When Christine Lagarde clinched the IMF top job in June, she faced the task of rebuilding the institution’s credibility in the eyes of its non-European shareholders, many of whom had been critical of the appointment of another European at its helm.
But the rapid escalation of the eurozone debt crisis is forcing the Fund to justify its role and raison d’etre to a much broader constituency – the wider international economic community.
The prospect of a default in Spain or Italy poses daunting questions for the Fund, which lacks the resources to deal with such a collapse, while calling into question its previously benign outlook on the European debt crisis, and its failure to adopt a more critical tone to previous rescue packages.
Lagarde has struck a more critical tone in recent weeks, calling for the recapitalization of the European banking system, in an attempt to assert her – and the Fund’s – independence and rebuild its legitimacy in the eyes of critics.
But the Fund appears to be at a crossroads. Without a major increase in its lending resources, it appears ill-equipped to play a larger role within the global economic system. Such an increase is likely only possible with the assistance of large emerging market economies, including China, which have the resources to back a further increase at a time when developed economies are on the brink of a renewed recession. But there are growing signs that large developing nations won’t agree to provide additional funds without a greater say in the IMF’s affairs.
“The involvement of the Fund in trying to solve today's challenges should not eliminate the urgent [need] for governance reform,” Agustín Carstens, Mexican central bank governor and the only emerging market candidate to challenge Lagarde for the managing directorship role in June, tells Emerging Markets.
“If there is one thing the crisis has made clear, it’s that emerging markets are more important today, that [we] are trusted partners in the running of the world economy and that we deserve to be more fairly and fully represented in an institution like the fund. If this doesn't take place in the coming years, the legitimacy of the fund is at stake.”
ANOTHER EUROPEAN
Prior to her appointment, a number of emerging market shareholders were openly critical of the prospect of appointing another European at the helm of the Fund.
Lagarde and other European and American shareholders argued that having a European in charge – and one who was aligned to the beliefs of her predecessor, Dominique Strauss-Kahn – would be vital to ensuring that the Fund could play a vital role in resolving the eurozone debt crisis.
But for many shareholders, this argument simply didn’t hold up to close scrutiny.
“No one said the IMF should be headed by an Asian at the time of the Asian crisis – even though Asia put up most of the money,” says Akira Ariyoshi a former head of the Fund’s Asia Pacific office in Tokyo.
For others, it was not Lagarde’s appointment, but the fact that European shareholders began campaigning before the nomination period had even closed that poses troubling questions about the fund’s governance.
“Even today I’m baffled by why the Europeans didn’t wait until the close of the nomination period before starting to campaign for their candidate,” Mohamed El-Erian, co-CIO of Pimco, who previously spent 15 years at the IMF, told Emerging Markets.
“It would have been better for them and better for the international monetary system had they just waited. The way it was done left a bitter taste in so many peoples’ mouths because it gave the impression that even today, [the role] is still an entitlement [for Europeans]. And that’s a problem.”
STANDING UP TO EUROPE
Opposition to Lagarde’s appointment extended beyond the fact of her nationality, however.
Some shareholders and many outside observers had accused the Fund of being too uncritical and willing to back European politicians’ to-date unsuccessful attempts to resolve the crisis through stop-gap bailouts, in particular with regard to Greece.
Many observers worried that by presenting herself as a continuity candidate, Lagarde would continue to tread a similarly uncritical line in her handling of the eurozone issue.
“Until now, the fund has sycophantically supported each new European initiative to rescue the over-indebted eurozone periphery,” Harvard professor and former IMF chief economist Ken Rogoff wrote in a recent article. “Unfortunately, the IMF is risking not only its members’ money but ultimately its own institutional credibility.”
Rogoff and others argue that the IMF has a crucial role to play in resolving the eurozone crisis, and that by doing so it can regain its place at the centre of the international financial system. But in order to do so, it first needs to declare its independence and adopt a much more critical tone.
Jack Boorman, a former senior IMF official, believes that the fund’s previous support for European bailouts for over-indebted peripheral members was misguided – the IMF has committed more than $100 billion to bailout packages for Greece, Portugal and Ireland to date.
“The IMF needs to help get the European programmes right,” Boorman tells Emerging Markets. “The Europeans have not managed to wrap their arms around this problem since it began. The initial financing package for Greece just was not credible and markets have come to the same conclusion. The new programme being negotiated in my mind also does not generate a credible and sustainable scenario.”
“The fact that the fund is there in Europe is very positive,” says Boorman, adding that regional monetary funds, whether in Europe or any other parts of the world, cannot tackle such problems on their own. “The European situation makes the point that I have been making for a long time – that it’s very difficult for neighbouring countries to enforce conditionality on each other. You need the far-away devil to be able to that.”
But, he adds, the far-away devil needs to assert its distance, adopting a different position from the regional authorities on various issues.
Since assuming her new role, Lagarde has shown signs of doing just that.
In August, she called for an urgent recapitalization of European banks as key part of any solution to the eurozone debt crisis.
“Financial exposures across the continent are transmitting weakness and spreading fear from market to market and from country to country,” she said in a speech to central bankers at the annual Jackson Hole conference. “They must be strong enough to withstand the risks of sovereigns and weak growth.”
This last point enraged European bankers and officials at the time. They said Lagarde had created unnecessary alarm over the health of European banks. “Ironically, Lagarde now needs to repair her relations with the Europeans,” quips Boorman.
Her concerns that have subsequently been borne out, with Moody’s downgrading two major French banks and with five central banks forced to intervene to shore up short-term liquidity in the European banking sector.
Rogoff sees her stance on bank recapitalization as a promising sign, not only of her willingness to declare her independence from her European policy background but in recasting the fund’s role and image. “Her call for forced recapitalization of Europe’s bankrupt banking system is a good start,” he wrote. “European officials’ incensed reaction should serve to buttress the fund’s determination to be sensible about Europe.”
But it is clear that skeptical emerging market shareholders will require more convincing.
“We have resolved that we will work with the new leadership team at the IMF, [but] it is for that leadership team to demonstrate its own impartiality and even-handedness in terms of the way in which it deals with small and large economies of the world,” South African finance minister Pravin Gordhan, tells Emerging Markets.
“It is for that leadership to demonstrate it has the both the independence and quality [to] lead boldly, not just in terms of conventional frameworks, but also to explore unconventional ways of resolving what are deep-rooted problems that confront the world today.”
For El-Erian, the fact that shareholders and executive directors (EDs) have been critical of the Fund’s approach to Europe highlights deep divisions.
“It is very unusual to have outspoken EDs that are questioning its approach, but we’ve had a number of EDs that have come out in public and questioned the IMF’s approach to Europe,” he says.
MORE RESOURCES NEEDED
It is clear that if the IMF is to play a major role in the resolution of the eurozone crisis – and more broadly within the global financial system – it will require a much bigger warchest to do so, especially with not just Europe, but the US as well on the brink of relapsing into crisis.
Supporting a bailout of Greece or Portugal is one thing, but should the crisis require a bailout of Italy or Spain, the Fund at present lacks the financial clout to play a meaningful role.
“The IMF needs to have larger resources. If you look at any ratios of resources available to the fund, they are still way behind what they were when the institution was founded and through most of its first decades of life,” says Boorman, who is calling for a “super-sizing of the IMF’s funding.
Whether through borrowing, fresh issues of SDRs or bond issuance, the IMF needs all possible means to enable it to tap “potential funds available for the job it needs to do in a world of inter-connected capital markets,” Boorman adds. “The volume of basic resources available to the IMF – quotas – is way too small. That is the best source of funds in that they are readily available. You don’t have to go out and negotiate new arrangements in the event of a crisis.”
Moves are now afoot to garner additional funding. Former IMF chief Johannes Witteveen recently called for a major increase in the fund’s resources, while other well-placed observers attest to the fact that conversations are taking place. “People are talking about it,” says Kemal Dervis, vice-president and director of the Brookings Institution, and former Turkish central bank governor, whose name was put forward as a possible challenger to Lagarde.
But the issue of raising additional capital is a tricky one for the new managing director, as any further capital increase would come just two years after the trebling of the fund’s quotes, from $250 billion to $750 billion at the London summit in 2009, alongside a $250 billion increase in SDRs.
Attempts to tap additional funds would also come at a time when the Fund’s largest shareholder, the US, which at present pays 17.7% of the fund’s subscriptions, is debating spending reduction measures which include scaling back its commitments to multilaterals such as the Fund.
Former US undersecretary for international affairs Tim Adams is less sympathetic to the idea of boosting IMF resources. “The fund has sufficient resources to deal with the issues that it confronts,” he tells Emerging Markets. “It has hundreds of billions of dollars that it can call upon for available resources and you can use those resources in conjunction with regional or country-specific resources and leverage it more.
“That doesn’t mean that if the European crisis were to become more acute, or the nature of it changes or we were to have some different crisis in the future that we couldn’t go back and ask for more. But I think the IMF has sufficient fire power and I worry that supply creates its own demand and that if we ramp up funding to extreme levels then we will just find ways to push money out the door.”
“We need to move beyond the mindset that tries to throw money at problems, and think about more creative, non-financial ways of dealing with regional or country-specific problems.”
ENTER EMERGING MARKETS
With G7 donors likely to be resistant to pleas for a funding increase, the quest for additional resources is therefore likely to see Lagarde turn her attentions to large emerging market economies with healthier fiscal positions and ample reserves.
But this will necessitate dealing with precisely those shareholders who had reservations about her appointment in the first-place.
Carstens, who ran against Lagarde for the MD role, says that he would back any quest for more resources – but only if it were allied to attempts to increase emerging market representation and influence over the fund.
“We have seen the amount of resources that for example Greece has needed, so certainly if other European countries will need some more resources, the fund would not have enough fire power,” he says.
“So I think that the fund urgently needs to be capitalized, but ... this would also be a very good opportunity for the rebalancing of the voting power that is needed in the fund... Actually this means that proportionally emerging markets should and can contribute [more] capital to the fund.”
But he warns that a failure to combine a funding increase governance and representational reform would undermine the fund’s credibility.
“The problems of today should not be a reason for us to put on the back burner these important issues of governance and legitimacy that i would say was the main motivation for my campaign trying to be the managing director of the IMF,” he adds.
For Dervis, if the IMF is to play the role of overseeing the world economy on behalf of all its members that many believe it now should, it would require at least “a doubling of its current capacity to lend”. However, he believes that it is vital that such an increase is accompanied by greater representation of its emerging market shareholders.
“The emerging markets should be happy that the IMF is becoming by force of events a truly global supervisor and a global lender and not just someone that supervises their economies. That requires more money and that requires governance structures that will allocate that money in a way that’s fair to all the participants,” he says.
“The experience of managing difficult transitions and adjustments in the emerging markets is actually very good. And in some ways the advanced countries had it too easy. So I think there’s a lot to be learned from the emerging markets.”
But without a reform of its approach to Europe and without broader government reforms, many question the capacity of the fund to achieve an increase in funding, or to play a prominent role in global financial and economic affairs in the future.
“It won’t get a capital increase unless it gains credibility ... Before even talking about more capital, people have to be convinced that the capital will be used in a credible fashion,” says Pimco’s El-Erian.
While he says that it would be easy for fund representatives to argue that the urgency of the eurozone crisis requires a capital increase now, with broader governance reform to follow later, he believes that this would be misguided, pointing to the lack of previous ECB bailouts to resolve the Greek debt crisis – moves supported by the IMF.
“This is what economists call the theory of the second best, that what may look to you like a second best may not be a second best at all,” he says. “It’s easy to say that the second best is simply to go ahead with more money, but if the system is not credible, [then this is not a viable solution].”