Fixing the IMF

Fixing the IMF

Mini Teaser: A proposal to reinvent a troubled but vital institution.

by Author(s): Charles W. CalomirisAllan Meltzer

Second, the IMF should start to require collateral to guarantee
repayment. By pledging collateral, the borrower shows that it has
valuable assets, and thereby is not insolvent or bankrupt. The
lender, meanwhile, gets a guarantee of repayment, and it can sell the
collateral in case of future default. Further, requiring collateral
for loans encourages countries to maintain liquid assets to be used
for this purpose in a crisis, thereby reducing the chance that a
banking crisis will occur. Some part of the collateral would consist
of negotiable foreign bonds, while the balance would consist of other
items. For example, to guaranteeits loan from the U.S. Treasury in
1995, the Mexican government pledged its receipts from oil sales.
These receipts were deposited at the New York Federal Reserve Bank
until the debt was repaid. Collateral could also include other
dollar-denominated assets owned by the borrowing country's central

Third, IMF lending would be restricted to member countries that adopt
the earlier prescribed banking standards.

If it followed these rules, the IMF would not bail out insolvent
banks or banking systems in the guise of protecting the liquidity of
member governments faced with a run on their currency. Unlike the
present system, the IMF would not impose conditions on the borrowing
country, other than membership rules and collateral requirements.
Countries would be free to adopt the economic policies of their
choice, not, as is frequently charged, policies imposed by the IMF
acting as the agent of the U.S. government. Private lenders, knowing
that they would not be bailed out without loss, would have an
incentive to scrutinize more carefully the policies of countries to
which they lend. Borrowing arrangements would be fixed in advance.
Countries would avoid the weeks or months of negotiation during which
the Mexican, Indonesian and Korean crises became more severe and more
costly to local populations.

To finance its lending, member governments would contribute
marketable bonds to the IMF. These bonds could be sold in the market
or to central banks in hard currency countries to fund IMF loans. The
IMF would be allowed to borrow, against collateral, from central
banks in countries with internationally accepted monies. The central
banks would lend risklessly at a market rate against collateral. They
would be free to offset the effect of the borrowing on their own
interest rates and economic activity to avoid any inflationary effect
or conflict with domestic policy.

All currency crises are not banking crises. Indeed, our plan
separates the two by requiring countries to develop and maintain
prudential standards for banking, and it increases reliance on
floating rates to avoid currency crises. As the number of countries
qualifying for the new IMF increases, banking crises would become
less frequent. Currency crises might continue in countries with fixed
exchange rates, but they would be less costly because banking systems
would be much more stable.

3) Other Foreign Assistance

Two other changes would be a necessary complement to our program:
first, Congress should abolish the Exchange Stabilization Fund, a
remnant of the 1930s; and second, the World Bank should be
restructured to concentrate on long-run assistance to spur economic
development. It should not participate in IMF loans or compete with
the IMF as a source of emergency lending, as it has often done.

Originally intended to support the dollar exchange rate after the
1934 dollar devaluation, the Exchange Stabilization Fund has become
an off-budget slush fund that the Treasury uses to make foreign
loans. The appeal of the Stabilization Fund to the Treasury and the
administration is that it enables them to avoid the congressional
appropriation process. They obtain funding, in part, by spending some
of the Stabilization Fund's $25-30 billion of foreign exchange
holdings and, in part, through a complex arrangement called
"warehousing", under which the Treasury borrows directly from the
Federal Reserve to augment the Fund. Closing the Exchange
Stabilization Fund would require the administration to use the normal
congressional budget process. Foreign assistance, like any other
expenditure, could only be proffered with congressional approval and

One of the IMF's most costly mistakes was to accept responsibility
for lending to Russia. It had no previous experience and no special
expertise in restructuring a non-market economy. It was unable to
enforce the lending conditions it imposed. And, because it was
committed to "successful transformation", it was reluctant to
withhold its loans.

Transformation lending to Russia took the IMF, with the support and
encouragement of the G-7 governments, far beyond its mandate and experience.
The Russian default is a principal reason for recent world financial
turbulence and the large losses borne by banks and financial
institutions in many countries. A restructured IMF would have been
prohibited by its charter, and also by the conditions of membership,
from lending to Russia. This was foreign aid that should have
required approval by the individual G-7 parliaments. The IMF and
World Bank should not become the means of circumventing parliamentary
oversight and appropriations.

Political Impediments to Reform

Experience shows that, economically, these reforms are feasible. For
over thirty years prior to World War I, market discipline reigned in
banking, and government interventions were typically limited to
liquidity assistance through Bagehotian lenders of last resort. An
integrated global capital market successfully mobilized far more
resources relative to economic activity for use by then-emerging
market economies than today's markets do. Lenders of last resort
operated successfully to stem liquidity crises. Banking crises in
emerging economies were infrequent; banking insolvency was a much
smaller problem; and currency collapses were rare compared to today's

Politically, however, there are significant impediments to reform.
Four constituencies will likely oppose some or all of our proposed
reforms: banks in developed economies; oligarchs in emerging markets;
IMF bureaucrats; and U.S. Treasury officials (and their counterparts
in other G-7 countries). Each of these groups would lose power,
influence or subsidies.

A possible quid pro quo to secure the support of global bankers is
the removal of barriers to the entry into new markets (which our plan
would require), and the expansion of their powers domestically and
abroad in exchange for the acceptance on their part of new capital
requirements based on market discipline. In fact, that is the
scenario envisioned by the Bankers' Roundtable in their recent
statements of support for enhancing market discipline in U.S.
banking. The Roundtable realizes that the creation of credible market
discipline would clear the way for deregulation, because it would
eliminate any possibility of a "safety net subsidy for risk."
Avoiding that subsidy has been one of Federal Reserve Chairman Alan
Greenspan's main arguments in blocking some of the most dramatic
elements of U.S. bank deregulation.

In emerging market economies, placating vested interests is more
complicated, particularly in countries with weak banking systems
where it would be difficult for banks to accept discipline. There are
countervailing pressures, however. Members of the World Trade
Organization have agreed to open their financial markets to
competition. Our proposal would strengthen this agreement by
restricting membership in the IMF, and therefore access to IMF
resources, to countries that adopt sound banking policies. Long-term
World Bank loans could be used to strengthen banks' capital structure
and, thus, their ability to compete.

Persuading the Treasury to relinquish its power to use the Exchange
Stabilization Fund, the IMF and the World Bank as off-budget slush
funds will not be easy. However, a large part of the public opposed
the recent appropriation to increase the IMF's resources. Congress
delayed approval for many months, insisted on minor reforms and
established an independent commission to recommend deeper reforms of
international financial institutions. Congressional recalcitrance and
public opposition have gained the attention of Treasury and IMF

The U.S. government is the largest contributor to IMF and World Bank
funding. If Congress responds to public concern about the large sums
spent in Mexico, Russia, Asia and Brazil, reform could be speedy,
credible and deep.

The IMF has responded to recent financial crises and its own past
failures by proposing increased transparency, better, more timely
release of information, and better surveillance and supervision.
These suggestions are useful but not in themselves adequate to
correct the problems in international financial arrangements.
Government supervision and accounting standards do not prevent
failures, as regulators sometimes fail to use available information
or look the other way when violations of prudential standards occur.

The incentive structure of the IMF is counterproductive to reform, as
it rewards officials for making loans, not for insisting on
prudential policies. Corruption in Russia, Indonesia and elsewhere
was not a secret. IMF officials had no incentive to emphasize
problems of this kind or even to insist on enforcement of the
conditions agreed to when the loans were made. The reason is clear:
unlike uninsured private market creditors, government and
international supervisors lack both the incentives and the ability to
enforce prudential standards. Supervisory failures of the U.S.
savings and loan system and the banking systems of Mexico, Japan,
Thailand, Korea, Indonesia and many other countries resulted from
failure to use available information in a timely way.

Essay Types: Essay