Comment: The Role of the IMF
- International Monetary Fund
- Published Date:
- September 2005
Lorenzo Bini Smaghi Director General for International Finance, Italian Ministry of the Economy and Finance
I will base my discussion on the following question: how do the two papers help us in addressing the key policy issues concerning the role of the International Monetary Fund 60 years after the Bretton Woods agreements?
These two papers fit quite nicely with the two key issues relating to the main tasks of the Fund: crisis prevention and crisis resolution.
I will use the paper by Eichengreen, Kletzer and Mody (“Monitoring International Borrowers: The IMF’s Role in Bank and Bond Markets “) as the basis for my remarks on crisis prevention, and the one by Chami, Sharma and Shim (“A model of the IMF as a Coinsurance Arrangement”) to address the issue of crisis resolution.
I draw from the first paper (EKM) the following considerations:
- In a world of imperfect information, the role of the Fund in surveillance is essential.
- Surveillance by the Fund is most valued by market participants when countries have a programme (i.e. they borrow), including precautionary.
- However, this is true only when the country has a sustainable level of debt.
Let me give the authors a note of caution on their findings. When this type of analysis is conducted, one should check for three main problems:
- Missing variables
- Alternative explanations.
For example, the paper tests the following causal relationship: an IMF programme means more information; more information means a lower risk premium, and a lower risk premium means more bond issuance.
There can be an alternative explanation: an IMF programme may be interpreted as the expectation of a bail-out, which means a lower risk premium, but also more bond issuance. The two hypotheses imply a similar relationship between the existence of an IMF programme and bond issuance.
The fact that the link between IMF programme and risk premium does not work at a high level of the debt should provide reassurance against this alternative hypothesis.
Another note of caution. Bank credit and bond issuance are not perfectly substitutable. They depend on a series of factors, related only on the creditors’ choice.
Third note of caution. Bank loans are not necessarily easier to restructure than bonds, as the paper seems to suggest. This was the case in the Asian crisis. However, the Turkish case (2002) has shown that it is increasingly difficult to coordinate bank roll-over, especially if the central banks do not play a leading role. The Argentine and Uruguay cases have shown that bondholders have over time found solutions to the coordination problem. (Politically it might become even more important in the future. Financial institutions do not vote, while bondholders do).
What are the main policy lessons that I draw from the EKM paper?
First, IMF programmes are a very important element in surveillance. This means two things:
- Surveillance needs to be strengthened independently of programmes.
- There should be a way for all countries to have access to the kind of surveillance and monitoring that is foreseen for countries that have an IMF programme.
The G7 is currently working on a strategic review of the Bretton Woods institutions. One idea is to have IMF programmes that do not necessarily entail borrowing from the IMF, the so-called “non-borrowing programmes”. Non-borrowing programmes would be based on strong policy commitments by countries. The Fund’s task would be to provide high frequency monitoring and sending clear signals on the extent to which the country is achieving the objectives. It would be stronger than staffmonitored programmes because it would involve the Board. The reports would also be published.
Such programmes could also help as “exit strategies” from programmes. They could also support the transition to accessing capital markets and could complement precautionary programmes, with less risk to the exposure of the Fund.
Second conclusion, IMF surveillance for high debt countries should be strengthened (at present it does not add much to available information) and be made more accountable and more transparent, i.e. more independent.
The IEO has shown that one of the main problems in surveillance and, in particular, Debt Sustainability Analysis, has come from the over-optimistic assumptions made by the IMF staff. This is not surprising. If you ask the same people who have designed a programme to assess it (in particular in terms of DSA, stress text, sensitivity analysis), they will select hypotheses which are consistent with the programme. There is a conflict of interest.
Surveillance (including DSA) is not sufficiently independent of programme design.
In any financial institution, the decision to lend is separate from risk management. The Analysis produced by risk management is provided independently to the Board.
In the IMF, the management has access to both assessments, but DSA is produced by country desk. The case of Argentina since 2001 is one where the information has not been provided transparently to the decision-making body, which is the Board. The risk profile of the IMF portfolio has to be decided by the Board.
In the Strategic Review, the G7 are examining ways to strengthen surveillance, ensuring greater accountability.
Two ideas can be put forward:
- Better integration between multilateral, bilateral and regional surveillance;
- Better separation between surveillance and programme design.
Concerning the second point, greater independence could be achieved by making PDR responsible for DSA. This would ensure independence of programme design.
Let me turn now to crisis resolution. Here I will use the paper by Chami, Sharma and Shim.
The main note of caution with this paper, as recognized in the paper itself, is in footnote 20: time inconsistency of the optimal policy by the country.
The paper does not include reference to private sector financing and its relationship with IMF financing. This is particularly relevant in addressing recent crises.
Another issue that the paper does not address, but which is very relevant to the current international debate is the status of the IMF as a preferred creditor. The ongoing discussions about Argentina underline the importance of this issue. How can an assumption on IMF repayment be made without some specific target concerning the primary surplus and independently of the hypothesis on haircut? How can the IMF defend disengagement while the private sector is taking a substantial hit?
The other issue that is not addressed in the paper is the possibility of defaulting with the IMF. The whole LIA policy is ignored.
Two counter-arguments have been put forward in the past: resources and micromanagement.
With respect to resources, some savings can be made in other areas, especially if bilateral and regional surveillance are more closely integrated. Concerning micromanagement by the Board, it is often forgotten that the principles of good Corporate Governance (e.g. those by the DECD) give responsibility to the Board to ensure that organizations are effective and avoid conflicts of interest.
As the paper recognizes, the key to ensuring the credibility of IMF policies is clear access limits. New procedures and criteria have been adopted recently. This has been a major innovation in IMF policy. We now have to implement it! This is the major challenge for the IMF. Recent research by the Banco de España shows that the main shortcomings in recent reforms has been implementation. One recent example is the concept of “negotiations in good faith” which has been questioned in the resolution of the Argentine crisis. Further clarification could be useful, in particular in the context of the Code of Conduct. This is an area where further progress would be very welcome.
Comment: Innovations in Private and Multilateral Lending
John Murray Advisor, Bank of Canada
I have been asked to discuss two thoughtful and interesting papers, and must admit at the outset that I have very little to offer by way of useful criticism or comment. Both papers present credible and convincing arguments for the positions that they advance, and I am in broad agreement with most of what they say. With these apologies duly recorded, allow me to make a few observations on what I regard as the papers’ major contributions as well as some modest suggestions concerning additional points that the authors might want to consider in future extensions of their work.
Let me begin with the paper by Eduardo Levy-Yeyati (“Dollar, Debts and the IFIs: Dedollarizing Multilateral Credit”). This paper focuses on the efforts of emerging market economies (EMEs) to develop strong domestic capital markets and to minimize the problems posed by foreign borrowing and currency mismatches. More interestingly, it advances an intriguing proposal for dedollarizing existing sovereign debt. According to Levy-Yeyati’s proposal, IFIs would be encouraged to roll-over their existing, largely dollar-denominated, loans for new obligations—denominated in local currencies. Levy-Yeyati notes that IFI debt now represents a significant portion of all outstanding EME liabilities, and that dedollarizing this debt would make an important contribution towards resolving the currency mismatch problem. In addition, the newly created stock of high grade, local currency, bonds could serve as a catalyst for the development of a more active and extensive domestic market in private and public sector debt. The IFIs would not lose anything through this conversion, the author suggests, since EMEs almost always repay their IFI debts and the loans could be indexed to guard against any loss in their real value. The IFIs, in turn, could finance these loans by tapping into the ready market created by emerging market investors who had sent their money off-shore, but who still might value the hedging opportunities afforded by risk free, local currency denominated, bonds.
Levy-Yeyati acknowledges the mixed reaction that similar proposals have received in the past, as well as the recent criticisms put forward by various IFIs, but claims that these concerns are misplaced or of limited relevance, given the unique features of his proposal. As I suggested earlier, I have some sympathy for both Levy-Yeyati’s proposal and his response to the critics. There might be a lack of investor and debtor interest in such instruments, as some critics have claimed, but it is not clear that anything would be lost by testing the waters. Any problems the IFIs might encounter would probably be of an operational nature, since the transactions costs associated with local-pay instruments might be slightly higher than those on dollar-denominated debt, and the resulting markets would probably be less liquid. In additional, it would be more difficult for IFIs to match their currency exposures on an ongoing basis. Non-resident investors would likely show little initial interest in these instruments, but resident investors who have shipped their money off-shore would seem to be obvious candidates.
The two main concerns that I have with Levy-Yeyati’s proposal are the following. First, it is possible that IFI claims would attract savings away from local EME financial institutions and capital markets, and draw towards off-shore financial centres. In other words, the IFIs could “cherry pick,” owing to their preferred creditor status, and actually frustrate or delay the development of local capital markets by redirecting funds that would have otherwise stayed at home. Second, from a broader perspective, it is not obvious that much would have been accomplished from the perspective of the EME. If sovereign obligations are (nearly) always repaid and the new loans are fully indexed, is there any material difference between these local currency instruments and the dollarized debt that they are replacing? There may be, in other words, a sort of “Modigliani-Miller irrelevance” aspect to this whole initiative.
By the same token, however, one could ask, what is the harm? If the new instruments are issued and there is limited take up or, alternatively, they simply substitute for existing claims, no one is worse off. On the other hand, there is a chance that they might actually do some good, and have the sort of catalytic effect that Levy-Yeyati claims.
The second paper1, co-authored by Andrew Haldane, Adrian Penalver, Victoria Saporta, and Hyun Song Shin, addresses a different, yet related, issue—the optimal design of collective action clauses for sovereign debt. Whereas Levy-Yeyati focuses on a specific innovation that might reduce the exposure of sovereign borrowers to sudden exchange rate movements and capital reversals, Haldane et al. (henceforth, HPSS) look at some of the endogenous elements that are in play when one designs collective action clauses (or CACs). Although CACs can both reduce the chances of a crisis emerging and facilitate the resolution of those which do occur, inappropriate or inflexible CAC features could have unintended and undesirable consequences.
The authors start with the observation that some bonds, recently issued by EMEs, incorporate slightly different features in their collective action clauses than the standard London-style instruments. More specifically, the voting thresholds required to approve a debt restructuring have, on occasion, exceeded the 75 per cent norm that has existed for many years on bonds issued under U.K. law. The major contribution of the paper is the construction of an elegant model which captures the inherent endogeneity of the decision process faced by borrowers and lenders, and which is also able to explain why some sovereign borrowers might want to issue bonds with a somewhat higher threshold. The logic runs as follows.
Countries which are perceived to be greater credit risks, as the authors suggest, may find it advantageous to raise the voting threshold because the potential costs that they might incur, in the form of a more difficult debt restructuring, are more than offset by the reduced probability that skittish investors will race for the exits in the event of a liquidity problem.
Once again, as I admitted earlier, I find it difficult to identify any significant flaws in the authors’ argument or the way the model is developed. Nevertheless, there are a few thoughts that occurred to me as I read the HPSS paper.
The first point that I would raise concerns the risk of giving too much significance to recent events. While it is true that Belize, Brazil, and Guatemala have all issued bonds in the last few months with somewhat higher voting thresholds, these seem to have been exceptional events that might not be repeated in the future. Indeed, one of the countries—Brazil—has come to the market again, but with a more traditional covenant. Although the reasons behind the initial decision to include a slightly higher voting threshold are not exactly clear, it might have had more to do with increased attention that CACs were attracting at the time, and a desire on the part of Brazil to give some recognition to the hard-line that the bondholder committees were espousing. Is it really the case that the risks associated with Belize, Brazil, and Guatemala were substantively different than those of the Philippines and Turkey? Why then were the Philippines and Turkey able to borrow with the traditional 75 per cent voting threshold? In addition, the results reported by researchers such as Richards and Gugiatti suggest that creditors are often completely unaware of CACs, let alone fine differences in their voting thresholds.
My second point is more conceptual in nature and relates to an important aspect of CACs that seems to have been under-appreciated in the authors’ model. It concerns the benefits that both borrowers and creditors are expected to realize from the inclusion of CACs in bond covenants. The gains that are realized from CACs, in terms of defusing the collective action problem and the cost of restructuring, should this be necessary, accrue to both parties. However, the model seems to assume that they reside mainly with the borrower. While problems might arise when the threshold is set too low, one wonders if the incentive to run and thereby trigger a liquidity crisis is materially different at a threshold of 75 per cent as opposed to 85 per cent.
Why then, one might ask, would groups such as EMCA push for higher voting thresholds? A cynical interpretation of events might run as follows. Certain borrowers and creditors found it advantageous to operate under the old system, without CACs, and did not want to introduce any arrangements that might make it easier to restructure debt in the case of serious liquidity or solvency problems. This is not because the resultant pain was viewed as a necessary deterrent to strategic default or moral risk on the part of borrowers, but because the old arrangements maximized the chances of a public sector bailout. Anything that would make debt workouts more efficient and reduce the need for official intervention was not in their joint interest therefore. Having resisted the adoption of CACs for so long, it would have been awkward to give way too easily and simply adopt the London terms. Creditors, and as a consequence some borrowers, may have felt it necessary be seen entering the new arrangements grudgingly. Having made their point, however, and saved face, they could then revert to the London norms prescribed by the G-10.
My final point turns the CAC issue on its head, and asks whether the authors’ hypothesis does not run counter to the Current strategy of the G-10. This strategy seems designed to push all emerging country borrowers onto the same template or CAC model. Does this make sense if, as the authors suggest, some variability in voting thresholds and other CAC conditions is welfare improving? On the other hand, does the fact that the 75 per cent threshold has existed for so long, and been applied so uniformly, indicate that the benefits from contract standardization far outweigh the benefits of tailoring the covenants to the debtors’ differing circumstances? Revealed preference would seem to indicate that the “boiler plate approach” dominates, in which case the G-10 is correct to push for uniformity and a common best practice. Time will tell whether the differences that HPSS have identified are important. The simulations that they report, however, suggest that they are likely to be rather small.
To conclude, HPSS have written an interesting and thought-provoking paper. The model that they have constructed is elegant, and captures important features of the multistage game which borrowers and creditors play. Nevertheless, I have some reservations about the practical significance of the differences that they highlight.
Comment: Future of the International Financial Architecture
Dr. Guillermo Ortiz Governor of the Bank of Mexico
I would like to begin by expressing my appreciation to the Banco de España and the IMF for inviting me to participate in this important conference to commemorate the sixtieth anniversary of the Bretton Woods institutions.
Since the second half of the nineties there has been an almost continuous debate and an extensive consideration of the changes that should be made to the architecture of the international financial system to improve its effectiveness. Let me say at the outset that after all these years of analysis and discussion, I remain convinced that:
- The broad principles of the Bretton Woods institutions as expressed in the articles of agreement remain valid today; and
- The institutional changes should be evolutionary and not revolutionary.
Most of the recent debate on the present and future role of the IMF originated from the economic crises that have been observed since the early nineties. Notwithstanding the many criticisms to which the Fund has been subject as a result of its involvement in these episodes, I am of the opinion that overall the IMF did a reasonable job. To a large extent, the challenge for this institution has been to understand the opportunities and difficulties that result from the impact of the globalization of capital markets on emerging economies.
My remarks will focus on four subjects related to these issues, which I consider central to the future of the international financial architecture:
- What have we learned from recent crises?
- Achievements and challenges in crisis prevention.
- Crisis resolution.
- Governance of the international financial institutions.
The Nature of Recent Crises
The economic crises observed in emerging market economies since the second half of the 1990s present a dual nature that distinguishes them from those observed in previous years.
Almost all of the crisis economies went through typical balance of payments problems that led to large current account deficits and appreciated real exchange rates, caused mainly by excessive spending by private or public sectors, financed by credit expansion and substantial capital inflows in the pre crisis stage. But the imbalances were generally not large enough to explain the virulence of the crises that followed. In fact, the main common element of these crises was the presence of financial panic and herd behavior, which translated in capital account shocks.
Beyond the role played by weak macroeconomic fundamentals and insufficient transparency, these events have shown us that countries are more prone to crisis under the presence of balance sheet mismatches, and weak and inefficient domestic financial markets.
The risks of a crisis are exacerbated under the presence of implicit or explicit government guarantees. I would point in particular to two of them.
First, during the 1990s international investors swiftly realized that implicit or explicit deposit insurance implied that in the case of a systemic crisis, liabilities of banks were effectively a contingent liability of the public sector.
A second, and even more important guarantee, relates to the economy’s exchange rate system. Fixed exchange rate regimes (in the context of open capital markets) encourage short term capital flows and currency mismatches, and accentuate the risks of capital flow reversals and self-fulfilling crises.
In fact, the merits of flexible exchange rate systems for those countries integrated to the international financial markets have been increasingly clear after the Argentine crisis, and as new evidence has emerged suggesting that emerging market economies should consider flexible exchange rate regimes as they develop economically and institutionally.1 The IMF could play a useful role here by providing technical assistance to help countries meet the conditions needed for a successful transition to a floating regime.
There is a last element that deserves emphasis. Countries that suffered crises were also characterized by deficient internal institutions: inappropriate frameworks for financial regulation and supervision, weak legal frameworks and judicial institutions, government inefficiency, widespread corruption, and so on.
Achievements and Challenges in Crisis Prevention
The improvements in the understanding of the nature of economic crises has allowed substantial progress in crisis prevention. At the domestic policy level, we are far more aware nowadays of the challenges faced by macroeconomic policies in an environment of balance of payments pressures dominated by the capital account, of the importance of strong and adequately supervised financial systems, and of the risks posed by balance sheet mismatches, among others.
The strengthening of the framework for crisis prevention has also included major efforts at the level of the IMF:
- The framework for surveillance has been improved;
- A huge amount of work has been carried out in the area of standards and codes. As of May 30, 2004, 400 ROSC modules had been published for 93 countries;
- A major contribution has been made by setting in motion the Financial Sector Assessment Programs;
- Transparency has improved substantially, both at the country and at the Fund level; etc.
Mexico has benefited a lot from these efforts. Suffice to say that we have undergone standards and codes assessments in 8 different areas, and that a Financial Sector Assessment Program for Mexico was carried out in 2001, an exercise which proved to be very valuable for us.
Although crisis prevention is one of the areas in which more tangible progress has been made during the last years, there is clearly room for improvement. I would like to refer to four specific issues in this connection:
- First, I agree with the view that crisis prevention will be made more effective if the Bretton Woods institutions complement each other in an efficient way2 that implies that the Fund and the Bank must focus on their core areas of responsibility. This is not an easy task. Traditionally, cooperation between the Bank and the Fund has been a difficult endeavor. At least to some extent, this has been the result of the fact that there are some areas where these institutions’ involvement is fundamental and where the division of responsibilities is not totally clear. For instance, it is important to include the Fund in the discussion of issues related to institution building, because these are central to assess a country’s credit risk and its financial stability.
- Second, the Fund must be flexible enough when assessing risks in any economy. It is a good idea to use a set of vulnerability indicators to support crisis prevention efforts. However, it would be a mistake to apply them mechanically, without taking into consideration each country’s particular situation. There is no such thing as a crisis-proof toolbox.
- Third, we must be aware that effective crisis prevention will require in many cases a joint effort on the part of the country’s authorities and the international community. Take the cases of Brazil and Turkey. Both countries have made strenuous efforts to achieve prudent macroeconomic policies, increase their primary surpluses, implement structural reforms, etc. And yet, in view of the large size of their public debts, they are very vulnerable in an environment of rising world interest rates. More generally, those countries which are highly integrated to international financial markets but whose domestic markets are relatively illiquid and present heavy debt burdens, are very exposed to speculative attacks during episodes of turbulence. Furthermore, debt levels can only be reduced gradually. What should the IMF do to be of help in these cases? I am convinced that the key question for crisis prevention here is to create the perception in international markets that both the resources of the institution and its access policy are such, that these economies will receive adequate support in case they need it. In other words, it is fundamental to avoid the perception that Fund financing will be subject to rigid rules or that countries are going to be forced into debt rescheduling. There is an additional element worth noting. The International Monetary Fund has been insisting on incorporating debt sustainability assessments as a major element of its crisis prevention toolkit. However, we must be very careful in making use of these analyses. As should be evident from my previous comments, even with the same policy stance debt sustainability can change drastically if our economic assumptions—for instance, the degree of risk aversion—are altered.
- Fourth, I am of the opinion that the IMF would have made a valuable contribution to crisis prevention by keeping a facility like the CCL alive. This is clearly an area to which we should be devoting closer attention in the near future.
Unfortunately, progress in the area of crisis resolution has been far more modest than in the case of crisis prevention. Let me begin with the consideration of the role of the Fund in crisis resolution through its financial support. I wish to make three comments in this respect.
- First, economic crises today, as was the case many years ago, need to be solved through a combination of adjustment and financing. The crucial point nowadays is that with the dual nature of crises, dominated by the capital account, an overshooting of both financing and policy adjustment are needed. For this reason, the Fund has nowadays a far more prominent role in attempting to give viability to the adjustment efforts of emerging market economies facing economic crises.
- Second, the Fund has responded to the challenges posed by recent capital account crises by helping members to meet unusually large financing needs. This has led to one of the main concerns that arise when discussing the role of the IMF: large financing and its potential implications for moral hazard. In my view, its importance has been greatly overstated. I have not seen as yet any convincing evidence to support the notion that moral hazard represents a serious difficulty.
- Third, the involvement of the Fund in crisis resolution in Argentina has put its reputation at stake. It is paradoxical and politically very questionable to see that Argentina is nowadays less vulnerable to increases in international interest rates because it is in default, while other emerging markets adhering closely to the recommendations of the Fund face a more complicated outlook. The Fund has been supporting Argentina under its policy of lending into arrears. The latter rests on the presumption that “the member is pursuing appropriate policies and is making a good faith effort to reach a collaborative agreement with creditors”. Given the doubts that have emerged, the Fund should attempt to clarify the specific meaning of these conditions. Broad political support of the membership is of course required.
Let me turn now to debt restructuring. I wish to say first of all that the Fund cannot be criticized for lack of effort on this front. In fact, the SDRM represents one of the main initiatives supported by Fund management in recent years. However, this initiative was doomed to fail and fortunately it did. The reasons are well known.
The contractual approach to sovereign debt restructuring, based on a more widespread use of Collective Action Clauses, represents a more realistic alternative. The strong support for the contractual approach from most participants in the international financial markets, the success of the Mexican as well as other subsequent issues of bonds with CACs, and the absence of evidence showing an interest rate spread associated to the use of CACs, have helped move the discussion forward. But I believe that the real test for the usefulness of CACs will come only at the time when a country having a majority of bonds issued with CACs faces the need to restructure its external debt. Evidently, it will take years before we face a situation like this.
Another avenue that has been getting attention recently as a mean to strengthen the framework for crisis resolution, is the design of a Code of Conduct for Sovereign Debt Restructuring. It has been argued that, by providing guidance on how debtors and creditors should behave during periods of difficulties, and by promoting dialogue between them, the drafting of a Code of Conduct would contribute to an early resolution of solvency problems. However, given the fact that the objectives of debtors and creditors are misaligned, to be able to reach an agreement the Code will have to be written at a high level of generality. Under such circumstances, its usefulness as a roadmap will likely be very limited.
Improving Governance in IFIs
Let me comment briefly now on decision making at the IFIs. While as I said before, I am not of the view that the Bretton Woods institutions need to be reinvented, we do need organizations that are able to adapt to the challenges posed by an evolving world economy.
In this process, it is essential that we set in place the institutional adjustments required to ensure that these objectives are met. An adequate decision making structure at these institutions is essential to this end. The changes that have been observed in recent years in the world economy have been accompanied by an increasing importance of the emerging markets. Unfortunately, these developments have not been reflected in the IFIs voting structure. For instance, in the case of the IMF, Horst Köhler underscored recently the existing scope for raising the voting share of emerging market countries, “whose quotas no longer reflect their true weight in the world economy.”3 I am certain that a revision of the voting structure aimed at allowing emerging markets to have a say in decision making at the Fund consistent with their position in the world economy, is essential if the Fund is to adjust its role in the world economy as needed in coming years.
Allow me one last comment before closing my intervention. We have spent by now nearly a decade debating on the international financial architecture. These discussions have been very productive, but they cannot go on forever. In my view, the time has come to move on to put this issue behind us and move from the consideration of the international financial architecture to the most concrete and substantive aspects of the international economic policy arena.
“Optimal Collective Action Clause Thresholds.”
See K. Rogoff, A:M. Husain, A. Mody, R. Brooks, and N. Oomes, Evolution and Performance of Exchange Rate Regimes, IMF Working Paper, December 2003.
See The Bush Administration’s Reform Agenda at the Bretton Woods Institutions: A Progress Report and Next Steps; Testimony by John B. Taylor, Under Secretary of Treasury for International Affairs before the Gommittee on Banking, Housing, and Urban Affairs, United States Senate, May 19, 2004.
Interview with Horst Köhler, IMF Survey, May 2004.