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Middle East and North Africa Can the IMF Tame Gorillas? View GEF Archive

The underlying cause of global imbalances is not the IMF’s usual debtors. Developing countries may be the usual suspects, but the real cause of current imbalances is not the IMF’s regular debtors from the developing world. Instead, its ‘developed’ creditors are largely responsible for today’s challenges. In our view, the ‘original sin’ is an unusually accommodative monetary stance in developed economies that created a glut of liquidity in the global capital markets, exacerbated by the reluctance to address structural weaknesses. Take, for example, the world’s leading engines of growth — the US on the demand side and China on the supply front. With the lowest national savings rate in history, America accounts for almost 75% of the global current account deficit, while China’s unwillingness to revalue its currency toward a realistic rate prevents a rebalancing in the world economy. The underlying risks, however, are beyond the widening trade deficits, and closely inter-related in today’s globalising world. The liquidity super-cycle operates in a circular fashion, financing above-trend growth, boosting the demand for commodities, and channelling excess funds back to the capital markets. Without doubt, the inability (or refusal) of oil producers to keep prices under control and improve their own economies’ absorption capacity is also an important source of global imbalances. Indeed, with higher prices, the cumulative current account surplus of oil exporters increased from 0.1% of world GDP in 1999 to 1.2% this year, which is even larger than China’s infamous surplus. And, of course, the recycling of petrodollars has kept fuelling liquidity-driven capital flows around the world. As a result, despite all the encouraging macroeconomic and structural improvements, developing countries with liberalised capital accounts remain exposed to the rise in speculative trading and therefore vulnerable to contagious herding behaviour in financial markets (see Carried Away, September 27, 2006).

Leveraged financial instruments exacerbate the volatility of capital flows. Private capital flows to developing countries soared from US$50 billion a year in the 1980s to US$675 billion last year, although these countries had a cumulative current account surplus of US$425 billion. It is not just the size of international capital inflows that creates serious challenges for emerging economies, the composition has also become far more sensitive to liquidity conditions. This may sound peculiar, especially when direct investments account for a greater share of total flows, but it is not if you look into the underlying funding structure. In a world of low interest rates, investors seek to generate higher returns through leveraged financial instruments. No wonder exchange-traded derivative instruments (which are only a part of the pool of structured products) increased from US$3.5 trillion in 1990 to over US$10 trillion this year, with annual turnover surging from 510 million contracts to more than 7 billion. Under normal circumstances, these complex instruments help distribute credit risk more broadly, but a sudden contraction of liquidity could easily amplify volatility in financial markets all around the world. In other words, what is designed to reduce risk becomes a systemic risk. Unfortunately, given the inadequate depth of their financial systems, emerging economies are simply unable to absorb such financial shocks.

The IMF has no leverage over the big countries that do not need its funding. So far these imbalances have had a benign influence over the global economy, but the sustainability is, to say the least, highly questionable. A disorderly correction would be extremely painful for all, especially considering market participants’ inability to provide adequate policy discipline and a tendency to impose overly severe punishments in times of higher risk aversion. This is why we believe that the IMF can still have an important role in overcoming market imperfections and addressing global imbalances. The problem, however, arises from the fact that it has no leverage over the big countries that do not need its funding but have an overwhelming presence in its governance structure. Therefore, in order to become more effective against global imbalances, the IMF must undertake institutional reforms. Although there have been some encouraging, but largely symbolic changes (such as increasing the voting weights of China, South Korea, Mexico and Turkey), the interest of smaller countries remains underrepresented and the Fund’s response function still focuses on crisis resolution instead of crisis prevention.

The Fund’s response function should move from crisis resolution to crisis prevention. Robert Feldman, our chief economist for Japan, argues that addressing global imbalances requires better surveillance methods and coordination among all the countries (see IMF Surveillance — From Trusted Advisor to Bully Pulpit, July 25, 2006). Even though the IMF may have the capacity to develop a multilateral system of surveillance on paper, political constraints would make actual implementation even more challenging than passing a resolution at the UN. Is it going to be a rule-based or discretionary approach? Who is going to convince politicians about a ‘projected’ crisis, especially when we still lack an adequate set of data on capital flows? Can we really develop ‘apolitical’ surveillance and intervention systems? And who is going to pull the trigger? Is the IMF — an institution that is used to coming to the rescue after the crises — ready and equipped to make such decisions? Its record of accomplishment in developing countries is certainly less than encouraging, and, as Robert points out, it has no real power of policy enforcement against countries that do not need the money but are the source of imbalances. Therefore, we need a new institutional architecture that could provide practical solutions to pressing problems, without impeding economic development. Unfortunately, since that is not likely to happen anytime soon, developing countries must learn to live with gorillas of the global economy.

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