Chapter 40 Assessing IMF’s Crisis Prevention and Management Record
- International Monetary Fund
- Published Date:
- January 2001
According to Robert Litan, the IMF is in the crisis prevention and management business.1 He does not, however, say anything about whether it has in fact prevented any activity or practice of its clients that would otherwise end in a crisis. And when it comes to crisis management, Litan does not dispute the IMF’s warts that critics have noted, including moral hazard and unwise macro and microeconomic conditions that it has imposed. Nevertheless, he argues that presence of mistakes does not warrant dismantling the fund. He draws an analogy with the Federal Reserve, which was not abolished, despite its big mistakes in the 1930s. The Federal Reserve may not have been eliminated after 1933, but it was subsequently stripped of policymaking power (even allowing for the 1937-38 increase in reserve requirements—the one break in system passivity) by the two-decade predominance of the Treasury in monetary matters. What happened to the Federal Reserve between 1933 and the 1950s may be a good example to follow were the IMF to be shorn of its delusions of global indispensability, given its sorry record of crisis prevention and management.
I shall first discuss the record, and then question the belief that there is no desirable alternative to the role the IMF has assumed since 1995.
1. RECORD OF PREVENTION AND MANAGEMENT
At least two features of the prelude to the Asian crises called for steps to limit what was in train. One was excessive credit expansion that capital inflows fueled by increasing liquidity. Another was the magnitude of short-term debt in foreign currencies that the private sector assumed.
To deal with the rapid expansion of credit that breeds banking crises, the IMF could have urged Asian central banks to neutralize the capital inflow. The central banks should have sold their notes to the market, offsetting the rise in liquidity. The Asian countries did indeed try, relying on unsuccessful measures, to reduce the liquidity of their monetary systems, but there is no evidence in IMF publications that it offered intellectual support for their efforts, particularly central bank sales to the money market of its own notes.
Short-term foreign loans denominated in a hard currency become a problem when a domestic currency is devalued. The domestic currency burden of the debt then escalates. Barry Eichengreen proposes that limits be imposed on short-term foreign-currency denominated borrowing by banks.2 There is no indication, however, that the IMF expressed concerns about this feature of the Asian boom years. Limiting foreign claims on domestic banks is Eichengreen’s choice of a policy to replace government’s reluctance “to suspend payments and negotiate an agreement with creditors to restructure the debt.” He notes all the procedural problems that currently exist and offers solutions that would help bring creditors to the bargaining table should borrowers seek to restructure a loan.
I question the assumption that underlies Eichengreen’s proposal. Are governments in fact reluctant to default, and would they not do so except for IMF intervention to bail out the lenders? The foreign lenders to Asian banks should have had reason to worry about default on their loans but Mexico’s experience with tesobonos taught them otherwise. Were there IMF warnings to the Asian borrowers that they were incurring growing risks from their exposure? The foreign lenders should have been warned that no bailouts were in prospect.
If the IMF did not bail out either the debtor or the creditor, market discipline would restrain cross-border lending by Americans and others and the willingness of borrowers to assume debts.
Eichengreen believes that the reason governments oppose writing down foreign claims on domestic banks is that governments seek to protect their domestic banks from the flight of foreign funds. The Latin American defaults of the 1980s tell a different story. It was the lenders’ money center banks that the lender governments sought to protect. Restructuring would not have been so protracted except for their delaying tactics.
The IMF’s discussions with its clients are confidential, so there is no public record of the advice it gives. The IMF has, however, pleaded, after the onset of a crisis for which critics have faulted its performance, that it gave good advice, but the clients rejected its advice, hence the crisis. The question that follows is, what qualifies the IMF to be in the crisis prevention and management business if it lacks the moral authority to win the respect of its clients for the advice it gives?
If there is a lesson to learn from the Asian crises, it is that prevention is preferable to post-crisis conditionality. Prevention should be a responsibility of a country’s central bank.
2. SUPPOSE THERE WERE NO IMF CRISIS MANAGER
Supporters of the IMF give a scare-mongering response to this suggestion. One such response is the threat of contagion. If the IMF fails to bail out investors in one emerging country’s markets, it is said, there will be a tequila effect on other emerging markets, so investors will abandon those markets as well. Pure contagion, however, would occur only in circumstances in which other emerging countries were free of the problems facing the first emerging country. No evidence exists of pure contagion. Brazil is currently assumed to be the innocent victim of crises in Asia and Russia, when investors are clearly disturbed by Brazil’s well-known economic policy mistakes. Transmission is different from contagion. Shocks to one country will spill over to other countries through trade and the capital accounts. When investors withdraw their capital from countries with the same problems as were present in the first such country, this is a demonstration effect, not contagion.
There is still another scare story supporters of the IMF invoke. Absent the IMF, they say, the world financial system would revert to the 1930s. For this transformation to occur, the United States would have to endure three years of bank runs, which the Federal Reserve would take no action to halt, a one-third decline in the money stock, a decline of one half in national income, a deflation of prices by one-quarter to one-third, and unemployment would have to reach twenty-five percent. The rest of the world would have to cling to a gold exchange standard that was enforcing deflation and depression until individual countries abandoned it. The advanced industrialized countries would have to embrace protectionism and controls on capital movements. Does anyone truly believe that the world of the 1930s would reappear if the IMF would no longer bail out newly emerging countries that have mismanaged their economies? Let me counter with an alternative scenario.
A country engulfed by a financial crisis has a recourse that excludes an IMF bailout. That recourse is today’s world of deep capital markets that are ready to lend to liquidity-constrained countries at interest rates that reflect true credit risk. A country that offers collateral, as Mexico did in 1995 by pledging oil revenue to the Federal Reserve and the ESF, and is willing to pay a market rate of interest that included a credit risk premium, as when it borrowed from German banks to repay its U.S. loans, can find a welcome in capital markets. The market evaluates borrowers on the basis of their financial prospects, not on the basis of subsidized IMF bailouts.
The IMF is said to be preparing a $30 billion package for Brazil. So long as Brazil can obtain these funds at a subsidized interest rate, why would it consider seeking a loan from commercial sources? But if the IMF were not in the picture, capital markets would not rebuff Brazil. It can offer collateral, and pay an interest charge that covers credit and exchange rate risk. The interest rate will be lower than the rate Brazil currently is prepared to pay to defend the real. The market will impose covenants on the loan that will require Brazil to rein in its fiscal deficit.
Someone will object that a country may lack collateral and may find a market rate of interest onerous. My answer is that the country should not be a borrower. Charles Calomiris would recreate the IMF as a lender only to countries that meet stringent criteria.3 Countries, which fall short of the standard he sets, may require outright grants, not loans.
A financial crisis can have several elements: a current account deficit, a problem of debt service and amortization of international debts, and an undercapitalized banking system with a portfolio of nonperforming loans. The capital market can provide a short-term loan to deal with the current account deficit. The private parties involved in the loan contract, not the IMF, must negotiate restructuring the original terms of the loan. Eichengreen’s suggestions for improving the process may be helpful. The government will need to adopt measures to repair the banking system. It is not the IMF but a country’s government that has to put its house in order.
An IMF austerity program is not needed. Market forces themselves would impose belt-tightening in a country with an unsustainable current account deficit because it had borrowed too much and not made prudent use of the capital inflow.
We tend to forget that the IMF role as crisis manager is barely four years old. Relieving the IMF of that role does not mean that the international financial system will be imperiled. Before the 1990s, rescue loans were made in an attempt to prevent devaluation or abandonment of a pegged exchange rate by the core industrialized countries. They were temporary loans, at commercial market interest rates, limited in magnitude, but sufficient to offset a current account deficit. No taxpayer money was involved. Loans in the past accompanied a package of remedial policies.
Loans in this decade have been extended to newly emerging countries after their attempt to defend a peg has failed. The loans have been multiples of the amounts that were granted in the past. The recent loans are designed to offset a capital account outflow, the effect of which was to endanger repayment of the lenders. The size of the loan is large enough to provide the wherewithal to repay foreign and domestic lenders. A wealth transfer from taxpayers to wealthy recipients is involved.
A pervasive problem in the past as well as present times has been pegged exchange rates. Foreign commercial banks and other private lenders in recent crises extended loans at interest rates that did not take into account exchange risk, based on the incorrect belief that adherence to the peg was durable and credible. This experience supports floating exchange rates to avoid speculative attacks on pegs. If countries maintain floating exchange rates, capital markets should be able to handle any exigencies of both private and public finance.
Robert E. Litan, 1998, “Does the IMF Have A Future? What Should It Be?,” paper given at this conference.
Barry Eichengreen, 1998, “Bailing In the Private Sector,” paper given at this conference.
Charles Calomiris, 1998, “Blueprints for a New Global Financial Architecture,” paper given at this conference.