Crises and their causes

Crises take different forms. They can be characterized by a large decline in consumer demand and investment by firms, higher unemployment, and lower incomes. They 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. Crises can originate in or affect the financial sector, and can lead to difficulties in banks and the payments system, causing damage to economic activity as well. A severe crisis (whether economic or financial) may be accompanied by a deep recession, debt defaults, and what is known as a sudden stop: a reversal in the flow of international capital.

Crises can be caused by both external or domestic factors.

External causes comprise a collapse of export prices, a drastic increase in import prices, a shift in investor perceptions about risk that causes capital outflows, a large depreciation or devaluation of the currency of a close trading partner, a retrenchment of local activities of international banks, or a sharp curtailment of credit or increase in interest rates in world markets.

Domestic causes include unsustainable fiscal deficits, a fragile banking system, an overvalued domestic currency, excessive monetary creation, political instability, and natural disasters. External shocks can have significant effects on vulnerable countries, which tend to have relatively high levels of private or public debt, weak financial systems, and a history of instability and inappropriate policies.

These factors often coincide, magnifying the depth and breadth of a crisis. Different sectors in the economy tend to be impacted differently depending on the sources of the crisis and underlying vulnerabilities. However, all crises are marked by a sudden worsening of perceptions about a country’s prospects, often including doubts about the ability of the government, banks, or corporations to honor their obligations. The ensuing loss of confidence often precipitates deleveraging of financial contracts, a collapse of domestic asset prices, and downward pressure on the value of the domestic currency.

Role of the IMF in fighting crises

Arresting economic and financial crises normally requires a timely package of decisive measures and financing adapted to the country’s circumstances. The implementation of this package is aimed at restoring confidence by addressing key problems and improving expectations about the country’s prospects. It requires isolating the most significant problems and dealing with them without crowding the program with non-essential measures. In a crisis case, it is critical to focus only on those measures that are essential to restore stability.

The IMF provides policy advice and financial support upon request by its member countries. An IMF staff team travels to the country to assess the sectors affected (for instance, government finances, financial institutions, the corporate sector) and discuss with the government what should be the appropriate policy response. The discussions include estimating the size of the country’s financing needs (that cannot be met by the private sector). Once understandings have been reached on policies and a financing package, a recommendation is made to the IMF’s Executive Board to endorse the program and disburse the loan. This process can be expedited under the IMF’s emergency financing procedures.

Program design

The policy measures contained in an IMF-supported program are based on a diagnosis of the situation and discussions with the government. Financial assistance is based on the estimated financing needs for the period of the program. Typically this will take the form of a new IMF loan but it can also take place through an augmentation of resources under an existing IMF arrangement. The policy program will normally have quantitative targets and a calendar of reforms and measures linked to future disbursements.

Under normal IMF policies to access its General Resources, countries can request financing up to 200 percent of their IMF quota on an annual basis and 600 percent of their quota cumulatively. If warranted by the severity of the crisis, additional resources can be requested under the IMF’s policy of exceptional access. There is no pre-specified maximum on such access, although the IMF will assess factors such as the size of balance of payment pressures, the country’s debt sustainability and its ability to regain access to financing from other sources, and the strength of the policies the government is proposing to adopt in response to the crisis. In crisis cases, disbursements are often front-loaded, with smaller subsequent tranches.

The IMF’s capacity to lend was previously about $250 billion but is now set to increase to $750 billion (as pledged by the Group of Twenty and endorsed by the International Monetary and Financial Committee). This amount includes bilateral and special arrangements with selected countries to borrow additional resources. Good progress toward achieving this goal is expected by end-2009.

For low-income countries affected by crises, the Fund can provide concessional resources, including through the Exogenous Shocks Facility. It is expected that the Fund’s concessional lending capacity will be strengthened significantly later in 2009 when donor countries have given their final consent to a set of wide-ranging reforms of the IMF’s facilities and financing framework for low-income countries (see IMF Support for Low-Income Countries).