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Does IMF Support Provide Stability or Create Moral Hazard?

Because the International Monetary Fund (IMF) support to countries without pegged exchange rates is still new, not much evidence indicates what this kind of support achieves. However, the IMF’s support to developing countries and the effects of its support have been widely examined.

The most important effect of the IMF’s support is the provision of much-needed liquidity to a country following a currency crisis. Private international lenders would be unwilling to step in and provide funds to a country in crisis.

With the help of the IMF, the crisis country with depleted foreign currency reserves can pay for its imports and make payments on its debt. Additionally, evidence indicates that IMF support decreases the spread on a country’s sovereign bonds and other debt instruments, which implies a decline in the default risk of a country.

Countries receiving financial support have widely criticized the IMF’s conditionality. In terms of its traditional lending to developing countries with pegged exchange rates, the IMF’s conditionality prescribes a reduction in public spending (reducing subsidies, freezing civil servants’ wages, and so on) and discipline in monetary policy.

Even the conditionality associated with the IMF’s recent lending to European countries such as Greece has been criticized for being too intrusive. Three facts can help put this view of intrusive IMF conditionality in perspective:

  • First, the IMF sometimes provides very large funds to troubled countries, so large that crisis countries can’t get these amounts from any other lender.

  • Second, interest rates associated with these funds are much lower than the market rate, meaning that they are much lower than the interest rate that a commercial bank would charge.

  • Third, most of the time, the problems forcing a country to go to the IMF are home-brewed or preventable problems.

Therefore, when putting these three facts together, conditionality serves as the shadow price of IMF programs because their nominal price (the interest rate on IMF loans) is so low.

Even though the IMF’s conditionality made sense, the institution introduced a new approach to its programs and conditionality in 2009, possibly because it grew tired of criticism. In its own words, the IMF modernized its conditionality to reduce the stigma associated with its lending. Here’s what it did:

  • First, the IMF wants conditions attached to IMF loans to reflect program countries’ strength in policies and fundamentals. This point reflects a change from ex-post to ex-ante conditionality. Before 2009, the IMF considered the crisis situation of a country and formulated its conditionality after the fact (ex-post).

    Now, especially when providing the short-term liquidity facility (SLF) to countries currently in a temporary crisis but otherwise with strong fundamentals, the Fund doesn’t engage in ex-post monitoring of these countries.

  • Second, the IMF wants stronger ownership of IMF programs by program countries. Program countries’ government should be able to defend the conditions attached to IMF loans to their constituents and work diligently to fulfill them.

  • Third, the IMF wants to be mindful of the effects of its conditions on the most vulnerable segments of the population in program countries.

Additionally, the IMF increased member countries’ access to quotas. The Bretton Woods system provided the IMF with its own funds through a quota system. It worked just like a membership subscription. The same setup continued after the end of the Bretton Woods era.

Of course, now the IMF has 188 member countries, and each member country is assigned a quota based on the country’s relative size in the world economy. In addition to the member country’s voting power, quota affects its access to the IMF’s financial support. The overhaul in 2009 doubled the access limits to 200 percent of quota on an annual basis and to a 600 percent of quota cumulative limit.

Exceptions include Greece, where the IMF’s support amounted to more than 3,200 percent of this country’s quota.

Reducing the nominal vigor of conditionality and substantially increasing member countries’ access to financial support may increase the criticism of the IMF, which focuses on moral hazard. The term moral hazard means creating an environment in which people or countries can make wrong decisions without paying the price for these decisions (or paying a much smaller price than they otherwise would).

One of the signs of moral hazard associated with IMF programs is the recidivism observed in these programs. In this context, recidivism means the recurrence of the economic problem that requires the country to seek the IMF’s assistance. In the post–Bretton Woods era, most developing countries with pegged exchange rates have received multiple IMF programs.

This fact has been interpreted as a sign of the ineffective nature of the IMF programs. The view implies that, despite conditionality, IMF programs cannot prevent future domestic macroeconomic policies that lead to a reserve loss.

It means that the total cost of IMF support (conditionality plus interest rate) may not be higher than the benefit of what countries think they are receiving by implementing policies that are incompatible with their peg. Now that, since 2009, the IMF has enlarged its support to developed countries without a peg but with a financial crisis, it can create a different kind of recidivism.

The counterfactual argument is used against the criticism of the IMF. In this context, the counterfactual indicates the outcome in the absence of the IMF’s support. The IMF and its supporters maintain that the economic outcome would have been much worse without the IMF’s support.

It means that, despite possible moral hazard, funds provided by the IMF prevent currency or financial crises from getting larger and more harmful. However, measuring the counterfactual and proving that the IMF’s support actually averts a much larger crisis is difficult, if not impossible.

Additionally, whether it’s a problem with pegged exchange rates in a developing country or a financial crisis in a developed country, the policy combinations leading to these crises are well known. If these policy combinations are avoided, to a large extent, receiving financial support from the IMF can be avoided as well.

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