Crisis Averter, Crisis Lender, Crisis Manager: The IMF in Search of a Systemic Role

Crisis Averter, Crisis Lender, Crisis

Manager: The IMF in Search of a

Systemic Role

Graham Bird

1. INTRODUCTION

G IVEN its high profile in the wake of the East Asian financial crisis, it isworth recalling that some observers in the mid-1990s were suggesting that

the IMF should be closed down. The essence of their argument was that in aworld of flexible exchange rates and private international capital markets, anagency such as the Fund was no longer needed.

With the demise of the Bretton Woods system, the Fund undoubtedly lost mostof its original systemic role. While it continued to lend to individual countriesencountering balance of payments difficulties, its systemic functions in terms ofmanaging global exchange rates, co-ordinating macroeconomic policy, andseeking to ensure that the quantity of international reserves was adequate all butdisappeared. Although initially the Third World debt crisis in the 1980s and thenthe fall of Communism and the transition of centrally planned economies tomarket-based systems in the early 1990s rekindled a systemic dimension to theFund’s operations, this was fairly transitory. By the time of its 50th anniversary in1994, discussions of the Fund’s systemic role had largely returned to the issues ofglobal exchange rate regimes and international policy co-ordination; yet therewas insufficient consensus on these issues to suggest that the Fund would regain asystemic role. The Mexican peso crisis hinted at global problems to come, but itwas unclear just how common such crises would be.

Five years later, and with further economic crises in East Asia, Russia andLatin America, the focus of attention has changed. For as long as it wasprincipally dealing with the poorest countries in the world where economicdifficulties did not have significant global externalities or threaten international

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GRAHAM BIRD is from the Centre for International Economic Studies, University of Surrey. Theauthor wishes to acknowledge helpful comments from two anonymous referees.

financial stability, there was little incentive to re-think the Fund’s systemic role.But economic crises in countries such as Mexico, Korea, Russia and Brazil dohave potential global consequences. Here there are worries about contagion.Ultimately, even industrial countries are not seen as immune. In an era whenglobalisation has become a popular notion, it has been realised that economiccrises may also be globalised. This has led industrial countries, which do notthemselves borrow from the IMF, to suggest reforms that will alter theinternational financial ‘architecture’. Part of the package involves reforming theIMF in such ways as to help avoid international financial crises, and better dealwith those that are not avoided.

While there have been a number of critical reviews of the Fund’s handling ofthe East Asian crisis and related issues, there has been relatively little systematicanalysis of the Fund’s potential systemic role as crisis averter, crisis lender, andcrisis manager. This paper focuses directly on these three (related) systemicfunctions.

The lay-out of the paper is as follows. Section 2 provides a brief statisticalpicture of the size and extent of the IMF’s operations in the late 1990s, and alsoidentifies recent trends in the pattern of Fund lending. One of these has been theFund’s heavy involvement in economically significant countries where crises havebeen or have threatened to be globally destabilising. Section 3 examines the extentto which the Fund might, in principle, contribute to averting economic crises of thissort. This section focuses in particular on the issues of moral hazard, conditionality,and delayed referral. Section 4 investigates the Fund’s lending role in the midst of acrisis and discusses its suitability as a fully fledged international lender of lastresort. In relation to this, the section also examines alternative ways of financingthe Fund. Section 5 analyses the role of the Fund in helping to manage internationalfinancial crises and explores the scope for influencing the behaviour of both debtorsand creditors. Section 6 offers a few concluding remarks. While it would be amistake to expect too much of the IMF, the analysis in this paper suggests that thereis a case for redefining its role and ensuring that it has both the appropriateorganisational structure and the resources necessary to perform it.

2. STATISTICAL BACKGROUND: KEY FEATURES

The data in Table 1 provide a snap-shot of the IMF’s operations towards theend of 1998. A number of features are notable. First, there were outstandingarrangements with 62 countries, representing about one third of the Fund’smembership. Second, the arrangements covered both developing countries andcountries in transition ranging from the better-off from amongst them, to the verypoorest countries in the world. Taking the UNDP’s Human Development Index,the highest ranked recipient of IMF finance was Korea (32), with the lowest

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ranked being Rwanda (174). Stand-by and extended arrangements were morecommon amongst the better-off developing countries and CITs, while ESAFloans were focused on the poorer countries. Of the 62 arrangements recorded inTable 1, 17 were with countries ranked in the top 100, according to the HDI,while the remaining 45 were with countries in the bottom 75.

Third, arrangements existed across most regions of the world including Africa,Asia, Latin America and Central and Eastern Europe. Fourth, in quantitativeterms, total Fund lending commitments (at nearly SDR 49 billion) wereconcentrated in a relatively small number of countries; arrangements in Korea(SDR 15.5 billion), Russia (SDR 13.2 billion), and Indonesia (SDR 4.7 billion),for example, accounted for about 68 per cent of the total amount of lendingapproved; on the other hand, lending to 36 low income countries under the ESAFamounted to only about the same as the single loan to Indonesia.

By comparison with ten years (or even five years) before, the Fund’soperations have increased significantly both in terms of the number of itsarrangements and the amount of money involved (see Figure 1). With theexception of industrial countries (and noting that Korea could be claimed to fallinto this category) the IMF is shown to be a genuinely global institution. If therewas any question about the need for the Fund, the extent to which its resourceshave been used appears to provide a fairly unequivocal answer. Revealedbehaviour implies thatprima faciethe Fund is needed.

However, Table 1 also shows the extent of the East Asian effect; loans toThailand, Korea, Indonesia and the Philippines amounted to over SDR 24.1billion, about half the Fund’s total lending commitments. With the exception ofthe Philippines, East Asian economies have not been frequent users of Fundfinance in the past. The East Asian phenomenon therefore also shows clearly howa financial crisis in a group of large economies can have a sudden and dramaticimpact on the overall size of IMF lending.

The increased use of its resources weakened the Fund’s own liquidity positionover 1994–98 (Figure 2). While the quota increases agreed as part of the EleventhGeneral Review of Quotas remained to be approved, the Fund was forced tonegotiate New Arrangements to Borrow in order to underwrite its lendingoperations. The ‘considerable strain’ on its own resources was in part associatedwith the fact that the Fund’s new Supplemental Reserve Facility which wasdesigned ‘to help members cope with sudden and disruptive loss of marketconfidence’ by-passed conventional access limits to Fund credit.

If financial crises and ‘sudden and disruptive’ flows of capital are to be anenduring feature of the international financial panorama, this raises a series ofquestions about the IMF. What can it do to help avert such crises? Certainly it didlittle to avert the East Asian crisis. Statements by the Fund prior to the crisisconcerning the perceived strength of economic fundamentals in the regionsuggest that it largely failed to foresee it. Faced with crises that threaten

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TABLE 1Stand-By, EFF, and ESAF Arrangements (as of 30 November, 1998)

Member Date of Expiration Date Amount Undrawn Real GDP HumanArrangement Approved Balance per Capita Development

(ppp $) 1994 Index Rank

Stand-By Arrangments 19834.17 4042.06Bosnia and Herzegovina 29 May, 1998 28 May, 1999 60.60 36.36Cape Verde 20 February, 1998 19 April, 1999 2.10 2.10 1,862 123Djibouti 15 April, 1996 31 March, 1999 8.25 1.95 1,270 162El Salvador 23 September, 1998 22 February, 2000 37.68 37.68 2,417 112Estonia 17 December, 1997 16 March, 1999 16.10 16.10 4,294 71Korea1 4 December, 1997 3 December, 2000 15500.00 2175.00 10,656 32Latvia 10 October, 1997 9 April, 1999 33.00 33.00 3,332 92Philippines 1 April, 1998 31 March, 2000 1020.79 823.42 2,681 98Thailand 20 August, 1997 19 June, 2000 2900.00 700.00 7,104 59Uruguay 20 June, 1997 19 March, 1999 125.00 125.00 6,752 37Zimbabwe 1 June, 1998 30 June, 1999 130.65 91.45 2,196 129EFF Arrangements 24414.26 15536.23Argentina 4 February, 1998 3 February, 2001 2080.00 2080.00 8,937 36Azerbaijan 20 December, 1996 19 December, 1999 58.50 17.56 1,670 106Bulgaria 25 September, 1998 24 September, 2001 627.62 523.02 4,533 69Croatia, Rupublic of 12 March, 1997 11 March, 2000 353.16 324.38 3,960 77Gabon 8 November, 1995 7 March, 1999 110.30 49.63 3,641 120Indonesia 25 August, 1998 5 November, 2000 4669.10 2566.70 3,740 99Jordan 9 February, 1996 8 February, 1999 238.04 35.52 4,187 84Kazakhstan 17 July, 1996 16 July, 1999 309.40 309.40 3,284 93Moldova 20 May, 1996 19 May, 1999 135.00 97.50 1,576 110Pakistan 20 October, 1997 19 October, 2000 454.92 398.06 2,154 139Panama 10 December, 1997 9 December, 2000 120.00 80.00 6,104 45Peru 1 July, 1996 31 March, 1999 300.20 139.70 3,645 89Russian Federation1 26 March, 1996 25 March, 2000 13206.57 7426.86 4,828 67Ukraine 4 September, 1998 3 September, 2001 1645.55 1400.00 2,718 95Yemen 29 October, 1997 28 October, 2000 105.90 87.90 805 148ESAF Arrangements 4580.98 2301.00Albania 13 May, 1998 12 May, 2001 35.30 29.42 2,788 102Armenia 14 February, 1996 13 February, 1999 101.25 33.75 1,737 103Azerbaijan 20 December, 1996 19 December, 1999 93.60 23.40 1,670 106Benin 28 August, 1996 27 August, 1999 27.10 18.12 1,696 146Bolivia 18 September, 1998 17 September, 2001 100.96 34.13 2,598 113

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Burkina Faso 14 June, 1996 13 June, 1999 39.78 6.63 796 172Cameroon 20 August, 1997 19 August, 2000 162.12 81.06 2,120 133Central African Republic 20 July, 1998 19 July, 2001 49.44 41.20 1,130 151Chad 1 September, 1995 28 April, 1999 49.56 8.26 700 164Congo, Republic of 28 June, 1996 27 June, 1999 69.48 55.58 2,410 130Cote d’Ivoire 17 March, 1998 16 March, 2001 285.84 202.47 1,668 145Ethiopia 11 October, 1996 10 October, 1999 88.47 58.98 427 170The Gambia 29 June, 1998 28 June, 2001 20.61 17.18 939 165Georgia 28 February, 1996 27 February, 1999 166.50 27.75 1,585 105Ghana 30 June, 1995 29 June, 1999 164.40 68.50 1,960 132Guinea 13 January, 1997 12 January, 2000 70.80 23.60 1,103 167Guyana 15 July, 1998 14 July, 2001 53.76 44.80 2,729 104Haiti 18 October, 1996 17 October, 1999 91.05 75.88 896 156Kenya 26 April, 1996 25 April, 1999 149.55 124.63 1,404 134Kyrgyz Republic 26 June, 1998 25 June, 2001 64.50 53.75 1,930 107Macedonia, FYR 11 April, 1997 10 April, 2000 54.56 27.28 3,965 80Madagascar 27 November, 1996 26 November, 1999 81.36 54.24 694 152Malawi 18 October, 1995 31 December, 1998 45.81 15.27 694 161Mali 10 April, 1996 5 August, 1999 62.01 10.34 543 171Mongolia 30 July, 1997 29 July, 2000 33.39 27.83 3,766 101Mozambique 21 June, 1996 24 August, 1999 75.60 12.60 986 166Nicaragua 18 March, 1998 17 March, 2001 100.91 84.09 1,580 127Niger 12 June, 1996 1 September, 1999 57.96 9.66 787 173Pakistan 20 October, 1997 19 October, 2000 682.38 454.92 2,154 139Rwanda 24 June, 1998 23 June, 2001 71.40 59.50 352 174Senegal 20 April, 1998 19 April, 2001 107.01 89.18 1,596 160Tajikistan 24 June, 1998 23 June, 2001 96.00 78.00 1,117 115Tanzania 8 November, 1996 7 November, 1999 161.59 38.76 656 149Uganda 10 November, 1997 9 November, 2000 100.43 43.52 1,370 159Yemen 29 October, 1997 28 October, 2000 264.75 176.75 805 148Zambia 6 December, 1995 5 December, 1998 701.68 40.00 962 143Total 48829.40 21879.29

Notes:1 Includes amounts under Supplemental Reserve Facility.EFF = Extended Fund Facility.ESAF = Enhanced Structural Adjustment Facility.Figures may not add up to totals owing to rounding.

Data: IMF Treasurer’s Department, UNDP, Human Development Report.

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FIGURE 1Total IMF Credit Outstanding to Members1 (billion SDRs, end of period)

Note:1 The IMF’s financial year begins on 1 May and ends on 30 April.

Data: IMF,Annual Report1998.

FIGURE 2IMF Liquidity Ratio (per cent, end of period)

Note:1 Figure for 1998 is as of 30 April.

Data: IMF,Annual Report1998.

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international financial stability, how should the Fund respond? How can it helprestore confidence? How much finance should the Fund itself lend or can itorchestrate other creditors to take on the financing role? These questions (andothers) are addressed in the sections that follow.

3. IMF AS CRISIS AVERTER

The IMF only lends to countries that are in serious balance of paymentsdifficulties. Moreover, most countries find borrowing from the Fund sufficientlyunpalatable that they only do it as a last resort, when all other options have beenclosed. Since crisis situations usually require crisis solutions, IMF conditionalitytends to be strict, and the consequential image of tough conditionality perpetuatesthe reluctance of countries to turn to the Fund unless they have no alternative; thisbasically means when they are confronted with a balance of payments crisis.

What can the Fund do to try and avert balance of payments crises? Muchdepends on what causes them in the first place. However, there is no universalcausation. Balance of payments crises may arise from either the current accountor the capital account. As far as the current account is concerned, traditionaltheory points to excess domestic expenditure or excess domestic credit creation,with fiscal deficits frequently playing a key role (Krugman, 1979; and Easterlyand Schmidt-Hebbel, 1993). As ‘new structuralists’ point out, these in themselvesmay or may not signal domestic economic mismanagement, since, for developingcountries, government expenditure and tax revenue may be particularlyvulnerable to external factors such as global economic activity, with recessionleading to export declines and declining export tax revenue, and global interestrates and exchange rates, with rising global interest rates or appreciation in thecurrency in which debt is denominated increasing the domestic currency cost ofservicing external government debt (Fanelli, Frenkel and Taylor, 1994).

The structure of trade, its composition and pattern, may also make developingcountries particularly vulnerable to external shocks, and, for countries which haveimpaired access to international financing, any resulting current account deficitswill be difficult to sustain. It is the extent of a country’s ability to sustain a currentaccount deficit that determines the extent to which a crisis results.

The conventional picture of the Fund’s involvement in developing countries isof a country in macroeconomic disequilibrium, which has allowed its fiscaldeficit to increase, has financed it through domestic monetary creation, andwhose economy has then been hit by some adverse external shock, such as asharp deterioration in its terms of trade, which tips the balance into crisis.

The novelty of the East Asian crisis was that the countries involvedencountered balance of payments crises largely as a consequence of weaknessesin terms of the capital account. Here it was the volatility of international capital



flows that accentuated current account difficulties. The sustainability of currentaccount deficits rapidly eroded as capital inflows quickly transformed into capitaloutflows. The response in East Asia, as it had been in Mexico, was initially todefer exchange rate devaluation and to deplete international reserves instead. But,of course, given that reserves are finite, this fuels speculative expectations thatdevaluation will ultimately occur. Another genre of theory relating to balance ofpayments crises emphasises the transparency (to speculators) of an inconsistencybetween internal and external targets.

If the cost of attaining an external target rises, a government’s commitment toit will become less credible in the eyes of speculators whose behaviour may thenincrease still further the cost of attaining it. Where the cost of defending a peggedexchange rate is a high domestic rate of interest which threatens recession,speculators may anticipate that the government will eventually abandon the pegand devalue. They will therefore sell the currency. This will put extra pressure onthe government to raise domestic interest rates and will therefore makedevaluation yet more likely.

Experience in East Asia, as well as in countries in transition (CITs), has alsoshown how balance of payments crises may arise where liberalising economicreform is inappropriately sequenced. Liberalisation of domestic financialmarkets, without improved regulation, when combined with capital accountliberalisation may prematurely accentuate a country’s exposure to the intrinsicvolatility of international capital flows. Capital inflows attracted by risingdomestic interest rates alongside a commitment to quasi-pegged nominalexchange rates may finance uneconomic domestic lending, and may generatemacroeconomic instability via its inflationary consequences and the relatedappreciation in the real exchange rate that then weakens the current account.When a sudden reversal in capital flows is triggered in some way, the currentaccount deficit becomes no longer sustainable and expected devaluation furtherencourages selling of the domestic currency.

What can the IMF do to help avert balance of payments crises? In principle, itcould seek to address the various causes examined above, but can it do this? Afundamental difficulty is that the Fund has to wait until it is approached byindividual countries for assistance; by which time there is usually already a crisis.It can offer advice as part of its regular Article IV consultations, but countries areunder no obligation to accept it. It is only within the context of negotiating aprogramme that the Fund exerts any real influence via conditionality. If this isboth well-designed and then implemented, IMF conditionality should help toreduce the probability of future crises, and in this way the Fund can, in principle,help to avert them. But if it is not well-designed or is not implemented, thebeneficial effects will not be forthcoming. Indeed, conditionality which is badlydesigned either in terms of its economics or in terms of recognising andaccommodating the national political context in which economic reform takes

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place, is likely to perpetuate the reluctance of countries to turn to the Fund inadvance of balance of payments crises.1 To the extent that this also impliespostponing necessary economic policy reform, the likelihood is that the incidenceof crises will increase. Postponing devaluation will, for example, increase the sizeand difficulty of economic adjustment when overvaluation is ultimatelyeradicated since the tradeables sector will have been disadvantaged for longer(Edwards and Montiel, 1989).

But how can the IMF encourage earlier referral at times when crises may beaverted? To answer this question adequately requires a full analysis of whycountries do and do not turn to the Fund (Bird, 1995). But assuming rationalbehaviour, it is reasonable to assume that the decision is influenced by theamount of finance available from the Fund, the nature of the expectedconditionality, and the cost of Fund credit. In circumstances where countriesstill retain access to private international capital (and this often seems to be thecase right up until a crisis hits), the Fund will need to offer a package of financing(quantity and cost), and conditionality which is competitivevis-a-vis privatecapital markets. If Fund lending is viewed as meagre in quantity, low inconcessionality, and high in conditionality, it will remain unattractive for as longas private capital is available. In other words, borrowing from the Fund will beunattractive in all but crisis situations.

Recent trends are towards stricter conditionality, with IMF programmescontaining an increasing number of prior actions and performance criteriacovering a wider and wider array of economic activity (Polak, 1991; and Killick,1995). Theories of bureaucracy would view this as the Fund exploiting itsmonopoly position in crisis conditions, when there is a high shadow price offoreign exchange (Vaubel, 1991).

Critics of the IMF-backed programmes in East Asia have viewed condition-ality as serving the political and economic interests of the Fund’s principalshareholders (in particular the US) rather than those of the recipient countries(Feldstein, 1998). Whatever its explanation, increasing conditionality is almostcertainly inconsistent with country ‘ownership’. Countries borrowing from theFund are likely to feel coerced into pursuing the Fund’s favoured reforms, ratherthan being committed to them (Killick, 1996). Or they may simply have resignedthemselves to losing national policy discretion.

In these circumstances, reforms are likely to be less successful. Implementa-tion will become more difficult because of the wide range of conditionality, and

1 There is a growing literature dealing with the political economy of policy reform. This is wellsummarised in Rodrik (1996). In a related paper Bird (1998) examines the political economy ofconditionality by, in particular, analysing why countries may agree a Fund-backed programme butthen not fully implement the conditions. It is unsatisfactory to put non-completion down simply to alack of political will. Similarly is it insufficient to consider only the design of conditionality withoutconsidering the circumstances which influence the extent to which it is implemented.



countries will be keen to pull away from the IMF as soon as possible because ofthe high perceived costs of conditionality (Bird, 1998a). IMF programmes aretherefore likely to show a strong tendency to break down. This is exactly whatthey do show. Taking as a measure of completion and non-completion thepercentage of the loan remaining undisbursed at the end of the period of theagreement, and using the 20 per cent cut-off point used and justified by Killick(1995), Figure 3 shows that the clear majority of Fund-backed programmesremain uncompleted and that if anything there has been a tendency for theproportion of non-completed programmes to rise over the most recent periodshown by the figure. If most Fund-backed programmes remain uncompleted, itfollows that conditionality will be an ineffective modality for averting futurecrises, except to the extent that the fear of being drawn into the Fund andsubjected to conditionality incentivises countries to avoid balance of paymentsdifficulties. But in these circumstances, why have the Fund at all? The logic ofhaving an international agency designed to provide balance of payments financeand then have it operate in a fashion that discourages countries from ever using itis uncompelling.

FIGURE 3Rate of Incompletion of IMF Agreements

Notes:Two alternative measures of incompletion are used. The first (IMF) simply shows the percentage of agreementsthat are cancelled. The second (Killick) shows the percentage of agreements where 20 per cent or more of theagreed resources remain undrawn by the end of the agreement, allowing for modification to the originalagreement. Killick (1995) finds this to be a good proxy for the breakdown of programmes.

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But what about the claim that the Fund actually makes crisesmore likely?There are two variants on this moral hazard theme.

The first claims that the availability of concessionary Fund finance positivelyencourages governments to run domestic policies in such a way as to induce thecrises that then justify their borrowing from the Fund. However, the evidence onboth the degree of concessionality and the behavioural responses to conditionalitydiscussed above are inconsistent with this hypothesis.2 Most countries behave in away that suggests that they are anxious to avoid borrowing from the IMF if at allpossible. Indeed, it is generally only in a crisis, when there are no other options,that countries turn to the Fund. In East Asia this was the case for Thailand, Koreaand Indonesia. Meanwhile, Singapore and Malaysia were prepared to pursuepainful domestic policies in order to avoid having to borrow from the IMF.

The second variant on the moral hazard theme, which is of a more recentvintage, arises from the fact that the Fund intervenes in crises to provide countrieswith foreign exchange which then enables governments or private debtors to meettheir outstanding foreign currency obligations. The potential moral hazard is thatforeign creditors anticipate an IMF bail-out in the event of a crisis and this lowersthe perceived risks of lending. They therefore overlend. This createsmacroeconomic instability by driving up real exchange rates. Currencyovervaluation then weakens the current account which opens the way for aspeculative crisis. What is more, capital inflows may be used to finance riskyinvestment projects with the consequence that risky long term assets arejuxtaposed against short term foreign currency denominated liabilities therebycreating illiquidity problems.

Moral hazard would not be a problem here if there was uncertaintysurrounding the probability of an IMF bail-out; foreign lenders would then needto factor this into their risk calculations. However, recent evidence from LatinAmerica and East Asia suggests that the probability of substantial IMF lending inthe event of a crisis is very high for countries that are globally significant.

So has the IMF almost unwittingly encouraged excess commercial lending andthereby contributed to causing the very crises that it then seeks to overcome?

Counter-arguments are that not all lenders will be bailed out, either because ofthe form of their lending (direct or portfolio investment for example), or becausethe size of Fund finance is likely to be small relative to total external obligations.Moreover, evidence on international lending by commercial banks suggests thatthey do not make such subtle calculations of risk. In practice, lending decisionsmay be driven by short term cosmetic economic factors as well as by

2 Bird (1995) provides data on the grant element on borrowing from the Fund over the period 1950–92. After 1985, with the basic rate of charge on the use of Fund resources close to the short termcommercial interest rate the grant element was less than five per cent. For ESAF which carries onlya nominal charge of 0.5 per cent the grant element is much higher but the conditionality content ofESAF programmes is high.



psychological factors (including the desire not to be left behind; bandwagoneffects), rather than by a full scientific analysis of expected risk-adjusted rates ofreturn based on economic fundamentals.3 The reality may therefore be closer tothe Fund’s claim that overlending reveals ‘excessive exuberance’. It is difficult tobelieve that the Fund has a strong, systematic, and significant effect on privatecapital flowsex ante, when the evidence generally fails to support anex postcatalytic effect (Bird and Rowlands, 1997). Although it may implicitly provide apartial safety net, the implication is that lenders will not hit the ground; they maystill fall.

While the existence of the Fund may, in principle, raise the overall quantity ofprivate international lending as compared with what it would have been withoutthe Fund, it is difficult to believe that the Fund significantly contributed tooverlending in either the Mexican or the East Asian case. After all, the Fund’sexistence has coincided with periods when there have been no capital surges aswell as periods when there have been. Furthermore, the Fund’s existence has notenticed private capital markets to lend heavily to low income countries; although,in this case, their small size may discriminate against the probability of a bail out.

Just as surges of capital inflows are unlikely to be induced by the IMF, so alsothe Fund has little to do with the ‘triggers’ that set off large capital outflows.These are much more likely to be exogenous economic or political events whichare difficult to predict with any precision, but which have the effect of changingmarket sentiment.

The conclusion emerges that the Fund probably does little to avert balance ofpayments crises caused either by current account or by capital account factors. G7proposals for reforming the international financial architecture focus onimproving the range and quality of information available about countries sothat lenders can make better lending decisions. In some respects this is a responseto the claim that it was a lack of information about the increasing extent ofexternal exposure and forward foreign exchange commitments that concealed thethreat of a crisis in East Asia. It is reasonable to assume that fuller and moretransparent information about countries should help. But it is unreasonable to

3 At the time of the Third World debt crisis in the 1980s, a number of studies investigated thelending policies of the commercial banks (for example, Guttentag and Herring, 1986; and Bird,1989). Bankers frequently described country risk analysis as an art rather than a science. In thesame vein, if capital movements are accurately characterised as being irrational it may beinconsistent to assume that creditors rationally calculate the probability of a Fund bail-out. Ifcreditors behave rationally they would not choose to lend to countries where IMF involvement isanticipated since this is itself an indicator of economic distress. The conclusion here is somewhat atodds with that of Krueger (1998) who claims that:

it seems plausible that, especially after Mexico bankers came to believe that the IMF wouldalways bail them out and therefore did not need to concern themselves greatly with individualcountries’ economic policies . . . there is fairly widespread agreement on the moral hazardargument as it pertains to international commercial banks (p. 2014).

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assume that this information will always be interpreted accurately and thatlending decisions will always be appropriate. A lesson from the Third World debtcrisis as well as subsequent international financial crises is that lenders maymisinterpret information. Even the Fund’s forecasts as revealed in itsWorldEconomic Outlookare frequently subject to a large margin of error. It may wellbe that the opinions of powerful market operators such as George Soros havemore influence than the opinions of the IMF.

In a world of liberalised international capital markets in which ourunderstanding of capital movements is still fairly rudimentary, where even ourbasic understanding of macroeconomics is far from complete, and where it is onlythe occurrence of unpredictable shocks that is predictable, it is most unlikely thatbalance of payments crises will be averted. Developing countries in particularwill be vulnerable to such crises either as a consequence of trade instability in thecase of low income countries or trade and capital instability in the case of better-off developing countries. The IMF’s existingmodus operandidoes little to helpavert crises. But can it help when they happen?

4. THE IMF AS CRISIS LENDER

As discussed above, developing countries only turn to the IMF as a last resortand, in this sense, the IMF is already a lender of last resort. Furthermore, the Fundhas lent heavily to Mexico, Korea, Indonesia, Russia and Brazil at times whenprivate markets would not. However, the international financial crises of the1990s have raised the question of whether the Fund should more formally beperforming the functions of an international lender of last resort (ILLR) alongsimilar lines to those of a national LLR.

In many respects, the analogy appears compelling. After all, LLRs aredesigned to create confidence in conditions of financial crisis and to preventweaknesses in financial markets from becoming contagious; the essence of asystemic role. The issues underlying the LLR role are well understood; lend onlyagainst sound collateral, lend freely but at a penalty rate, and deal with the moralhazard problem by regulation, the costs of assistance, and lack of precisionoutside general principles.

Lending by private capital markets has been volatile, has shown elements ofcontagion, and has suffered from crises of confidence. Surely an ILLR is what isneeded? Should the IMF take on the role?4

In part, the answer is a matter of semantics. In conditions of internationalfinancial crisis it is almost inevitable that the Fund will be asked to provide

4 Fischer (1999) provides a brief summary of the Fund’s own answer to this question which seemsto be a guarded ‘yes’.



financial assistance. For developing countries and CITs, the IMF is literally aninternational lender of last resort. But it is not an international central bank. Itdoes not have the ability to create high-powered international money. Ininstitutional terms, it is more like an international credit union. Thisfundamentally limits its ability to play the role of a fully fledged ILLR. Doubtsabout the adequacy of its own resource base will constrain its operations and willlimit the confidence that it can generate.

As a consequence, the East Asian crisis exposed the Fund’s incipientilliquidity. There was a sharp decline in its liquidity ratio. To offer the amount offinancial assistance that was deemed appropriate, the Fund had to relax its accesslimits by introducing a new lending facility – the Supplemental Reserve Facility –and then had to negotiate New Arrangements to Borrow in order to ensure that ithad the resources necessary to meet the demand for them. All this at a time whenit was still awaiting final approval to the quota increases envisaged in theEleventh General Review.5

Ad hoc crises beget ad hoc measures. But ad hoc measures may not provide thebest solution to problems that are apparently increasingly systemic. Critics of thequota-based system of financing the Fund have long argued that its resourcesshould be more automatically linked to the level of world trade, rather than beingperiodically adjusted using procedures that open up the Fund to internationalpolitics, and can, prior to an adjustment, expose the Fund to illiquidity problems(Bird, 1987). To the extent that balance of payments crises are increasinglyrelated to volatile capital movements, is a logical extension of this argument tolink the Fund’s own resources to the size of private international capital markets?

There are a number of problems with this idea. First, governments that havebeen reluctant to approve the quota increases contained in the Eleventh Reviewwould even more strongly resist the very much larger increases in the Fund’sresources that would be associated with linking them to the size of private capitalmarkets. Second, should it be the Fund’s role to underwrite private internationalcapital markets as an ILLR would do? It is in this context that the Fund has beenexposed to the criticism that it has operated to bail out private creditors. If theFund dramatically increased its lending capacity in order to fulfil this role, itcould open itself up to the moral hazard difficulties discussed earlier. An attemptto deal with some of these via conditionality could then diminish the Fund’salready rather minor role as a crisis-averter.

The conclusion emerges that, while the Fund has an important and justifiablerole as an international lending institution because of the inefficiency anddistributional ‘failures’ of private international capital markets, and while there is

5 Access limits (in per cent of a member’s quota) are as follows: Stand-bys and extendedarrangements, annual 100, and cumulative 300; SRF, none; compensatory and contingencyfinancing facility 80–90; buffer stock financing facility 35; ESAF, regular 190 and exceptional 255.The Eleventh Review of Quotas raised total quotas to SDR 212 billion.

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scope for improving significantly the ways in which the Fund’s own resources areincreased, it is probably both unwise and impracticable to attempt to convert theFund into a fully-fledged international lender of last resort agency. The Fund hasa role as a crisis lender, but this needs to remain focused towards assisting themember countries that are borrowing, rather than underwriting, internationalcapital markets.6 Is there a more important part for the IMF to play ininternational financial crises?

5. THE IMF AS A CRISIS MANAGER

In a world of large liberalised capital markets, of unpredictable shocks, and ofnot fully understood macroeconomic relationships, international financial criseswill almost certainly continue to occur. The Fund could perform a moresignificant role in helping to avert such crises if it could encourage countries toturn to it earlier. But viewed from the borrowers’ perspective, this would requirea combination of increased benefits (more finance) and lower costs (largely lessstrict conditionality). In the midst of a crisis policy options will be few; indeedthe crisis will itself necessitate policy actions that would not have been requiredhad the crisis been averted (Boughton, 1999). Inducing a rapid turnaround in thebalance of payments is very likely to involve deflating domestic aggregatedemand. Governments may be prepared to accept such conditions in order tosecure a loan from the IMF, since in a crisis strengthening the balance ofpayments will have become a high policy priority. However, once crises are over,governments may return to viewing the balance of payments as a constraint onother policy objectives, and this will widen the gap between their preferredpolicies and those of the IMF and this will discourage country referral. Unless theunderlying objective functions can be made to better coincide, early referralseems unlikely.

Even so, in its crisis management role the Fund should seek to support policieswhich, while effective in strengthening the balance of payments, do minimumdamage to other governmental policy objectives. The Fund needs to avoid policyoverkill and its related contagion effects.

6 In a sense the Fund’s lending role derives from the need for it ‘to put its money where its mouthis’. As Rodrik (1995) observes:

in the absence of direct lending by the multilateral agencies, there is very little to ensure thatthese agencies will exercise their informational function as competently as possible. If their ownmoney is not at stake, they may be more influenced by political demands . . . in their certificationof credit worthiness (p. 174).

Moreover, to the extent that the Fund’s involvement is associated with a positive catalytic effectthis may, in principle, be as much to do with the Fund’s injection of liquidity as its seal of policyapproval.



Moreover, to the extent that there will be adjustment costs, it is also desirableto try to ensure that they are reasonably equitably shared rather than fallingdisproportionately on either debtors or creditors. It is in this context that the Fundcan play an important role.

Potential crises often become actual crises because of co-ordination failures. Itis for this reason that we have fire drills. International financial crises may also beviewed as co-ordination failures. Creditors adopt an acutely short termperspective, and behave in accordance with the belief that other creditors havea similar perspective. It is this that rapidly transforms capital inflows into capitaloutflows. The behaviour of creditors then creates further liquidity problemswhich seem to justify the original behaviour. Prophecies of illiquidity becomeself-fulfilling.

Crises as co-ordination failures create a role for a co-ordinating agency. In thecontext of international financial crises, this is an appropriate systemic role forthe IMF. In this capacity the Fund could provide a combination of inputscomprising its own lending, conditionality advice, and the orchestration of re-scheduling by private international creditors. The appropriate combination woulddiffer according to individual country circumstances, but there would be guidingprinciples. These would include endeavouring to ensure that crises were nothandled by forcing member countries into deep recessions that would then beglobally transmitted to other countries. The objective would be that of an ‘orderlywork out’ rather than disorderly chaos. The proposal is akin to those for someform of international bankruptcy arrangements to deal with the problems ofhighly indebted countries (Cohen, 1989; Sachs, 1989; Corden, 1988; and Radeletand Sachs, 1998).

The advantages are that, first, the Fund could move away from the essentiallyad hocapproach to crisis resolution that has been observed during the 1990s.Second, it would not need the dramatic increase in resources that would beassociated with the full ILLR role. Third, it would still be able to use a significantproportion of its resources to help alleviate the external financing problemsencountered by low income countries rather than risk having them tied up inassisting better-off developing and emerging economies. Fourth, to the extent thatit was able to establish a track record of success, it would gain a reputation as anhonest broker and would thereby help to instil confidence; this would in itselfmitigate against the development of crises as well as ease their resolution.Moreover, by ensuring that creditors were not completely bailed out, the Fundcould systemically discourage over-lending in non-crisis conditions, and couldthereby help reduce the volatility of capital flows.

In seeking to establish a track record of success, the Fund needs to address atleast three issues. These are: the design and implementation of conditionality; theappropriate blend between adjustment and external financing; and the ability ofthe Fund to catalyse other sources of external finance. However, while important,

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these issues lie beyond the scope of this paper and each of them has a largeassociated literature.

6. CONCLUDING REMARKS

The IMF has historically played a systemic international financial role. Duringthe era of the Bretton Woods system it co-ordinated global macroeconomicpolicy through the management of pegged exchange rates. However, with thecollapse of the Bretton Woods system, it lost this systemic role and in some sensehas been searching for a new one ever since. The international financial crises ofthe 1990s suggest that there is a systemic role to be played and the IMF may bethe best international agency to play it.

Proposals for reform coming from the G7 have emphasised the need for moreinformation and greater transparency, for better regulation and supervision offinancial markets and for ‘improved’ conditionality. ‘Strengthening’ the IMF hasbeen presented as a key element in achieving these objectives.

While in general terms it is difficult to challenge proposals that seek to‘improve’ and ‘strengthen’ the international monetary system, the analysis in thispaper casts doubts over whether this may realistically be achieved by the G7’spreferred reforms.

In terms of crisis prevention, more and better information and greatertransparency in economic policy-making may clearly help, but can it beguaranteed that information will always be accurately interpreted? Experiencedoes not give cause for great confidence. Moreover, at present, the Fund tendsonly to become involved in countries that are already in crisis conditions;although where the crisis is protracted, as in some low income countries, so too isthe Fund’s involvement. To shift towards a role of crisis prevention represents amajor philosophical change for the Fund. A strategically important step inmaking this shift is to encourage member countries to seek advice and financialsupport from the IMF in advance of a crisis, when there is a chance that it may beaverted. ‘Stronger’ conditionality is unlikely to achieve this. Other things beingeven, stronger conditionality may further induce delayed referral. ‘Improved’conditionality should not be confused with ‘more’ conditionality. Indeed, limitingit in such a way as to concentrate on a more restricted range of performancecriteria, where general agreement may be gained, may serve to raise thecommitment of governments to reform, reduce domestic political opposition, andobviate many of the recent criticisms of the Fund which argue that itsconditionality is needlessly far-reaching and sometimes motivated by the interestsof its richer shareholders. Increasing the degree to which IMF-backedprogrammes are fully implemented may, therefore, require a much deeperanalysis of the fundamentals of conditionality than is currently envisaged and



may result in changes to conditionality that reverse rather than extend recenttrends. Without measures which effectively address the issue of delayed referral,it is extremely doubtful that the Fund can have much impact on averting crises.Yet at the same time it is doubtful that the Fund induces crises through the moralhazard effects of its lending as has been claimed by some observers.

Moral hazard could become a more significant concern if the Fund were tobecome a fully-fledged international lender of last resort, but, in any case,considerations of political economy make this unlikely to happen. It is difficult toenvisage the Fund becoming an international central bank with money-creatingpowers. This having been said, the Fund isde factoa lending institution to whichmember countries turn as a last resort, and, in this context, it needs sufficientresources to be able to support well-designed programmes incorporating theoptimum combination of adjustment and external financing (Bird, 1997). This, inturn, implies that current methods for financing the Fund need to be reformedwith greater emphasis being placed on automaticity and the link between theFund’s available resources and the contemporaneous need for them. Periodicquota reviews combined withad hoc arrangements to provide supplementaryresources when subscriptions are inadequate provide an inappropriate financialfoundation for the world’s premier international financial institution. The Fundwill be unable to play a systemic confidence-creating role while its own resourcebase is in doubt.

In addition to its own lending, the Fund needs to more fully examine thecircumstances under which it can influence the lending decisions of privatecreditors. At present, claims of an important catalysing role remain unsupportedby the empirical evidence. Enhancing this role also requires a fundamentalreassessment of conditionality, since there is little to suggest that catalysis ispositively related to the breadth and depth of conditionality.

While in the aftermath of the Third World debt crisis of the 1980s, the Fundperformed a catalysing role by coercing commercial creditors to lend, this doesnot offer a long term modality for catalysis. However, in the context of the debtcrisis, a number of proposals were made for establishing the Fund as a debtrediscounting agency or a quasi-international bankruptcy ‘court’. Its principalfunction here was envisaged to be that of co-ordinating creditors in order toovercome the public good and free-rider aspects of debt relief. To the extent thatinternational financial crises also represent co-ordination failures, the Fund canplay a key role as a crisis co-ordinator or manager. The attractions of thisproposal in part lie in the underlying theoretical principles that are based on theFund acting to offset and neutralise the failures of private international capitalmarkets, rather than by seeking to replace such markets, but they also derive fromthe modest implications for resourcing the Fund, which would not beunderwriting or bailing out private international capital markets. It is thereforea role that is politically feasible.

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The IMF is an institution in need of overhaul. Its recent history reveals anevolution that has often been driven by crisis responses of one type or another. Asa consequence, its lending windows have proliferated (stand-bys, BSFF, EFF,ESAF, CCFF, STF, SRF, with others still being proposed) and its own resourcebase has had to be augmented by supplementary arrangements to cover thedeficiencies of its underlying quota-based sources of financing. Reform hastended to occur by formalising in the longer term solutions that were initiallyconstructed to deal with short term crises, the most recent of which has been thefinancial crisis in East Asia. There is surely scope for rationalising the Fund’scurrent array of lending facilities by focusing on the two broad groups ofcountries that currently form its clientele. The first group constitutes the lowincome countries that have been largely by-passed by private international capitalmarkets. Here long term structurally oriented and concessionary lending is oftenappropriate. The second group constitutes better-off developing countries andCITs where referral to the Fund may reflect a (temporary) loss of marketconfidence. Here quick-disbursing finance combined with short-term stabilisationmay be more relevant.

It is in the context of the latter group that the Fund may find a systemic role.Until recently, however, the Fund’s preferred reform priority has been capitalaccount liberalisation. The arguments for and against this have been rehearsedelsewhere in the literature (Bird, 1998b; and Fischer et al., 1998). Basically, ifprivate international capital markets allocate capital efficiently global welfarewill be raised by removing capital controls. However, for as long as there arecapital movements which are explained not by economic fundamentals but bymyopic psychology, it may be unwise to aim universally for free capitalconvertibility. Pursuing this objective could mean that the Fund facilitates futurecrises rather than helps to avert them. Premature capital account liberalisationcould make things worse rather than better.

It is certainly an appropriate time to be reassessing the role of the IMF, a rolethat is largely dictated by the inefficiencies and distributional inequities ofprivate international capital markets, and to be rethinking the way in which theFund may be resourced in order to perform this role. However, a better sense ofdirection is needed than the reform creep of which the G7’s proposals representbut the most recent episode. Reforming the international financial architecturemay be attractive as a catch phrase but it implies an underlying blueprint. Up tonow, it seems to be the blueprint that is missing. New international financialarchitecture will only help to build a better international monetary system if itdistinguishes clearly between what is both desirable and feasible and what isnot. A ‘reality check’ suggests that, while the Fund could play an enhanced co-ordination role in the context of financial crises, its ability to play some of theother roles that have been touted for it is limited. Pursuing them in aninconsistent way (e.g. emphasising crisis prevention but with no willingness to



redesign conditionality) will only lead to a further loss of institutionalreputation.

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Crisis Averter, Crisis Lender, Crisis Manager: The IMF in Search of a Systemic Role

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