IMF: The road that should be taken
Crisis prevention measures in a new framework for financial stability
The string of financial crises in developing countries is the result of financial liberalisation policies promoted by the IMF and other institutions. In fact this is a deviation from the IMF’s original mission of promoting financial stability. The IMF should now change tack and encourage developing countries to protect themselves from the devastating effects of capital flows.
THE raison d’etre of the IMF at its creation and in the era of the Bretton Woods system is to ensure global financial stability. This arose from the recognition that left to itself the financial institutions, markets and players, can become a too-powerful force with the potential of destabilising the financial system itself as well as undermining the real economy.
The IMF’s implicit mission included taming and regulating global and national finance so that finance would serve the real sector objectives of growth, output, income and employment.
The original Post WW2 framework supported this function. It included a system predominated by fixed exchange rates (which could be adjusted with IMF assistance when needed by objective conditions), BOP adjustment through country-IMF discussion when needed, limited crossborder financial flows, and the normality of national capital controls.
Policy was influenced by an understanding of the need for caution on the potential for instability, volatility and harm to the real economy that could be caused by unregulated finance and by speculative activity.
This regulatory system and the period of relative financial stability ended with the 1972 Smithsonian Agreement. Floating replaced fixed exchange rates, financial deregulation and liberalisation took off in the OECD countries, new financial instruments developed, there has been a massive explosion in crossborder short term capital flows and in speculative financial activity.
There has also been the spread of capital liberalisation to developing countries, to which advice from developed countries and from the IMF contributed. These developments underlie the frequent occurrence of financial crises.
The failure of the IMF and other international financial agencies to prevent such crises should be recognised as one of its major flaws, and this should be rectified. Indeed, the failure of the IMF in preventing the global financial system from going down the road of such rapid deregulation and liberalisation (with the consequences of currency instability, volatility of capital flows and financial speculation), and instead presiding over this road that was taken, is a major mistake. It also goes against the original role of the IMF to establish and maintain a stable financial order.
There needs to be a backtracking to the crossroads and take a new turning which is more true to the IMF’s original mission of establishing financial stability. That is the road of crisis prevention through establishment of greater stability through better understanding and regulation of capital flows and capital markets; and a more stable system of exchange rates (including among the major reserve currencies, and in the currencies of developing countries).
There is need to understand capital markets and the role and methods of players like highly leveraged institutions (for example hedge funds) which are now non-transparent and unaccountable but have major impact on global and national finance and real economy.
There is need especially to curb manipulative financial activity. Recently the Fund’s Managing Director announced he had encouraged his staff to get knowledge of how capital markets work. This is a statement to be welcomed. It also implies the Fund’s previous and current lack of knowledge of capital markets. It is a serious blind spot for the world’s premier international financial institution to have. How could the Fund have given good advice on handling the recent financial crises arising from the workings of the capital markets when its knowledge of these markets was limited?
There is need to understand the behaviour and potential and real effects of various kinds of capital flows to developing countries Š including credit (to the public and private sectors), portfolio investment, foreign direct investment (and its varieties, such as mergers and acquisitions, Greenfield investment, and FDI that produces for the domestic or the foreign market).
There is need to look at inflows and outflows arising from each, including the potential for volatility of each, and the effects, especially on reserves and the balance-of-payments.
What are the implications for policy and what guidelines should be given? For example, when should (or should not) a government or company borrow in foreign currency? Regulations and guidelines are needed because the market lacks a mechanism that can ensure appropriate outcomes.
One guideline that is most relevant could be that local companies should be allowed to borrow in foreign currency only if (and to the extent) the loan is utilised for projects that earn foreign exchange to repay the debt. This was a regulation that the Malaysian Central Bank had maintained, and it had helped Malaysia avoid falling into the kind of debt trap that Thailand, Indonesia and South Korea had got into, when the private sector borrowed heavily in foreign currency denominated loans.
The potential for devastating effects of short-term capital flows should be recognised and acted on, to prevent developing countries from the dangers of falling into debt traps. The IMF must recognise this and have an action plan (or at least be part of a coordinated action plan) that:
(i) regulates global capital flows, through international regulations or through currency transaction taxes;
(ii) establishes surveillance mechanisms and disciplines on countries that are major sources of credit so that the authorities in these countries monitor and regulate the behaviour and flows emanating from their capital markets and institutional sources of funds;
(iii) provides warnings for developing countries of the potential hazards of accepting different types of capital inflows and provides guidelines on the judicious and careful use of the various kinds of funds;
(iv) educates members and the public on how capital markets work and establishes surveillance and accountability mechanisms to guide and regulate the workings of the markets;
(v) appreciates and advises countries on the functions and selective uses of capital controls at national level, and helps them establish the capacity to introduce or maintain such controls;
(vi) identifies and curbs the use and abuse of financial instruments and methods that manipulate prices, currencies and markets, and prevents the development of new manipulative or destabilising instruments and methods;
(vii) stabilises exchange rates at international and national levels, which could include mechanisms to stabilise the three major currencies, and measures that can provide more stability and more accurate pricing of currencies of developing countries;
(viii) provides sufficient liquidity and credit to developing countries to finance development.
The prevention of crises through a more stable global financial order is more beneficial and cost effective than allowing the continuation of a fundamentally unstable and crisis-prone system which would then throw up the need of frequent bail-outs with accompanying conditionality.
The above is abstracted from A Critique of the IMF’s Role and Policy Conditionality, which was published by Third World Network in its Global Economy Series.