Speech

Keynote Address by Raghuram G. Rajan, Economic Counsellor and Director of Research
International Monetary Fund
At the International Conference on Global Asset Allocation at the Arison School of Business in Israel. ¹
May 17, 2006

Good afternoon. As this conference has suggested, the world, especially the financial world, is changing rapidly. Capital markets are becoming more integrated through cross-border capital flows, especially as the "home bias" of investors diminishes, product markets are becoming integrated through trade, and labor markets are becoming more seamless, partly through immigration but also partly through new technology that allows services to be provided at a distance. In such an increasingly integrated world, it is useful to ask what role an organization like the International Monetary Fund can play. The question is especially pertinent as emerging markets are becoming more mature and many believe the crises that were our focus have become curious artifacts of history.

I think, if anything, the role of the IMF has become more important. Clearly, growing integration increases the possibilities of spillovers from a country's domestic policies to the outside world. At the minimum, this entails more multilateral dialogue, but the nature of the spillovers could even imply coordinated action. A multilateral organization like the IMF, with the capability of analysis, and the legitimacy that comes from its mandate and its membership, is ideally placed to help such a process. Second, even though international capital markets have become deeper and more capable of taking on risk, they are not immune to fads and fashion. A dramatic withdrawal of foreign capital from riskier emerging markets, perhaps because of a rise in industrial country rates, can still have severe adverse effects on the emerging markets -- pain that is not internalized by foreign investors. Fund financing can help reduce these effects. When the current benign environment turns, there will indeed be a renewed role for Fund financing. But undoubtedly many "advanced" emerging markets, while still vulnerable, have become more mature, with more sensible policies, so the Fund should revisit how it finances.

Finally, a changing world means a changing structure of economic power. A Fund whose governance structure does not respect these changes, as well as the need to give each member some voice and representation, will be an anachronism, without the legitimacy or the appearance of impartiality necessary to undertake the sometimes intrusive tasks entailed in facilitating international policy dialogue or international lending. This is why Fund governance has to change, giving more power to rising economies.

The International Monetary and Financial Committee, composed of governors of the Fund, in the recently concluded Spring Meetings has endorsed the Managing Director's Medium Term Strategy which emphasizes the need for change in all these areas. What I want to do today is outline some of my thoughts on the issues with a long term perspective in mind. I should emphasize that what follows are my views only and not necessarily those of the management or Board of the Fund.

Multilateral Action

Perhaps the best place to see the Fund's possible role in encouraging multilateral action is in the growing global current account imbalances. The United States 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.

A useful way to think about the build up of the global current account imbalances is to see them as developing in three stages. In the first stage in the late 1990s, a variety of crises in the emerging markets and Japan reduced investment opportunities there, freeing up savings, while strong productivity growth made the United States an attractive place to invest in. It is quite reasonable, even if somewhat imprecise, to say that at this stage the U.S. capital account surplus was driving its current account deficit.

In the second stage in the early 2000s, the bursting of the IT bubble was met with very accommodative policies in developed countries, particularly the United States. Consumption increased to offset the fall in investment, especially in countries with strong mortgage markets, where rising house prices and the associated wealth effects were a strong support. The accommodative policies were not reckless--they offset what would otherwise have been a collapse in global demand and growth.

In the third stage, strong growth the world over, but especially in countries with commodity intensive demand like China and the United States, came up against the limited past investment that had taken place in that sector. The oil and commodity price shock has widened but also shifted the current account imbalances.

Under this reading of the development of imbalances, at least three points are worth noting: First, the imbalances were a consequence of a series of different shocks, and associated policy responses, all of which tended to aggravate the U.S. current account deficit. Globalization has indeed permitted shocks to the world economy to be spread more widely, and the resultant imbalances financed, without serious consequence to world growth. Policies were appropriate for the times, and these include the Chinese decision to maintain the peg against the dollar during the Asian currency crisis, which helped avert further destabilizing devaluations in Asia.

Second, however, this does not mean that a continuation of past policies, that were appropriate when initiated, is now desirable. Also, one must not neglect the role of policies that were not undertaken, in producing the situation we are in today. For example, if structural reforms had produced high productivity growth in the Euro area in the late 1990s, perhaps the Euro area might have attracted a significant share of the capital inflows that went to the United States. Or if Emerging Asia outside of China had improved its business climate substantially after the Asian crisis perhaps investment would have rebounded quickly and the countries would have run lower surpluses. Or if the U.S. had stronger policies encouraging energy conservation, perhaps its deficit would not have expanded as much with the rise in energy prices.

Third, it is hard to say when, where, and how future shocks will hit. The ability to run current account imbalances allows the world to buffer shocks and spread them widely. This is a good thing. It is important, therefore, that we bring down imbalances in stable times so that we have room to expand them when future shocks hit--this is just prudent counter-cyclic global policy.

In sum, the imbalances are unsustainable at their current level--even with increasing economic integration, there is a limit to how much a country can depend on the outside world. Deficit countries have to start thinking about weaning themselves off reliance on global savings while surplus countries have to find ways to depend less on external demand. Since adjustment is inevitable, would it not be better to commit to a medium term policy framework today so that public policy can support the needed 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, or into calls for one country alone to narrow its deficits or another to appreciate its exchange rate, which will be ineffective by themselves. 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.

What prevents countries from offering such frameworks without the coaxing of the outside world?

A change of domestic policy, especially if current policies are doing no visible damage, is undoubtedly politically costly because it risks alienating constituencies that have grown to support current policies. Similarly, a variety of structural reforms inflict current pain in return for future gain (WEO 2004). It does not take genius to recognize that the personal calculus for the short-sighted politician militates against undertaking policies that have such a pattern of payoffs. But are there not far-sighted politicians? Isn't the benefit from global risk reduction worth the costs that will anyway eventually have to be paid since the policies the Fund recommends--lowering deficits, structural reforms, allowing exchange rates to appreciate--are in countries' long term interest?

Unfortunately, even if the politicians in a country are far sighted, only domestic benefits will enter their calculus--the effects of their actions on reducing risks for everyone else is heavily discounted. As a result, policies that have large external spillover effects may not be undertaken. This means some way has to be found to persuade countries to internalize the beneficial effects their policies will have on everyone else--to internalize the spillover effects.

Another possibility is that country policies may have much greater effect when they are exerted in concert, and little effect when exerted separately. In the jargon, policies may be strategic complements. For example, current accounts may shift dramatically in the desired direction if deficit countries contract demand and surplus countries allow their exchange rate to appreciate, while they may not change much if only one side undertakes actions. In such situations, a multilateral commitment to undertake policies may be the only way to get policy action.²

So is the limited movement on policy actions to narrow global imbalances because (1) politicians don't think the risks of an abrupt adjustment are high or that the recommended policies will do anything to narrow imbalance; or

(2) they think the risks are high but they care more about the high cost to their own political futures if they undertake corrective policies; or

(3) they think the risks are high, and they want to do what is right for the country, but the domestic cost of action outweighs the domestic benefit because much of the benefit redounds to the rest of the world; or

(4) they think the risks are high but they cannot move unless others move?

My sense is that some element of all four of these are playing a role in limiting policy movement thus far. The IMF can help here. Through its analysis of a country's situation, the Fund can point out (and has pointed out) when the benefits of action are high, and exceed the costs. Because the Fund does not have a vested interest in the country's political debates, it can show where the high road lies, and urge the country's authorities to take it. In the first two cases above, multilateral dialogue can help only to the extent that peer pressure (or peer support) is useful. Given that countries are often diplomatic in multilateral settings, the Fund could play a role through impartial and careful analysis and by being brutally honest on who is not playing their part. And when there are international spillover effects, the Fund can bring countries together to consider joint action. Even if there is no way for a country to internalize the risk-reducing effects its actions will have on a second country, it may be persuaded to undertake the actions if it knows that the second country will also undertake actions that have positive spillovers for the first country. Finally, when there are significant complementarities so that coordinated action is required, the Fund can help identify these and help broker an agreement.

But we must also recognize that the Fund can only take members to water but cannot make them drink. If they are not persuaded by the power of analysis or the possibility of joint action, the only resort the Fund has is to appeal to the collective persuasive power of its members. It is important therefore that the membership be fully supportive of the Fund's endeavors.

IMF Lending

As global financing conditions become less benign, it will also be important to examine whether the Fund has the right lending instruments. The issue becomes all the more important because a number of emerging markets now have strong policies even though underlying structural vulnerabilities still exist.

One of the concerns expressed by our membership has been about the degree to which Fund support will be available in a time of crisis. At present, if a country looks like it is getting into trouble with financial markets and calls on the Fund, the Fund evaluates its needs, negotiates the conditions it will require to ensure the country can regain access to financial markets, and if a "program" is agreed to, initiates lending. Before such negotiations are concluded, though, there is some uncertainty about the quantity of Fund lending a country will have access to and the conditions that will be imposed. The negotiation of a program also takes time, though the Fund has sped up the process in the past when needed.

Thus members and financial markets would probably like as much clarity about Fund intentions as possible a priori, so that Fund support can reassure markets rather than be a source of uncertainty.

A second concern emerging market members have is about the degree of conditionality that will be involved in order to get support. A little background is probably useful here. Simplifying somewhat, the Fund requires members who want loans to undertake actions that will ensure they get back on their feet, and this forms the basis of Fund conditionality. Conditions could be about policies (e.g. the size of the fiscal deficit) or about the structure of the economy (e.g., the size and extent of tariffs, the extent of state ownership, etc.). Structural conditionality increased tremendously in the early 1980s as the Fund's lending shifted from industrial countries to emerging markets, who had more structural constraints and vulnerabilities.

This last move, though motivated by the need to foster growth, has not been universally welcomed. Even though the Fund has taken significant steps to streamline conditionality, we are still reminded by Asians of the 140 or so conditions imposed on Indonesia in 1998. Our emerging market members do indeed fear that if they ever get into trouble again, they will be open to all manner of intrusive conditions if they approach the Fund for a loan, including possibly those motivated by the ideology of powerful members or their need to secure a political or competitive advantage. While I believe these fears are excessive, one cannot deny they exist. In fact, in order to maintain their "independence" from the Fund, a number of emerging markets have built large pools of reserves, in the process intervening heavily in exchange markets.

If the Fund is to persuade these member countries to reduce their costly self-insurance and the distortionary policies that accompany a large reserve build up, it has to offer lending that recognizes the greater maturity and continuity of policies and reforms in some of these countries. A greater focus on identifying which countries have mature policies (what the private sector calls screening, or what in Fund parlance could be termed "ex ante" conditionality) could reduce the need for program conditionality, especially structural conditionality (what the private sector calls loan covenants or the Fund calls "ex post" conditionality). This will enable the Fund to move towards more of a system of insurance for some countries, where it largely pre-commits to help them up to a certain pre-specified amount when they have the need, with only light, largely policy-related conditionality, thus reducing the need for these countries to build up their own separate reserves.

What are the benefits of Fund insurance based on ex ante assessments of the quality of a country's policies? It sends a clear signal to financial markets about the extent of Fund support that would be available. In this sense it reduces uncertainty and thus provides true insurance to a country - the Fund helps prevent crises rather than coming after the fact, following a period where the market second-guesses the amount of Fund support available, when runs on the country have already started. Also, the clear signal of a country's policies provided by the assessment, and the fear of loss of insurance if the country deviates from good policies, gives countries an incentive to stay on the straight and narrow, thus reducing potential moral hazard. Finally, the public nature of such assessments gives the Fund more of an incentive to sharpen them (rather than mask concerns in reports through language that is clear only to Fund officials), and for the Fund's Board to play an active role in the routine assessment of policies since those assessments will mean a meaningful commitment to provide funds.

These benefits have to be traded off against concerns. First and foremost, important players may dislike such a system--countries because they are being assessed even outside a Fund program (though the genuinely committed may favor such a system of reducing uncertainty) and large member countries because it reduces their (ex post) discretion over determining Fund lending.

Yet the reason for the dislike is precisely because the system might deliver what the Fund is supposed to do. Country assessments are supposed to be precise and candid ("ruthless truth-telling" or "brutally honest" in the words of some central bankers³), especially in a world where the Fund is an aid to international capital markets rather than a substitute. Large member countries do seem to want to bind their own future selves--witness the attempt to limit the quantity of exceptional access a Fund borrower will have through rules.

Is "insurance", largely based on ex ante assessments, overly difficult to operate? Commercial banks do it all the time when they extend irrevocable lines of credit to corporations. Of course, banks typically also include a material adverse change clause which is invoked on the rare occasion when the client does something extraordinary to vitiate its own creditworthiness. The Fund could similarly reduce its exposure to a totally unanticipated change in a country's policies by reserving the right to curtail previously determined insurance if a supermajority of the Board approves. Of course, this right should be invoked only in the rarest of rare cases.

Will the Fund be held responsible for precipitating crises if it "downgrades" a country's access? Not if it is doing its job and sending signals about policies going off-track well before a crisis. Of course, the risks here depend on the extent to which access is linked to ex ante assessments. In the Contingent Credit Line, an earlier attempt by the Fund to provide some sort of insurance based largely on ex ante assessments, countries were assessed on whether they qualified for such a line--a discrete "in" or "out" assessment. This raised concerns about an "entry" problem--would a country alarm markets if it applied for such a line--and an "exit" problem--would the Fund alarm markets if it decided a country's policies no longer qualified it for access to the line? The way around the problem would be to make qualification and assessments more routine and the degree of access more gradated (that is, countries qualify for varying degrees of insurance). In this way, "entry" would not be news nor would "exit" be a sudden event. Of course, more gradated assessments and access raise a whole new set of issues that I do not have the space to go into here.

The point I want to make here is that the Fund is indeed engaged in finding new and better ways of crisis prevention, all of which will help us serve the needs of our membership better.

Governance

Another way to reassure emerging markets and developing countries that their interests will not be overridden is to give them more of a say in the governance of the Fund. This will ensure the Fund has continued legitimacy, especially important if the Fund is to be perceived as impartial, bring countries together for dialogue, and step up its assessment of country policies. Clearly greater votes for countries that are underrepresented given their economic power is a necessary first step. A transparent process for choosing Fund management is also important, as suggested by the Managing Director's strategy paper.

But in the fullness of time, we should also consider another anomaly. And that is that a country's voting power, access to finance, and contribution to Fund resources are all determined by the same number--its quota. In practice, the Fund finds ways to get away from the tyranny of the quota (exceptional access in lending being one example) but in the long run, we need to find a more flexible system.

For instance, emerging market countries that have excess reserves may want to pool them with others for use when a country gets into trouble. They may want to use the Fund to assess each other's macroeconomic performance and need for resources, but may want more say over the kind of conditionality that will be applied than the Fund's governance structure will ever allow for. In short, they may want to finance a separate pool that relies on some of the organizational expertise of the Fund but allows the countries themselves a greater say in governance of the pool and greater flexibility in its design. The Fund has to recognize these needs and work towards a system that makes best use of the international expertise it has built up. The alternative is to see countries move away to setting up their own small arrangements independent of the Fund, which will waste the Fund's expertise, limit the Fund's ability to enhance the quality of multilateral dialogue, and forego the diversification benefits that would materialize if the Fund created worldwide pools.

Conclusion

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 indeed key elements of our medium term strategy, and I hope that I have given you enough food for thought so that you too can participate in the immensely important debate over how to change one of our most important multilateral institutions. Thank you.

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¹ I thank David Robinson for useful conversations, Graham Hacche, Laura Kodres, and Jonathan Ostry for useful comments.

² It may also be that the political room for one country to undertake difficult policies may increase if it can show that other countries are also experiencing some painful adjustment for the global good.

³ See recent speeches by Governor King and Governor Dodge.