The Role of the International Monetary Fund in a Changing World: Lecture delivered by Raghuram G. Rajan, Economic Counselor and Director of Research, IMF
April 10, 2006Lecture delivered by Raghuram G. Rajan, Economic Counselor and Director of Research, International Monetary Fund
at the Kiel Institute, April 10, 20061
I thank Professor Snower and the Kiel Institute for inviting me to give this talk. There are many questions being raised about the future of the International Monetary Fund. I will argue in today's talk that the Fund has a clear and important role to play. The IMF offers a legitimate venue where multilateral dialogue can take place. But there has to be a strong desire for that dialogue. Unfortunately, even as rapid globalization has increased the economic need for multilateral dialogue in the world today, the forces of reaction, of economic patriotism as protectionism is now called, are gaining strength. People tend to dismiss these forces as minor frictions — sand in wheels of the globalization juggernaut. History, however, suggests the distance from economic patriotism to unbridled nationalism is a short one. This is why it is critically important for us to revive the quality of multilateral dialogue, and support multilateral organizations like the IMF, so that we can all continue to benefit from globalization in an atmosphere of mutual responsibility and shared destiny.
With that as preamble, let me provide details, starting at the beginning, with the founding of the Fund.2
The origins of the Fund and its objectives.
The midwives at the Fund's birth in 1944 were political tragedy and economic despair. During the inter-war depression years, countries, suffering from overcapacity and unemployment, tried to export their way out of trouble by devaluing their currency, even while raising their own tariffs to protect against imports. Of course, other countries had the same problem, and tried the same solution — known colloquially as beggar-thy-neighbor policies. The result? Global trade collapsed, while exchange rates and capital flows became volatile.
What the world needed, according to the Fund's founders, John Maynard Keynes and Harry Dexter White, were rules to govern international exchange and flows, and an impartial arbitrator to point out when those rules were being violated. With the spirit of internationalism reinforced by recent memory, the Fund was conceived at the 1944 Bretton Woods Conference with the prime objective of facilitating "...the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income...". i
It was to do this, in part, by "promoting exchange [rate] stability" and avoiding "competitive exchange depreciation". This required the Fund to "exercise firm surveillance" over the exchange rate policies of members so that they "avoid manipulating exchange rates or the international monetary system" to prevent adjustment or "gain an unfair competitive advantage over other members".ii
In addition to monitoring country policies through surveillance, the Fund was set up to work as a sort of credit union, lending to countries that suffered balance of payments problems.iiiThe availability of this line of credit helped a member in a number of ways. The IMF could help countries correct balance of payments difficulties by providing temporary financing to smooth the required adjustment and limit the impact on economic activity at home and abroad. Thus the country's incentives to export its problems to the rest of the world were mitigated; in fact, the IMF's financing would be conditional on policies that would limit or avoid such effects. Furthermore, countries became more welcoming of trade, knowing that they could borrow resources to weather adverse external shocks. The importance of Fund financing should therefore not be underestimated — it was a carrot that gave countries an incentive to play by the rules.
The Ebbing of Internationalism
Since the early days of the Fund (leaving out the abnormal post-war lows), world trade has grown, from 10% of world GDP in 1960 to almost triple that in 2005. World GDP itself has grown at an average rate of 3.5% over this period, faster than at any other period in human history. In short, judging by the Fund's goals at its founding, it has been a great success. We could spend the rest of the evening here debating how much it contributed to that success but I want to focus on something else.
It is this: Even as the world has become more interconnected through trade and finance, even as the Fund's members have become more successful, the spirit of cooperation that prevailed amongst the members at the time of the founding of the Fund, seems to have waned. I believe the trends are not unconnected. Let me explain.
At the risk of simplifying to the point of caricature, in the initial post-war years, virtually all countries with the possible exception of the United States had fragile economies. Given that they might need help, they were willing occasionally to subsume domestic interests for the international good. The Fund was a partnership of the heedful, and given that a country could be a creditor one day and a debtor the next, it was also a community of common interests.
Over time, however, industrial countries recovered from their post-war weakness. They rebuilt their capability to undertake policy analysis. And the system of capital controls and fixed but adjustable exchange rates broke down for reasons well described elsewhere. Most industrial countries moved to floating exchange rates. This move, coupled with their political stability and strong institutions, ensured that private capital markets would be a reliable source of finance. As a result, industrial countries stopped borrowing from the Fund — as late as 1975, nearly half of Fund lending was to industrial countries, but by the late 1980s, it was zero.
This had two important consequences. The first was that with little to gain from the vetting of their policies by the larger Fund membership, important industrial countries started forming groups outside the Fund, with serious policy discussion and economic co-operation taking place within these groups. The most prominent avatar of this First Circle is now the G-7. While not denying the global benefits of frank policy dialogue and coordination within the group, an unfortunate consequence has been to diminish the relevance of the multilateral discussion that takes place within the Fund.
The second consequence was that the Fund itself was divided — between industrial country creditors who would never borrow and held the weight of the shareholding, and potential debtors who had to subject their policies to multilateral advice either within the context of a Fund-supported policy program or for fear they might otherwise lose access to Fund resources in their time of need. The tensions between these groups centered around program conditionality — the conditions the Fund imposed in lending programs to ensure repayment, and to ensure that the resources were used to promote, rather than postpone, adjustment and reform.
In the early days of the Fund, conditions were primarily imposed on a country's exchange rate and macroeconomic policies. But as the Fund began lending to more developing, emerging market, and formerly planned economies, it began to place conditions relating to structural reforms — such as privatization, fiscal reforms, financial sector reforms, trade reforms, central bank independence, etc. These were more intrusive than prior Fund conditionality — the canonical example of what generally came to be viewed as excess being the 140 or so conditions imposed on Indonesia in 1998 including measures dealing with reforestation programs, disbanding the clove monopoly, and introducing a micro-credit scheme.ivWhether all these conditions were really needed, or whether the Fund was freer with conditionality because its largest shareholders did not ever anticipate borrowing is something that can again be debated for a long time. What is true is that even though the Fund has taken important steps to streamline conditionality — as exemplified by the recent program with Brazil — the fear of excessive conditionality persists.
Most recently, some emerging markets have built up their foreign reserves to such an extent that they are unlikely to need Fund resources at least in the short term. Given the precedent set by the industrial countries, these "advanced" emerging markets are not keen to be seen heeding Fund advice, though many of them value it privately. Unfortunately, paying attention to the global community is seen as weakness today rather than responsible global citizenship.
This development is particularly pernicious for a number of reasons. Unlike industrial countries, these advanced emerging markets still have structural vulnerabilities which are currently papered over by the excellent global economic condition. After all, with the United States running a huge current account deficit, it becomes easier for many emerging markets to run current account surpluses, and reduce their external borrowing. Similarly, fiscal surpluses are easier to run when buoyant export revenues provide easy-to-collect taxes. The times will change, though not necessarily soon, and while emerging markets are trying to use current conditions to reduce their vulnerabilities, I expect many will continue to benefit tremendously from Fund surveillance. They may well need Fund resources in the future.
More important, many of them are now significant players in the world economy, who affect each other, as well as the rest of the world. They could play a valuable role in the multilateral dialogue — and I will give some examples shortly. Their collective will could be a powerful force in reforming multilateral fora, but it is not being asserted, partly because they have diverse interests. Equally problematic, industrial countries are only slowly, too slowly in my view, figuring out that their groups need to be reformed — the smallest countries are a particular drag here because any reform that includes new members is likely to leave them out. Moreover, industrial countries have gotten used to domestic policy independence. They need to realize that if they want the advanced emerging markets to alter their policies to further the common interest, they themselves have to accept some multilateral constraints on their policies.
The ebbing spirit of internationalism is not felt only by the IMF. More generally, it seems to me that the rapidity with which the private sector has embraced globalization worries citizens. Some governments see their role increasingly as slowing this process, extracting political mileage by pandering to vociferous interest groups obstructing change, rather than educating citizens to accept it. Economic patriotism is protectionist old wine in a mislabeled new bottle, but it is all the more dangerous in a world where multilateral dialogue is becoming so critical. The beggar-thy-neighbor policies being contemplated by some countries on the capital account-shielding large swathes of their own economy from corporate takeovers while encouraging their own companies to take advantage of the continued openness of others deserves to be roundly condemned. If not stopped immediately, these policies will only spread, with action breeding reaction.
It is amidst this background of diminishing multilateral dialogue that calls are being made to reform the Fund. Part of the Fund's response to its largest shareholders has to be, "Physician, heal thyself". But the larger part of the Fund's response has to be to find ways to re-engage all of its member countries. Let me offer an example of a current issue where the Fund is playing a role.
Fund Surveillance in an Era of Floating Exchange Rates
IMF surveillance — that is its periodic monitoring of a country's economic policies — focuses on two related issues: the sustainability of a country's policies and their external effects.vWhile the exchange rate is at the heart of the IMF's mandate for surveillance, the level of the exchange rate (and its departure from some notion of equilibrium), is just one of the gauges of the appropriateness of policy.
Why do we need the Fund to analyze the sustainability of a country's policies? In the past, one hurdle used to be that countries simply did not have the high quality personnel or the wealth of data and country experience the Fund staff had. Increasingly, though, our member countries recruit officials with qualifications comparable to those of Fund staff, and have access to the same databases that the Fund uses. While they do not usually have the wealth of cross-country experience we have, countries do talk to one another.
But as important as the quality of analysis is impartiality. This is where the Fund still has an important advantage. Let me explain.
Politicians need to be re-elected. This shortens their policy horizons and increases their incentive to take on long-dated risks with short-dated returns. Growth before elections is much valued, growth after elections is highly discounted. Inflicting pain on current generations, especially those who are vocal and vote, in order to ease the way for future generations, is especially difficult. Unfortunately, future generations do not have a voice, and not all the electorate see the consequences of myopic policies. Populism is indeed popular!
Lack of sustainability as politicians follow willfully myopic policies is why so many countries have had to borrow from the Fund in the past, and why so many emerging markets have got into trouble in the past decade. Foreign investors are willing to finance unsustainable spending for a while — they give you a long rope to hang yourself, but when the drop finally comes, it is quick and extremely painful.
Sustainability could be a domestic matter. It is because unsustainable policies will eventually require outside (Fund) financing, or force costly adjustment on other countries, that the Fund, representing the global community, has a legitimate interest. And in matters of unsustainability, emerging markets are not the only offenders.
Consider the United States, which is running a current account deficit of 6.5 percent of GDP — meaning it spends far more than it saves — in the process absorbing nearly 70 percent of world external savings. Any industrial country running such a large deficit becomes reliant on the mood of foreign investors not so much because foreign investors will inflict a "sudden stop" but because they are likely, at some point, to start demanding a much higher premium for continuing to finance. Thus far they have not, not even pricing in the eventually needed real dollar depreciation, perhaps another example of the long rope markets provide.
But even if we accept that the United States is special, and foreign investors will continue to accumulate for a long time, there is another side of this that is unsustainable. U.S. household savings rates have been negative for the last six months. A recent study finds that U.S. households are overly reliant for their retirement savings on the value of their house. With bold moves on social security reform postponed into the indefinite future — the brevity of President Bush's brave foray reaffirming the adage that social security reform is the third rail of U.S. politics — U.S. households will wake up one day to the fact that their retirement savings are insufficient, especially if the housing market continues slowing.
When they cut back on spending, the effect on U.S. output may well be limited under some scenarios, especially if the spending slowdown is accompanied by interest rate cuts and exchange rate depreciation. Perhaps this is why there seems so little concern amongst U.S. lawmakers about the problem. They would do well to worry more. Almost certainly though, the rest of the world, which has become reliant on U.S. demand, will face a serious adverse shock to growth and significant adjustment costs. This is why the Fund has been so vocal about the problem of global current account imbalances, and the need for the United States to increase savings in a measured way.
Moreover, the counterpart of the U.S. deficit, the current account surpluses and reserve build-up that have so fortified emerging markets, are also unsustainable. When the deficit shrinks the surpluses will shrink — this is simply a matter of adding up. The question every country has to ask itself is "Am I prepared for the day the U.S. consumer finally decides to hang up the shopping bag and save?"
It is concerns about sustainability and external effects that motivate the Fund's advice to China. China is becoming overly reliant on external demand. Its exchange rate policy distorts the pattern of investment even while weighing on consumption, and prevents the central bank from using interest rates as an effective tool of policy. While corporate and financial sector reform is probably key to medium-term sustainability in China, allowing exchange rate appreciation must be an integral part of the strategy.
Ultimately, adjustment of the global imbalances will be a good thing, for it does seem against the natural order for countries with massive development needs to finance the asset price booms and the under-saving of rich countries (leaving aside the distortionary exchange intervention and demand compression that underlies some of the reserve build-up). Nevertheless, there are those who question the need for any concern about imbalances, given that they have been financed so long. After all, the US was running a large current account deficit in the late 1980s, and that imbalance resolved itself smoothly.
I think there is need for concern. For one, the benign global financing conditions appear to be turning so the recent past need not say much about the future. More important, the U.S. current account deficit is twice the size of what it was in the 1980s — even with increasing economic integration, there is a limit to how much a country can depend on the outside world . Since adjustment is inevitable, would it not be better for each country to commit to a medium term policy framework today so that public policy can support private sector adjustment and ensure the process is smooth?
A set of such frameworks for all the major players would have two additional effects. First, it would indicate that the imbalances are a shared responsibility and help prevent concerns about imbalances degenerating into protectionism. Second, it would reassure financial markets that a policy framework for supporting adjustment is in place, thus limiting the risk of an abrupt and costly, market-induced, adjustment.
It is to facilitate international dialogue on this issue that the Managing Director has called the countries most associated with the imbalances together in a few weeks for a conference at the Fund. The conference will feed into the IMFC, the Fund's governing body, where we will ask our members to strengthen the IMF's mandate to monitor these imbalances and to work together to narrow them. In particular, the Managing Director has called for a new modality called "multilateral consultations", which will recognize the multilateral nature of these imbalances and bring together key countries for a dialogue whenever deemed necessary.
I do not have any illusion that the spirit of internationalism will suddenly be reawakened. But there is reason for hope. As industrial countries recognize they are affected by policies in advanced emerging markets like the BRICs (Brazil, Russia, India, and China), they want to be able to influence those policies. But the advanced emerging markets are unwilling to be lectured to. At the same time, they too want influence over the policies of the industrial countries, for these have serious external effects. If the Fund can re-engage both groups more, it will not only be the natural and legitimate forum for much needed multilateral dialogue (given its near universal membership), it will also be a more effective one. And it will be better able to serve its poorest members.
Providing a better forum for multilateral dialogue is an essential step to re-engage the major players. Equally important if the Fund can convince advanced emerging markets that they still have much to gain by listening to the Fund, these countries can be drawn back to the Fund. In turn, this will make the Fund a more interesting place for industrial economies to engage in multilateral dialogue.
I believe insurance will be the key to re-engagement. I argued earlier that the advanced emerging markets still have vulnerabilities — such as underdeveloped financial sectors — that are being papered over by massive reserve holdings. As I have just suggested, the underlying imbalances driving the reserve build-up may reverse in the future. As the reserves of advanced emerging markets fall, they may well want to re-engage with the Fund, but on their own terms. They will be open to some kind of insurance from the Fund, but will be wary of the creditor-biased conditionality that they believe accompanies it. Some industrial countries do not want to offer automatic access for fear of encouraging lax policies or moral hazard. Is there any way to satisfy both potential debtors and creditors, draw the advanced emerging markets back to the Fund, and in the process give industrial countries more of an incentive to engage?
A proposal for future Fund "insurance" to emerging markets.
Let me speculate on what a potential solution could be. The more automatic access a country wants to financing in case of crisis, the more pre-screening is necessary. One way to offer this is to condition a country's automatic access to Fund financing on the quality of its policies, as determined by regular Fund surveillance. If a country's policies are judged to be sensible, its access to automatic financing in case it is hit by an unexpected shock improves. Access to automatic financing then becomes a precise, meaningful, and continuous signal of a country's policies. Precise because it is a number, meaningful because it implies automatic access, and continuous because it is constantly updated based on a country's policies. Such a system of "ex ante" conditionality would give countries added incentive to stay on the straight and narrow, even outside normal Fund programs.vi Industrial countries may be reluctant to provide financing for such a scheme. But there may be ways of minimizing the call on their purse. The range of innovative possibilities that would give advanced emerging markets more of a say over Fund policies, a greater role in financing, and more attractive insurance facilities from the Fund, is large and is well worth further examination. For instance, one extreme would be simply be a more global version of the Chiang Mai initiative, where countries offer to lend reserves to each other, mediated by the Fund. Some initial drawing level would be automatic, but more would require an IMF program. At the other extreme would be a more formal pooling of country reserves within the Fund, as part of a new insurance facility that would offer far more automatic access in times of trouble in return for more ex ante conditionality. The Managing Director has indeed called for an examination of the possibilities in his strategic review.
With advanced emerging markets more engaged, perhaps industrial countries will also see more value in the Fund as a forum for dialogue, and the spirit of internationalism will be rekindled once more.
Let me conclude. A little over 60 years after Bretton Woods, it is legitimate to ask whether the Fund indeed has a role. I have no doubt that it has, but the role is not the same as the one that was envisaged at the time of its founding. The times have changed. So has the Fund, and more change will be needed. The Fund is not perfect, and we have a host of critics — well-meaning and otherwise — to remind us of that. The Fund can provide a better forum for multilateral dialogue as well as provide better services to its members. Our members can also make the Fund's governance more reflective of the changed world economic situation, which will enhance its legitimacy. All these are key elements of the Managing Director's medium term strategy.
But that strategy cannot work in isolation. As emerging markets grow and gain economic power, they do not seem as interested in multilateral dialogue, or in combining forces to mold multilateral institutions in ways they think appropriate. Growth and increasing self-confidence are leading to disengagement. Industrial countries do not help by holding on to archaic power structures, or by attempting to exercise the influence of an era that is long past. Increasing integration needs stronger global institutions to combat the protectionist reaction that comes so naturally. We at the Fund can do our bit, but the world also needs to see that we have precious few multilateral institutions. We owe it to the generations that bequeathed these strong institutions to us, as well as to the generations that will follow, that we rediscover the spirit of internationalism. Thank you.
1 I thank, without implicating, James Boughton, Graham Hacche, Laura Kodres, Jonathan Ostry, David Robinson, and Arvind Subramanian for valuable comments on earlier drafts. This talk reflects my views and not necessarily those of the International Monetary Fund, its management, or its Board.
2 While my focus will be selective, Mr. Rodrigo de Rato, the IMF's Managing Director has laid out a comprehensive vision for the Fund's medium term strategy and it is available on the IMF web page www.imf.org.
i Quotes are from the Articles of Agreement of the International Monetary Fund.
ii These words were adopted by the Fund in the late 1970s in the Second Amendment of its Articles of Agreement, following the collapse of the "Bretton Woods" system of pegged exchange rates.
iii The Fund was asked to "give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity."
iv See "IMF Structural Conditionality: How much is too much?" by Morris Goldstein, October 2000.
v Subsumed within sustainability is the development of the country's economic institutions.
vi See Jonathan Ostry and Jeromin Zettlemeyer, "Strengthening IMF crisis prevention", WP/05/206, IMF working paper for a detailed proposal.