June 2004

Global Economic Challenges for the IMF's New Chief

At the beginning of June, Rodrigo Rato assumed the helm of the International Monetary Fund as its new managing director. At a June 9 AEI conference, experts discussed how the IMF must meet the challenges of exchange rate instability and the effects of higher global interest rates on the larger emerging market economies.

John Taylor
U.S. Department of the Treasury

The IMF and World Bank are still guided by two goals: to improve economic stability in the world and to increase economic growth. There have been many changes in the world economy since these institutions were founded, such as the sharp increase in private cross-border capital flows and the higher proportion of flows in the form of securities rather than loans. Naturally, these institutions have to reform and change as well. I will mention six reforms and talk about a couple of them: the introduction of collective action clauses in emerging market debt, the creation of clearer limits and criteria for exceptional access lending by the IMF, a more streamlined conditionality by the IMF, a new system to measure results at the World Bank, the creation of a grant window at the World Bank to partially replace loans for very poor countries, and a greater degree of focus on core responsibilities at the IMF and the World Bank.
 
The number and magnitude of financial crises in the 1990s was much larger than in previous decades, demonstrating that changes in financial markets--such as securitization--are having systemic effects on the international financial system that need to be addressed. The approach to these crises was to make short-term fixes rather than develop longer-term strategy. The tendency of these responses to be more government-focused (either large official-sector loans or government encouraged bail-ins) raised concerns that large financial packages would have adverse effects on incentives and expectations. What was missing from this framework was more predictability and more systematic behavior on the part of the official sector in the event of a sovereign debt restructuring. This has been addressed in a G-7 plan that called for the introduction of collective action clauses in sovereign debt, something the Bush administration actively promoted.

This leads us to the effort to clarify limits on exceptional lending, of which there are three key elements: One is to establish the presumption that the IMF, as distinct from the official creditor governments, would be the source of the exceptional financing. This makes it easier to clarify what the limits are. The second element is to have ways to signal the intent in advance, which allows the markets to adjust more gradually. The reaction to the Russian default in 1998 had contagion, while the Argentina default in 2001 had no contagion. To some extent, that was the result of an effort to communicate what was going on. Finally, last year the IMF voted to do two things about exceptional access: specify some criteria a country must satisfy to have exceptional access and hold them to it, and require that an exceptional access report be submitted and made public in the event of an exceptional access, to provide accountability. 

Kenneth Rogoff
Harvard University

Though the global economy is very strong right now, significant risks remain. Emerging markets have very high debt levels, and although world interest rates are currently low, rising interest rates will pose risks to emerging markets, especially among heavy borrowers. Another risk is the U.S. current account: although the unwinding of the current account at the end of the 1980s did not seem so bad, we have to be concerned that it might unwind in a situation that looks more like the late 1960s and 1970s. Also, another problem is China, though I believe the probability of a crisis there is not as high as has been reported. Finally, there is the problem of Argentina, were the stakes are high because it needs to reach an agreement which offers sustainability without setting a bad precedent for other countries.

Looking at the big picture, Mr. Rato needs to make sure the IMF does not get trapped in the role of bailing out middle-income emerging markets, and instead should play a leadership role in the entire global financial system, in the surveillance of exchange rates and deficits in large countries as well as small countries. The really bad episodes for the world economy, the 1930s and 1970s, came from major countries. Also, in the maturing of the Bretton Woods system, it is time to end the presumption that an American heads the World Bank and a European heads the IMF. As we begin to work with the new IMF managing director and look forward to the next head of the World Bank, it is important to expand the vision.

I have long written that the World Bank should be converted completely to grants, and not loans; I think the way it was set up after Bretton Woods is utterly misconceived and leads to a lot of policy errors. You need to find some way of having accountability for the World Bank, and I think the administration has really made some important gains in this. The Millennium Challenge Account, which is a work in progress, has a lot of these elements right--making grants not loans, and making them in circumstances where you are not doing harm. Also, the IMF should not have any money; it has $150 billion right now, which is simply not adequate to meet some problems we might imagine, like China. I do not think access limits is going to do it until the funds go down to zero because there are always going to be reasons why a country is too nuclear to fail, too Islamic to fail, etc. In addition, not having funds would have the added benefit of making it impossible for countries to obtain funds from the IMF to maintain a fixed exchange rate for a little bit longer. It is good that Asia is building reserves, but at the same time they have moved to fixed exchange rates, and they will find that these reserves will be useless if a point is reached where people decide exchange rates are highly overvalued.

Edwin M. Truman
Institute of International Economics

The IMF needs to maintain its role as a collective action body designed to address market failures. The IMF is part of the solution rather than the problem, even if it does make mistakes. Argentina is the principal immediate challenge for the IMF, and Argentina needs to have a comprehensive, sustainable restructuring. However, Argentina should not focus on the debt issue to the exclusion of other policies in need of reform.

The main long-run challenge for the IMF is how to be a Fund for all members. The original concept was that the Fund would be a revolving fund, with members rotating between borrowing and lending. But the membership has expanded to 104 countries, and now it has different types of members: some large industrial countries that do not draw on the Fund, and some developing countries that draw on it quite often. To maintain the Fund's universal character, I have three suggestions: First, when countries go through regular surveillance, part of the process is to create a report on what needs to be done, so that if a country needs a loan, a set of conditions would be ready. Second, the Fund needs to be more proactive on the issue of exchange rates-though what China is doing may not be violating the articles, it is violating the spirit of the articles in terms of social responsibility, as is Japan. Third, the Fund should avoid putting countries in categories-- industrial countries, poorest countries, etc.--as in the long run we would like all of those countries to be industrial.

Mr. Rato has a process challenge, living with the G-8, which is not a balanced group and has lacked consensus in recent years. Many people are skeptical that the strategic review will produce much, and though I think the Fund's role should be continuously reviewed, most likely nothing will happen. The biggest risk is that the review will undermine U.S. political support for the IMF.

It is important to define the IMF's core responsibilities, though doing so can be very difficult. I think one should monitor and control mission creep. Also, governance is an issue that must be dealt with, as the voice and the vote of the Europeans are excessive. Lastly, regarding internal management, it has governors, board members, and a management separated from the staff. This makes shaping an IMF view on things very difficult, and my sense is that the system is fundamentally broken.

R. Glenn Hubbard
AEI and Columbia University

It is instructive to think about this problem as one of institutional design. For example, while monetary policy institutions have been successful in standardizing goals and finding the process needed to achieve them, leading to a low-inflation in most parts of the world, budget policy institutions have been less successful, with sustainability issues arising in countries both poor and rich.

I question how practical it is to imagine that surveillance from the IMF will be valuable. For big countries, there are many occasions where in my own view as an economist, the IMF's answers are wrong. The IMF could be more productively spending its time thinking about the problem of asymmetries of growth around the world and promoting policies for sustainable economic growth.

If Japan were to pursue an inflationary monetary policy, as most economists would like, that would lead to predictable movements in the yen. I do not think of that as currency manipulation, but rather sound policy. Regarding China, I am not as worried about exchange rate issues as I am the financial system, which is archaic and a dangerous allocator of capital. Any economy saving 40 percent of GDP is wasting a great deal.

On the question of IMF lending policy, for the budgets of many contributing countries, including the United States, the IMF is pitched as a riskless transaction. But typically, in the United States, when one makes a risky loan, the loan subsidy is scored and presented as an appropriation. One way to bring teeth to access limits is to bring it into the congressional budget process.

As for Argentina, the situation shows the need to think about a restructuring process that involves more richly the private sector. I would add to the contractual provisions emphasized earlier a voluntary dispute resolution forum, as opposed to a mandatory sovereign debt restructuring mechanism. Also, I think the administration's leadership on the Millennium Challenge Account is great; I think it is the future. I am less persuaded that there is a large and expanding role for the World Bank in this world.

John Lipsky
J. P. Morgan Chase

We learned in the Mexican crisis that the Fund's standard operating procedures no longer work, because with securitized finance, the Fund could no longer compel bail-ins from the private sector as they could when the world was dominated by bank finance. The private sector criticized the risk management procedures of private lending institutions that had produced some systematic improvements. The Fund clarified their role with regard to private capital flows by altering the Articles of Agreement to incorporate what I will call capital account convertibility as one of the primary goals of membership in the IMF. Though this proposal was criticized, it has an interesting analogy to the original agreement to eliminate current account restrictions, which were cleaned up over time after World War II and worked so well that we now take for granted the idea of current account convertibility. So now this approach has been extended to capital account controls, where the process of cleaning up capital account restrictions would be gradual one, and the Fund would have a legal responsibility to approve any capital restrictions.

In the wake of the 1997-1998 crisis, we were overwhelmed by what we called, at the time, contagion. I maintained then and today that it really represented the failure of IMF and others to grasp the importance of regional interconnections that had grown up, especially in the Asian region. The data shows that the world has become more regionalized than globalized, but that had not been really taken into account.

Looking forward, there are several important issues: What is the Fund's role relative to private markets? Should the Fund's policy analysis be made public? Should the Fund be providing funding? I think there is quite limited consensus on all of these topics.
In the near term, there are measures that I think have either happened or are on the table. One is the collective action clauses, which have already happened, and second is the code of conduct (by private institutions). Third is non-borrowing programs, and my remark here is that the Fund used to do non-borrowing programs in the 1960s, and there was a policy decision in the 1970s to stop them. There are also three measures that have not been discussed. What is the proper role of the Special Drawing Right, and should the Fund continue this program? And finally, we are quickly evolving a dual reserve currency system, and the Articles of Agreement do not seem to contemplate this in any way, shape, or form. And I think the big challenge is the monetary arrangements in Asia as a successor to the East Asian dollar standard.

Allan H. Meltzer
AEI and Carnegie Mellon University

There are several things I would highlight out of the remarks that were made here and some that were not. One concerns the Asian Monetary Fund and the accumulation of reserves by Asian countries. Have these countries thought about loosening their ties to the Fund and self-insuring, so they do not have to go through the system of conditionality again? Second is the viability of the Fund--with 70 percent of its loans in four countries, how will the fund deal with a possible crisis? When people ask what role the Fund has in negotiations (with Argentina or Brazil), the answer is the Fund specifies what the surplus in those countries is and then sets the amount the country is going to have to be able to settle with its private creditors. I personally think that is perhaps as good a system as we are likely to have at the moment.

The core responsibilities of the IMF come back to the two public goods it provides: the improvement of the quality of information about individual countries, which helps the private market function effectively; and the vital reduction of risk that people bear to the minimum, which it can do by providing an order in the capital markets that would not otherwise exist, seeing that fewer crises start, and seeing that those that do start do not spread globally.

One problem that has to be faced directly is the problem of trying to make sure that we can find some enforceable, time-consistent polices for the Fund to operate with. We were talking about promises that added up to be $250 billion, and that is unsustainable. We have had that policy, and people have gotten accustomed to it, so this is a central problem.

In terms of the political aspect, the Fund has to find a way to cut off countries that will not commit to structural changes, or otherwise, reward the performance. We cannot only promise money to those countries that make the reforms, but we also have to withhold money from those countries unwilling to make the reforms. We need to think about mechanisms that solve the time-consistency problem. For dealing with big countries, some of the proposals I hear would give greater control to the developing and debtor countries, which are non-starters, as the countries that are putting up the money are the ones that will control the Fund, and we have to think about governance within that framework.

It seems to me that it is in the Fund's interest to shift from command-and-control policies to an incentive-based system. Right now the Fund gets blamed for everything that goes wrong in a country, but with an incentive-based system, where countries are only given help if they meet certain standards, it becomes a case of the country making the right or wrong choice. Finally, I think the Bank is a terribly inefficient, ineffective institution that is badly in need of reform. They need to get some idea as to which Bank programs actually reduce poverty and which ones do not, building on the former and disposing of the latter.

AEI intern Philo Davidson prepared this summary.