The Role and Evolution of the International Monetary Fund

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1 The Role and Evolution of the International Monetary Fund Esteban Ugalde Introduction During the Great Depression ( in the United States) many countries tried to raise barriers to foreign trade in an effort to help their failing economies. These attempts were useless and caused world trade to decline drastically, leading to a drop in employment and living standards in many countries. This led to the 1957 founding of the International Monetary Fund (IMF), an institution charged with managing the international monetary system (the system of exchange rates and international payments that enables countries and their citizens to buy goods and services from each other). The goals of this organization were to ensure stable exchange rates and encourage all member countries to eliminate exchange rate restrictions that got in the way of international trade. The Work of the IMF The work of the IMF occurs in three main ways. When a country becomes a member of the IMF, this country makes a pledge to use policies that will encourage economic growth and price stability so that the desire to gain an unfair competitive advantage by manipulating exchange rates can be avoided. The IMF monitors the country s economic policies to identify weaknesses that could cause financial or economic instability. This process is known as surveillance. Secondly, the IMF provides technical assistance to member countries by helping them to manage their economic policy and 39

2 financial affairs productively. The IMF does this by helping countries to reinforce their human and capital resources, and by proposing appropriate macroeconomic financial re-structuring policies. Finally, the IMF is most well-known for its work with lending to member countries. A country with serious financial trouble that is unable to pay its international bills could be a potential problem for the global international financial system. The IMF was created to protect countries from this international financial problem; it was created to be a lender of last resort. Any member country can go to the IMF for loans if the member country displays a balance of payments need. This means that the member country does not have necessary resources in the capital markets to make its international payments and keep a safe level of assets. The Lender of Last Resort The IMF s main framework deals with this lending. If the IMF did not lend, many countries would be in financial crisis. The IMF uses a specific process in order to approve a loan to a member country. An IMF staff team travels to the member country in need of a loan. Once in the member country, the team members and the country s leaders will assess what the financial needs of the member country may be. As soon as an understanding of the financial needs has been reached an IMF officer formulates a financial package that will aid the member country to bring its capital back to a competitive level. Once this financial package has been prepared, the package is then sent to the IMF s executive board to review. When the executive board agrees on the package the loan is disbursed to the member country. IMF lending gives breathing room to countries so they can put into practice policies and reforms that will restore strong and sustainable growth, employment, and investment. In the 1980s the IMF was a lender of last resort for most of the developing countries at the time. Many of the developing countries have applied for loans during this financial crisis as well, making specific arrangements with the Fund. The most common arrangement that 40

3 developing countries have with the IMF is a precautionary arrangement, which means they will not draw from the Fund unless it is needed (About the IMF, n.d.). For example, Jamaica signed a 1.3 billion dollar loan with the IMF hoping that it can address the country s economic imbalances and give the country a sustainable growth. This arrangement made by the Jamaican government and the IMF will only be accessible if Jamaica cannot cover their international debt. Many of the financial needs that come from countries like Jamaica have come from an increase in imports and a decline in exports. But the biggest problem many of the Caribbean, and low income, countries face is mismanagement of, and consequent decline in, tourism. Additionally, many other low income countries that have depended on tourism from the recently weakened United States and European markets, have experienced a decline in those revenues. This has in turn created problem for these countries to serve their external debts. After the recent global financial meltdown ( ), many more developed countries have exercised their right to borrow from the IMF; most recently Greece and Ireland have borrowed from the IMF. This has happened because, for many of the developed countries, an end to the recession is not in sight. Industrial countries with strong economies borrowed money from the IMF in the 1900s to help them advance in technology and other things that would help those countries to be competitive in international markets. The vast majority of these industrial countries did not find the need to borrow from the IMF after they paid back their initial loans because their economies seemed stable and able to meet their international financial duties. During the recent global economic downturn, several industrialized countries had to resort to the IMF for help. As noted, one of these countries has been Greece. Greece has experienced financial need following years of much low cost borrowing and little fiscal discipline; the government was continuing in its practice of not reinforcing financial reforms when the global economic downturn struck. 41

4 Figure 1, below, shows Greece s economic problem indicators. In 2005, Greece had the highest budget deficit and it was projected to return to this level in This graph also displays Greece s public debt. In 2005, the public debt was 98.5% of their GDP. The next two years this public debt was reduced marginally, but grew again in 2008 and it was projected to go as high as 103.4%. Greece s debt has reached close to $413.6 billion, which is bigger than the country s economy and the biggest debt that has been seen in a European country in years. Figure 1. Budget Deficit Changes and National Debt GREECE S ECONOMIC INDICATORS BUDGET DEFICIT PUBLIC DEBT (AS % OF GDP): (AS % OF GDP): (projected) (projected) SOURCE: Eurostate Copyright STRATFOR com Figure 2 illustrates that the actual deficit as a percentage of GDP rose alarmingly in 2009, far higher than projected as Greece was caught up in the world wide recession. These numbers, combined with conditions in credit markets, assured that Greece access to financing on private markets would be extremely limited and very expensive. These conditions led to application for an IMF loan. 42

5 Figure 2. Impact of the Great Recession on Greece Greece s Fiscal Deficit 0.0 Percentage of GDP Year Source: Edward Hugh, So What s It All About, Costas? Global Economic Perspectives, Greece Economy Watch, December 14, 2009, available at (accessed March 15, 2010). IMF Policy Any country that is entering the lending process with the IMF needs to go through a process. As a part of this process, the country must agree to follow all IMF s policies, which include monetary austerity, fiscal austerity, privatization, and financial liberalization. Monetary austerity means a tightening up the nation s money supply designed to increase internal interest rates to whatever level is deemed necessary in order to stabilize the value of home currency (About the IMF, n.d.). This form of policy is likely to have the effect of raising domestic returns, but is likely to put downward pressure on the country s GDP. Also, this policy will force the exchange rate to decrease, making the currency in this country appreciate. This will eventually benefit the country s economy by making their currency stronger relative to other currencies, allowing its citizens and businesses to import at lower cost (Feenstra and Taylor, 2007). 43

6 The second policy, fiscal austerity, is the imposition of fiscal discipline within the country by increasing tax collections and reducing government spending drastically (About the IMF, n.d.). This policy is designed to limit interest rate increases caused by monetary austerity, reign in excessive government spending, and eventually lead to an interest rate drop, based on reduced government debt load. This should cause GDP to grow and will make domestic investment more appealing (Feenstra and Taylor, 2007). The next policy, privatization, is related to fiscal austerity; this policy requires the sale, and oversight of sales, of public enterprises to the private sector. This policy is designed to help the borrowing country s markets run freely, without government intervention. The final policy, related to privatization, is financial liberalization. Financial liberalization is implemented to do away with restrictions on the inflow and outflow of international capital as well as restrictions on what foreign businesses and banks are allowed to buy, own, and operate. This policy is designed to encourage international market investment in the country, though in a managed way so that the country s currency does not drop in value. Only when all of these policies are met will the IMF let the member country borrow money from the Fund to cover international loans that would be due and otherwise unpayable (About the IMF, n.d.). The Debate Regarding the Impact of IMF Policies Do these policies really help countries? Is there such a thing as one economy fits all? Many people have argued that the IMF involvement in many poor, low income countries has hurt them drastically in the past. Under the guiding hand of the IMF, national income in most African countries income dropped by 23 percent (Shah, 2010). This is not the only difficulty that low income countries face. Also when low income countries get involved with the IMF, the policies implemented by the Fund often undermine fledgling democracies in those countries by preventing their governments from making important investments for their people. Low income countries 44

7 often require investment in health, education and infrastructure before they are able to compete in the international markets. IMF policies remove a government s ability to make such investments, while forcing low income countries into competition in the international markets. These low income countries are not capable of competing in international markets on an equal footing with developed nations. For this reason, many argue that the IMF undermines the economic development of low income countries and ignores the needs of citizens of these countries. According to the United Nations International Children s Emergency Fund (UNICEF) over 500,000 children in the late 1980s died under the IMF s structural adjustment programs because many of these programs required the termination of price supports and essential food-stuffs (Shah, 2010). As George (1988) has written, The IMF cannot seem to understand that investing in [a] healthy, well-fed, literate population is the most intelligent economic choice a country can make. IMF policies also encourage all of its member countries that have made loan arrangements with it, to export; free trade is a major goal of the IMF. But for a developing country export will likely mean the export of raw materials, again discouraging domestic development of industry, which in turn limits the overall export exports of a nation. Figure 3 illustrates the export history of several African nations relative to those of the United States. 45

8 Figure 3. Exports of Several African Nations versus those of the US Source: IMF Balance of Payments from 2009 Yearbook The figure illustrates the limited international involvement of these countries, where most exports are in fact raw materials, often oil. The encouragement, by the IMF, of export behavior has a different impact on low income countries than it does on developed nations. A similar contrast can be seen when comparing specific developed nations, however. Figure 4 illustrates exports for China, the United States, and several European Union nations, all developed economies. For several European Union countries, a request for loans from the IMF has become necessity during the current economic downturn; if not for actual loan arrangements, some nations have felt the need to formulate backup plans with the IMF should their own austerity initiatives not be sufficient to encourage international investments. As discussed previously, one example of this is Greece. This nation has a very large GDP compared to countries like the African nations discussed above and, as a member of the European Union (EU), could have the support of the EU if necessary. Greece has had debt related difficulties, however, that have gone beyond what could be supported by the EU only and has had to resort to going to the IMF for financial relief. The IMF and Greece came to an agreement in the spring of 2010; in this agreement the IMF committed to becoming 46

9 involved only on the condition that the EU would be willing to work with Greece s debt as well. In Figure 4, it is illustrated that Greece s exports compare to those of its healthier developed peers in much the same way that African nations compare to the US. Figure 4. Export Data for Greece, the United States, China, and other European Union Members Source: IMF Balance of Payments from 2009 Yearbook As the figure shows, most of the other nations featured have seen great increases in their exports, as compared to Greece. The unique situation faced by other members of the EU is that this economic crisis faced by Greece will ultimately have a negative effect on other EU member nations as well, as all member nations share the Euro currency. This means that an extreme current account deficit in Greece could create a current account deficit to be experienced by the Union as a whole. A nation s current account measures current international activity and broadly measures that nation s trade deficit; that is exports minus imports. Where exports minus imports results in a negative value, this deficit will drag down the nation s GDP. That Greece s deficit could be contagious for other EU nations, and drag down the Euro zone overall, makes its situation desperate far beyond its own national borders. Figure 5, below, shows Greece s current account deficit and how it is projected to go lower in the years to come. 47

10 Figure 5. Greece Current Account Projected through 2011 Greece s Current Account Deficit Annual Percentage of GDP Source: Edward Hugh, The IMF Is Ready to Help Greece If Asked So Why Not Ask Them? Global Economic Perspectives, Greece Economy Watch, January 5, 2020, Year available at (accessed March 15, 2010) The IMF policies are designed to trigger growth in the Greek economy and bring down the current account deficit. It remains to be seen whether the experience of Greece will resemble that of its fellow developed nations in the past, or whether it will look like the experience of those African nations that have not yet become fully participating international players. During the current crisis, however, reducing the current account deficit provides Greece and its fellow EU member nations some breathing room. A similar argument can be made for Ireland, a more recent recipient of IMF intervention. Emerging Markets The role of IMF as a lender of last resort in the global financial system has been recently challenged by emergence of new economic powerhouses. The Great Recession ( ) has been the biggest financial crisis since the Great Depression and many markets have 48

11 suffered greatly from it. Certain countries have emerged out of this financial crisis however, more quickly and strongly, and have the capacity to help the international economy substantially. The most noted of these countries are the BRICs, Brazil, Russia, India, and China. These BRIC nations hold close to 40 percent of the population and also hold 25 percent of the global GDP (Lettieri and Raimondi, 2009). Figure 6 illustrates projections of the combined GDPs of the BRICs nations relative to the historic economic powerhouse of the G6 nations (France, Germany, Italy, Japan, the United Kingdom, and the United States). As illustrated, the BRIC nations will surpass the GDP of the G6 nations in less than forty years, making the BRICs the biggest emerging economies in the world. Figure 6. GDP of the BRICs Nations as Compared to the G6 GDP BRICs Have a Larger US$GDP Than the G6 (2003 us$bn) in Less Than 40 Years 100,000 By 2040: 90,000 BRICs G6 2025: BRICs BRICS 80,000 economies overtake 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 over half as large as the G6 the G Source: IMF World Economic Outlook In a slightly broader view, from the IMF s own data, figure 7 illustrates GDP growth rates, emerging nations as compared to developed nations. The emerging economies have surpassed the developed countries in their annual GDP growth by close to five percent and in the future they could eventually double their growth. 49

12 Figure 7: GDP Growth Rates, Emerging Nations Compared to Developed Nations Annual GDP Growth Rate (%) 8% 7% 6% 5% 4% 3% 2% 1% 0% Developed Emerging Source: IMF World Economic Outlook What is significant about the economies of emerging nations, relative to the experience of developed nations, is their different, and often far smaller, reliance on exports. In Brazil and India, exports accounted for less than 15 percent of their GDP in 2008 (Lettieri and Raimondi, 2009). Even China, the largest of the BRIC economies suffered a 25 percent decline in exports in 2008, but the economy still grew six percent by the first half of India also had a four percent growth, excelling in the export of textiles and electronics, but sharing with the other BRICs nations an increased reliance on domestic investment. BRIC nations are an essential part of the international economy and are demanding changes in the IMF. As they make these demands, the BRIC nations are not tying their own economic welfare exclusively to that of the large developed nations, but instead are working independently and trying to maintain a close relationship with one another. An illustration of this can be seen in Figue 8 which shows Brazil s changing trade status. Brazil is moving away from exports relying greatly on the United States; instead Brazil is exporting far more to China now, increasing its ties with the Chinese economy. 50

13 Figure 8. Brazil s Exports to the US and China Note: 2009 data thru Oct. Source: Brazil Ministry of Development, Industry, and Commerce. BRICs Demands to the IMF Among their demands to the IMF, is the BRIC demand that the IMF be reorganized in such a way that the greater economic power of BRICs nations be recognized by giving a greater voice to BRICs nations. The ability of the BRICs nations to bring pressure to the IMF stems from the IMF need for more financing to meet demands brought on by the great recession. The IMF has had to raise over 1 trillion dollars from its member countries. BRICs nations, unlike other nations, have this kind of capital during these economic times and have used their ability to control financial assets to gain more voting power. These gains are not proportionate, however, to the economic gains, existing and projected, of the BRICs countries. Nations from the historic leading member countries of the IMF have not been quick to recognize a new world order and other demands made by the BRICs countries have been paid little attention by world leaders. Even if the BRICs are the main countries to drive global economic recovery, giving them an increased role in the IMF would make their international influence substantially greater than is deemed desirable by many of leaders of the G-20. The Group of Twenty (G-20) 51

14 Finance Ministers and Central Bank Governors was established in 1999 to bring together systemically important industrialized and developing economies to discuss key issues in the global economy ; this group includes the BRICs nations but works closely with the European led IMF and US led World Bank (What is G-20, n.d.). This ongoing debate about how much influence should be wielded by the emerging economies is likely to continue. In addition, there is the BRIC request that the international monetary system move away from one based on the US dollar, to a system based on a market basket of currencies. BRIC nations hold a great deal of US dollar denominated reserves, based on the current structure of the IMF, and are vulnerable to a decline in the value of the dollar. Several BRIC countries have raised the issue of moving away from the dollar (and US influence), most clearly China; other nations, specifically Iran has announced its intention of holding its reserves in Euros and gold (Boyle, 2010). The call to restructure the IMF to better reflect a new economic order has not only been made by BRICs nations, but this group is increasingly making its voice heard in the IMF and world groups. The IMF Post Crisis: Conclusions As time passes and the extremes of the Great Recession recede, the IMF still recognizes the huge issues facing the world economy. In advanced economies, financial markets are still acting with great caution, especially in reference to sovereign debt. Banks in those nations have been slow to increase lending to the degree that unemployment may be driven down and economic growth can gain momentum. The historic mission of the IMF to make loans to developing nations has been recognized as insufficient by many member nations. Currently, IMF focus has been on rebalancing world trade between developed nations which often are deficit nations, and the emerging economies, which are generally surplus nations. This focus does not generally jibe with that of emerging nations, especially China and Brazil. 52

15 The IMF mission of providing relief to countries in trouble is an essential part of the international economy. The IMF, acting as lender of last resort, provides breathing room for many countries during times of economic crisis, but the lesser role allowed to emerging economies and the IMF approach of one economy fits all is outdated. A reorganized IMF, one that is not as Euro and US-centric and recognizes the legitimacy of its critics, would better fulfill its mission as enabler of world trade and interaction. References About the IMF. (n.d.). International Monetary Fund website. Retrieved April , from Bird, G. (1995). IMF lending to developing countries: issues and evidence. New York: Routledge. Boyle, J. (Dec. 29, 2010 Jan. 4, 2011). Brazil new contributor to IMF. The Rio Times, Issue LXXXXIV - Weekly Edition: December 29 - January 4, Retrieved December , from BRICs show new influence at G-20 finance ministers meeting. (2009). Bridges Weekly Trade News Digest, 13(10), Retrieved April , from web. Emmanuel. (2009, April 27). What BRICs want from IMF in exchange for $750b. Retrieved from Feenstra, R. and Taylor, A.M. (2007). International macroeconomics. New York: Worth Publishers. George, S. (1988). A fate worse than debt: The world financial crisis and the poor. New York: Grove Weidenfeld. The IMF s approach to international trade policy issues. (2008, June 13). Retrieved from 53

16 Will IMF loans hurt the poor this time around? (2009, February 13). Retrieved from Jidong, D, & Yang, A. (2010, April 16). BRIC has growing world influence. Retrieved from Lettieri, M, & Raimondi, P. (2009, July 22). BRICs drive global economic recovery. IMF Survey Magazine: What readers say. International Monetary Fund. Retrieved May , from Presto: another $750 billion. (2009, April 19). The Wall Street Journal, Retrieved from Roff, P. (2009, June 5). Democrats shouldn t put IMF bailout over troops. U.S. News, 1, Retrieved from Shah, A. (2010, February 20). Structural adjustment a major cause of poverty. Retrieved from Thomas, A. (2009, March 11). Financial crises and emerging market trade. International Monetary Fund. Retrieved from Truman, E. (2009, January 23). The IMF and the global crisis: role and reform. Retrieved from What is G-20. (n.d.) About G-20. Group of Twenty. Retrieved April 14, 2010, from 54