Contents of the course

1
International Finance
Part 1 Fundamentals of International Finance
- Lecture n 6 The IMF and the provision of
finance
2
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.

3
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 1980s, 1990s
  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.

4
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.

5
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 1980s, 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.

6
The role of the IMF

• IMF lending volumes since 1984 (in MM SDR -
  Source IMF)

7
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.

8
The role of the IMF

• IMF Net Flows of Fund since 1984 (in MM SDR -
  Source IMF)

9
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.

10
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)

11
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 1980s.
• 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.

12
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.

13
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

14
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

15
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.

16
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.

17
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.

18
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.

19
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.

20
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.

21
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.

22
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.

23
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.

24
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 export earning instability
  worsen the picture.

25
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.

26
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 monetary transmission mechanism does
  not operate.

27
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.

28
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.

29
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.

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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 econometric models.

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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 they had before,
  or than other countries.

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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.