Why do crises occur?

The causes of economic and financial crises are varied and complex. Key factors can include weak domestic financial systems; large and persistent external or domestic imbalances (including current account deficits or fiscal deficits, or both); high levels of external and/or public debt; exchange rates fixed at inappropriate levels; spillovers of economic and financial crises from other countries; natural disasters; armed conflicts or large swings in the price of key commodities, such as food and fuel.

Exogenous shocks, ranging from natural disasters to terms of trade or foreign demand shocks, are common causes of economic distress. This is especially true in low-income countries, which have limited capacity to invest in disaster prevention, and are dependent on a narrow range of exports of mostly primary goods.

Crises can take many different forms:

External crises can be characterized by severe balance of payment problems, which often lead to pressure on the currency, a large decline in consumer demand and investment by firms, higher unemployment, and lower incomes. Crises are often accompanied by heightened uncertainty in financial markets and declines in the prices of stocks, bonds and, quite frequently, the value of the domestic currency.

Financial crises can originate in or affect the financial sector, and can be caused by or accompanied by heightened uncertainty in financial markets, leading to declines in the prices of stocks and bonds. They can also be caused by or lead to difficulties in banks and the payments system, causing damage to the real sector and to economic activity more generally.

A severe crisis (whether external or financial) is often accompanied by a deep recession and what is known as a “sudden stop”: a reversal in the flow of international capital. In acute crisis cases, debt moratoria and defaults may not be avoided.

How IMF lending helps

IMF lending aims to give countries breathing room to implement adjustment policies and reforms that will restore conditions for strong and sustainable growth, employment, and social investment. These policies will vary depending upon the country’s circumstances. For instance, a country facing a sudden drop in the price of a key export may simply need financial assistance to tide it over until prices recover, and to help ease the pain of an otherwise sudden and sharp adjustment. A country suffering from sudden or rapid capital outflows needs to address the problems that led to the loss of investor confidence. Perhaps interest rates are too low, the budget deficit and debt stock are growing too fast, or the banking system is inefficient or poorly regulated.

The IMF has also strengthened its ability to prevent crises by introducing the Flexible Credit Line (FCL) and the Precautionary and Liquidity Line (PLL), and through greater use of High Access Precautionary Stand-By Arrangements (HAPAs), amongst other measures.

To meet member countries’ urgent balance of payment needs, the IMF has introduced the non-concessional Rapid Financing Instrument (RFI). In addition, for low-income countries, the Rapid Credit Facility (RCF) was created under the Poverty Reduction and Growth Trust (PRGT).

IMF lending in action

The IMF provides policy advice and financial support upon request by its member countries. An IMF staff team assesses the macroeconomic situation of the country in question (including public finances, financial institutions, and the corporate sector). In most cases, the team travels to the country and holds discussions with the government on what should be the appropriate policy response.

As part of these discussions, IMF staff and the government assess the size of the country’s overall financing needs and whether Fund resources are not expected to be drawn as they are needed as a form of insurance to prevent the occurrence of a full-blown crisis or whether Fund resources are expected to be disbursed to fill emerging financing shortfalls and smoothen adjustment.

Typically, before a member country can receive a loan, the country’s authorities and the IMF must agree on a program of economic policies. A country’s commitments to undertake certain policy actions, i.e., policy conditionality, are in most cases an integral part of an IMF lending arrangement. In contrast, FCLs do not entail any ex post policy conditionality—the country is provided access to this credit line based on a rigorous qualification process that aims to ascertain the ability of the country to adjust on its own, i.e., without the need to establish ex post policy conditionality. PLLs also rely on qualification criteria but, in addition, have focused ex post policy conditionality. Fund financial support under the RFI and RCF is provided as a disbursement with limited conditionality. In general, a country’s return to economic and financial health ensures that IMF funds are repaid so that the funds can be made available to other member countries.

Once an understanding has been reached on policies and a financing package, a recommend-ation is made to the IMF’s Executive Board to endorse the country’s policy intentions and disburse the loan. This process can be expedited under the IMF’s emergency financing procedures (see box).

In the absence of IMF financing, the adjustment process for the country would be more difficult. For example, if investors become unwilling to provide new financing, the country would have no choice but to adjust—often through a painful compression of government spending, imports and economic activity. IMF financing facilitates a more gradual and carefully considered adjustment.