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Reforming International Financial Governance [2013] UNSWLRS 80

Last Updated: 18 December 2013

Reforming International Financial Governance

Ross P. Buckley, University of New South Wales^[1]

Citation

This paper was published in Macdonald, Marshall, and Pinto (eds), New Visions for Market Governance: Crisis and Renewal, (Oxford: Routledge, 2012) 43-51. This paper may be referenced as [2013] UNSWLRS 80.

Abstract

This paper outlines the contemporary challenges for International Monetary Fund (IMF) reform. The chapter argues that market principles and disciplines have been abrogated systematically by IMF policy makers whenever the unimpeded operation of markets has failed to deliver profits to the international banks and the elites in the developing countries. In this sense, the IMF should be understood as behaving most consistently not in its commitment to the allocative efficiency of markets, but rather in its commitment to furthering the interests of key groups of economic and political elites. One of the principal challenges in reforming the IMF and the World Bank is therefore to embed, not to re-embed, important market principles and practices; specifically, to let the market allocate losses among borrowers and lenders when loans go sour – a market discipline that has been notably absent from our system of global financial governance for several decades at least. The paper proposes a number of reforms of the IMF which would increase its legitimacy and representativeness.

INTRODUCTION

The principal criticisms of the International Financial Institutions (IFIs) such as the International Monetary Fund (IMF) and the World Bank centre on their addiction to neoliberalism and insistence on smaller government and an increased allocative role for markets (Vines and Gilbert 2004; Meltzer 2000). It is therefore reasonable to assume that markets have figured prominently in the policies and practices of the IFIs and that the Global Financial Crisis (GFC) has potentially shaken the extent to which market disciplines and practices are embedded in the IFIs. It is a reasonable assumption but a wrong one.

One of the principal challenges in reforming the IFIs is to embed, not re-embed, important market principles and practices; specifically, to let the market allocate losses among borrowers and lenders when loans go sour. This market discipline has been notably absent from our system of global financial governance since at least 1982. When analyzing the re-embedding of markets, it is vital to understand the areas in which the World Bank and particularly the IMF have never allowed market principles to govern.

HOW THE IMF HAS CONSISTENTLY ABROGATED MARKET PRINCIPLES

The multilateral system of international financial governance, with the IMF at its centre, works to reward the international commercial banks and the elites in developing countries, at the expense of the common people in the debtor countries. It does this by only selectively applying market principles and disciplines. The market is allowed to operate unimpeded when it delivers profits to the international banks and the elites in the developing countries, and its operation is interfered with, grossly, when market forces impose massive losses on the banks and/or the developing country elites.

A few examples will suffice to demonstrate this dynamic.

After the 1982 debt crisis struck a mechanism was needed to allow hundreds of creditors to negotiate with hundreds of debtors in each nation. The commercial banks appointed steering committees of six to eight banks to represent all creditors, and persuaded the sovereign to represent all debtors within its jurisdiction (including state governments, state-owned industries and private corporations). This was sensible. The banks, however, went further, and persuaded debtor nations to bring all debt incurred by all entities within their jurisdiction under their sovereign guarantee. This was unnecessary and, for the people of the debtor nations, deeply unjust. The inevitable, massive shortfall between what the sovereign now owed the bank creditors and what it could recover from the original debtors was added to the nation’s debt. The people paid in reduced services or higher taxes so that the foreign banks could receive a free credit upgrade on their assets (Marichal 1989; Buckley 1999).

Likewise after the Asian economic crisis, the IMF and foreign commercial banks insisted Indonesia assume the obligations of the local banks to foreign lenders, and then recover the funds from the local banks. Recovery of such sums from insolvent Indonesian banks was always going to be problematic, and eventually only about 28 per cent of the total liabilities assumed were recovered (ADB 2009). Accordingly, almost three-quarters of the costs of repaying these foreign loans was borne by the Indonesian people, and without good reason. The market mechanism, if left to work, would have seen many Indonesian banks made bankrupt by their Western creditors who would have recovered a portion of their claims in the bankruptcy. Instead insolvent local banks were put into bankruptcy by Indonesia, the creditors were repaid in full, and the Indonesian people bore most of the cost. The funds to repay the creditors came from the long-term loans organized by the IMF, contributed by the Pacific Rim developed countries (except the US), and invariably described as bailouts of the debtor nations. Yet the terms of these loans required they be used to repay outstanding indebtedness, so the bailouts were of the foreign banks. In Indonesia, the IMF coordinated a restructuring that socialized massive amounts of private sector debt (Buckley 2002).

Similarly, the centrepiece of the G20 response to the GFC in April 2009 was a US$500 billion additional credit facility for debtor nations. However, the conditions required to be eligible for these loans exclude virtually all African and most Latin American nations. While it is not apparent on the face of the conditions, they are carefully crafted so that most of these loans will go to East European countries, where German banks are heavily overexposed. So this additional credit facility, in large measure, is designed to bail out the German banks. The funds will be repaid. Official credit always is. The loss will fall on the people of Eastern Europe who will carry massive debt burdens for decades to come. Once again normal market processes, which in Eastern Europe would have led to German banks incurring large losses on their ill-judged lending, are abrogated to prefer foreign banks over the people of debtor nations (Arner 2010).

The benefits of the current system of global financial governance to the commercial banks are thus manifestly clear. The market is given full rein when yielding large profits to the banks, but is interfered with when it would yield large losses. The benefits to the elites in developing countries are less obvious, but nonetheless substantial, and why voices well-placed to argue against the current system are rarely raised against it.

Consider the situation in Indonesia after the Asian crisis. When the assets of insolvent local banks were sold, who was best placed to bid for them? Who knew everything about the assets and their precise value? The families that had owned them, as the principal shareholders of the banks – that is who. So these families were able to regain control of the assets they had owned before the crisis, with their foreign debts discharged by their government, for an average cost of 28 per cent. Who would speak out against such largesse? Our system of financial governance transferred the real cost of the crisis, which should have been borne by Indonesian and foreign banks that had engaged in imprudent borrowing and lending, onto the innocent people of the debtor nations. These debts foisted in this way upon the Indonesian people now represent almost 30 per cent of the total sovereign indebtedness of Indonesia (CIA 2009; Soesastro et al. 2003).

Sadly, after Argentina’s economic implosion in 2000, the international financial community, with the assistance of a compliant Argentine government and the IMF, found two ways to socialize private indebtedness. The first is the familiar IMF bailout, in this case a US$40 billion loan to Argentina in late 2000, that was required to be used to repay a mix of public and corporate debt (Hershberg 2002). The second was a new way to achieve an old end: having the people repay corporate debts. This technique was known as ‘pesofication’.

Under pesofication, banks were required to convert their assets (such as loans) into pesos at a one-for-one rate and their liabilities (such as deposits) into pesos at a rate of 1.4 to one. This generated huge losses for the banks for which the government sought to compensate them by a massive issue of government bonds (Gaudin 2002).

Thus the circle was completed in the usual way – the ultimate burden fell on the public purse. In the words of Pedro Pou, President of the Central Bank of Argentina until mid-2001, ‘[t]he government has transferred about 40% of private debt to workers. ... We are experiencing a mega-redistribution of wealth and income unprecedented in the history of the capitalist world’ (Gaudin 2002).

To require the common people to repay corporations’ debts, through increased taxes and reduced services, is immoral. It is a massive interference with the market mechanism that the IMF professes to support. In each of these crises, the market, through the mechanism of bankruptcy, would have allocated the costs of the poor lending and borrowing decisions onto the lenders and borrowers. The IMF, either as architect or complicit partner, in each case allocated the costs of poor decisions to parties who had nothing to do with them: the common people of the debtor nations (Buckley 2002).

Yet the system was not designed to do this. Its architects were Keynes and White at Bretton Woods in 1944. Their primary goal was the promotion of global trade. Fixed exchange rates were to facilitate that trade. The IMF was established to provide short-term loans and technical advice to nations to facilitate their management of these fixed rates. This fixed exchange rate system ended in the 1970s as the US went off the gold standard and floated its currency, and other developed nations followed suit. During the 1970s, the IMF’s core mission ended.

Yet global institutions are notoriously hard to kill. Witness the Bank for International Settlements, which Keynes and White had intended be closed, but which lived on to become the most significant global banking regulatory institution.

So the IMF continued on until the debt crisis of 1982 gave it a new role. The commercial banks needed to keep lending to the sovereign debtors so they could service their debts, but didn’t want to advance more funds without changes to the policies that had led these nations to the brink of insolvency. Yet it was politically impossible for a US commercial bank to be dictating economic policy to Brazil or Argentina. The IMF stepped in. As a supposedly independent IFI it was well-positioned to play the role of crisis-manager of nations in trouble. It was well-positioned for the role but not staffed or equipped to discharge it. So the IMF performed poorly, with disastrous consequences for the human rights of poor people in poor nations. Yet it has continued to fulfill this function, with substantially unchanged policies, ever since. Over time, as its litany of policy failures began to mount, the IMF attracted and sustained unrelenting criticism from both sides of politics in the US and from developing countries, and it was allowed to shrink in size (Vines and Gilbert 2004; Stiglitz 2002; Meltzer 2000).

Yet in 2009 another crisis rescued the Fund. The GFC meant the G20 needed an organization through which it could channel most of its US$1.1 trillion funding package. And so, the credibility of the IMF has been somewhat restored by having a new role, and its staffing levels are again climbing.

So why do the normal checks and balances of democratic systems not rein in and redirect the system of global financial governance if it so often implements ends that serve the rich and hurt the poor? Part of the answer is that voters in rich countries cannot understand how international finance works, and care far less about the problems of people in poor countries than they do about their own backyards. This lack of understanding is promoted by the poor job done by the media in covering global financial governance. The media typically focuses on the most recent development, and reports it, shorn of context. Its coverage is often inaccurate, promoted by the closeness with which information is guarded in this sector. The poverty of the media coverage means the powerful can continue to exploit the system free from countervailing pressures from civil society and democratic voters.

Two examples will suffice. In late 1997 the IMF-organized bailouts of Indonesia, Korea and Thailand were reported widely as if they were grants, not loans. Furthermore, the purpose for which the bailout funds could be applied was not reported at all, because that information was not made available. Yet, as we later learned, the loans could only be applied to debt then due, which was mostly short-term debt. So the bailouts were essentially bailouts of Western banks, not East Asian nations, and the bailouts rewarded the lenders who advanced the most destabilizing form of loans, short-term ones, at the expense of those who had advanced less volatile, longer term debt (Sachs 1997). Thus was perpetrated a disastrous policy which received no critical media coverage until it was old news, years later.

In 2009 the G20’s principal response to the GFC was a US$1.1 trillion dollar funding package. US$100 billion was concessional financing for poor nations. US$250 billion was to support trade finance. Another US$250 billion was an increase in Special Drawing Rights, the IMF quasi-reserve-capital. And the final US$500 billion was the additional credit facility we have already considered (Arner 2010).

The first two tranches are readily understandable, the latter two are not. Special Drawing Rights (SDRs) are based on a basket of four currencies, the US Dollar, Pound Sterling, Euro and Yen, and are the ways nations make their contributions to the IMF. They are an excellent source of funding for poorer nations and the increase in them is a laudable response to the GFC. However, SDRs can only be drawn down in proportion to a nation’s quota. Accordingly, nearly two-thirds of the increase in SDRs is available to OECD nations, leaving only US$100 billion for developing countries, of which only US$19 billion is available for low-income nations (Oxfam International 2009; IMF 2009a). So reporting the US$250 billion increase in SDRs as principally a measure to assist poor countries was quite misleading.

The most frequent criticisms of the IMF focus upon their applying market disciplines and policies too rigidly and in institutional settings unable to support efficiently operating markets. There is no paradox here. The IMF is consistent – not in its commitment to the allocative efficiency of markets, but in its commitment to furthering the interests of the international commercial banks and the elites in some debtor countries. For when it suits the international commercial banks and the elites in the debtor countries, the Fund turns its back on market principles and engineers massive interventions in the market, and at other times when it suits the international commercial banks and elites in debtor countries, the IMF applies market principles with extreme rigor.

How the IMF has Consistently Applied Inappropriate Market Doctrines: The Rise of Market Fundamentalism

The basket of IMF policies has come to be known as the Washington Consensus. The criticisms of these policies have become legion, and rather than repeating them, I’ll simply analyse one recent instance.

Throughout the late 1980s and 1990s, IMF Structural Adjustment Policies (SAPs) were decried by critics for their failure to reduce poverty significantly (Sanchez and Cash 2003). Poverty Reduction Strategy Papers (PRSPs) were introduced in 1999 in response to this global outcry and were to contain policies negotiated between debtor nations and the IMF that would lead to poverty reduction, and provide the basis for debt relief and access to new funding.

According to the IMF, ‘PRSPs are prepared by the member countries through a participatory process involving domestic stakeholders’ (IMF 2007). PRSPs are to outline the economic, social, and structural programs to be used to reduce poverty (Steward and Wang 2003). Instead of focusing on macroeconomic stability and growth like SAPs, PRSPs, were to put poverty reduction at the core of the nation’s economic policies.

The IMF has its own internal evaluation division, the Independent Evaluation Office, and in March 2007 it released The IMF and Aid to Sub-Saharan Africa (IEO 2007), which evaluated the IMF’s performance in Africa. The report noted the differences of views among the Executive Board of the Fund about its role and policies in poor countries, and concluded that

lacking clarity on what they should do on the mobilization of aid, ... and the application of poverty and social impact analysis, IMF staff tended to focus on macroeconomic stability, in line with the institution’s core mandate and their deeply ingrained professional culture.

(IEO 2007: vii)

In other words, over seven years after the replacement of SAPs with PRSPs and over seven years after the establishment of the Poverty Reduction and Growth Facility, IMF staff were unclear on the priority to be given to poverty reduction and how to achieve it, and so sought to attain that which they knew how to attain, macroeconomic stability. This is ridiculous. For an institution that had maintained steadfastly since 2000 that poverty reduction was its highest priority, to still be trying to bed down poverty reduction initiatives in 2007 is utterly unacceptable.

The Report also found the IMF’s policies accommodated increased aid ‘in countries whose recent policies have led to high stocks of reserves and low inflation’, but ‘in other countries additional aid was programmed to be saved to increase reserves or to retire domestic debt’ (IEO 2007: 2). Very few African countries have high reserves and low inflation. Accordingly, across Sub-Saharan Africa the IMF channelled extra aid into foreign exchange reserves or into debt repayment. Such an approach has two flaws:

1. It diverts extra aid away from healthcare, education and other social welfare expenditures; and
2. It risks being a ‘self-fulfilling prophecy’ as diverting aid flows into reserves and debt reduction is likely to dissuade donors from giving more aid. Most donors want to give aid to assist suffering people directly, not to improve a nation’s macroeconomic profile.

On the basis of the report by the IMF evaluation office, while the rhetoric of the IMF has changed, in practice its officers still give primacy to macroeconomic stability at the expense of assisting the poor and investing in the human capital of a nation.

So the pressing issue is: how can the IMF apply sensible economic policies with moderation and insight and appropriate allowance for the institutional fragility of the recipient countries, rather than as doctrinaire rules?

How to Reform the IMF

Seven steps are required to reform global financial governance. The initial step is to applaud the move from the G7 to the G20. Such a move was decades overdue. I agree with Jose Antonio Ocampo that this role needs to be given to a more representative institution than any ‘G-club’, such as a body of the United Nations (Ocampo, 2011). But if this is not achievable, and it may well not be, then at the least the G20 could be made more representative by the inclusion of more regional representatives. The EU is currently the only regional member. The addition of regional representation of North Africa and the Middle East, Sub-Saharan African, South Asia, East Asia and Latin America would result in a G25 that directly or indirectly represents virtually all nations. While it will be extremely difficult to remove the seat of any current nation politically, logically Italy should lose its seat, Saudi Arabia’s seat should go to the regional grouping for North Africa and the Middle East, and Argentina’s seat to the regional grouping for Latin America. This would result in a G22, a grouping of manageable size (Bergsten 2004; Helleiner 2001).

The next step is to reform the governance of the IFIs. There have been tiny reforms in the past two years, but, essentially, most votes are in the hands of the US and the leading European countries. So the IMF and World Bank, whose clients are the world’s poorer countries, do the bidding of the richest countries. This is absurd.

The communiqués of the World Bank and IMF at Istanbul in October 2009 promised for the IMF ‘a shift in quota share to dynamic emerging market and developing countries of at least 5 per cent from over-represented countries’ (IMF 2009b). Likewise, the World Bank committed to increase by at least 3 per cent ‘voting power for developing and transition countries’ (World Bank 2009). The need for reform of the IMF voting rights has been widely recognized (Thimann 2009; Leech 2009).

Yet these tiny changes won’t shift the fundamental balance of power in the World Bank and the IMF. The European nations, in particular, are grossly overrepresented on the IFIs, as they are in the G20. Fully one quarter of the seats on the G20 go to Europe: those of Britain, France, Germany, Italy and the EU. Europe needs to provide real leadership on these issues.

In addition to reforming IMF governance, we need to return it to its original mandate. It is only on this issue, that I part company significantly from Professor Ocampo. He argues that we need to place the IMF at the centre of global macroeconomic policy coordination. Yet, as I see it, the IMF has become a fundamentalist organization and unless the Fund can be so fundamentally reformed that it sees the world through an entirely new lens, its policy prescriptions will routinely be flawed.

The skills required to turn around poorly performing economies are utterly different from those typically held by central bankers and PhD graduates in macroeconomics, the two most common backgrounds of IMF staffers. The IMF is the wrong organization to set economic policy for nations in crisis and it should be removed from this role. If an IFI is required to play this role, a new one, with the right skills set, attitudes and culture needs to be established. This change would limit the IMF to data collection, technical surveillance and advice giving roles.

Next we need to make three fundamental changes to the international financial architecture: (i) new financial mechanisms to mitigate risk, including international institutions lending in local currencies; (ii) a moratorium or partial cancellation of debt for a much wider range of countries than currently are eligible; and (iii) new mechanisms for handling sovereign debt restructuring, such as a sovereign bankruptcy regime (Stiglitz 2009).

There are strong reasons why all reschedulings of rich country to poor country loans should be in local currency, as should all lending by IFIs such as the IMF and World Bank (Buckley and Dirou 2006). Our current system places the currency risk on the party least able to bear it, the borrower. Lending in local currency puts the currency risk on those best able to bear it and hedge against it, the lenders.

Likewise there are strong arguments for debt relief, or at least a moratoria on interest repayments, for far more countries than currently qualify under the Highly Indebted Poor Country initiative and the Multilateral Debt Relief Initiative. A repayments moratorium would assist poorer nations hurt by the GFC far more than saddling them with yet more debt.

Likewise, as Professor Ocampo has stressed, there is a pressing need for an orderly, rules-based approach to sovereign insolvencies (Buckley 2009). The prospect of substantial losses in a debtor’s bankruptcy focuses a bank’s mind in making credit decisions. No national financial system is able to operate without this discipline. Its absence in the international system explains much of the over-lending we have seen across the world in the past 35 years. Why shouldn’t banks over-lend when they can expect borrowers to increase taxes, reduce services and re-borrow from the IMF so as to service the loans (Bolton and Jeanne 2007; Sachs 1995)?

Finally, we need a new global reserve currency, and I agree with all Professor Ocampo has written in this regard. Whenever one nation’s currency serves as the global reserve currency the extra liquidity required in order to meet the global liquidity needs inevitably puts downward pressure on the currency’s value and thereby makes it more volatile and less attractive as a reserve currency. In addition, financial markets don’t impose fiscal discipline on the reserve issuing country. Our system will remain unstable for as long as any one nation’s currency serves as the global reserve currency.

China is concerned about holding most of its reserves in dollars. Twice in 2009 the governor of China’s central bank called for a new reserve currency regime focused on special drawing rights (Bergsten 2009; Xiaochuan 2009). China is hard at work researching alternatives, such as denominating and settling its trade with Brazil in real and renminbis, not dollars (Wheatley 2009).

Today, when it comes to currencies, China and the US are in the same boat, and it has one inch of freeboard. There are better vessels available: vessels that are a mix of currencies, which offer far more stability and fewer problems for the Treasuries of the currencies in the basket. But to move from the current inadequate vessel to a better one requires cooperation. No one can afford to rock a boat with one inch of freeboard. China cannot – most of its foreign exchange reserves are in US dollars, and it serves to lose massively if it triggers a collapse in the value of the US dollar. The US cannot, for if China precipitately places its reserves in other currencies, and uses other currencies to price and pay for all its foreign trade, the demand for dollars will drop dramatically. So, for now, China keeps saying it wants out of this unstable boat and the US keeps replying, ‘No, please stay in here with us’. This is simply not a long-term answer.

Europe’s difficult challenge is to work towards only having the number of seats in the G20 and the number of votes in the IFIs that their size and population warrants.

America’s difficult challenge is to accept its currency can no longer serve as the global reserve currency and to cooperate with China, Japan and Europe in managing the orderly transition to a more stable regime.

The IFIs’ difficult challenge is to embed market principles in their approaches to crisis resolution. Whenever a crisis hits, the commercial banks will work hard to transfer the losses onto the common people of the debtor nations. The IFIs must be vigilant to prevent this happening. In crises markets must be allowed to allocate losses upon creditors, as well as debtors.

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^[1] CIFR King & Wood Mallesons Professor of International Finance and Regulation, and Scientia Professor of Law, University of New South Wales; Honorary Fellow, Asian Institute for International Finance Law, University of Hong Kong. Sincere thanks to the Australian Research Council for the Discovery Grant, which has helped support this research, and to Lara K. Hall for her invaluable research assistance. All responsibility is mine. This appeared in Macdonald, Marshall, and Pinto (eds), New Visions for Market Governance: Crisis and Renewal, (Oxford: Routledge, 2012) 43-51.