Today, I mark my one hundred and fiftieth Red Notes column. As I started writing…
The IMF’s Unresolved Financial Crisis
It is ironic, to say the least, that the IMF’s financing paradigm that has often been a major factor behind the economic problems of many lower and middle income sovereign borrowers since 1982, has landed the Fund itself in a financial crisis. It is now official – so far, the IMF’s financial well-being has depended on it being unsuccessful in its primary mission, which is to prevent financial crises. This is what the Committee to study the sustainable long-term financing of the IMF has proclaimed in its final report submitted recently. The Committee has criticised the IMF’s existing financing model, which relies primarily on interest income derived from lending to fund the whole range of Fund’s activities – a point that has been highlighted by international debt analysts since the early 1990s.
IMF Chief Rodrigo Rato appointed the Committee headed by Andrew Crockett, the former director-general of the Bank for International Settlements (BIS), to recommend specific income models that would avert a cash crisis for the global lender, whose operational income is declining as debtor nations repay their loans early.
The current income model, which has been in place since 1981, operates on a cost-plus basis. Thus the interest rate on credit outstanding is set at the start of each financial year at the level needed to cover the Fund’s funding and operating costs and generate a “net-income target” of five percent of reserves. Apart from the income earned on the Fund’s reserves (SDR 6 billion, which were recently invested in a separate Investment Account), the main source of income has thus been the charges and fees on Fund credit financed from the General Resources Account (GRA). The latter covers the provision of credit mainly to middle-income member countries.The current model has thus been relying mainly on the income derived from credit operations associated with crisis resolution to meet funding costs, cover the expenses of running the Fund and build up reserves.
Given this financing strategy, it is no wonder that the Fund would always insist on full repayment of its loans, even if its erroneous policy conditionalities caused damage to its borrowers’ economies. The Fund’s own internal staff reviews have acknowledged the mistakes in its loan conditionalities of neo-liberal market reforms and public spending cuts, which have aggravated post-crisis economic slowdown and increased the debt burden of many countries in crisis. But, clearly, the IMF can gain financially from its errors by extending new loans necessary to repair the economic devastation brought about by previous loans, as has long been highlighted by several debt analysts. Even so, financial accountability in terms of taking responsibility for its mistakes and alleviating the drastic economic and social consequences by accepting debt write off or even debt reduction has totally eluded the Fund. Thus, even though both bilateral (official) and private creditors have accepted reductions of their claims in various debt rescheduling/write-offs, the Fund (along with other IFIs), very “rationally”, continues not to do so. On the contrary, it has always insisted on its make believe “preferred creditor” status even as there is no legal basis for this, and have added to the payments problems of sovereigns in crisis .
The failures of the Fund to either rectify the moral hazard problems arising from such risk-less lending, or discard the discredited conditionalities associated with these credit lines, or accept financial responsibility for its policy mistakes, have therefore been central to the disengagement of countries from the Fund. Four of IMF’s major debtors namely, Argentina, Brazil, Indonesia and Uruguay prepaid their debts over the last two years. The Philippines became the latest sovereign in December 2006 to repay the Fund ahead of schedule, in order to avoid future interest payments and to declare independence from the conditionalities that take away their policy autonomy. A rapid reduction in credit outstanding to borrowing members has thus resulted in a drop in Fund income and a base-case projection that it will fall further.
The Fund’s Executive Board agreed in March 2006 on a two-pronged strategy to face the financing challenges. To meet the immediate financing needs for FY 2007, it agreed on a package of measures, including the establishment of the Investment Account, a pause in the accumulation of reserves and the use of the Fund’s existing reserves to meet remaining income shortfalls. An Investment Account was established in June 2006 and funded with an amount equivalent to the Fund’s reserves in order to earn extra income from bond markets. The second and more critical long-term aspect of the strategy is to ensure a lasting and sustainable solution to the institution’s income needs and this has been the Crockett Committee’s mandate.
Major Recommendations
Funding Credit Intermediation
The Committee believes as a general principle that the income from credit intermediation should not have the objective of continuing to fund the whole range of IMF activities, which include the provision of public goods and bilateral services.However, on a long-term basis, lending should yield enough to cover intermediation costs and the accumulation of reserves, since the latter are needed to mitigate the effects of credit losses on GRA activities. The lending rate therefore should be set at a reasonable level in alignment with long-term average market credit conditions. However, the Committee has also proposed the possibility of applying a premium on the basis of the duration of a member’s borrowing, in an extension of the Fund’s current practice of charging more for programs involving higher level of access to its resources. Such a proposal needs to be rejected outright since it would be preposterous to impose heavier interest charges on borrower countries who continue to be on the payroll of the Fund with a series of programs, often because of the Fund’s own ideological fixations.
Funding Public Goods
Fund’s public goods provision that dominates its expenditures to the extent of up to 44 per cent consists of global, regional and bilateral monitoring or surveillance, as well as standards & codes and financial sector assessments. The Committee does concede that insofar as the Fund is providing a public good to the world economy, it is appropriate for the public good activities to be financed by means which derive proportionately from resources provided by all members. It has considered three potential sources of income to provide funding for public goods: periodic charges levied on member countries; investment operations; and the creation of an endowment. Let us consider them here in the reverse order.
(1) In the Committee’s view, income from an endowment that can be generated in an equitable way and whose long-term real value can be preserved, could be used to help cover administrative expenses. If the real rate of return were, for instance 3%, each SDR 1 billion of resources would generate SDR 30 million per year, without diminishing the real value of the endowment. One option would be to request a one-off contribution from members to create this endowment. However, the Committee thinks that this is an uncertain source for the endowment due to the need for legislative approval in the member countries.
According to the Committee, the most likely alternative source of financing for such an endowment would be the proceeds from a limited sale of Fund gold, which should be ring-fenced to exclude further sales. The IMF holds 3,217 tonnes of gold in total, which is carried in its balance sheet at SDR 35 per ounce. The committee has suggested that the IMF could sell about 400 metric tons of gold, which has a current market value of $6.6 billion based on a $500 per ounce price (an average of the gold prices in a two-year period). Assuming a real rate of return of 3%, investment of the proceeds from the gold sale could yield an approximate annual return of $195 million.
The Report has recommended that the impact of gold sales on the market could be taken care of by subjecting the sales to strong safeguards. Thus, IMF’s gold sales would need to be coordinated with the existing and possible future central bank gold agreements to ensure that they would be accommodated by reductions in the amounts of gold that central banks might sell under the Central Bank Gold Agreement.
Civil society organisations across the globe have consistently argued that the IMF’s massively undervalued gold reserves should be put to productive use to cancel the multilateral debt of the poorest countries. In 2004, in a paper prepared by the Fund’s Department of Finance at the request of the major creditor nations, the Fund had in fact joined debt campaigners across the globe by stating the technical feasibility of gold sales very clearly and saying that these resources could be spent on the cancellation of developing country debt. However, the subsequent IMF board meeting saw this proposal quashed.
In the light of this rejection earlier by the major IMF shareholders of the proposal to use gold sales to fund debt cancellation, the Crockett Committee’s proposal to use gold sales to fund IMF’s administrative expenditure is a definite contradiction and is totally indefensible. The other contradiction is that while the Committee has clearly suggested that “public goods, by definition, cannot be financed by market mechanisms”, its suggestions for financing are both market-based.
(2) Thus, the other major recommendation of the Committee is that the Fund could generate additional revenue by relaxing the restrictive mandate on the investment of its reserves, which is currently more conservative than those of the World Bank and other AAA-rated multilateral development banks (MDBs). The World Bank, for instance, can invest in government and agency obligations (AA- and above), asset-backed securities (AAA only), and time deposits with commercial banks. Based on returns achieved at the MDBs on their portfolios of liquid investments, the Committee believes that a reserve portfolio of SDR 6 billion under “normal market conditions” would produce an additional income of SDR 30 million. Similarly, it is recommended that a portion of the currencies subscribed by member countries can also be invested in higher-yielding marketable interest-bearing securities.
The Committee does acknowledge that returns from both these types of investments would depend on conditions in the capital markets at the time. Further, since the quota resources used to fund market investment might be needed at any point of time for lending to member countries, a portion of the portfolio may need to be liquidated at short notice, which may in fact result in losses. Thus, by its own admission, the expansion of investment activities of the Fund in the capital markets would not provide a stable source of income, contradicting what the Committee holds forth as an essential characteristic of the income flow required to fund public goods. Further, this income model is untenable in supporting the Fund’s lender-of-last resort role.
More crucially, whether managing investments using funds from an endowment or reserves and quota resources, once the Fund begins investing in the capital markets in a major way, there could be a conflict of interests between IMF’s role as a global financial supervisor and stabiliser and its need to maximise its own investment income. The potential for such a conflict of interests is indeed mentioned in passing by the Report. The Committee believes that this concern can be removed or alleviated by “outsourcing investment activities (as is currently done for the Investment Account) or by establishing appropriate Chinese walls” in case the investment activity is undertaken internally.
However, there are two processes that need to be considered while assessing the implications of the IMF becoming an investor in the international capital markets. It is evident that countries are increasingly liberalising their financial markets internally and externally, and there is an increased reliance on capital markets for their financing needs. It should also be remembered that the relatively higher capital requirements prescribed by Basel II under several categories of lending are projected to both reduce private bank lending to developing and less developed countries, as well as increase their borrowing costs. This could increase their reliance on the capital markets further.
With active IMF involvement in the capital markets as an investor, even if the Fund would be theoretically de-linking itself from the investment decisions through outsourcing, it is difficult to imagine that the “rationality” of the Fund’s professional investment managers would be different from that of a large investment fund or pension fund manager, for whom the investment decisions and risk (and therefore, returns) go hand-in-hand. It is well known how various emerging country capital markets have been subjected to manipulations by these foreign institutional investors, who bring in and take out very large amounts of money according to their whims and fancies. Therefore, with a heavy reliance on unstable international private capital inflows together with an interest rate shock, developing countries could find themselves in a situation similar to that of the early 1980s and in need of the support of IMF funding. Thus, the entry of the Fund as an investor in the capital markets would give rise to severe conflicts of interests, which could even possibly get emerging market economies indebted to the Fund again!
(3) The Report begins by stating that the burden of supporting the Fund’s public goods provision should be spread broadly in proportion to quotas, rather than being put on a subset of members – the developing country borrowers. In complete contradiction to this stated objective in looking for alternative income models, the Committee rejects the suggestion to collect annual or other periodic levies from its members in proportion to their quotas, as the UN and the OECD do. It is suggested that periodic levies on Fund members may not be a practical way of financing the Fund’s public good activities. The argument is that since such levies would, in most countries, be subject to parliamentary approval, this would subject the Fund’s expenditures to national budgetary procedures, which in turn would threaten the independence of the Fund’s policy advice. Given that the UN does not find itself facing such a constraint, this argument put forth by the Committee to reject quota-based periodic levies obviously stands on tenuous grounds.
Funding Bilateral Services
The recommendation in the case of financing bilateral services is to impose charges for such services.
The use of technical assistance and capacity building services offered by the Fund are relatively more utilised by the lower income and poor countries. Since the Committee recommends that donors should help to defray the costs for countries unable to afford these charges, this can be seen to have both a positive and negative impact. Those countries who have donors backing them in their capacity building efforts might be worse off as, they find themselves burdened with some more conditionalities or orthodox policymaking, as is happening presently. On the other hand, those poor countries that do not find donor support to pay for these Fund services might be better off, since they would escape policy indoctrination entrench ed in the rigid neo-liberal framework.
Conclusion
To the extent that the Fund’s search for sustainable income streams breaks the totally illogical link between its interest income on lending to countries in distress and its revenue base, alternative income models should be welcomed. However, one finds that there are inherent contradictions in the Crockett Committee’s suggestions, which make most of them not only untenable, but even harmful for the global financial system. Crucially, since the markets cannot be imagined to replace the Fund’s lender-of-last resort role, which is the fundamental rationale for its continuing existence, the market-based income models put forth by the Committee that offer unsteady income solutions to the IMF’s financial crisis are unacceptable.
