Monday, July 30, 2007

Question 3.4

2.4 Special Drawing Rights (SDR’s)
Often when you study the financing role of the IMF, you will come across the term ‘Special Drawing Rights’, or SDRs. The SDR and its origins are closely bound up with the debates that took place when the IMF was established. You saw in Unit 1 that the founders of the IMF considered one of the principal goals of the new institution to be to facilitate the expansion and balanced growth of international trade after the end of the Second World War. Of course, if the IMF were to contribute to this objective, it would need to ensure that there was The International Monetary Fund and Economic Policy 8 University of London sufficient liquidity, in the form of international reserve assets, available to the international financial system to underpin the expansion of trade.

Several proposals had been put forward to create the necessary international reserve assets. Lord Keynes, you will recall, had originally proposed that the IMF should issue its own currency, the Bancor. The US authorities, by contrast, had argued against the establishment of a new global currency, as they were keen to see the US dollar becoming the dominant international currency and were also concerned that the IMF, if it had unlimited authority to issue a new currency, could stimulate global inflation. With the US’s dominant influence, it was consequently decided at the Bretton Woods conference against granting the IMF the power to establish a new global currency.

The decade and a half after the IMF’s establishment consequently witnessed the strong emergence of the US dollar as the major preferred currency for the conduct of global trade. Over time, however, with the very significant growth in international trade which had taken place since the end of the war and with the increasing growth in capital flows across borders, it became clear that many countries, particularly industrial countries whose share in global trade was significant, had not been able to accumulate sufficient foreign exchange reserves to maintain stable exchange rates and stable external accounts as their economies grew. In addition, it became increasingly apparent that there were insufficient international reserve assets to provide the liquidity needed to foster a strong expansion in international trade.

To address the growing need for additional international reserve assets, the IMF
created the Special Drawing Right (SDR) in 1969. Because of the nature of the IMF’s membership, which included all of the world’s major trading countries, the SDR immediately became recognised as an international reserve asset, which could be held by an IMF member country as part of its international reserves. The IMF consequently allocated SDRs to its members in proportion to their IMF quotas to meet a long-term global need to supplement existing reserve assets. As a result, even to the present day, an IMF member may use SDRs to obtain foreign exchange reserves from other members and to make payments to the IMF. Such use does not constitute a loan; members are allocated SDRs unconditionally and may use them to meet a balance of payments financing need without undertaking economic policy measures or repayment obligations.
However, a member that makes net use of its allocated SDRs pays the SDR interest rate, while a member that acquires SDRs in excess of its allocation receives interest. A total of SDR 21.4 billion has been allocated to members, in two allocations, most recently in 1981.

With the SDR established, the IMF now had the ability to issue unlimited liquidity into the international financial system. However, as you will see below, the SDR would not constitute a new international currency, but would instead be comprised of a basket of existing currencies. In addition, tight rules would be established, to prevent SDRs being issued on a regular basis, so avoiding the inflationary threat which the unchecked issuance of SDRs by the IMF could pose to the international financial system. Aside from its role as an international reserve asset, the SDR has also come to serve a variety of important purposes. For example, the SDR now also serves as the unit of account for the IMF, and the SDR interest rate provides the basis for Unit 2 The IMF’s Approach to Stabilisation Centre for Financial and Management Studies 9 calculating the interest charges on regular IMF financing and the interest rate paid to members that are creditors to the IMF.
2.4.1 Special one-time allocation
In September 1997, the IMF Board of Governors proposed an amendment to the Articles of Agreement to allow a special one-time allocation of SDRs to correct for the fact that more than one-fifth of the IMF membership had never received an SDR allocation since they joined the IMF after the last allocation in 1981. The special allocation of SDRs would enable all members of the IMF to participate in the SDR system on an equitable basis and would double cumulative SDR allocations to SDR 42.87 billion.
SDR valuation
The value of the SDR is based on the value of a basket of currencies. The currency basket is reviewed every five years to ensure that the currencies included in it are representative of those used in international transactions, and that the weights assigned to the currencies reflect their relative importance in the world’s trading and financial system. The latest valuation review was completed in October 2000, and the IMF Executive Board decided on changes in the valuation basket, effective 1 January 2001, to take account of the introduction of the euro as the common currency for a number of IMF members, and reflect the growing role of international financial markets. The 2001 valuation basket includes the US dollar, the euro, Japanese yen and pound sterling, and its value is determined daily based on exchange rates quoted on major international currency markets.
SDR interest rate
The SDR interest rate is determined every week and is based on a weighted
average of representative interest rates on short-term instruments in the markets
of the currencies included in the SDR valuation basket.
SDR Currency Weights
The weights assigned for the currencies in the SDR basket are based on
• the value of the exports of goods and services of members or monetary
unions, and
• the amount of reserves denominated in the respective currencies that are
held by other members of the IMF.
The IMF has determined that the four currencies cited above meet both selection
criteria for inclusion in the SDR valuation basket for the period 2002–05. These
currencies have been assigned the weights listed in the table below, based on
their roles in international trade and finance
Table 2.2 Currency Weights in SDR Basket (per cent)
Currency**Revision of 1 Jan 2001**Revision of 1 Jan 1996
US dollar** 45 *******************39
Euro ****** 20
Deutschmark **********************21
French franc *********************11
Japanese yen15********************18
Pound Sterling11******************11


Wednesday, July 25, 2007

3.5 The Financial Sector Assessment Programme (FSAP)

Question 3.5

5.2.3 The Financial Sector Assessment Programme (FSAP)
The most comprehensive medium term response of the IMF to the financial crises that arose from 1997 was the development of the Financial Sector Assessment Programme, or FSAP. The FSAP consists of a detailed assessment and diagnosis of the state of health of a country’s financial system. It is an assessment conducted by a variety of agencies, including particularly the IMF and the World Bank. Importantly, however, it also uses the services of financial sector experts from the central banks and Finance Ministries of a wide range of countries.

The FSAP was introduced in May 1999, less than a year after the East Asian crisis had set in. It was established by the IMF and the World Bank to strengthen the monitoring of financial systems in the context of the IMF’s bilateral surveillance and the Bank’s financial sector development work. The overall purpose of the FSAP is to assist the countries for which this assessment exercise is conducted, to strengthen their resistance to crises and cross-border contagion, and to foster growth, by promoting financial system soundness and financial sector diversity.
The FSAP aims to alert national authorities to likely vulnerabilities in their financial sectors – whether originating from inside the country or from outside
sources – and to assist them in the design of measures to reduce these vulnerabilities. The emphasis of the FSAP is on prevention and mitigation rather than
crisis resolution. At the same time, it ascertains the financial sector's development
needs. Sectoral developments, risks, and vulnerabilities are analysed using a range of measures known as Financial Soundness Indicators. You will soon read a Report that describes the Financial Soundness Indicators for one country. Other structural underpinnings of financial stability, which include systemic liquidity arrangements, the institutional and legal framework for crisis management and loan recovery, transparency, accountability, and governance structures, are also examined as needed to ensure a comprehensive assessment of both stability and developmental needs. As part of the process, the FSAP provides assessments of observance of various internationally accepted financial sector standards set within the broader institutional and macro-prudential context. You will examine these standards and codes, in particular those relevant to financial system soundness, in the next section of the unit.

FSAP reports are designed to assess the stability of the financial system as a whole, and not that of individual institutions. Furthermore, FSAP reports represent the views of the assessment team, and not necessarily the views of the country’s own authorities or the Executive Boards of the Fund or Bank.
Implications for the work of the IMF and World Bank
The FSAP fosters consistent analysis and advice in the financial sector work of the Fund and Bank, optimises scarce expert resources, and reduces duplication of efforts by involving broader cooperation and drawing on experts from national and international agencies. It informs the IMF's surveillance process and the Bank’s other financial system activities. Both IMF-supported programmes and technical assistance build on FSAP findings.

The IMF’s focus in the FSAP is on the linkages between the soundness and operations of the financial sector and macroeconomic performance, and the support of policies that make financial systems more resilient to shocks or lessen the likelihood and severity of financial system crises. The World Bank’s focus in the FSAP is on strengthening the financial sector to promote economic development and reduce poverty. For industrialised countries, FSAP work is entirely the responsibility of the IMF, although the World Bank may provide experts in specific fields.
The process following FSAP preparation
Once the FSAP assessment has been made by the IMF and World Bank, working with a range of international experts, the IMF and the Bank staff then each prepare separate reports for their Executive Boards. The IMF staff prepare what is known as a Financial System Stability Assessment (FSSA), and the World Bank staff prepare a Financial Sector Assessment (FSA). Each of these reports focuses on the issues identified in the overall FSAP assessment as most directly relevant to the mandate of the institution. Once the Executive Boards of the two institutions have discussed the documents, technical assistance and other forms of support are then agreed upon and provided to countries where vulnerabilities and development needs have been identified.
By the end of August 2003, 101 countries had participated or were participating in the FSAP, and thirty-three of these countries have posted their associated Financial System Stability Assessments (FSSAs) on the IMF's website.


Tuesday, July 24, 2007

Q. 3.6 Mechanisms for Sovereign Debt Restructuring

IMF initiatives on sovereign debt restructuring
One of the key manifestations of a severe financial crisis is the occurrence of a
sovereign debt default. In such an instance, the country itself defaults on its debt
payments to international creditors, sparking an immediate cessation in the country’s ability to access any new external financial flows. The moment immediately following the declaration of sovereign default can be critical. If well managed, the occasion can be used to settle markets and to find quick agreement among international creditors that have been affected by the default, on the way in which the country will resume its access to capital markets and in so doing repay the creditors. If well managed, this process can also contribute to a situation in which the affected creditors decide not to pursue legal processes to reclaim the amounts due to them – in effect, staying or holding back legal action momentarily.

By contrast, if the moment following default is not well managed, this can lead to legal action by affected creditors, large-scale attempts by these and other creditors to take their money out of the country, a precipitous decline in confidence and in economic activity. This is the scenario which confronted most of the East Asian countries in 1997 and subsequently.

In the section above, on the IMF’s policy on lending into sovereign arrears, you studied the approach the IMF takes when lending to a country in arrears in its
payments to private creditors. The purpose of this lending is to enable the country to overcome short-term liquidity crises and to ensure a speedy resumption of private capital flows. An important element in this process is the need for the country to arrive at an arrangement with private creditors, which calms creditor concerns and arrives at a restructuring of sovereign debt in a manner that minimises capital outflows.

In the period since 1997, after modifying its policy to allow for lending into
sovereign arrears to private creditors, the IMF has also focused attention on the
issue of what would be required to achieve a sovereign debt restructuring in a manner least disruptive to capital flows, which protected creditor interests and which also ensured that countries have the time and space in which to come to an orderly restructuring arrangement with their private creditors.

The focus of the IMF’s work on sovereign debt restructuring has been to find ways to create a more orderly and transparent legal framework for such restructurings and to identify more clearly the considerations that should guide the availability of Fund financing during and after a restructuring. This issue has received international attention, with the tabling of an initial set of proposals by the First Deputy Managing Director, Anne Krueger.

One of the key challenges in restructuring sovereign debt once a country has defaulted to its private creditors, is the danger that individual creditors will
refuse to participate in a voluntary restructuring process, in the hope that these
individual creditors will recover payments due to them on the original contractual
terms of the loan. Where a significant number of creditors adopts such an approach, it becomes difficult for the country to negotiate with creditors collectively, and accordingly it becomes much more difficult to stem a rush by creditors to withdraw their loans.

One of the most significant challenges in sovereign debt restructuring has therefore become the challenge of finding mechanisms to convince creditors to act as a group and not to fragment their responses. For by acting as a group, an orderly debt workout can prevent the herd behaviour that causes creditors to individually rush to call in their loans, the worst-case scenario which creditors themselves fear. The IMF has promoted two such mechanisms in its contribution to finding ways to achieve orderly sovereign debt restructuring:
• the promotion of the process of including collective action clauses in
sovereign bond contracts
• the recommendation to establish a statutory framework to guide creditors
and debtors in all instances of sovereign debt restructuring, thereby
preventing individual creditors splitting from the broader creditor group
and precipitating a panic.
Collective action clauses are provisions in bond contracts that enable the sovereign
that issues the bond and a qualified majority of those who hold the bond to make decisions that become binding on all bondholders of that particular issuance. Perhaps the most important provision of these clauses is majority restructuring, which enables a qualified majority of bondholders to bind all bondholders within the same issuance to the terms of a restructuring agreement, either before or after default. In addition, majority enforcement enables a qualified majority of bondholders to prevent individual creditors from taking disruptive legal actions after a default takes place but before a restructuring agreement is reached.

Majority restructuring provisions currently exist in sovereign bonds governed by English, Japanese and Luxembourg law. But bonds governed by New York law, which currently represent the largest portion of the emerging market sovereign bond market, have traditionally not included majority-restructuring provisions. For this reason, the recent decision by a number of emerging market countries to include these provisions in bonds issued under New York law represents an important breakthrough.
Proposed Sovereign Debt Restructuring Mechanism
Besides encouraging CACs, the IMF has also followed a second, parallel, approach in seeking ways to ensure orderly debt workouts once a sovereign debt default occurs. This second approach has focused on a proposal by the IMF to institute a formal, legally binding, Sovereign Debt Restructuring Mechanism (SDRM). There are two key distinguishing features of this proposal. The first is that a statutory SDRM as proposed by the IMF would create a legally binding framework that provides for collective action for all instruments involved in a sovereign debt default, including those whose contracts stipulate that the financial terms can only be restructured through a unanimous decision of all creditors. The implication of the statutory SDRM is that because it would be legally binding, its force would over-ride contracts which explicitly recognised the ability of a single creditor to step outside a collective creditor arrangement.

The second important distinguishing feature of the statutory SDRM proposal is that it seeks a comprehensive solution, rather than an instrument-byinstrument, or bond-by-bond, solution to a sovereign debt default. For this reason, the SDRM proposes that the votes of similarly situated creditors who Unit 5 Stabilisation and the Financial Sector Centre for Financial and Management Studies 19
hold participating debt instruments will be aggregated, so that a single vote will
be able to be taken among all creditors, to restructure multiple debt instruments.
The statutory SDRM effectively contains three key provisions: firstly that a qualified majority of creditors across aggregated claims could vote to accept new terms under a restructuring agreement, thereby binding all affected creditors. Secondly, that the mechanism would include provisions to prevent enforcement actions by creditors from disrupting the negotiating process, or delaying agreement on a restructuring that could be acceptable to a broad majority of creditors.

The third key element of the statutory SDRM proposals is the proposal to create an independent dispute resolution forum, to verify claims, to ensure the integrity of the voting process and to adjudicate disputes that could arise once the SDRM has been activated.

The IMF’s proposal to establish a statutory SDRM is a relatively new proposal, which was first broached in 2002. However, both the legally binding element and the proposal to aggregate votes across different classes of debt instrument have opened the IMF to considerable criticism. Firstly, it is argued that the IMF is not a party to international bond contracts between sovereigns and their private creditors and should therefore not influence the nature of the provisions contained in these contracts. Secondly, critics argue that IMF financing, even when it is provided in the context of sovereign debt defaults, is comparatively small in relation to total financial requirements during the crisis period. Accordingly, the relative influence of the IMF’s approach should be diminished. Thirdly, creditors have objected to the concept that clauses which they negotiate with their debtors can be over-ridden by a seemingly supra-national entity.

Thus far, the proposal for a statutory SDRM has not been accepted by all IMF members, with three key issues requiring further consensus before an agreement is likely:
• arrangements for improving equity among creditors, as the current proposals significantly favour those who are likely to have a majority of voting power in any dispute
• the need to enhance transparency and disclosure, as some creditors fear
that their interests are likely to be over-ridden in any debt resolution, by
side-deals in which they are not present
• concern regarding the principle of aggregation of votes, as well as the
process through which aggregation takes place.


Monday, July 23, 2007

Q3.7| International Standards and Codes

Question 3.7

5.3 Developing International Standards and Codes
Prior to the East Asian crisis, there had been no systematic effort by international
agencies such as the IMF and the World Bank, or the other international financial agencies with responsibilities for monitoring the global financial sector, to establish standards and codes of good practice in regard to the financial
sector. The East Asian crisis highlighted the fact that there was no standard
set of benchmarks against which different countries’ financial sectors could be
assessed. In the absence of these benchmarks, it was argued, it would be difficult
either to give useful advice to countries, or to help prevent crises arising from the financial sector. For each country’s financial sector differed considerably, in its institutional structure, its degree of interconnectedness with global financial markets and in the calibre of policies applied by the financial authorities
and by financial institutions themselves, in regulating, supervising and managing the sector and its institutions.

Following the East Asian crisis, a large volume of work was conducted to create
standards and codes by which all countries might be benchmarked. The main
organisations involved were the IMF, the World Bank and other international
agencies such as the Bank for International Settlements, a long established central bankers’ organisation located in Basel. As this process has evolved, the IMF and the World Bank have come to assess whether countries are observing internationally recognised standards and codes in twelve separate areas. Following these assessments, the IMF and the World Bank also offer technical assistance to implement necessary reforms.

5.3.1 The Standards and Codes Framework
Since 1997, standards and codes have developed to advance:
• (1) transparency
• (2) the financial sector as a whole
• (3) market integrity.
Within those groups, the IMF and the World Bank (in cooperation with other standard setting authorities) have focused their work on twelve specific areas:
• data quality
• monetary and financial policy transparency
• fiscal transparency
• Transparency standards
Why transparency? It is a basic principle of financial economics that markets work best if full information is widely available. That is especially important for information about government economic policy and macroeconomic information
about the economy as a whole. The 1997 financial crises in Asia gave a wake-up call to bodies such as the IMF, for its staff discovered that, even for an industrialised country as advanced as South Korea, accurate data on such key variables as foreign exchange reserves had not been readily available.

Following that wake-up call, internationally recognised standards and codes covering government policy-making and operations were among the first to be developed. The IMF played a key role as standard setter in this area and three important sets of codes and standards on transparency have been developed.

Firstly, to improve the quality and timeliness of data, the IMF has been encouraging
its members to subscribe to the Special Data Dissemination Standard (SDDS) or participate in the General Data Dissemination System (GDDS). The SDDS is designed to guide countries that have, or are seeking, access to international capital markets. In subscribing to the SDDS, countries commit themselves to publish data according to a standard format, and to explain their data disseminationpractices. The GDDS is open for all member countries and covers socio-demographic, macro-economic and financial data. In agreeing to participatein the GDDS, countries commit themselves to publish their statistical practices, as well as plans for improving them. The GDDS is typically used by developing countries that do not have access to international capital markets.

Second, through a collaborative effort with its member countries, the IMF published a Code of Good Practices in Fiscal Transparency. The code outlines a series of standards for the collection and dissemination of fiscal data and information. The ultimate objective of the code is to encourage a well-informed public debate about the design and results of fiscal policy, thereby making governments more accountable.

Third, the IMF has also – and again with cooperation from its various member
countries – developed and published a Code of Good Practices on Transparency
in Monetary and Financial Policies. This code identifies desirable data transparency
practices for central banks and other financial agencies. One driving force
for promoting transparency in relation to monetary policy is the belief, supported
by macroeconomic theory, that a central bank’s efforts to control
inflation and achieve other objectives of macroeconomic stabilisation policy can
be most successful if the central bank can influence people’s expectations about
inflation and interest rates. Transparency can contribute to that, although in
major financial centres central bankers have reason to include some ambiguity
in their overall assessment of the economy and pronouncements about future

2. Financial sector standards
International financial sector standards have been established to assist both
national authorities and the international financial agencies, to prevent financial
crises from emerging. Unlike the GDDS, SDDS and the Codes of Good Practice in Fiscal Policy and in Transparency in Monetary and Financial Policies, the IMF and the World Bank are not the standard-setters themselves, in regard to many of these financial sector standards. Instead, the IMF and the World Bank cooperate with other agencies, including the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions, the International Association of Insurance Supervisors, and the Committee on Payment and Settlement Systems, all of which have established standards in their respective spheres of authority.

In one partial respect, however, the IMF and the World Bank have positioned themselves as partial standard-setters in regard to financial sector standards.
This occurred in late 2002, when the IMF and the World Bank added recommendations
developed by the Financial Action Task Force to combat money laundering and the financing of terrorism to the list of areas they assessed.

3. Market integrity standards
Progress has also been made on standards covering corporate governance, insolvency, accounting and auditing. Although the IMF is involved, the World Bank takes the lead in this area, in cooperation with the Organisation for Economic Cooperation and Development (OECD), the International Accounting Standards Board and the International Federation of Accountants. The development of efficient legal systems for dealing with bankruptcy of firms, banks and other borrowers is seen as an important foundation for financial market integrity. The World Bank has developed Principles and Guidelines for Insolvency and Creditor Rights Regimes and actively promotes the development of sound bankruptcy systems. How does it contribute to the strength of the financial sector? Here is how the World Bank team summarised the case in their June 2004 Report on Observance of Standards and Codes (ROSC) for Chile:
Predictable mechanisms for debt enforcement and insolvency proceedings contribute to the development of a modern market economy. Such predictability also fosters confidence that fuels investment, credit, lending and commerce and contributes to a constructive credit-delivery competition. An effective insolvency and creditor rights system plays an important role in creating and
maintaining the confidence of both domestic and foreign investors. The general public perception as to the predictability and effectiveness of said insolvency and creditor rights systems not only contributes to the capital flows to Chile but also to the cost decrease of credits. World Bank (2004:3)

5.3.2 Assessing compliance with standards and codes
A country’s observance of internationally recognised standards and codes is examined by IMF and World Bank staff and summarised in what are known as Reports on the Observance of Standards and Codes (ROSCs). ROSCs covering the financial sector and monetary and financial policy transparency are usually prepared within the framework of the Financial Sector Assessment Program (FSAP), which you studied in the previous section.

The assessments are not designed to rank countries, or to seek to embarrass them. Instead, the assessments try to reflect the country’s particular circumstances,
including its stage of development and institutional capacity. Accordingly, no ratings or pass-fail grades are issued. Those practices are not simply due to diplomatic tact and the IMF and World Bank’s principle of seeking to achieve agreement and partnership with member countries’ governments. The avoidance of criticism or ratings is also prompted by knowledge of the damage that a clear ‘fail’ rating could do to a country’s ability to borrow and to the stability of a financial system that, by definition, is already fragile. By the end of March 2003, almost half of the IMF’s 184 member countries had completed one or more ROSC modules.

Countries themselves are responsible for implementing the recommendations contained in a ROSC or FSAP. Many developing countries, however, request technical assistance from the IMF and other international bodies in doing so. Finally, in order to keep ROSCs current, IMF and World Bank staff provide follow-up assessments. These range from brief factual updates to more detailed re-appraisals, where warranted.


Sunday, July 22, 2007

Q. 3.8: The Enhanced Heavily Indebted Poor Country (HIPC)

7.4 The Enhanced Heavily Indebted Poor Country (HIPC)
Debt Initiative

Closely linked to the PRGF and the PRSP process is the Enhanced Heavily
Indebted Poor Countries (HIPC) Initiative, which was prompted by the belief of
several governments and by strong arguments by non-governmental organisa-
tions that poverty in low income countries could not be addressed only by
concessional loans and domestic policies with poverty reduction. Instead, it was
argued, that an external constraint – high inherited levels of foreign debt –
crippled individual countries’ capacity to overcome poverty. Surely, it was
argued, a country that pays more each month in interest and debt payments to
foreign creditors than the money it pays for running schools or hospitals has
spending priorities that are not conducive to poverty reduction or to growth. To
put it another way, it is often asked why a government should cut its budget
expenditure to support a surplus on the current account of the balance of
payments (as in old stabilisation programmes) when the former involves a cut
in funds for schools, medicine and social programmes and the latter is used to
finance the servicing of old debt.
The priority given to paying creditors was enforced by the creditors themselves
and by the discipline required for a country’s credibility in international capital
markets. Proposals to ‘forgive’ or ‘cancel’ debt through HIPC or other mechanisms
were opposed by many creditor countries. One ground for opposition
was the argument that ‘cancelling’ debt would not necessarily lead to the debtor
country putting more resources into poverty reduction or economic growth
strategies. Nevertheless, the IMF and the World Bank launched the original
HIPC initiative in 1996 as the first comprehensive effort to eliminate unsustainable
debt in the world’s poorest, most heavily indebted countries. It was a
complex programme involving long application and approval processes, and it
included measures justified as an attempt to ensure that reduction of debt led to
In October 1999, the international community agreed to make the initiative
broader, deeper and faster by increasing the number of eligible countries,
raising the amount of debt relief each eligible country would receive, and
speeding up its delivery. This agreement occurred at a summit meeting of the
heads of state of the G-7 industrial countries in Cologne, Germany. The Cologne
summit agreed to improve the debt relief package in place since 1996 and to
initiate a new framework, which came to be known as the Enhanced HIPC
The enhanced HIPC initiative does not set out to completely forgive all indebtedness
of low-income countries. Instead, it focuses on achieving a level of
indebtedness in each country that is the beneficiary of the initiative, which will
enable that country to continue to service its indebtedness in a sustainable
To achieve this objective, the initiative examines, for each country, the actual
level of indebtedness as well as its debt-servicing burden. And it matches these
actual circumstances with a theoretical level of indebtedness and debt servicing
that could be considered to be sustainable. This theoretical level is held constant
for all countries, so that once debt relief has been provided, they will be able to
have reached a comparable level of sustainable indebtedness.
The theoretical sustainable levels are predetermined and are based on the levels
the large industrial countries, to whom the debt is owed, consider to be reasonable.
For this reason, the Cologne summit decided that the initiative would
provide sufficient debt relief to each eligible country to enable it to reduce the
net present value of its debt to a maximum of 150 percent of its exports or 250
percent of its government revenue. The G-7 summit also decided that the
assistance would be provided in addition to debt-relief mechanisms that had
prevailed up until the summit meeting.
7.4.1 Two stages in the HIPC process
Eligible countries qualify for debt relief in two stages. In the first stage, the
debtor country needs to demonstrate the capacity to use prudently the assistance
granted by establishing a satisfactory track record, normally of three
years, under programmes supported by the IMF and the International Development
Association (IDA). As you have seen, this means that the country must
have embarked on a PRGF arrangement with the IMF. And in turn, this also
means that the country must have completed at least an interim-PRSP. In the
first stage, a detailed assessment is also made, to determine the debt relief needs
of the country. If a country’s external debt ratio is found to be above the predetermined
threshold for the value of debt to exports (or in some instances above
the predetermined level of the value of debt to fiscal revenues), that country is
considered eligible to qualify for debt relief assistance.
The second stage occurs when it is formally decided to begin providing a
country with debt relief. This moment is known as the ‘Decision Point’. The
Decision Point occurs when the IMF and the World Bank Executive Boards
agree that the country has qualified for debt relief. After reaching the Decision
Point under the initiative, the country must then implement a full-fledged
poverty reduction strategy, which has been prepared with the broad participation
of civil society and an agreed set of measures aimed at enhancing economic
growth and contained in the PRGF financing arrangement. The Decision Point
also marks the point at which the international community commits to provide
assistance by a particular future date in an amount that would enable the
country to achieve debt sustainability.
During this stage, the IMF and the IDA grant interim relief, provided that the
country stays on track with its IMF- and IDA-supported programmes. In
addition, countries that have made loans bilaterally (mainly Paris Club creditors,
countries that participate in ‘Paris Club’ negotiations with indebted poor
countries) are expected to grant debt relief on highly concessional terms. The
end of the second stage is marked by a further decision, that the country has
completed the requirements to receive debt relief. This moment is known as the
‘Completion Point’. The Completion Point is again marked by successful Board
decisions by the IMF and the World Bank Executive Boards. Once the Completion
Point has been reached, the IMF and the World Bank’s IDA provide the
remainder of the committed debt relief, while Paris Club creditors enter into a
highly concessional stock-of-debt operation with the country involved. Other
multilateral and bilateral creditors need to contribute to the debt relief on
comparable terms.
When the HIPC initiative was originally launched, countries were obliged to
wait for a further three years after the Decision Point before the Completion
Point could be reached. This delayed the receipt of debt relief for recipient
countries, including those that had achieved all of the requirements set out by
the IMF. To speed up the delivery of debt relief, the concept of ‘floating Completion
Points’ was introduced when the Enhanced Initiative was launched in
1999. Consequently, debt relief can now be delivered more quickly by introducing
‘floating’ completion points not linked to a rigid timeframe, but rather
determined by progress toward implementing measures that will reduce
poverty in a sustainable manner. The actual time period between a country’s
decision and completion points has become flexible and now depends on how
quickly the country can formulate and implement its own poverty reduction
strategy, sustain macroeconomic stability and put in place mechanisms to
safeguard and track the use of funds freed by debt relief. Several countries have
subsequently benefited by receiving earlier debt relief.
7.4.2 Qualifying thresholds for debt relief
The sustainability targets under the original HIPC framework were set in the
light of empirical research that had examined largely middle-income countries,
and many non-governmental organisations felt that low-income countries had
less capacity to sustain external debt. Thus, in 1999, the World Bank and the IMF
carried out a review of the HIPC Initiative in broad consultation with such civil
society organisations and public officials. As a result of this review, the international
community agreed to enhance the Initiative and committed itself to
providing faster, broader, and deeper debt relief. Under the enhanced HIPC the
qualifying thresholds have been lowered, and more countries became eligible
for debt relief and some previously eligible countries, such as Mozambique and
Uganda, were able to seek greater relief.
Countries have been able to qualify through one of two routes – either by
demonstrating an unsustainable debt-to-export level, or under the ‘fiscal
window’ by demonstrating an unsustainable debt-to-government revenue level.
The ability to qualify under either approach was taken after the Cologne Summit,
in recognition of the fact that some low-income countries confronted low
levels of exports, while others manifested very low levels of government
revenue; and that both challenges directly influenced the ability of these countries
to achieve levels of indebtedness sustainable in the medium and longer
term. Accordingly, after the Cologne Summit, the debt-to-exports target was
lowered to 150 percent, from 200–250 percent under the original HIPC initiative,
and the debt-to-fiscal revenue target was set at 250 percent (down from 280
percent under the original initiative) for countries qualifying under the fiscal
7.4.3 Debt relief to date
The Enhanced HIPC Initiative represented a substantial improvement over the
original debt relief programme established in 1996. In terms of the enhanced
initiative, approximately 37 countries, most of which are sub-Saharan African
countries, are expected to qualify for assistance aggregating approximately
US$51.1 billion in net present value terms.
By September 2003, debt-relief packages had been approved, at least up to the
Decision Point, for 27 countries under the enhanced HIPC Initiative framework.
The agreements together with other debt relief sources have resulted in a
reduction in the total external debt stock of these countries by approximately
two-thirds, with the total external debt stock of these countries being reduced
from $54 billion to approximately $20 billion in net present value terms. The
corresponding savings in total future debt service payments (in nominal terms)
is estimated at US$53 billion.
The IMF’s most recent estimates are that the average annual debt service due for
these countries is expected to be about 24 percent lower during the period
2001–2006, compared to the level in 1998–99. In addition, debt service as a
percentage of exports has declined from 16.9 percent in 1998, to an estimated 9.8
percent in 2003. As a share of government revenue, debt service is expected to
decline from over 25 percent in 1998 to below 15 percent after 2003.
7.4.4 Ongoing challenges with the HIPC Initiative
Notwithstanding progress, there are many significant challenges with the
Enhanced HIPC Initiative. These include those described here:
• post-Completion-Point sustainability
• pace of debt relief
• fiscal dimension of unsustainable debt
• insufficient attention to human development goals
• diversion of aid resources
• HIPC debt to non-Paris Club members
• HIPC-to-HIPC debt.
Post-completion-Point sustainability
Even countries that have achieved the Completion Point are experiencing
significant difficulties in remaining in a situation of sustainable indebtedness.
The terms of trade have shifted against these countries, usually due to external
factors beyond the control of member authorities; and this has rendered their
debt sustainability ratios clearly unsustainable. For these members, the current
HIPC framework provides no remedies, because there is no provision for
additional relief after the completion point.
Pace of debt relief
The pace of debt relief has been slow. The HIPC initiative was launched in 1996
and there remain many countries that have not received any relief at all. Many
developing countries consider that the reason for the slow pace of relief has
been the design of the HIPC initiative, in particular the two-stage qualifying
process and the arduous requirements which countries must achieve before
receiving debt relief.
Fiscal dimension of unsustainable debt
It is frequently argued that the HIPC debt sustainability ratios do not adequately
consider the fiscal capacity of governments, and for this reason place
unsustainable fiscal burdens on member countries emerging from the HIPC
initiative. Accordingly, the fiscal threshold of 250 percent is considered to result
in countries achieving debt relief yet still remaining in a situation of unsustainable
Insufficient attention to human development goals
Similarly, it is argued that the HIPC framework, which focuses on macroeconomic
variables to determine debt sustainability, does not take adequate
account of the objectives of human development – in particular the financing
needs necessary to achieve certain basic levels of social development and
human and institutional capacity, all of which are necessary to ensure a sustainable
exit from unsustainable levels of debt.
Diversion of aid resources
A further emerging difficulty with the HIPC framework is that net aid resources
to developing countries have not increased despite the initiative. As a consequence,
it is argued that there has been, at best, a diversion of aid resources,
rather than a necessary increase in the overall quantum of financial resources to
developing countries.
HIPC debt to non-Paris Club members
An emerging challenge to the HIPC initiative has been the recent expansion in
litigation by creditors who are not part of the Paris Club arrangement, against
HIPC governments. These creditors refuse to be bound by the terms of the HIPC
and are increasingly securing judgment against HIPC countries. This process
subverts the overall intention of the HIPC framework. Note that the challenge is
similar to the challenge of trying to coordinate creditor action in the case of the
large emerging markets, which was examined in Unit 6. For if some creditors
achieve a better outcome than others, in securing a higher proportion of repayment
than the average for the remaining creditor group, the incentive to achieve
a collective agreement between the broadest spectrum of creditors and the
debtor country is weakened.
HIPC-to-HIPC debt
A further challenge to the Enhanced HIPC Initiative is the presence of a situation
in which both debtor and creditor are HIPC countries. An example is the
case of Burundi, which is a creditor to Uganda. Both HIPC members can be
argued to have an important basis to claim, at least in terms of principles of
economic development, with Burundi claiming that it is entitled to be repaid the
loans it originally made to Uganda, and Uganda claiming that as a Heavily
Indebted Poor Country, it is entitled to secure debt relief from Burundi.
In fact, both countries have limited financial capacity and neither should be
placed in a position where they find themselves litigating against each other.
The large industrial country creditors have recognised this challenge, but thus
far no systematic resolution of the problem has been found. Consequently,
developing countries have argued that the HIPC framework, which did not
foresee this challenge, ought to be revised to provide a remedy for this type of


Q. 3.9: The Poverty Reduction Strategy Paper (PRSP)

7.3 The Poverty Reduction Strategy Paper (PRSP)
It has been noted that the PRGF arose as a result of dissatisfaction with the
ESAF facility. Indeed, one of the most important lessons of the ESAF external
review, which itself led to the establishment of the PRGF, was the fact that ESAF
programmes had been designed in the absence of detailed input from the
country authorities themselves. As a consequence, it was argued, programmes
were unlikely to succeed, as they were not founded on a proper assessment of
the scale and nature of poverty in the recipient countries, nor were they based
on an accurate assessment of the macroeconomic, institutional and other
challenges in those countries and neither were they likely to secure the policy
commitment needed to succeed, because the countries did not feel a sense of
ownership of the ESAF programmes.
Accordingly, when the PRGF was launched, it was accompanied by a new
institutional device, known as the Poverty Reduction Strategy Paper (PRSP)
process. The PRSP represented a joint initiative between the IMF and the World
Bank and was intended to overcome the institutional flaws that had resulted in
poor outcomes from both the IMF’s ESAF arrangement and from the World
Bank’s experience of lending to low-income countries through its International
Development Association (IDA) facility.
The PRSP initiative envisaged that governments themselves would prepare
their own strategies for reducing poverty, and that these strategies would be
linked to manageable macroeconomic objectives and targets consistent with the
objectives being set by governments themselves. For this reason, it is the governments
concerned that prepare the PRSPs.
7.3.1 Linkage of PRSP to PRGF
When the IMF launched the PRGF and the PRSP, it linked the PRSP process
with the PRGF, by making it a condition that whenever a member applies for a
PRGF financial arrangement it will have already produced a PRSP. In the initial
stages, because of the very significant institutional resources needed to produce
a comprehensive and fully costed national poverty reduction strategy, the IMF
indicated that it would consider an ‘Interim PRSP’ as a satisfactory initial step
for access to the PRGF. However, from 2001, it has increasingly became necessary
for countries to prepare fully developed strategies for reducing poverty.
To promote the concept of broad domestic ownership of the poverty reduction
strategy, the IMF strongly urges that the PRSP process be based on a process
involving the active participation of civil society, NGOs, donors and international
institutions. While the country authorities develop the strategy, the IMF
and other donors expect that countries will keep civil society informed about
The International Monetary Fund and Economic Policy
10 University of London
developments in the programme, and will ensure that they are involved in
monitoring its implementation. That means involving a range of social and
economic bodies including employers’ associations, trades unions, chambers of
commerce, charities, rural associations, women’s groups and, ideally, publicising
the programme through the media.
One of the most important ingredients in the PRSP approach is its insistence on
measuring the budgetary costs of the country’s proposed poverty reduction
strategy. The budgetary tools used to achieve this assessment have become
increasingly complex, resulting in countries being able to assess not only the
short-term, but also the medium- and longer-term costs of trying to achieving
their selected poverty reduction objectives. This has been a helpful device for
the countries themselves, as it has forced to the attention of national authorities
the likelihood that poverty reduction strategies will be constrained by the
availability of financial resources; and in turn this has tended to promote
stronger recognition of the need to prioritise among various objectives. At the
same time, the process has also helped the IMF to better recognise the immensity
of the fiscal challenge that low-income countries confront in trying to
achieve poverty reduction and ensure macroeconomic stability.
Between its start in 1999 and 2004, over 30 countries have completed full PRSPs.
Both the PRSP and the PRGF initiatives have been subject to regular reviews by
the IMF. The most recent and extensive review of the PRSP took place in mid-
2003, and the findings were published in September 2003.
Your next reading, by James Levinsohn, traces the history and background to
the PRSP process, and provides a critical insight into the approach taken in the
first few years of the PRSP, following its launch in 1999.
􀀁 Reading
Please turn now to the second reading, ‘The Poverty Reduction Strategy Approach: Good
Marketing or Good Policy?’ In this chapter, which considers the experience countries have had
with this new approach since 1999, Levinsohn asks whether the very significant administrative
costs countries have borne in order to prepare these elaborate and detailed poverty reduction
strategies has been matched by equally significant benefits.
􀀃 Levinsohn’s chapter is critical of the early experience with the PRSP. As you read his chapter,
I would like you to make notes on the following issues:
􀀄 What are the five key principles on which PRSPs are expected to be based?
􀀄 Levinsohn outlines four elements of a PRSP which in his view should be present in all PRSPs.
What are these four elements ?
􀀄 Finally, based on the 2001 review of the PRSP process conducted by the IMF, to what extent
do you think that these four components of a sound PRSP have been present in the early
country examples?


Friday, July 20, 2007

Q 4: Types of Conditionality

Outline the types of conditionality found in IMF programmes. With reference to country examples, explain why it is important for countries to fulfill programme conditionalities; and outline how IMF conditionality has evolved in recent years.
1.10 Types of IMF Conditionality
We have seen that the IMF adopts a particular approach to stabilisation policy.
But how is this approach actually applied? In practice, the IMF applies its
approach to stabilisation policy by attaching conditions to the use of its financing
facilities. Consequently, member countries that apply for and accept IMF
financing are obliged to fulfil these conditions. This approach is known as the
IMF’s ‘conditionality’ policy. In this section, you will consider two sets of issues
pertaining to conditionality. Firstly, in which specific ways does the IMF apply
its conditionality policy? And secondly, how stringently is conditionality
1.10.1 Instruments of IMF conditionality
Conditionality is applied in four key ways in Fund-supported financing programmes:
• Performance Criteria (PCs)
• Programme Reviews
• Prior Actions (PAs)
• Structural Benchmarks (SBs).
1. Performance Criteria
The most basic monitoring tool comprises Performance Criteria (PCs). PCs are
conditions that are formally specified in the country’s financing arrangement
with the IMF. These are set when the arrangement commences. At that time, the
country receives a first tranche, or disbursement of financial resources, with the
remaining disbursements made conditional on the fulfilment of a variety of
conditions, including PCs.
PCs are the strongest form of conditionality, and they must be observed if the
country is to be allowed to obtain the next tranche of financing. Where PCs are
not achieved as stipulated in the relevant IMF arrangement, this constitutes a
serious breach of the arrangement. In many cases, the programme can be
suspended, unless the IMF Executive Board grants the country a waiver of the
relevant performance criterion. Applications for waivers are considered during
the periodic Executive Board reviews of the country’s financing arrangement.
Waivers can be granted by the Executive Board in instances where the nonobservance
of the conditionality is minor or temporary; or where the member is
shown to have been prepared to take corrective action.
Performance criteria feature in IMF arrangements in two types. Firstly, quantitative
performance criteria: examples include
• setting a floor or minimum level of net international reserves
• limiting the size of a member’s budget deficit, usually by setting a ceiling
or maximum on the level of net domestic credit extension to the
government by the banking sector
• setting a maximum level of non-concessional external borrowing
permissible in terms of the financing arrangement.
The second feature includes structural performance criteria, such new banking
legislation, or the establishment of a new bankruptcy law.
The International Monetary Fund and Economic Policy
30 University of London
PCs are specified on actions or measures that can be monitored by staff and are
subject to the control of the authorities. These criteria are derived directly from
the financial programming model that the IMF uses to derive quantitative
assessments of the various measures in the financial programme. In Unit 2, you
will see more clearly which types of PCs are most often used in IMF financial
programmes, and why these PCs are important to the IMF’s approach to
2. Programme Reviews
A second major tool of conditionality is the Programme Review. These represent
the formal condition that all financial programmes with the IMF must be
reviewed at set intervals. After the initial financial disbursement is made,
subsequent tranches are conditional on the successful completion of a Programme
Review and endorsement by the Executive Board.
In 1979, the IMF Executive Board developed guidelines for the staff members of
the IMF. These guidelines were intended to assist IMF staff during their missions
to member countries, by illustrating in what circumstances certain types of
conditionalities would be appropriate. The 1979 Conditionality Guidelines
envisaged that the Programme Reviews would be used for the purpose of
setting PCs in cases where it was impossible to set them sufficiently far ahead at
the outset of the programme, and in cases where an essential feature of a
programme could not be formulated as a PC at the beginning of a programme
year because of substantial uncertainty regarding major economic trends.
The main advantage of the Programme Review is that it provides an opportunity
to update the information on which both the IMF and the country rely,
when assessing the progress of the programme. Programme Reviews enable
both the IMF and the member country to modify a programme as it progresses.
Programme Reviews are also used to establish conditions for future drawings,
and to assess progress toward structural policy objectives that may take time to
come to fruition. For that reason, they have become more prevalent with the
growing structural content of Fund-supported programmes.
3. Prior Actions
Prior Actions (PAs) are additional tools of IMF conditionality that affect the
country’s access to the Fund’s resources. PAs are steps that the authorities agree
to take before a Board decision on the use of Fund’s resources. The use of PAs
has expanded considerably in recent years. In some cases, they are viewed as a
way of signalling the authorities’ commitment to the programme. In general,
PAs are negotiated between the authorities and the staff but they are not
specified in advance and only affect the Board decision on the programme after
they have been implemented.
PAs generally comprise structural measures, which tend to be relied on where
the member country’s past track record is poor. PAs were previously not
considered a formal conditionality, but have recently become a much more
integral part of formal IMF conditionality.
4. Structural Benchmarks
A further major method of applying IMF conditionality is through Structural
Benchmarks (SBs). Structural benchmarks have become increasingly prevalent
since their introduction in the context of IMF structural adjustment programmes
in the 1980s. They have also subsequently been adopted in the more recent IMF
programmes in low-income countries. These programmes are known as Poverty
Reduction and Growth Facility (PRGF) arrangements.
Because the key structural reforms take considerable time to implement, SBs
map out a series of steps towards a desired policy outcome, such as central bank
independence or a broader tax base. Measures that start out as structural
benchmarks, or merely measures listed in a matrix, may become performance
criteria or prior actions for subsequent reviews; other measures may be downgraded
or dropped from the programme. Such shifts often reflect the changing
economic situation as well as the experience with programme implementation,
which may alter the priority attached by the IMF to different measures.
5. Indicative Targets
Indicative targets are utilised where a PC would normally be used, but cannot
be established, due to uncertainty about economic trends.
1.10.2 The importance of fulfilling IMF conditionality
If these are the major tools through which IMF conditionality is applied, how
stringently are these conditions applied? In practice, the IMF attaches very
significant weight to the application of its conditions. For each of the various
types of financing arrangement, the IMF provides its financial support in
tranches. Disbursements of each tranche hinge upon the fulfilment of the
conditions that were set at the point of disbursement of the previous tranche.
When conditions are judged not to have been met, the Executive Board is
informed by the IMF staff.
The Executive Board is empowered to take one of two broad sets of decisions.
Either it can refuse to complete the programme review, pending the completion
of the specified conditions; or it can grant one or more waivers of conditions
that have not been fulfilled. In practice, in each programme there are a host of
conditions. And it is often the case that one or more conditions may not have
been completely fulfilled at the time of a programme review. In the bulk of
cases, the IMF Executive Board grants waivers, the review is completed and the
overall financial arrangement moves to the next stage – the disbursement of a
further tranche and the imposition of a further set of conditions.
In some cases, however, where there have been fundamental breaches of
conditions, or substantial non-achievement of conditions, the Executive Board
decides not to proceed with the review. In such instances, financing programmes
are stalled. In IMF language, these programmes ‘go off-track’.
Sometimes, corrective action by the country authorities results in the programme
coming back on track and proceeding. In some cases, however,
programmes remain off-track for long periods of time. Often in these cases, it is
decided to abandon the original programme and, when appropriate, to commence
a new programme.
For countries seeking to stabilise their economies, this can represent a very
difficult set of circumstances. For once the IMF indicates that its programme
with a member country has gone off-track, other multilateral and bilateral
creditors, including private-sector creditors, invariably also decide to cease new
lending and in some instances call for early repayment of their loans to the
country. You will see later in this course, in Units 4 and 5, that these decisions
can in turn precipitate a serious outflow of capital, causing further adverse
consequences for the economy. For these reasons, IMF member countries that
have taken IMF financing facilities typically ensure that they are fully compliant
with the conditionalities they accepted at the start of an IMF programme.
1.11 The Evolution of IMF Conditionality
The IMF’s policy on conditionality has evolved substantially over the history of
the institution. Some element of policy conditionality has been attached to Fund
financing since the mid-1950s, but the scope of conditionality expanded considerably,
particularly from the early 1980s. In the process, tensions arose between
the desire to cover aspects of policy central to programme objectives and the
importance of minimising intrusion into national decision-making processes.
The expansion in IMF conditionality from the early 1980s is ironic. For in 1979,
the IMF established Guidelines on conditionality, which it issued to its staff. The
purpose of the guidelines was to ensure that IMF staff who negotiated programmes
with IMF member countries understood the parameters within which
the IMF would impose conditions as part of its lending programmes. The 1979
conditionality guidelines underscored the principle that conditionalities should
be limited rather than comprehensive, and that the number and scope of
performance criteria needed to be limited to the minimum needed to evaluate
policy implementation. The Guidelines also stressed that the IMF’s staff should
pay due regard to the country's social and political objectives, economic priorities
and circumstances when deciding what conditions should be imposed.
Notwithstanding the 1979 Guidelines, the period since the approval of the
Guidelines saw a major expansion of conditionality, particularly in the structural
area. While structural measures were rarely an element in Fund-supported
programmes until the 1980s, by the 1990s almost all programmes included some
element of structural conditionality. The expansion of structural conditionality
was also reflected in increasing numbers of performance criteria, structural
benchmarks, and prior actions.
The increasing structural content of Fund-supported programmes and the
changing approach to programme monitoring prompted wide-ranging concerns
that the Fund was overstepping its mandate and core area of expertise. Moreover,
the expansion of conditionality raised issues regarding its effectiveness.
Developing countries asserted that if conditionality were made too comprehensive,
it might undermine the assurances which had been given by the IMF to its
member countries, that these countries could purchase resources from the Fund,
since it would increase the chance of failing to meet all conditions even when
the policies that were critical to programme objectives were actually on track. A
proliferation of conditions also had the potential to blur the Fund’s focus on
what was essential to ensuring that the programme fulfilled its purposes.
Concerns were also raised about whether recent Fund-supported programmes
had taken adequate account of the authorities’ ability to muster political support
for a multitude of policy changes at one time, as well as their capacity to implement
these reforms. Increasingly, the authorities in countries which had entered
Unit I Macroeconomic Stabilisation and the Role of the International Monetary Fund
Centre for Financial and Management Studies 33
into IMF-supported financing arrangements argued that conditionalities had
become too detailed and too intrusive, and had begun to short-circuit national
decision making processes, so undermining the authorities’ ability to muster
public support for policy implementation and thereby debilitating national
ownership of the reform process.
For all these reasons, in particular as a result of growing evidence of the failure
of a number of IMF-supported programmes in achieving their initial objectives,
the IMF embarked on a significant review of its conditionality policy, commencing
in 2000. The review was completed about two years later.
The 2000–2002 Review of IMF Conditionality concluded that the IMF would
need to reduce the number and scope of its conditionalities and would need to
focus more clearly on its core areas of expertise and mandate. In addition, it was
decided to shift away from the approach that had developed up to that point,
with its presumption that conditionality would be comprehensive. Instead, the
dominant presumption now became that conditionality would be limited and
The most recent conditionality guidelines also introduced the concept of ‘Floating
Tranche Conditionality’. This form of conditionality applies mainly to
structural performance criteria that are important for medium-term external
sustainability and growth and is applied where a structural measure or performance
target is to be implemented during a programme, but not by a specific
date. This enables the relevant member country to control the timeframe for
implementation and in this manner contributes to promoting domestic ownership
of the programme.
The new approach to conditionality also represents a stronger attempt to
coordinate policy advice with other international financial institutions, including
particularly the World Bank. In this instance, the guidelines also introduce
the concept of a ‘Lead Agency’ vis-à-vis the World Bank, in which either the
Bank or the Fund are designated the lead agency in the Bretton Woods Institutions’
overall dealings with the member country.
The IMF’s new approach to conditionality policy has been in operation for
about two years. Initial evidence suggests that fewer conditions are being
applied to IMF-supported programmes and that these tend to be more focused.
It is premature, however, to come to conclusions as to whether or not the new
approach has led to an improvement in programme outcomes.


Wednesday, July 18, 2007

Q 5. FE 201 IMF (FPA), Intro and Criticism 1

Describe and discuss the major controversies and criticisms associated with the IMF's approach to stabilization.

Most of this question is answered at my other post (International Monetary Fund Assignment), but I will post the texts passages also in some posts.
3.2 Key Shortcomings and Criticisms of the IMF Financial Programming Approach
Almost from the start, the IMF experienced a large number of criticisms of its approach to stabilisation. The range of criticisms has been broad and the intensity of criticism has been varied, sometimes gaining momentum in response to
particular global economic and other developments and sometimes becoming more muted, but overall the criticisms have grown in breadth and intensity since the 1980s. They have become part of a larger public debate and their greater strength has led to more engagement with the issues by the IMF itself. While it is not possible to summarise the full range of criticisms, in this section of Unit 3 I will focus on seven broad themes around which criticisms of the IMF approach to stabilisation can usefully be grouped:

1• overstepping it mandate
2• too little regard for the country’s financial sector
3• a ‘one-size-its-all’ attitude
4• imbalanced representation and policy advice
5• the nature of its conditionality
6• failure to achieve intended objectives
7• excessive social costs.

3.2.1 Criticism 1: Problems arising from overstepping the IMF’s traditional mandate
One of the most frequently cited criticisms of the IMF’s role in stabilisation
policy is that the institution has lost its original focus and entered into activities that go beyond its mandate. This set of arguments focuses on the fact that
Article 1 of the IMF’s Articles of Agreement, which you studied in Unit 1, defines the IMF as a short-term lender of financial resources to correct a member’s temporary balance of payments requirements. Critics of the IMF argue that since the IMF was founded in 1944, the institution has gone well beyond the mandate granted to it by Article 1. As you saw in Unit 1, the lending facilities of the IMF now extend well beyond the Stand-By Arrangement and include very large-scale lending packages, as well as long-term facilities, which explicitly recognise that the funding provided by the IMF is to correct long-term and not short-term balance of payments difficulties.

Commentators who adopt this particular criticism of the IMF tend to recognise that after fifty years it is quite plausible for the IMF to exceed the vision originally
conceived in 1944, for it is important for the institution to keep up with prevailing global economic, financial and other developments.

However, the main thrust of the criticism is that by going beyond its original mandate, the IMF has entered into areas of activity, including lending activity, in which it not only has no mandate, but in which, most importantly, it has no expertise. Whereas the IMF’s core areas of competence are macroeconomic and
exchange rate policy, the Fund’s more recent decisions, to provide long-term lending to its members and to embed in its conditions structural and other longterm objectives, have made it vulnerable to the criticism that it provides advice
and recommendations that other institutions, particularly the World Bank, are
more skilled at providing.

This set of criticisms focus on a variety of shortcomings, including insufficient
numbers of IMF staff who have a grasp of the historical and institutional
obstacles and challenges to economic progress in member countries, poorly
designed financing programmes and lack of sufficient appreciation of the
political processes in countries that borrow from the IMF and subsequently illconsidered
and unrealistic conditionalities.
􀀂 Review Question
Pause for a moment and re-read the first part of Unit 1, in which the role of the IMF and the Articles of Agreement are discussed. Then examine the structural conditionalities in the Republic of Croatia Letter of Intent, in Unit 2. Can the structural conditions in the Croatia LOI be reconciled with the short-term focus specified in the Articles of Agreement? How do you think the IMF responds to critics who argue that the IMF has gone beyond its mandate?


Monday, July 16, 2007

The Swan Diagram/Mundell-Fleming Cont.

Swan diagram-Wiki

It looks like Krugman has another chart of interest with the article: LATIN AMERICA’S SWAN SONG

The writer has taken liberty it seems to boil absorption to only the Fiscal Side. Supply Siders might differ with that assessment.

Note this does not correspond with above diagrams, these notes are from the book where exchange rate is reversed (units of foreign exchange for a unit of domestic), and thus the chart is flipped on the curves.
On the vertical axis is the real exchange rate defined as domestic currency units per unit of foreign currency, thus lower is an appreciation and higher is a depreciation. On the horizontal axis is the amount of real domestic absorption (sum of consumption, investment and government expenditures). IB (demand) is Internal Balance-full employment and stable prices and EB (supply) is External Balance-equilibrium in Current Account. To the right of the IB are inflationary pressures (left Unemployment). To the right of the EB is CA deficit (left/ surplus).
The Swan diagram concentrates on the relation between internal equilibrium on the current account of the balance of payments (not the capital account); and it uses the absorption approach, the model you studied in the previous unit (unit 3). Pilbeam mentions two distinct trypes of policy designed to change the current account of the balance of payments (page 76): expenditure switching and expenditure changing policies (the latter are often called 'expenditure reducing' policies.

Thus many times to achieve both internal and external balance it is needed two tools to do this as elaborated by Jan Tinbergen (1952) which became the Tinbergen's Instruments-Targets Rule.

The article by the Australian Government Treasury is entitled The Chinese currency: how undervalued and how much does it matter?
Opportunity costs also arise from the fact that accumulated foreign reserves could have otherwise been used to repay its foreign debt (estimated at 5 per cent of GDP). Interest rates paid by China on its external borrowing are higher than those received on its foreign reserve assets. Yields on long-term Chinese government external debt (about a quarter of the total) have recently been 60-70 basis points above US Treasury yields, and spreads on other debt are likely to be higher.

There is also a large exposure to future currency losses. China’s foreign reserves were equal to 38 per cent of GDP at the end of 2004. Assuming at least 80 per cent of these reserves are dollar-denominated, each 10 per cent appreciation against the dollar would mean a currency loss equivalent to about 3 per cent of GDP. Potential losses increase the longer China continues to accumulate reserves to hold down the RMB.
Hence, RMB adjustment would need to be combined with measures to expand domestic demand in China in order to have a significant impact on external imbalances. Given that Chinese investment is already very high, this will most likely take the form of measures to address factors contributing to China’s high saving rate. These factors include financial underdevelopment, limited social safety nets and corporate governance shortcomings that contribute to high corporate saving. While exchange rate adjustment is important, it should not be overemphasised at the expense of other elements required to address imbalances.
The appropriate rate of adjustment will also depend on whether the PBoC can continue to sterilise the monetary impacts of reserve accumulation. If monetary control becomes more difficult, there may be an argument for a faster pace of adjustment. Excessive monetary expansion would only aggravate future financial sector problems. One of the problems associated with a gradual approach is that speculative inflows are more likely to persist because the currency is seen as a ‘one way bet’ , which means continued high reserve accumulation.

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Saturday, July 14, 2007

Mundell-Fleming|Model Part One|IS-LM-BP Model

The LM schedule is an upward-sloping curve representing the role of finance and money. The initials LM stand for "Liquidity preference/Money supply equilibrium" but is easier to understand as the equilibrium of the demand to hold money as an asset and the supply of money by banks and the central bank. The interest rate is determined along this line for each level of real GDP.

Construction of the LM (Money Market Equilibrium) curve...
M(Supply Fixed)=M(Demand)=c(0) + c(1)Y - c(2)r
Which means that for equilibrium MS=MD which equals an autonomous amount c(0) and the transaction demand of money as a percentage of Income and "the opportunity cost of holding [cash] balances" which inversely affects MD by the interest rate r (this is often referred to as the speculative demand for money).
Factors that Shift the LM Schedule
Two factors that will shift the LM curve are changes in the exogenously fixed money stock and shifts in the money demand function.

A shift in the money demand function means a change in the amount of money demanded for given levels of interest rate and income, what Keynes called a shift in liquidity preference.
A shift in the money demand function that increases the demand for money at a given level of both the interest rate and income shift the LM schedule (upward and) to the left.

2. increase in the money stock will shift the LM schedule (downward and) to the right.

The LM Schedule: Summary
The LM curve:
1. is the schedule giving all the combinations of values of income and the interest rate that produce equilibrium in the MONEY MARKET.
2. Slopes upward to the right.
3. Will be relatively flat in the interest elasticity of money demand is relatively high (steep/low).
4. Will shift to the right with an increase in the quantity of money (left/decrease).
5. Will shift to the left with a shift in the money demand function, which increase the amoung of money demanded at given levels of income and the interest rate (right/decreases).

Construction of the IS (Product Market Equilibrium) Schedule
The initials IS stand for "Investment/Saving equilibrium" but since 1937 have been used to represent the locus of all equilibria where total spending (Consumer spending + planned private Investment + Government purchases + net exports) equals an economy's total output (equivalent to income, Y, or GDP).

Equilibrium in the Product (Commodity) Market is:
Y = C + I + G
I + G = S + T

Determining the Slope of the IS:
1. The curve will be relatively steep if the interest elasticity of investment is low.
2. ...the IS curve will be relatively steeper, the higher the MPS. (Marginal Propensity to Save)

Factors that Shift the IS Schedule
I(r) + G = S(Y - T) + T
1. Government spending (incresase) will shift the schedule to the right.
The amount of the shift will be Change in G over the MPS (1-b).
2. An increase in Tax revenues will shift the IS schedule to the left by:
3. An autonomous increase in investments will shift the IS Schedule to the right by:
1/(1-b) or 1/MPS
4. Open Economy: an autonomous increase in exports will shift the IS schedule to the right.

The IS Schedule: Summary
1. The IS curve slopes downward to the right.
2. The IS curve will be relatively flat if the interest elasticity of investment is relatively high (steep/low).
3. The IS curve will shift to the right when there is an increase in the level of government expenditures (left/decrease).
4. The IS curve will shift to the left when the level of taxes increases (right/declines).
5. An autonomous increase in investment expenditures will shift the IS curve to the right (decrease/left).
6. The IS curve will be relatively steeper the higher the MPS.

Left and Above the LM schedule indicates an excess supply of money (interest rate too high for the money market equilibrium).
Right and above the IS schedule indicates an excess supply of output.

An Open Economy/BP Schedule
IS Equation for an open economy is stated as:
S(Y) + T + Z(Y) = I(r) + G + X
Thus Exports (X) is exogenous and Imports (Z) is a fraction of total income.
And thus in an open economy we need to notice that an increase in autonomous exports will shift the IS Schedule to the right. And an autonomous decline in import demand will shift the IS Schedule to the right assuming that there is an increase in domestic output consumption.

BP Schedule plots all interest rate-income combinations that result in balance of payments equilibrium at a given exchange rate. By balance of payments equilibrium is meant that the official reserves transaction balance is zero. Equation:
X(R) - Z(Y,R) + F(r) = 0
R is the exchange rate and F is the capital inflow.
Factors that shift the BP Schedule:
1. An increase in R (Exchange Rate-actually a depreciation of Currency- a worsening terms of trade) will shift the schedule horizontally to the right.
2. Exogenous increase in Exports or fall in Import demand will shift the BP Schedule to the right.

Points to the right (& below) indicate a deficit in the balance of payments.

Monetary and Fiscal Policy in an Open Economy: Fixed Exchange Rates
Monetary policy expansion under a Fixed Exchange rate will shift the LM curve to the Right and result in a BoP deficit (or any other action causing the LM to shift to right).

Fiscal expansionary policy will have an indeterminate effect on BoP depending on LM/BP slopes with regard to each other.
If the LM schedule is steeper it will result in a favorable BoP. And if the BP is steeper then BoP will be negative and the intersection will be to the right of the BP slope.
This follows since ceteris paribus the steeper the LM schedule, the larger the increase in interest rate (which produces the favorable capital inflow) and the smaller the increase in income (which produces the unfavorable effect on the trade balance) as a result of expansionary policy action.

Monetary and Fiscal Policy in an Open Economy: Flexible Exchange Rates
Monetary expansion will shift the LM curve to the right, but in a flexible exchange rate it also: exchange rates will rise and shift the BP schedule to the right and the higher exchange rate will shift the IS schedule to the right from exports rising and imports will fall.
With a flexible exchange rate, the rise in the exchange rate will futher stimulate income by increasing exports and reducing import demand (for a given income level). Monetary policy is therefore a more potent stabilization tool in a flexible exchange rate regime.

Again the effects of an increase in Fiscal Expansionary Policy is indeterminate:
When the LM curve is more steep than the BP curve (as in classical economics): then as Government spends more the IS shifts to the right. BoP is in a surplus rates must fall and thus shift the BP schedule to the left. The fall in exchange rate will also cause the IS schedule to shift leftward caused by lower level of exports and stimulate import demand. Thus if the LM curve is perfectly inelastic there would be no effect of expansionary policy.

On the other hand if BP schedule is steeper than the LM schedule then expansionary Fiscal Policy will result in BoP deficit causing exchange rates to rise and shift both the BP and the IS schedules to the right. And thus the multiplier effect is larger-although unlikely.

Note: a rise in exchange rates means an actual devaluation.

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