Being and nothingness - A Frenchman’s dilemma

Today’s financial market crisis is the IMF’s most profound test in years. Without fresh thinking on how to handle it, the institution risks obscurity

  • By Anthony Rowley
  • 10 Oct 2008
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On the eve of his appointment as managing director last November, Dominique Strauss Kahn pledged to revitalize the IMF’s role as global financial watchdog.

In an interview with Emerging Markets the former French finance minister said he strongly endorsed various proposals by the International Monetary and Financial Committee, the IMF’s governing body, to boost the Fund’s surveillance role, grant greater voice to developing countries and overhaul the institution’s funding model.

“When I listened to what they are saying at the IMFC, it’s clear that they are really asking for reform,” he acknowledged at the time, stressing that he was well placed to reinvigorate the institution, as “the candidate of reform”.

A year later, as the US financial crisis has unfolded dramatically and in ways few had anticipated, the IMF has been noticeable mainly for its absence. The question now is whether the institution’s governors and management can restore its relevance.

Cut down to size

As that debate gathers pace, the IMF, meanwhile, is in process of being downsized. But size is not really what counts in the eyes of those who argue that even in its restructured form the Fund will be unable to remain viable or relevant unless it adapts to the realities of a changing world.

It is no longer just a question reforming IMF governance – issues such as ‘voice’ and representation – but of whether the Fund should continue to operate as presently constituted or, instead, give way to a new entity combining the powers of the G7 or other official groups with those of private financial institutions and official regulatory bodies. IMF lending has fallen dramatically in recent years and there is no longer room for an official lender of last resort, some say.

At the beginning of September Strauss Kahn appointed a committee of eminent persons “to assess the adequacy of the Fund’s current framework for decision-making and to advise on any modifications that might enable the institution to fulfil its global mandate more effectively.” The committee, however, will be looking at possible governance reforms at the IMF rather than reviewing its basic mission.

One of those “eminent persons” is Mexico’s central bank governor Guillermo Ortiz. In an interview with Emerging Markets, he admits that the central question facing the IMF is one of credibility.

“There is a problem of asymmetry—-in surveillance, what the Fund recommends has a different weight in the large economies than in the small economies,” Ortiz says. “Certainly the IMF was not required to prepare a Financial System Assessment Program (FSAP) for the American system. In the last Article IV (on the US), the Fund warned about these risks. I think that the opinion of American authorities of the Fund is that it is irrelevant. “The Fund has lost relevance in surveillance. It has to regain credibility.”

It’s a view echoed by many other experts surveyed by Emerging Markets. Former IMF chief economist Raghuram Rajan says the fundamental problem rests in the institution’s structure. “There’s a great hesitation to second-guess the policies of large industrial countries, particularly the US,” he says.

“That’s unfortunate, especially in today’s financial crisis. The Fund has the expertise. It could have advised [US] Treasury on how to handle this [crisis],” adds Rajan. “There’s a suspicion that the Fund and the Bank still do the bidding of the large industrial countries. This has to change – that’s the only way to Fund will have traction.”

Still relevant

Former managing director Rodrigo de Rato believes that the IMF will continue to have an important role as a global lender of last resort in a crisis-prone world. He is not alone in that view: Richard Erb, a former deputy managing director, says he too is concerned that monetary and fiscal responses to current financial turmoil and “bad economic experiments” particularly in Latin America lead to “balance of payment developments requiring an increase in IMF lending.

“You can never tell when a crisis may come back again and the IMF may be asked to increase lending,” agrees Shigemitsu Sugisaki, another former deputy managing director.

Indeed, the IMF may again be called upon to address crisis situations, especially given current global financial turmoil and a looming economic slowdown, says Charles Dallara, managing director of the Institute for International Finance.

“There are reasons for concern going forward and I would hope that someone would be prepared to step in if it became necessary,” says Dallara, a former US assistant Treasury Secretary and one-time US executive director at the IMF.

High inflation rates, falling commodity prices, overvalued exchange rates caused by capital inflows and falling demand from the US, Europe and Japan could trigger new crises, Dallara tells Emerging Markets.

Ken Rogoff, former IMF chief economist, says that today’s global economic downturn –and its likely damaging impact on more vulnerable emerging economies –will provide the Fund with a renewed mandate: “There’s been a lot of talk about how to finance the IMF, and how to change its structure. But that problem will disappear,” he says. “There are a number of big sovereign defaults around the corner and the Fund will soon be back in business again.”

Indeed, today’s financial crisis could spill over into emerging market economies and “spread rapidly in unexpected ways,” warns Jack Boorman, former director of the IMF’s policy development and review department. He notes that major emerging markets have been in a “sweet spot” in the global economy in recent years as a result of high commodity prices, strong growth and abundant capital flows. But this is “unlikely to last” and unpredictable events could create situations where the IMF will be called on “to provide distress financing to some of its members.”

Structural adjustment

But even those who believe the IMF will be needed again stress that more must be done than shrinking the institution. Boorman, who served with the Fund from 1974 to 2006 argued in a recent paper that what’s needed is a broad reform agenda.

He says the Fund’s lending role must be clarified, as must its surveillance, over members’ economies and also over the global economy and over financial markets. But first, the Fund’s governors must decide its basic mission as this will influence the size and skill mix of its staff and what financial resources the Fund requires.

“New lending by the Fund is negligible; its role as policy advisor seems diminished; and its oversight role in fostering stability in the international monetary system is uncertain,” he says.

Some argue that Strauss Kahn has put the cart before the horse by downsizing the Fund’s staff before such questions have been properly addressed. A mid-term review was conducted in 2006 under de Rato but this did not address longer-term issues, they assert. Likewise, the Crockett Committee which reviewed the IMF’s income model acted on the assumption that its role would remain basically unchanged.

Yet, as many sources point out, Strauss Kahn inherited an order issued by the G7 in the spring of 2007, when de Rato was still at the helm to downsize the IMF staff of around 3,000 by 10-15%, notes. This was a pre-condition by the G7 for agreeing to reforms in the ‘quota’ or shareholding structure of the Fund, and some G7 members have suggested that the initial staff cut should be “only a start” to downsizing of the Fund.

“There are some very legitimate reasons for downsizing” at the IMF, says Sugisaki. “The era of [IMF] credit expansion is ended,” he suggests to Emerging Markets. “The Fund should downsize because there is no need - at least at the moment - for country assistance.Even after the present [staff] cuts the number is much bigger than it used to be,” he adds while noting that the IMF underwent a significant staff expansion at the time of emerging market crisis in Asia and elsewhere during the late 1990s.

“The order of the increase in staff in recent years has been several hundred,” adds Sugisaki who says the Strauss Kahn cuts simply restore the status-quo-ante.

“I basically support what Strauss Kahn has done,” says Eisuke Sakakibara, Japan’s former vice finance minister for international affairs and the man who at the time of the Asian financial crisis in 1997 proposed an Asian Monetary Fund as a regional alternative to the IMF. A stern critic of what he says was the “terrible” performance of the IMF in Thailand and Indonesia during the Asian crisis, Sakakibara adds, “whether the IMF will be needed in time of future crisis is something that is very ambiguous.”

Wanted: market experience

But more profoundly, critics say that a lack of financial market expertise is the Fund’s biggest vulnerability in today’s world. “The world is different now,” Sakakibara tells Emerging Markets. “You cannot really resolve a crisis by macro-economic policy. You need to know the markets,” an area where he says the Fund lacks expertise. “The IMF may be a somewhat archaic institution because the days of macro-economics seem to be over now.”

Strauss Kahn appeared to respond to some of these concerns at the IMF’s spring meetings in April, where he tried to reposition the Fund as the world’s premier body to analyse the linkages between financial markets and the real economy – and craft policy recommendations accordingly.

He claimed no other body had the technical expertise or global scope to do this as effectively as the IMF. “I think you’ll find the IMF is back,” he said at the spring meetings.

He added that the global financial turmoil that originated in rising defaults on US subprime mortgages was the biggest financial crisis since the Great Depression of the 1930s.

Yet capital market participants remain sceptical that the IMF is suddenly presenting itself as a world centre of expertise on financial markets when in the past few months it has seemed to be left stranded by events.

Dallara also stresses the need for the IMF to focus more on financial markets. “This is really crucial because increasingly emerging markets, especially middle-income markets – have gained access to global capital markets and this has tended to marginalise the Fund,” he says. “It has been too slow to respond to the integration of emerging markets into global capital markets and has lost a significant amount of its operational leverage in emerging markets with regard to policies and financing.”

Horst Kohler, who preceded de Rato as managing director of the IMF, attempted to create a synthesis between the traditional role of the IMF in intermediating official funds to advanced or emerging economies in need of foreign exchange and capital markets that have since become the principal conduits for such flows. He strengthened the IMF’s capital markets division and afforded it a higher priority within the Fund’s overall operations. The experiment met with limited success, however.

“I think this was partly because there was too much cultural resistance inside the Fund to inject a capital markets mentality throughout the organisation,” says Dallara. He says that although the Fund’s capital markets department is now less isolated than they a few years ago, the culture of the Fund “has developed antibodies that have inhibited its ability to take the skills in the capital markets department and allow them to infuse the macro-economic knowledge that exists in the Fund.”

Boorman too notes, in his critique of the IMF, that there remains an urgent need for the genuine integration of financial sector issues with “the world-class macro-economic analysis that has been the hallmark of the Fund over its entire history.” Many give the IMF and its staff “high marks for its analytic capacity and increasing familiarity with institutional issues in the financial sector,” says Boorman. But this does not always translate into timely and effective advice to members, adds the former IMF official, blaming this largely on lack of support from leading IMF members for a more “forceful” role by the Fund.

Erb is among those who defend the IMF’s record in this regard, noting that the institution provides a forum for finance and central bank officials to meet and take stock of developments in the global economy and inform each other about their own policy intentions.

“This has been a particularly important function over the past year of financial turmoil It provides a place to address policy issues that are very difficult from both an analytical and political perspective. China’s exchange rate policy is one example of where the Fund provided a forum over the past few years for conducting in depth analyses and policy discussions.”

Refining roles

But there also remain fundamental differences over what should be the Fund’s future role in the international system. Japan’s Sakakibara, who a decade ago lambasted the Fund as an instrument of the “Washington Consenus” remains equally radical in his criticism of the institution today: “I don’t know whether an institution like the IMF is really necessary today [but] I think it is quite doubtful,” he tells Emerging Markets.

Sakakibara is tipped to become Japan’s finance minister should the Democratic Party of Japan win a general election due before September, 2009; his views could carry weight in the ongoing debate about the IMF’s future. The economist favours replacing the IMF with a core governmental group such as the G7 plus a few key emerging economies working together with key banking sector and other financial market players, regulators and central banks to avert or deal with crises..

“The world has become very globalised, complicated and interactive,” says Skakibara. “Addressing one country at a time and talking about macro-economic policy alone [as he claims the IMF does] is really only a very small part of crisis resolution. It is no longer good enough for the IMF to seek “outreach” contact with other bodies and with private institutions, he argues. A new and integrated institutional arrangement is needed, grouped around a few key economies to replace the unwieldy IMF which is answerable to 185 governments , he adds.

But in order to tackle complex global economic issues meaningfully, the must “sit the right countries around the table”. The IMF “has not been able to do this,” says Dallara but he adds that, “ I don’t criticise Fund leadership here so much as the unwillingness of the G7 to allow the IMF to do what it could do and to modify its own decision making structures.”

Where the IMF should focus mission is in “a more active, operationally meaningful multilateral surveillance process,” Dallara says.

Part of the problem he says, is that multilateral surveillance is undermined by the G7’s “anachronistic” structure, and the latter’s reluctance to “empower the IMF to provide stronger leadership today”.

“It simply is no longer sufficient for the IMF to be focussing on China as one market, the Middle East the next and Germany the next. They really have to bring together their analytical skills at a time when markets are so fragile.”

Bottom Line

Strauss-Kahn says it is “unfair” to blame the IMF, as some have done, for deregulation in the financial sector that has fuelled the credit crisis, pointing out that many countries had already adopted the Fund’s Financial Sector Assessment Programme (FSAP) — a wide-ranging financial surveillance plan introduced in 1999, which aims to promote the soundness of financial systems in member countries.

He notes that until earlier this year, the US had refused to implement the FSAP.But Michel Camdessus, a former IMF managing director, told Emerging Markets that the Fund had failed to learn the lessons of the past. In particular, he said this year’s financial crisis would not have happened if the Fund’s members had implemented reforms agreed a decade ago.

Camdessus, who has been closely advising Strauss-Kahn, said the new chief would have to work hard to reach consensus on key reforms. He added: “Only then will the world be reassured that it no longer has Damocles’ sword above its head.”

But whether today’s financial crisis will be the call to action so urgently needed by the institution is still an open question. As UC Berkeley economist Barry Eichengreen writes in a recent article: “It is sometimes said that the crisis is a reminder of why we have the IMF. If the Fund doesn’t come up with some new ideas for how to handle it, the crisis may only remind us why we can forget it.”

  • By Anthony Rowley
  • 10 Oct 2008

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