Financial crisis: IMF chases its own tail

29 September 2008

As global finance dries up, economic markets crash and banks go bust, criticisms mount of the IMF and its inability to convince its largest members to better regulate the financial sector or curb speculation.

Former Indian finance minister Yashwant Sinha said in June, “I believe that the international institutions we have at the moment, are woefully inadequate in dealing with the global challenges. … There is a major regulatory failing in the US. What is the IMF doing about the US? Nothing.”

The IMF’s predictions in April of $1 trillion in losses from the sub-prime crisis, ridiculed by some, may turn out to be too low. But in fact over time the IMF has been very unsure of whether the crisis is starting or ending. Over the last 12 months, its prognosis has flip-flopped more times than can be counted. For example in August 2007, when credit markets first started to contract in the US and UK, the IMF sought to calm fears by asserting that the credit risk was “manageable”. The tone was the same heading into September, however by the time the month was through Rodrigo de Rato, then head of the Fund, acknowledged that although it would take some months for the impact to become evident they “[did] not see a prompt resolution of the credit crisis.”

What is the IMF doing about the US? Nothing.

By December a new managing director had come to the Fund, and magically it seemed no crisis existed. Dominique Strauss-Kahn was quoted by an Italian newspaper as saying “There is no deep crisis on the markets.” This continued from May through July as Strauss-Kahn made declarations that “there are good reasons to believe the worst news is behind us”. By the end-July release of the Global Financial Stability Report, press reports interpreted the IMF’s stance as saying the credit crunch was still worsening, but that it would be over in 2009.

So where do we find ourselves one year on? The recent collapse of US investment bank Lehman Brothers and the buy out of another investment bank Merrill Lynch raises fears that we are, if anything just entering round two. Strauss-Kahn now humbly admits “I cannot say the worst of the financial crisis is behind us.”

The turbulent months of August and September saw the US Treasury nationalise two giant mortgage guarantee companies and the world’s largest insurance company, on top of numerous bankruptcies and financial sectors mergers in the US and UK. In each case of major policy intervention, the IMF nodded its approval after the US government announced its plans. Strauss-Kahn welcomed the late September proposed $700 billion financial bailout package from the US Treasury despite not knowing any details of how the bailout would be conducted and before the US congress had considered and approved the deal. Strauss-Kahn seemed to ignore the criticisms levelled at the package by commentators from the left and right.

Asians going their own way?

NGOs Third World Network and the Consumers Association of Penang convened a major international conference on the management of capital flows and the global financial crisis in Malaysia in August. The meeting of Asian academics, policy-makers, and NGOs sought to chart a way forward for economic management against the backdrop of instability.

While the papers analysing capital flows in Asia faulted the IMF’s lack of robust advice on capital controls, they were also downbeat on some Asian countries that had not put their own houses in order. Yilmaz Akyuz, former chief economist at UNCTAD, was critical of a number of countries that are vulnerable to reversals of capital flows and contagion.

The build up of massive stockpiles of foreign reserves in Asia has turned into a serious debate. Initially these reserves were seen as a self-insurance mechanism against having to approach the IMF, a move applauded by the detractors of the Washington-based institution, but decried as senseless by IMF staff. As the reserves have grown larger and larger – China’s foreigner reserves are approaching the $2 trillion mark – the critics and fans may have changed places.

A hot topic is the cost of holding such large levels of reserves, as special monetary policy instruments must be used to prevent the accumulation from disturbing exchange and interest rates. This usually works as an implicit subsidy of the US, because developing countries earn low interest on the dollar bonds, but pay higher interest on the domestic bonds they issue as part of so-called sterilisation operations. As the cost of doing this has mounted, many policy makers and academics alike have worried about the social cost of foregone investment in the social sectors in Asian countries. China is unique amongst the high-reserves holders in having very strong control of banks, allowing it to mitigate the cost to the government of holding such reserves.

But an August working paper by Marta Ruiz-Arranz and Milan Zavadjil of the IMF’s Asia-Pacific department “does not suggest that reserves are ‘too high’ in the majority of Asian countries, though China may be a special case. Much of the reserve increase in Asia can be explained by an optimal insurance model”. As if on cue, South Korea experienced pressure for a devaluation of its currency in financial markets at the end of August, leading the government to intervene to prop up the value of the won by using some of Korea’s nearly $250 billion in reserves. Other Asian countries have experienced similar bouts of volatility in exchange rates since then, prompting them to call on their reserves to defend their currencies.

This may foreshadow a renewed focus on the presumptive Asian Monetary Fund (see Update 61). Some of the more vulnerable countries in Asia just might be forced to use the currency swap arrangements before the crisis ends. Regional exchange rate cooperation was viewed as a second-best but necessary policy intervention by the conference participants, but they worried that it required greater political will, which seems to be lacking.

Exchange rates debate

Among others, UNCTAD’s director of the division on globalisation Heiner Flassback has called for more international cooperation on exchange rate management. This has been a focal criticism of the IMF from developing countries, the US and Europeans alike. Developing countries want greater help in stabilising exchange rates and preventing speculation on currencies. Developed countries on the other hand want the IMF to play a stronger role in disciplining developing countries that manage or fix their exchange rates, particularly China.

Into this gap, the IMF issued a guidance note in early August which was to clarify the new IMF exchange rate surveillance policy (see Update 57, 56) for IMF staff. But the clarification seemed to reawaken debates about Chinese exchange rate management. The guidance note spelled out the procedures for the initiation of special consultations between IMF staff and a member state if the staff was worried that a currency was “fundamentally misaligned”.

“The staff and management have certainly been very clear about our view that the Chinese currency needs to appreciate, but whether this will trigger an ad hoc consultation is something we need to see,” said Mark Allen, the interim director of the Fund’s policy department. The IMF board usually considers it annual Article IV report on China in the summer, but the 2007 report was never completed because of Chinese opposition to the new exchange rate policy. The first consultation under the new policy may debut this autumn when the board should consider the this year’s annual review on China’s economy.

Financial sector and speculation in the crosshairs

Exchange rate misalignment seems like a minor worry for the global economy compared to the turmoil in the financial sector. While the financial system seems to be crashing, the IMF will be finally getting around to performing an assessment of the United States under the financial sector assessment programme (FSAP).

The FSAP programme was launched in the wake of the Asian financial crisis to help identify risks and problems in the regulation of banks and other financial institutions. While most developed countries agreed to FSAPs years ago, the US held out and only agreed on the exercise in 2007. By the time to Fund gets around to doing the analytical work on the FSAP in 2009, all of the problems may have already have manifested themselves in failures and bankruptcies. The Fund has been repeatedly criticised for not being able to influence US economic policy even though it has dramatic effects on the rest of the world. The asymmetry of Fund influence promises to be cornerstone of the communiqué of the G24 group of developing countries in October.

The IMF also agreed to look at the role of speculation in the rises fuel, particularly oil, prices. This was officially a request from the G8 summit in Japan, but developing countries will be keen to hear the IMF’s take. They have long blamed currency and commodity speculators for causing crises of various kinds. This time the worry about speculation was strongly supported by Italy and France, with the US and UK eventually succumbing to their pressure to agree to ask the IMF to look at the problem.

The Fund was to deliver its paper before the annual meetings, but it likely will not tackle the speculation and short-selling of financial institution shares that have been at the centre of the crash of investment banks in the US and UK.

Even if there is a finding that fluctuations in prices were due to speculation, there is no agreement on what the countries, let alone the Fund should do about it. While the US and UK have tried to clamp down on short-selling, these moves have been limited to financial institution shares and ignore the everyday speculation on currencies and commodities, often through complex derivative instruments.

Though speculative activity in financial markets in the rich world may have real effects on the economies of developing countries, the IMF has no mandate to actually do anything about it. While a September European Parliament report demands that the European Commission initiate a process for regulating hedge funds and other unregulated financial actors, there seems be little appetite in the major capitals to take action. Without the agreement of the US and the UK, there is little chance the IMF could ever tackle the problem.