Fixing the IMF.

• Author: Calomiris, Charles W.
• Position: Reforming the International Monetary Fund

The future role of the International Monetary Fund (IMF) is today in doubt. Former Treasury Secretaries George Shultz and William Simon have urged that it be closed. President Clinton wants the IMF to devote more attention to preventing crises rather than responding to them. Even the IMF criticized its own recent operations in Asia for protecting foreign lenders at great cost to borrowing countries and their citizens. Protestors in the Asian countries and elsewhere complain that the IMF is a lackey of the United States, doing the U.S. government's bidding to the detriment of local populations.

Before agreeing to provide more money for the IMF as part of the 1998 budget agreement, Congress insisted on greater transparency in decision making and higher interest rates on IMF loans. These changes are first steps toward reform of international lending institutions. Still, more fundamental reforms are needed to reduce the risks of destabilizing crises that have become more frequent and more costly. Even the losses suffered by bank depositors during the Great Depression pale by comparison to recent losses in Mexico, South America and Asia.

Five factors go a long way toward explaining why there have been so many large financial and foreign exchange crises in developing countries during the current period of sustained growth and development in the world economy: weak banks; government interference and direction of lending (part of crony capitalism); a large volume of misdirected bank lending; domestic government and IMF bailouts to protect foreign lenders and domestic oligarchs; and fixed, unsustainable exchange rates.

The proposal for reforming the IMF that we shall make in this article seeks to restore international lending while avoiding the excessive risk-taking that leads to financial bailouts and severe depressions, as in Mexico, Thailand, Indonesia, Korea and Russia. The new IMF would avoid both the problem of excessive risk-taking, followed by collapse, and the risk of a protracted reduction in capital flows to developing countries. The challenge is to reduce the costs of the present system while retaining the benefits for economic development of international lending and capital movements.

A Record of Failure

The IMF and the World Bank were created at the end of World War II to foster long-term economic growth and stability in an environment of weak international capital markets. The World Bank's role was to boost capital flows to promote long-term growth. The IMF's role was to provide short-term assistance to facilitate the maintenance of fixed exchange rates. The presumptions underlying the creation of these Bretton Woods institutions were that, first, countries would maintain fixed exchange rates tied to gold and the dollar and, second, that private international capital flows would be rather modest.

Both presumptions proved to be wrong. The fixed exchange rate system ended in 1971, when President Nixon devalued the dollar and closed the gold window. All major currencies - the dollar, yen and deutschemark - soon began a managed float. And instead of a dearth of private lending, large-scale lending to developing countries has coincided with all of the major financial crises of the past twenty years.

Why have these institutions, intended to foster growth and promote stability, failed so badly in the Eighties and Nineties? Many reasons have been offered. Two aspects of private financial arrangements are of central importance: the form of international capital flows and the structure of domestic banking systems in emerging market economies.

Under current arrangements, corporations and bankers in the developing countries borrow from financial institutions and markets abroad. The loans are made at fixed exchange rates and denominated in dollars, marks or yen, so the lender is paid in his own currency and the borrower therefore bears the full risk of devaluation.

At present, banking systems in many developing countries are poorly capitalized and, therefore, unable to withstand heavy withdrawals. Bank depositors and stockholders are protected against loss by local governments. Banks often act either as agents of their government's development plans, or as captive financial arms of local industrial firms, lending at below-market rates to favored enterprises without careful screening for credit worthiness. Unlike prudent lenders, they do not diversify loans over borrowers in many different industries.

When problems arise in a developing country or the world economy as a whole, the financial position of banks in emerging market economies weakens. Because governments protect domestic banks from failure, banking losses become a fiscal burden on government and, therefore, on domestic taxpayers. To pay for these losses, governments borrow more from domestic and foreign lenders. The additional foreign borrowing strains their ability to repay, increasing the risk of devaluation, default and a foreign exchange crisis. Instead of renewing or increasing short-term loans, some foreign banks demand repayment in their own currency, further draining the borrowing country's reserves of dollars, marks and yen. Other lenders, seeing the loss of reserves, also demand repayment at the fixed exchange rate. As foreign reserves decline and the country can no longer honor its commitment to repay foreign borrowers at a fixed exchange rate, it must default, resulting in devaluation and a currency crisis. The crisis deepens the insolvency of domestic banks that have borrowed abroad in foreign currency and have assets priced in domestic currency. The currency and the weak domestic banking system collapse. The economy goes into recession, or deep depression, triggering additional bankruptcies, inability to repay domestic banks, and thus more bank failures and defaults on foreign loans.

To prevent such defaults, the IMF has taken on the role of lending to governments of developing countries in times of crisis. Much of the money that the IMF supplies is used to pay off foreign banks and to maintain the appearance of solvency at domestic financial institutions. Local taxpayers must repay these debts to the IMF in the future, so the banks' rescue is also at taxpayers' expense. The countries are often left in deep depression. Mexico in 1995 and Thailand and Korea in 1998 are the clearest examples.

Banking system insolvencies and improper government policies, not unwarranted speculative attacks on exchange rates, are among the principal reasons behind currency instability and financial failure. The IMF adds to the problem by fostering the belief that it will bail out the banks, however imprudent or insolvent they may be. The ultimate cost is then borne by local taxpayers.

The Orchestrator of Bailouts

Prior to 1987, the IMF would not lend until borrowers worked out agreements with private foreign creditors. This forced debtors to negotiate in good faith with their creditors. Since 1987, the IMF has often been a lender not of last but of first resort, offering loans before private debtors and creditors reach agreement.

Why has the IMF undertaken the role of...