials with growing urgency that its foreign short-term bank debt was rising to dangerous heights; its advice fell on deaf ears. In such cases, the IMF does not want to yell "Fire!" and ignite the crisis it is trying to prevent. And as a multilateral without supranational authority, it cannot force members to accept its advice.

But the IMF may have been slow to recognize how the crisis might spread—with hindsight, its October World Economic Outlook and the December supplement seem incredibly optimistic about Asia; of course, it still faced the "Fire" issue. More important, while "fundamental" problems—real exchange rate appreciation and deteriorating current accounts, poorly regulated banking systems weakened by excessive levels of bad debt, unwise real estate investments, to name a few—help explain the start and spread of the turmoil, once under way these currency/banking crises can become wildly unstable. As growing crowds of investors refuse to renew foreign-currency loans, exchange rates drop, interest rates soar, and more and more borrowers face liquidity and then solvency problems. Deals and firms that were viable at one set of exchange and interest rates become nonviable at another set. These "multiple-equilibria situations" are by nature highly unpredictable; no one can say when the cumulative collapse will run out of steam.

IMF "Bailouts." Critics also claim that IMF rescue programs provide "bailouts" to (a) irresponsible or undemocratic governments or (b) undeserving investors. But, as already described, IMF programs do not provide bailouts to countries or governments of any stripe; they provide conditional, (subsidized) interest-bearing loans that may be rescheduled on occasion but, to date, have always been repaid. Moreover, these crises are very costly—in terms of lost output and reduced living standards—to the borrowing countries. Indeed, the primary intent of IMF programs is to limit needless suffering by innocent bystanders when errors in debtor and lender countries turn markets unstable. At base, these loans are public investments in global stability.

Nevertheless, IMF loan programs may, in fact, increase the probability of future crises by signaling investors that they are likely to be rescued from their mistakes if trouble develops. Thus, the Mexican "bailout" may have contributed to the Asian crisis by encouraging investors to make excessively risky loans in the belief that they would reap the gains if all went well but would bear little cost if a crisis developed. While the possibility of increasing "moral hazard" is a serious issue for domestic authorities as well as the international community, most nations opt for a domestic lender-of-last-resort facility because the systemic costs of a bank run are very high. Governments try to minimize excessive risk taking by limiting deposit insurance (thus giving depositors a reason to favor sound banks) and by ensuring that the shareholders and managers of insolvent institutions suffer the consequences of their mistakes.

In the Asian crisis, many investors have actually taken big losses. Foreigners investing in East Asian equities lost $80 billion to $100 billion in the second half of 1997, and some U.S. and European banks have announced that Asia-related losses have dented recent earnings. Still, IMF rescue programs probably do provide an element of "bailout" to some private investors. For example, the Korean financial crisis finally stabilized in early 1998 when the international banks agreed to roll over Korea's short-term debt at longer maturities and at interest rates two to three percentage points above the London interbank rate. But the debt now carries a Korean government guarantee made possible by the multilateral rescue program. All told, the creditor banks are probably paying a relatively small share of the total cost of Korea's crisis. Similarly, IMF rules that borrowers must be current with private creditors before IMF funds are disbursed tend to put the banks in the driver's seat.

Adding Fuel? IMF detractors also claim that the Fund's reform programs "do more harm than good" because (a) they inflame the panic by exposing financial system weakness, and (b) they require restrictive monetary and fiscal policies that slow economic activity, hurting the poor in particular. In a domestic banking panic, it is true, the generally accepted prescription calls for the monetary authority to lend freely to restore confidence; tightening monetary policy would not seem appropriate. But in Asia, a bank panic was compounded by a currency crisis; the latter usually calls for hiking interest rates and cutting government spending. In this dilemma, priority probably had to go to halting the contagious currency collapse, which was ballooning the cost of the Asian banks' dollar-denominated debt and pushing already weak institutions toward insolvency. Under the circumstances, it seems unlikely that global investors would have reacted favorably to IMF yells of "Lower rates, spend freely." Nor does it seem likely that IMF requirements alerted investors to banking system weakness; they had already noticed. Once the cat was out of the bag, they needed to know that real reform was under way.

Unfortunately, with or without the IMF, a sharp devaluation slashes living standards in the devaluing country—since it takes more domestic output to buy a given quantity of imports. The increase in the price of essential imports feeds domestic inflation but also absorbs funds that would otherwise have been spent at home; thus, like a tax increase, it dampens demand for domestic output. But a devaluation also makes a country's products less costly in global markets and thus provides the foundation for recovery. In time, exports will strengthen, paving the way to growth—unless a surge in inflation destroys the country's new competitive edge. This need to protect the basis for recovery underlies IMF advocacy of tight monetary and fiscal policies following a currency crisis. Moreover, as the Asian crisis dragged on, often because of political and policy uncertainties in the borrowing countries, the IMF has been quite flexible about changing fiscal and other targets as they became overly optimistic. Again, early on, the IMF cannot set its targets to match the worst-possible scenario without inviting that outcome.

Inappropriate Advice? The IMF also stands accused of always addressing the last crisis and of giving advice that is inappropriate to the current case—with some justification. With hindsight, the IMF may have been slow to emphasize the importance of a healthy banking system to growth and stability. Nor, as many now urge, did the Fund point out that strong bank supervision and regulation, which takes time to develop, must precede financial market liberalization. Similarly, IMF staff and many others chose to focus on reassuring international markets and failed to consider that closing several banks in a country, like Indonesia, with no deposit insurance and no experience with bank failures, was likely to create a domestic panic. Sequencing, setting, and psychology turn out to be important.

In that context, IMF staff are sometimes charged with being insensitive, undemocratic, and lacking good understanding of the country in question. But governments only go to the IMF under duress. Indeed, in the midst of a financial crisis, the sky really is falling, and officials from "miracle" countries must feel quite disoriented, thrust into IMF negotiations with no experience with anything but success. No wonder tensions run high, and suspicions are prevalent. Still, a multilateral institution is more likely to be disinterested than a private-sector group or another government. And if the IMF does not fully grasp what makes each borrower unique, it does understand world financial markets, a key perspective in times of crisis.

As for being undemocratic, the IMF clearly recommends actions that inflict short-term pain (occasionally even permanent losses) on individuals to whom it is not directly accountable. While some critics would let apolitical (and unaccountable) private markets provide a resolution, crisis prevention or management is not the markets' strong suit. Moreover, while IMF programs, like the crisis itself, may have political consequences, that's one reason why governments prefer a multilateral to a bilateral approach; they seek to avoid direct political involvement. The IMF itself is, of course, a creature of and accountable to its members.

WHY THE WORLD NEEDS AN INSTITUTION ALMOST LIKE THE IMF

Even IMF critics agree that the world needs a multilateral institution to collect and distribute (preferably more) national data on an international basis. Many players also want a neutral observer to evaluate economic policies in individual countries and to share those evaluations (more) publicly. The need for an international lender of last resort is more controversial, but world capital flows are now massive; over a trillion dollars flow through the foreign exchange markets each day, and international loans outstanding totaled roughly $10 trillion at the end of 1997. Usually beneficial, international capital flows are easily spooked. When global investors panic and flee a country's banks, a domestic lender of last resort is in no position to create the dollars or other foreign currency needed to provide liquidity and restore confidence. And the cleanup process requires a neutral, apolitical referee. All told, the world needs an international lender of last resort almost like the IMF. The most promising proposals for change address the conflicts the IMF faces as a multilateral institution—generally by requiring the private sector to play a larger role in preventing or paying for international financial crises. The IMF, well aware of recent criticisms, has already included many of these suggestions on its working agenda.

One way to increase the role of the private sector may be to improve the transparency of government, bank, and nonbank corporate finances, as suggested by U.S. Treasury Secretary Rubin. Right now, contrary to the situation in the United States, where the domestic lender of last resort supervises the institutions that might need help, the IMF must rely on member governments to provide adequate supervision and shut insolvent institutions. It also relies on sovereign governments to carry out the policy changes negotiated as part of its rescue programs.

Alternatively, if the IMF and other organizations, like the Bank for International Settlements, further develop international capital, accounting, and reporting standards for governments and financial and nonfinancial firms, private markets will gain additional disciplinary powers. Once such standards are available, market pressures are likely to force their use since countries that fail to release this information will face higher borrowing costs. Such "competitive transparency," to use Morris Goldstein's phrase, would allow the private markets to augment the IMF's powers of persuasion. By encouraging timely corrective action, such increased transparency might even reduce the frequency of international financial crises and the use of safety net facilities.

The IMF could also publish its full and frank appraisal of member countries' economic policies and the details of borrower reform programs. (It currently publishes part of its assessment—only if the member consents.) Such a proposal raises dangers that governments might be less forthcoming and that revealing the IMF's unvarnished views could precipitate the crisis it seeks to avoid. After all, historically, bank regulators in the United States and most other countries have treated the examination results for individual institutions as highly confidential. But in the end, market reactions to a failure to publish IMF reports may resolve many of these issues.

The private markets may also—eventually—help reduce the moral hazard created by IMF rescue programs by requiring that the private sector bear a greater share of the costs of international financial crises. While some market participants object that this proposal would raise borrowing costs for developing countries, that is precisely the idea. The Asian crisis occurred because these countries were encouraged to borrow too much by interest rates that barely exceeded rates on U.S. Treasury securities and did not accurately reflect the risks involved.

How can risk be shifted to the private sector? One proposal, associated with Jeffrey Sachs, calls for allowing governments facing an international financial crisis to declare bankruptcy, as municipal governments can in U.S. law. Under such procedures, the IMF would call a standstill on servicing all existing public and private debt until these loans could be rescheduled or written down. Because the debtor country could borrow new, privileged funds ("working capital" in effect) in the interim, it would be able to maintain higher levels of public service than possible currently. The debtor would thus enter the negotiation/settlement phase without the pressures of a rapidly deteriorating situation. But international bankruptcy procedures for governments are unlikely to be available any time soon. That achievement would require resolving conflicts between national bankruptcy laws and developing a way to coordinate the claims of large numbers of diverse debt holders. While these problems may not prove insurmountable, finding solutions will take time.

Alternatively, Catherine Mann of the Institute for International Economics and others have suggested that financial institutions could design new assets that specify at time of issue their status in the event of default. Another relatively straightforward step would let countries draw on the IMF even when they are in arrears to private creditors. These ideas are worth pursuing because finding ways to shift part of the cost of future crises to the private sector is likely to reduce the use of lender-of-last-resort facilities and thus moral hazard.

But the need for international lender-of-last-resort facilities will remain. Raising the potential cost of mistakes to the private sector may decrease the frequency of those mistakes but will not eliminate them. Similarly, improved availability of data and analysis may reduce but will not end overoptimism and herd behavior. Accordingly, the IMF needs adequate funding so that it can forestall a crisis before it gathers momentum. Forcing the IMF to search out funds once trouble starts merely allows crises to build and needless damage to occur. Indeed, the industrial world's initially hesitant response may well have aggravated the Asian crisis. Unfortunately, the IMF's current liquidity position—the ratio of readily available funds to potential requests—is unusually weak. Enhancing the IMF's ability to prevent future crises requires funding the New Arrangements to Borrow and the quota increase.

The IMF is far from perfect. But much of the criticism surrounding it has been unbalanced, and many of the issues it confronts do not have perfect solutions. Thus, the world needs an international lender of last resort. While the IMF may make some mistakes, it also does many things right. And it is the only institution the world has that is capable of performing the truly essential role of international lender of last resort.

MEXICO — BY COMPARISON
In late 1994, Mexico faced a currency crisis in which the peso fell 40 percent. Within two months, the IMF and the United States organized a $40 billion multilateral rescue package ($17 billion from the IMF, $20 billion from this country). After a rocky start, Mexican officials, many of whom had experienced the debt crisis of the 1980s, soon persuaded financial markets that they were reacting constructively. Although Mexican output collapsed by 6 percent in 1995, recovery was under way just six months after the peso's fall. Mexico had repaid its collateralized, interest-bearing loan to this country in full by early 1997, is prepaying its IMF debt, and has regained access to private capital markets. With help from strong U.S. demand, output reached its precrisis level in late 1996. Equally important, the contagion was limited. Only Argentina (where GDP fell 4.5 percent) and Brazil (where growth merely slowed) felt serious spillover effects.

SOME IMF BASICS

Each of the IMF's 182 members contributes a fee or "quota" based on its economic strength. Quota size determines voting power and access to IMF funds; the U.S. pays most (18%) and has an effective veto over IMF decisions.
Quotas (equal to $194 billion in April 1998) fund the General Resources Account (GRA) used to lend to members in financial need. Members pay about 25% of their quota in currencies specified by the IMF, the rest in domestic money. Since most currencies are little used outside the issuing country, the GRA's effective size is about half its total.
In early 1998, the Fund had standby and other arrangements to lend $60 billion to 68 countries; loans totaling $44 billion were approved in 1997-98. Seven countries were in arrears by $3 billion; no country has defaulted on an IMF loan.
Readily usable IMF resources were about $32 billion in April 1997. The proposed quota increase of $88 billion (U.S. share is $14.5 billion) would add $58 billion in readily useful, uncommitted funds. The IMF can also borrow from official or private sources at market-based rates. In 1962, the General Arrangements to Borrow (GAB) set up a credit line from 11 industrialized countries for use in case of need by GAB members. In 1997, after the Mexican crisis, the IMF's executive board approved the New Arrangements to Borrow (NAB) with 25 countries to provide more generally useful emergency funds. NAB and GAB combined total $45 billion, with NAB to be the main source of emergency loans. But NAB awaits needed approval by its top-five contributors. The U.S. share of NAB is $3.2 billion.
—Anna Sokolinski