The decline of the IMF: is it reversible? Should it be reversed?

Dieter, Heribert

The venue had been chosen thoughtfully. In a speech delivered in New Delhi, capital of an emerging Asian economic power, Mervyn King, governor of the Bank of England, called for a radical reform of the International Monetary Fund (IMF). In unusually stark terms, King cautioned against letting the IMF slip into obscurity. The institution needed to be modernized and its tasks reconsidered, he argued in February 2006. (1) Since then, several other central bankers, politicians, and academics have contributed to the debate on the future of the Fund. This discussion on the future of the IMF partly reflects the relative calmness in financial markets. The Fund did not have to manage any major financial crisis in recent years, in contrast to the days of the Asian crisis in 1997 or the collapse of the Argentine economy in 2002. But the debate also reflects a deeper concern over the international financial architecture for the twenty-first century.

Two unresolved issues cloud the future of the IMF. First, the governance structures of the Fund itself ought to be changed. Today, there is an unsustainable asymmetry: OECD countries shape the IMF's policies, which affect primarily developing countries and newly industrialized economies. Second, the IMF does not provide a convincing safety net for financial crises. If it does not modernize its lending policies, alternative structures of financial governance will continue to be developed. In the absence of a credible institution of global financial governance--providing both crisis prevention and management--governments in countries that have experienced financial crises are developing their own measures, both unilaterally and at the regional level.

Consequently, there are many reasons for discussing the future of the International Monetary Fund, the most important being that customers are abandoning the Fund. In contrast to the 1990s, today two important regions have turned away from the IMF. Since a radical restructuring of the Fund--for instance, a considerable strengthening of the voting rights of developing and newly industrializing countries or fundamental changes in the provision of liquidity--is not forthcoming, East Asia and Latin America, each in a very different fashion, are currently developing methods of emancipating themselves from the IMF.

The fact that many countries have turned away from the IMF is already reflected in the Fund's balance sheets. In the last fiscal year, new loans granted by the IMF accounted for only US$2.5 billion, the lowest level since the 1970s. The sum of outstanding loans decreased from $90 billion in April 2004 to $66 billion in November 2005 and has since further declined dramatically. Within six months, the governments of Argentina, Brazil, and Indonesia have decided to repay their outstanding debt prematurely--a step that causes trouble for the Fund. Since the Fund finances the cost of its operations from the interest surplus it generates, reduced lending results in a decrease of revenue. According to IMF projections, income from charges and interest payments would shrink from $3.19 billion in 2005 to $1.39 billion in 2006. By 2009, these payments will decrease further to $635 million, about 20 percent of the level in 2005. (2)

The IMF's loss of relevance and credibility has three primary causes: First, although the IMF portrays itself as a nonpartisan adviser and banker, it has shown a high level of bias in its work, particularly in the event of a financial crisis. Rodrigo Rato, the IMF's managing director, complained in September 2005 that "change is held back by politics," ignoring that change itself is politics. (3) When receiving IMF assistance, governments in Asia and Latin America were subject to strict conditionality, which was supposed to guarantee repayments of loans. But the IMF took advantage of financial crises for the implementation of policies that had little, if any, relation to the causes and resolution of the crisis--for instance, the opening of South Korea to foreign investors. (4)

Second, the Fund's crisis management has proved to be procyclical, particularly in Asia. By demanding budget cuts and high interest rates, the Fund contributed to a deepening of the downturn, rather than contributing to its solution.

Third, the Fund's general policy recommendations have not generated sufficient benefits for the developing and newly industrializing countries concerned and have frequently backfired. In particular, the IMF has long advocated the comprehensive liberalization of capital flows but has ignored the risks that are associated with such steps, especially for so-called emerging markets.

The emancipation process is particularly discernible in East Asia. The central banks in the region have accumulated giant currency reserves in the past eight years. China's currency reserves alone (including Hong Kong) amount to $1,000 billion. South Korea has more than decupled its reserves since 1998, up to more than $210 billion. The small island republic of Singapore has $120 billion in currency reserves at its disposal--more than China had back in 1997.

These currency reserves enable most economies in East Asia to successfully ward off speculative attacks on their own currencies or a dramatic drain of foreign capital. Having currency reserves of over $2,500 trillion, East Asian countries will be able to do without the IMF in future crises. These reserves make previous emergency loans look smallish: during the Asian crisis, the IMF, the World Bank, and bilateral donors together pledged $110 billion in loans.

However, East Asian countries do not content themselves with unilaterally accumulating currency reserves. Simultaneously, since 2000, an East Asian liquidity fund has evolved in the context of the so-called Chiang Mai Initiative. In 2005, the available resources were doubled, and the hitherto existing bilateral swap agreements were converted into a regional fund. Countries in the region are betting on their own resources as well as on those that are provided regionally, but they try to avoid the IMF at any cost. After the great crisis of 1997, East Asia has started to create a new international regime for the stabilization of monetary and financial relations. While Asian countries are not yet prepared to establish strong regional institutions, they nevertheless display a clearly discernible desire for emancipation from the weakly legitimized power of the International Monetary Fund.

In a very different manner, Latin America has reduced the IMF's influence. Undoubtedly, the Fund had an unusually high degree of power over the economic policies of Latin American countries since the 1980s. These countries came to depend on the IMF and its policy recommendations in the course of the debt crisis. The Fund had asserted a model of economic policy that interpreted macroeconomic stability primarily as price stability, promoted the privatization of state-owned enterprises, and pushed for the comprehensive liberalization of capital flows.

Latin America was home to some of the IMF's poster children, and these suffered a particularly bitter disappointment. (5) Argentina, for instance, had implemented virtually all recommendations of the Fund since 1991--ranging from the exchange rate regime to the comprehensive privatization of state-owned enterprises to the unilateral lowering of external tariffs. As late as 1999, the IMF had praised Argentina's economic policy. Two years later, the house of cards collapsed and Argentina suffered a catastrophic breakdown of its economy. The conclusion many Latin Americans have drawn from this is that they were exposed to risks without reaping the corresponding benefits.

Now, in what sense are Latin American countries turning away from the Fund? The IMF's loss of relevance is twofold: To begin with, the IMF's important debtors (Argentina and Brazil) settled their liabilities ahead of schedule, at the end of 2005. On 13 December, Brazil's secretary of the treasury announced that Brazil would pay back the remaining debt of $15.5 billion ahead of time; two days later, Argentine president Nestor Kirchner declared that Argentina too would settle its debts of $9.8 billion before the end of 2005. (6) This puts both countries in a position of relative independence from the IMF's conditions.

Even more significant, though, is the fact that Argentina shows how much more favorably its national economy has developed absent the IMF's influence. Since the 2002 crash, Argentina's economy has been witnessing a spectacular growth of about 9 percent per year. Since the crisis, exports have risen by 50 percent, and currency reserves were tripled. This does not yet mean that the country is on a sustainable path and will continue to grow, but the perception in Argentina is that the IMF's recommendations contributed to the country's plunge into a severe crisis, but without the Fund the economy grows spectacularly.

The financial crises in Asia and Latin America--and the failure of the IMF's crisis management--have allowed hostility and mistrust to permeate the relations between state actors. At the risk of generalization, one can argue that many developing and newly industrializing countries have lost confidence in the policies of developed countries and the institutions that are governed by them--the IMF in particular. Especially in Asia, the experience of receiving only lukewarm support from both the IMF and the United States during the crisis has caused a continuing trauma. In South Korea, for instance, the Asian crisis is perceived as the second case of "national disgrace." The first was the colonization by the Japanese in 1910.

In addition, the Fund is suffering from a considerable legitimacy deficit. It is the big shareholders, in particular the United States, that are calling the shots in the IMF. The North-South divide is clearly discernible: since 1978 no OECD country, apart from new members Mexico (1994/95) and South Korea (1997), has received financial assistance from the Fund. Put differently, the industrialized countries determine the Fund's policies, the effects of which are almost exclusively felt by developing and newly industrializing countries. Although industrialized countries provide the IMF's capital, the Fund does not spend that money but borrows against it. (7) The developing countries are both affected by the Fund's policies and pay for its operation, yet it is the industrialized countries that decide, although in practice they do not even risk their capital. One could even argue that today's incentive structures are counterproductive: quotas in the IMF have no price--they provide influence without significant cost.

Having considered the existing weaknesses of the IMF, one could ask whether it would not be useful if the much-criticized fund ceased to exist. Instead of a multilateral organization that lost its purpose, national or regional institutions could provide the functions of the Fund. But this conclusion would be a shortsighted one. In an era of increasing capital flows, the need for a multilateral institution that provides certain, defined services is ever increasing. First and foremost, there continues to be a need for a global lender of last resort. The accumulation of unprecedented foreign reserves by many countries--de facto the creation of their self-made lender of last resort--illustrates that governments assume that financial liberalization requires emergency lending facilities. These ought to be provided by a multilateral institution, which should provide liquidity in a crisis, whether homemade or caused by unwarranted investor panic. Sufficiently high interest rates--that is, higher than market rates in nonpanic times--are one method to avoid so-called moral hazard.

A multilateral lender of last resort would be dramatically more efficient than the holding of large reserves by individual countries. Holding reserves in dollars or euros generates very low returns, especially when compared, for example, with investment in human capital or infrastructure. If the reserves of developing countries were halved from today's level of over $2,500 billion, and if the saved money were invested with an average return of 5 percent, the annual income of over $60 billion would equal today's entire official development assistance. Savings would be even greater if the level of reserve holding in developing countries--on average about 30 percent of gross domestic product (GDP) in 2004--could be reduced to the level in industrialized countries, which hold reserves of less than 5 percent of GDP, a figure that has remained more or less steady since the 1950s. (8) In the twenty-first century, the need for a multilateral institution that contributes to global financial governance is greater than ever, but its structural makeup would have to be different.

The reforms that should be envisaged fall into three categories: increasing the Fund's legitimacy, streamlining its management, and clarifying its function in a crisis. First, these reforms are about granting more rights to developing and newly industrializing countries. This will necessarily come at the expense of European countries. Altogether, European Union (EU) countries hold 31.4 percent of voting rights, whereas the United States holds 17.1 percent. Asian countries are not sufficiently represented. For instance, China holds fewer voting rights than Italy. Indonesia, a country of 200 million inhabitants and an important client of the IMF in the Asian crisis, has less voting power than Sweden. (9) Either the influence of Asian countries in the IMF will increase or the IMF's influence in Asia will decrease further.

The second category of reform proposals concerns the management of the IMF. The Fund's executive board is currently engaged in a multitude of minor decisionmaking tasks. In 2004, a year without any major financial crisis, the executive board, which is composed of twenty-four members, met for more than 500 hours. This intensity is costly: the direct costs of running the executive board alone account for 10 percent of the IMF's administrative budget. Mervyn King therefore suggests doing without the Washington-based executive board and creating a supervisory board that would meet six to eight times a year and make decisions of strategic importance. The day-to-day business should be left to the Fund.

Third, the IMF's crisis management requires a structural overhaul. Making the Fund's crisis management more efficient is thus a pressing task, but it is precisely one to which the IMF has not yet responded. New borrowing instruments introduced after the Asian crisis, such as contingent credit lines (CCLs), were abolished shortly thereafter due to a lack of demand. Developing and newly industrializing countries can expect the Fund to make a transparent and binding offer of liquidity supply in the event of a borrowing crisis, but in this regard new proposals are missing.

And what is the IMF's contribution to the reform debate? The Fund's chief economist, Raghuram Rajan, has reacted to the debate by blaming the member countries for their lack of support. In particular, the successful developing countries are abandoning the IMF, Rajan argues, because their success has made them complacent about the need for multilateral institutions. He goes on to argue that this reflects a lack of responsibility: "Unfortunately, paying attention to the global community is seen as a weakness rather than responsible global citizenship." (10) Blaming the members for an "ebbing spirit of internationalisation" without considering the Fund's own contribution to that process does not appear to be a promising strategy. The Fund, despite some progress in transparency and openness, still has some way to go before it can be considered accountable for its own actions.

So far, the reform proposals made by IMF managing director Rodrigo Rato are not convincing. He has been advocating, among other things, the publication of advice the IMF is giving to individual countries, particularly in cases where vulnerabilities in some countries create risks for other economies. (11) But that would change the role of the IMF to a rating agency, a role not all member countries would appreciate. More important, however, is the forecasting problem: the Fund would have to know exactly which economic developments are dangerous and which are not. Given the Fund's track record, the implementation of such a strategy is unlikely. For example, neither the Fund nor anybody else was able to forecast the Asian crisis. The sustainability of the US current account deficit and the dollar exchange rate are other areas where forecasting has proved to be particularly inaccurate.

In the absence of the radical reforms demanded by Mervyn King, the International Monetary Fund is unlikely to play an important role in regulating international financial markets in the future. In the 1990s, the IMF committed grave errors, but this does not mean that the Fund is dispensable. Integrated global financial markets require an institution that is both efficient and legitimate and that plays an important role in the governance of financial markets. One important function is the provision of liquidity in the event of a financial crisis. European governments have thus far rejected structural reforms of the IMF, but without answering the question of how the Fund's extant legitimacy deficits and its failed crisis management could be avoided in the future. Considering the fact that East Asia and Latin America have already turned their backs on the Fund, business as usual is certainly not the way to go. Taking timid steps toward reform will not halt the IMF's looming loss of relevance.

Notes

Heribert Dieter is a senior research fellow at the German Institute for International and Security Affairs and associate fellow at the Centre for the Study of Globalisation and Regionalisation at the University of Warwick.

1. Mervyn King, "Reform of the International Monetary Fund," presentation at the Indian Council of Research on International Economic Relations (ICRIER), New Delhi, 20 February 2006, available at www.bankofengland.co.uk/publications/speeches/2006/speech267.pdf. Shortly thereafter, Martin Wolf, writing for the Financial Times (22 February 2006, p. 15), used even more explicit language, warning that the IMF was on its way to irrelevance.

2. Ngaire Woods, "The Globalizers in Search of a Future: Four Reasons Why the IMF and the World Bank Must Change, and Four Ways They Can," in Center for Global Development Brief, 20 April 2006.

3. International Monetary Fund (2005): "The Managing Director's Report on the Fund's Medium-Term Strategy," 15 September 2005, p. 6.

4. Prior to the crisis, foreign ownership was limited to a maximum of 7 percent. The IMF forced the South Korean government to raise that limit to 50 percent.

5. On Argentina, see Manuel Pastor and Carol Wise, "From Poster Child to Basket Case," Foreign Affairs 80, no. 6 (November-December): 60-72.

6. The irony is that Argentina has used money provided by Hugo Chavez's government to settle its obligations with the IMF ahead of schedule. Argentina sold US$496 million in bonds to Venezuela in December 2005, with a total of $1.48 billion in 2005 (Miami Herald, 21 December 2005).

7. David P. Rapkin and Jonathan R. Strand, "Reforming the IMF's Weighted Voting System," World Economy 29, no. 3 (March 2006): 305-324.

8. Dani Rodrik, "The Social Cost of Foreign Reserves," paper prepared for the meeting of the American Economic Association, Boston, January 2006 (mimeograph), p. 4.

9. For a detailed discussion of several proposals for voting rights reform, see Rapkin and Strand, "Reforming the IMF's Weighted Voting System."

10. Raghuram Rajan, "The Ebbing Spirit of Internationalisation and the International Monetary Fund," lecture at the Stern School, New York, 8 March 2006.

11. Rodrigo Rato, "What the IMF Can Do," International Herald Tribune, 19 April 2006.