P-K4 Project Editorial
Part of our EURO week, where we look at more serious stuff like IMF, and on a more light-hearted and sporty note, the European Cup final featuring Spain VS Italy
The International Monetary Fund (IMF) had its beginnings at a conference in Bretton Woods, New Hampshire, USA, towards the end of World War II. Its main agenda was to rebuild Europe and the global economic system after devastation caused by the war. Bretton Woods was to play host to two major viewpoints, represented by John Maynard Keynes of the British delegation, versus that of the US delegation. Keynes believed that the IMF should function as a “cooperative fund” which member states can rely upon when going through periods of crisis to sustain economic activity and employment. The US delegation however saw the IMF as a bank, making sure that member states could pay their debts on time (this point will be revisited later), and is less concerned with addressing employment issues and recession. The US view was to ultimately prevail. Over the years of IMF’s existence, it has gradually grown to be seen as an international lender of last resort, with varying degrees of reception, from support of that role to criticisms.
Thus, who is the main power broker (s) in IMF? It is none other than the US Treasury, which leads the US government’s engagement in the IMF, and shared to some extent with the European Union (EU) and Japan. Voting in the IMF is weighted by financial contribution and this is where the US, EU and Japan enjoy a comfortable majority. Hence, the IMF serves as a proxy which allowed the Treasury to intervene in developing countries, which are host to IMF’s economic programmes.
What are the problems, as the title suggests with IMF? A number of them in fact, the first of which is the moral hazard problem, followed by flawed assessment of long-term debt prospects of the countries which it lend to, terms and conditions of the loans which worsen outcomes in countries, and negative societal consequences related to the terms and conditions.
There are two angles to the moral hazard problem that will be discussed, involving 1) foreign financial institutions (banks) 2) Governments or/and policymakers
Addressing the first angle regarding foreign institutions, knowledge of the bailout by the likes of IMF encourages risk-taking behaviour, and in this case, lending to high-risk countries. IMF ensures that the bailout rescues these foreign institutions, and as a result, the disincentive to lend to high-risk countries is removed, knowing that they will be insulated from losses by the likes of IMF anyway. Hence, the moral hazard problem with the knowledge of IMF as an “international lender of last resort”.
What are the consequences of such bailouts – an asymmetrical distribution of wealth from the domestic, middle class tax payers to the wealthiest and politically powerful within the country. In the case of the Mexico crisis from 1994 to 1995, IMF not only bailed out foreign and domestic bankers who lent funds to Mexican firms before the crisis but also resulted in a situation where billions of dollars are transferred from the Mexican tax payers collectively to the country’s wealthiest and most politically powerful. During the bailout of Korea in the Asian Financial crisis, IMF funds were channelled to the banks, which were passed with impunity to conglomerates who owned them.
Bong Joon Yoon, a professor in the Department of Economics, State University of New York at Binghamton, was less than generous in his assessment regarding the IMF bailout in Korea. In a paper entitled “The IMF Bailout in Korea: A Socialist Poison”, Bong wrote that the IMF bailout resulted in socialisation of private debts, which forced tax payers to foot $57 billion of IMF’s loans for the mistakes of chaebols (conglomerates), banks and foreign institutions themselves, implicating innocent people in the process. He described” the bailouts as not medicine, not even an ineffective placebo, but [a] socialist poison”.
When IMF grants a bailout, debtor countries attempt to repay the loans. The question is how they are repaid by member countries. Consequently, IMF loans provide impetus for policy-makers to increase taxation to repay the loans, which is why tax payers are the biggest losers in the end. Ultimately, increased taxation has a contractionary impact on the local economy.
What are the possible impacts of this moral hazard problem on the worldwide financial system? The crux of the problem lies in what Charles Calomiris, currently the Henry Kauffman Professor of Financial Institutions at Columbia University, described as “quasi public banks”. Private businesses in developing countries are dominated by oligopolistic conglomerates, which are controlled by wealthy, and politically influential families and corporations. And governments tended to form unhealthy partnerships with such businesses, with entities known as “quasi public banks” serving as the conduit of such partnerships.
These banks are owned and controlled by conglomerates, but are funded by public finances. The moral hazard problem manifest with risky practices, any profits is pocketed by the banks and conglomerates, while losses are borne by the public as a consequence of bailouts. The Korean example as mentioned perfectly illustrated this unhealthy arrangement.
Studies by World Bank and IMF have seen a rise in incidence of high-cost bank insolvency, where banks are unable to pay off their debts. In 90 episodes of banking crises since 1982, 20 of which are where the bailout costs exceeded 10% of the Gross Domestic Product (GDP). In half of those cases, the losses amounted up to approximately 25% of the GDP.
Moving on to the next argument on moral hazard problem affecting government officials and policy makers, it must be noted that a crisis can also be caused by poor fiscal policies that causes the country to run into budget deficits. Poor fiscal policies, for instance, involve excessive and unnecessary government spending, or/and inefficient tax collection. It happened in Russia, and is now the cause of Greece’s current economic woes.
Knowledge of a bailout does not give policy-makers and governments any incentive to avoid coming up with fiscal policies that result in budget deficits, i.e. there is no motivation for them to rein in their spending or/and ramp up efficiencies in collecting taxes. This is not to say that all budget deficits are bad; the specifics are important. When the government runs a deficit to stimulate the economy in the middle or a recession, running one is justified under such circumstances. In the case of Greece, however, it is a question of maintaining fiscal discipline and reining in government spending. The question is whether the moral hazard associated with bailout will discourage future governments from doing (exercising fiscal discipline) so.
Meaningless Debt Analysis
It is essential to consider what constitutes debt sustainability when we grapple with the topic of debt sustainability analysis. The IMF carries out what is known as debt sustainability analysis, which allows it to determine which debts are sustainable and which are not. To the IMF, a debt is sustainable so long as it satisfied the debt solvency condition; debt solvency is achieved when future primary surpluses will be large enough to pay back the debt, both principal and interest. The opposite of this is insolvency, and the country defaults on its debt.
The question is what is the problem with IMF’s debt sustainability analysis? The major problem with it is the fact that it is forward-looking, which means it cannot be assessed with certainty, which makes the exercise impossible. Debt projections are amenable to assumptions on growth, outcomes of fiscal policies and interest rates. Thus, it is generally impossible to achieve any degree of precision for such projections, which are at best mere guesses.
The analysis can also be complicated by inflation. Depreciation of exchange rate follows high inflation. When a country undergoes high inflation, there is an increase in prices of goods and services relative to that of other countries. In order to purchase relatively cheaper goods and services from another country, citizens have to purchase its currency , and thus, the currency of their country depreciates relative to that of its trading partner. How the exchange rate is impacted is dependent on inflation rate relative to other countries. High inflation rate relative to other countries results in currency depreciation.
The problems come in when exchange rates do not reflect inflation, i.e. when the exchange rate depreciates so quickly, which makes the foreign currency debt more expensive in terms of the domestic currency. The problem posed by the depreciation of domestic currency is indeed a fascinating one. The term “original sin” was coined by economists Ricardo Hausmann and Brian Eichengreen which described a problem in which poor countries face when they are not able to borrow abroad in their domestic currency. Depreciation of the borrowing country’s currency will make it worth less relative with the loan, thereby resulting in a greater debt burden.
Finally, there is also the issue of whether the debt sustainability analysis will truly tell us whether the country will default, even if they are sustainable. Economists Bernd Lucke and Eckhard Wurzel demonstrated in a paper that even if a country like Greece can sustain their debt, a strategy that aims to maximise welfare in the country (in economics terms, welfare refers to the allocation of resources to bring about a certain level of social welfare/good) can be achieved by defaulting.
Incorporating Greek data into the model which they developed, they found that Greece may well declare themselves insolvent (meaning they default on their loans), because defaulting on the debt will result in higher welfare than the best non-defaulting strategy. This can be simply illustrated using game theory – the Prisoner’s dilemma – though there are slight differences. Two prisoners are faced with two choices each, cooperate with the police or defect. Assuming that the other prisoner cooperates, defecting will gain the defecting prisoner the best pay-off. In this case, Greece knows they have been offered a bailout, and if they are looking at the level of welfare gained as a pay-off, then selecting the default strategy will make sense as it results in the best pay-off.
This is precisely why debt sustainability analyses rarely tell us anything about a country’s ability to sustain the debt, and nothing about the strategies that the governments will take in choosing between defaulting or not, which raises the question of whether they are meaningful at all. This is why detractors of this debt analysis are resigned to the fact it would have been better to accept from the outset that the Greek debt cannot be repaid.
Questionable Terms & Conditions
It is said that instead of putting out the fire, IMF only managed to add fuel to the fire especially during the Asian Financial crisis of 1997 – 2000.
Asian banks were debtors to foreign creditors, but the crisis took root with concerns with currency over-valuation, bank scandals and weak real estate markets, which prompted these foreign creditors to withdraw credit from Asia. Each creditor will rush for the exit, just like what other creditors were doing. The best policy in such a scenario is reassuring the foreign creditors in a concerted attempt to slow their flight. In a sense, the right approach is to avoid a self-defeating panic. However, IMF became the spoiler, pushing the panic button in the process, and triggering a flight of capital in the process.
IMF deepened the sense of panic with its proclamations of all is not well, and a set of questionable terms and conditions. To be able to receive IMF’s loans, countries must adhere to IMF’s terms and conditions – high interest rates, budget cuts and immediate bank closures. There is a double whammy. Institutions who made risky investment decisions were bailed out by IMF’s funds, and the domestic middle class end up footing the loan repayment as mentioned earlier. The other problem is that high interest rates and bank closures meant that firms have high barrier and reduced access to credit as higher interest rates discouraged lending from banks, so the local economy contracted as a result. The insistence on budget cuts, or “austerity” measures for the use of a more popular buzzword nowadays is at best a controversial approach. There is no such thing as a one size-fits-all “austerity” measure; every country has its unique circumstances. Criticisms, for instance, have been levelled at IMF’s demand on balanced budgets in Thailand, when there was a need for government investments in education and infrastructure, but made impossible due to this demand.
It was Malaysia’s success story which demonstrated that IMF’s prescriptions were indeed way off mark. What the Malaysia policy makers did was the opposite of the IMF’s terms and conditions. Instead of increasing interest rates, it reduced interest rates, facilitating bank lending and resulting in increased investment and consumption, stimulating the economy. It also reduced statutory reserve requirement in banks; the physical cash stored in bank vaults. Reduced interest rate will result in the depreciation of exchange rate. Depreciation of exchange rate will increase the debt burden as mentioned earlier, and increase the likelihood of debt default. Hence, the Malaysian government intervened and fixed the ringgit at 3.80 to US$1.
There are ways in which governments can fix their exchange rates. One is to maintain foreign currency reserves, if the exchange rate drifts below targeted rate, the government can purchase its domestic currency using the reserve. If the exchange rate increases above the target value, the government sells its domestic currency. Another way to achieve this is to ban trading currency at other rates. The Malaysian government also closed down overseas trading of the ringgit, further preventing offshore speculative attack on it. The Malaysians also recognised the problem posed by the flight of capital that triggered the crisis, and thus the government moved in to regulate capital flows, particularly capital outflow by foreigners and citizens. It must be stated that the Malaysian government initially took on IMF’s prescriptions, but that did not work out, which prompted the switch. In a sense, its success indicates one glaring weakness of IMF’s terms and conditions – it wasn’t a medicine for the local economy.
Austerity has now become the bargaining chip in exchange for loans from IMF and European governments. Yet, it has not brought about desired economic outcomes in Greece, Spain, Italy, Portugal and Britain. They have resulted on the other hand in shortfalls in revenues and rising unemployment. As such, it cannot be a one size fits all approach, as circumstances, e.g. patterns of government spending, efficiency of tax collection, matter. The type of policies (tax collection, policies to improve employment and tax revenues) the governments are implementing, and the appropriate changes matter in the outcome of the government’s budget, and specific approaches unique to each country are more appropriate than demands on austerity across the board (deficits happen for a number of reasons, governments may spend excessively or may have inefficient tax collection system, high unemployment rates, all of this is unique to a country). It is about going to the root of the problem and addressing it rather than providing bailout loans and demanding austerity measures in a one size-fits-all approach.
Negative societal impact of austerity measures
In order to meet IMF’s demands on austerity, government spending on certain areas will be reduced, and of such is healthcare. A study of Eastern Europe and former Soviet Union countries who participated in IMF programmes found that tuberculosis death rates have increased by at least 17% between 1991 and 2000. This could be possibly attributed to reduced funding for clinics, hospitals and health services.
Perception of Conflict of Interest
Kenneth Jeyaretnam, the secretary-general of Reform Party, an opposition party in Singapore, raised an issue earlier regarding the committment of a USD$4 billion loan to the IMF via the Monetary Authority of Singapore (MAS), the republic’s central bank. Jeyaretnam contended that the loan was not approved by the President of Singapore, who by constitution is the custodian of the republic’s national reserves. In email communications with the President’s office, Jeyaretnam learnt that the MAS is to serve as the vehicle to channel loan funds to the IMF.
In our email correspondence with Jeyaretnam, he also highlighted an issue of perception of a conflict of interest – Tharman Shanmugaratnam is a chairman of the International Monetary and Financial Committee (IMFC), the policy advisory committee of IMF. Shanmugaratnam is currently a Deputy Prime Minister, Minister for Finance and Minister for Manpower. Shanmugaratnam is also responsible for overseeing MAS, hence, the perception of conflict of interest that Jeyaretnam is alluding to.
Apparently, Singapore’s southeast asian neighbour, Philippines has seen more public disapproval of loans to IMF. The country loaned $1 billion to IMF, and this resulted in the Partido ng Manggagawa (Workers’ Party) and Philippine Airlines Employees’ Association staging a protest. They picketed the Bangko Sentral headquarters and office of the Department of Finance to protest against the controversial loan, chanting “Help the needy not the greedy! Support Europeans thru solidarity not austerity!”
Some final words
The way IMF has conducted itself creates problems of moral hazard, and there will be doubts that such will address the source behind the economic mess that some countries have gotten themselves into. Secondly, the debt sustainability analysis adopted by IMF is a meaningless exercise in assessing likelihood of default. Next, is the austerity measures that it uses as a bargaining chip for countries seeking loans, which should not be a one size fits all approach, given the unique circumstances present in each country. However, as a result of austerity measures, negative outcomes, particularly in the area of human health have been reported.
IMF critics have contended that the IMF loans have favoured politically powerful institutions and families at the expense of the domestic middle class. Perhaps, IMF is aptly the abbreviation of “I’M Fat”, the fat cat beneficiaries of IMF’s bailouts and policies. Yes, it is time to say no to loans to IMF.
Photo courtesy of Corporation to Community