The International Lender of Last Resort concept originates from the principle of central banking which was directed by Walter Bagehot almost a century ago. This principle states that in a financial crisis, the central bank should perform its duty “to lend freely, quickly, usually at penalty rates, and usually against good collateral” (Little and Olive).1 This implies that in a financial crisis situation, there exists a situation of the multiple equilibriums and it can be controlled by providing temporarily liquidity to those firms which are illiquid but solvent. This could help avoiding the real economic harm. In case of International lending the LLR concept requires the judgement that the same principle apply to sovereign financial crisis which is largely devoid of tangible collateral. Such a difference in domestic and international lending highlights the importance of having the right judgement that the concerned sovereign is willing and able to secure the resources in sufficient time that makes sure it is solvent based on complete faith and credit. One of the basic assumptions of the lender of last resort, whether domestic or international, is that after the crisis is over, the reflow of private lending will appear and the central bank or IMF will be repaid rapidly. However, the international studies depict that this process takes longer time in international crises than domestic financial crises. In this research paper our study will analyse the origin of crisis in three major countries namely Argentina, Zimbabwe and Brazil. We will further analyse the role of IMF in the sustaining the economy from the crisis.
The main role of the IMF from 1946 to 1973 was to control the fixed international exchange rates system that was agreed on at Breton Woods. The value of US dollar was pegged to gold at $35 per ounce and the member countries' exchange rate was pegged to dollar at different rates. The IMF helped the member countries to conquer the balance of payment crisis with
1 Traditionally, LOLR principles were developed by Henry Thornton, the Banking School writers, and most completely by Walter Bagehot, the editor of the Economist. Bagehot's rule was to lend freely to the market on good collateral at a penalty rate. See Humphrey and Kelleher, op. cit., pp. 299-305.
short duration loans by observing the macroeconomic and exchange rate policies of these countries. This helped the member countries to bring back the currencies to their agreed gvalue. However, when the Breton woods system finally collapsed in 1973, many economists expected the collapse of IMF towards its lending operations. Conversely, from 1970 to 1975 the amount of IMF lending was almost doubled in real terms. Again from 1975 to 1982, the lending rose by 58 percent in real terms.
However, IMF involvement in sustaining a country's adverse balance of payments crisis has been associated with conditionality. Conditionality is the commitments which the country's government make on economic and financial policies when borrowing from IMF and that IMF justifies as a guarantee and monitoring tool that its loan is being used effectively in resolving the borrower's economic difficulties, so that the country will be able to repay promptly.
Argentina used to be IMF's model country because IMF was continuously engaged in Argentina since 1991 when the “Convertibility Plan” fixed the Argentine Peso at par with U.S. dollar in a currency convertibility regime. The convertibility regime was successful solution to stabilize the hyperinflation that existed in the beginning of 1990s. As a result the inflation rate which was 27 percent in 1991 declined to single digit in 1993. The growth rate was high till early 1998. However, a series of external shocks started hitting Argentine economy and caused growth to slow down in the second half of 1998. Eventually, In 2001-2002, Argentina faced the worst economic crisis in its history when a partial deposit freeze, a default on government debt and the abandon of fixed exchange rate system led to fall in output by 20 percent over 3 years, high level of inflation, rise in unemployment and a collapse of banking system. Moreover there were induced budget restrictions which undercut the government's ability to sustain national infrastructure even in crucial area such as education, health and security. These incidents raised the questions on the country's relationship with IMF because the economic policies of Argentina were under the close scrutiny of IMF.
2Reference taken from issue paper of Independent Evaluation Office (IEO), The role of the IMF in Argentina, 1991-2002, July 2003 volume.
There were four major IMF agreements with Argentina; out of that two were approved under Extended Fund Facility (EFF) in 1992 and 1998. The other two financing arrangements were under Stand-By Arrangements (SBA) which was approved in 1996 and 2000. The 1998 EFF was treated as preventive as there was no intention of the authorities to draw on the resources made available under the arrangement, The 2000 SBA also made available to Argentina resources under the Supplemental Reserve Facility (SRF).2By September 2001, Argentine's total commitment to IMF was raised to $22 billion.
Literature on different factors related to the Argentina's crisis has flourished over the past few years with the different opinions based on the root cause of crisis. We will analyse some of the important literature reviews:-
Mussa (2002) argues that the root cause of crisis was insufficient fiscal tightening during 1998 when the economy was expanding at over 7 percent per annum. His discussion was partly related to the overestimation of potential output growth in Argentina during the 1990s. This argument is based on the fact that IMF itself made a wrong assessment of Argentina economy by overestimating its growth potential and underestimating its vulnerabilities. This led to the IMF supported programmes insufficiently ambitious and more accommodative of slippages specifically through 1998 when the economy was booming. The IMF being a Lender of Last Resort continued to provide its financial assistance on the basis of inadequate policies, even after issuing warnings to the Argentine's government authorities on the country's growing vulnerabilities and stressing them to adopt structural reforms and fiscal adjustments during early 1998.But the ability to deliver necessary fiscal discipline and structural reforms was lacking.
Joseph Stieglitz (2002)3 wrote an article soon after IMF suspended its aid to Argentine in December 2001, where he argued that the IMF made a “fatal mistake” by encouraging Argentine government to follow fiscal austerity in the hope that it will restore the confidence. He further argued that IMF programme did not fulfil its commitments and confidence is never restored as economy went into deeper recession and the double digit unemployment. However Stiglitz also looked the mistakes by Argentine authorities as they adopted dollar pegged peso exchange rate which was a failure in itself due to the external shocks that were caused by the international volatility market. He criticized IMF's support to this and rather states that IMF should have encouraged Argentine to move to a more flexible exchange rate system that would be more reflective to its trading patterns.
Hausman and Velasco (2002) emphasizes that the crisis originated from the sharp downturn of 1998. At that time, expected future growth of export declined sharply, resulted in higher risk premium and smaller capital inflows. This led to lower domestic investment, which in turn reduced output and further curtailed creditworthiness and the ability to borrow. In 1998, after the crisis of Asia, Russia and Brazil, Argentina felt the effects of uncertainty of investor which led to the increase in interest rates. Argentina's economy got affected when the Brazilian Real was deposited and Argentines domestic products could not compete with the Brazilians cheaper export. IMF's responsibility was to help Argentina during this crisis by making its convertibility system discarded and deflates the bubble economy which emerged in 1990's. However IMF lent Argentina billions of more to up hold its economy for little longer time.
Feldstein (2002) places much focus on the exchange rate regime in explaining the crisis. He explains that with the fixed exchange rate system it is difficult to achieve competition by traditional currency devaluation (in comparison with various countries including UK, Korea and Brazil). Moreover, the struggle of unions against lower wages prohibited the fall in production costs that could have achieved the same real devaluation without a change in the exchange rate. IMF could have played an important role of LLR in encouraging the authorities by giving them exit options through their policy advice and financial support much earlier in 1990's before Argentine came under pressure.
Roubini (2001) and De la Torre et al. (2002), with the similar views, have argued that convertibility does not inoculate a country from the balance-sheet effects of a real exchange rate adjustment; it only creates the adjustment through deflation and unemployment which erodes the repayment capacity of debtors whose major earnings come from the non-tradable sector. They argue that the dollar peg made the country less capable to export and grow. Lower export earnings reduced Argentine's capacity to repay debt and thus limited amount of foreign lending. The limited external resources resulted in fall of investment and output which in turn reduced demand for domestic production.
Calvo (2002), however, emphasizes the unexpected reversal of capital flows to Latin America in later 1998 and differentiates the ability of various Latin American countries to tackle with the reversal depending on the degree of the openness of the country and the degree of dollarization liability. He explains that since Argentine was a closed economy with high dollarization liability, the real exchange rate change was large to remove the current account deficit.
The Argentine study, thus, prove that the IMF's assistance as a Lender of Last Resort helped the country initially but its conditionality were not able to recover the country from external shocks. IMF should have given the options to the authorities to come out of the convertibility regime in early 1990's itself. However, we will also consider that fact that the interaction between the currency board and fiscal policy played a crucial role in moving the country towards crisis, a variety of other factors including unfavourable external developments were also held responsible. Moreover, government of Argentine did not adopt the policies which were synchronised with IMF's conditionality. Of course, the key policy decision and lack of supportive fiscal and structural polices raised the question on IMF's role as a Lender of Last Resort. The Argentine crisis reflects the limitations in IMF's surveillance to identify the vulnerabilities at the early stages of boom and in bringing about required changes when these vulnerabilities become perceptible. The fund's fiscal policy assessment was also inadequate and did not consider risk to debt sustainability in case of slower growth rate.
Zimbabwe tied up with the IMF on September 29, 1980 and its quota is SDR 261.3 million (about US$385 million). Zimbabwe has currently the highest rate of inflation in the world (an annual rate of 1,730 percent in February, 2007). The high rates of inflation have contributed to the contraction of the economy, which has declined by about 30 percent since 1999. Zimbabwe crippled economy received a boost when the IMF sanctioned a $510m (£311m) loan, its first to the country in a decade. But the move stirred conflict between the partners in Zimbabwe's unity government and was also feared to be shored up by the political sharks in President Robert Mugabe's regime. Gideon Gono, Zimbabwe's reserve bank governor, said the IMF had paid it $400m via a fund for developing countries hit by the global recession, with a further $110m to follow. Zimbabwe outlined its plans stating that it would use the money from IMF to reload on its depleting foreign currency reserves.IMF released the funds on precondition that it is not sidetracked to other projects. Political experts welcomed the move by Zimbabwe's unity government as a symbol of it ending the country's spell in the international backwoods. The IMF wound down its programme there 10 years ago and formally withdrew in 2002, adopting a "declaration of noncooperation" with Mugabe's government.
The Executive Board of the International Monetary Fund (IMF) lifted the suspension of Fund technical assistance to Zimbabwe in targeted areas effective from May4, 2009. The liaison with IMF was for technical assistance to be provided in the areas of (i) tax policy and administration; (ii) payments systems; (iii) lender-of-last-resort operations and banking supervision; and (iv) central banking governance and accounting.
IMF took the decision after reviewing a considerable improvement in Zimbabwe's cooperation on economic policies to address its arrears problems and severe capacity constraints in the IMF's core areas of expertise that represent a major risk to the implementation of the government's macroeconomic stabilization program.
Zimbabwe has been in continuous arrears to the IMF since February 2001 and is the only case of protracted arrears to the Poverty Reduction and Growth Facility-Exogenous Shock Facility (PRGF-ESF) Trust, which currently amount to SDR 89 million (about US$133 million). The remedial measures that have been imposed on Zimbabwe with respect to these arrears are the suspension of technical assistance (now partially lifted); the removal of Zimbabwe from the list of PRGF-ESF-eligible countries.
Several key authors have a varied view point on the Economic crisis and IMF's aid to Zimbabwe. Some of them have been outlined below:
Thomas J. Hornes (2009) highlights in his article that IMF, as a global lender has been used by its principal powerful shareholders, to penalise Zimbabwe for its national policies. He states that IMF instead of ensuring world economic stability was complicit in economic destabilisation of Zimbabwe. The unfair treatment of IMF towards Zimbabwe w When Zimbabwe defaulted on its IMF debt in 2001, the IMF refused to reschedule this debt, or offer Zimbabwe alternative lines of credit or other support geared at ensuring that the economy remained relatively stable. IMF has lent such support to countries such as Argentina which defaulted on their sovereign debts. Instead expulsion procedures were activated against Zimbabwe. He traces the desperation of Zimbabwe to print Zimbabwe dollars to finance the payment of its IMF foreign currency debts.
Tawanda Hondora (2009) criticizes IMF's insistence on Zimbabwe for the payment of over US$175 million of arrears or face expulsion from the institution. Zimbabwe recently managed to stave its expulsion from the IMF by reportedly paying £150 million towards its debt obligations to the institution. She sates that Zimbabwe paid the money out of desperation. The country cannot afford the payment it made. Zimbabwe paid the money because, owing to US influence among others, it was unable to formally reschedule its IMF loan payments. She highlights that the country has critical foreign currency shortages, has run dry of fuel and other essentials, has record high unemployment levels, and now has crippling inflation rates. In addition, the UN suggests Zimbabwe is suffering from famine.
Terence Kairiza in his publication ‘Unbundling Zimbabwe's journey to hyperinflation and official dollarization' highlights the country's economic and financial dislocation (characterized by hyperinflation at its peak) which ended in the adoption of official dollarization in 2008. These events came in the backdrop of the fast-track land reform programme, which entailed the taking away of white-owned commercial farms for redistribution to the landless black majority. He observes that IMF as the lender of the last resort resumed cooperation in May 2009 on observing substantial improvement in the Zimbabwean government's cooperation on economic policies to address its arrears problems provided the critical boost to the failing economy. However he also highlights a letter written by the finance Ministry of Zimbabwe to the IMF seeking funds puts the funds to finance the war at USD1.3 million per month in1998 or 0.4 percent of GDP and in 1999 when additional troops were deployed at USD3 million per month or at 0.6 percent of GDP (IMF, 1999). He however, postulates on the basis of a leaked memorandum form the ministry, the costs to have been at least ten times the official figures. The situation, be that as it was, the country could not spare foreign exchange outlays of such magnitude and this consequently weakened the currency, again with pernicious effect on price stability.
The Zimbabwe case study highlights the initial boost to the crippled economy that the IMF loan provided especially in areas of tax policy administration, infrastructural development and upheaval of the ailing healthcare framework. The IMF loan opened doors for Zimbabwe into the western economic reserves. However the IMF loan to the government has been plagued with reports of illegal hoarding by politicians and the funds being sidetracked to warfare and ammunition development. Also the suspension of technical assistance in 2002 led to a setback in the economic development policies and the pressure to pay back the mounting IMF arrears caused further destabilization of the Zimbabwean currency.IMF as the lender of the last resort should implement comprehensive economic and structural reforms. Though these reforms need not necessarily be IMF sponsored or structured, the IMF along with the government should put in place an economic regime that engenders stability and growth. The IMF must be part of the solution and not be part of the problem.
Causes of the crisis: Real Plan, Crawling Peg and Inflation
Brazil initiated a plan in 1994, named after its new currency the real, to stabilise its economy after a few other plans to stabilise the price failed which also resulted in high inflation.
The optimism was on rife although there were thought to be fundamental issues with the Real Plan. The areas that the Brazil attempted to address are the following:
- Correction in large government deficits
- Reduction in fund transfer by Central Government to State Governments and more local governments
- Increase income tax
- Restraints on monetary policy.
As a final step, the Brazilian Government pegged the real to the dollar. The way ‘Pegging' works is that the use of the central reserve of dollar to buy the reais and vice versa as deemed necessary to control the exchange rate between dollar and the real. This means that the government would free the supply of dollars should there be a less supply of dollars that holders of real wanted to buy from a free market holder(s). This way Brazilian Government was making the world known about its monetary policy.
The pegging of dollar to its currency, Brazil should have had a parallel monetary policy to that of the United States. A very real possibility is that, ultimately, there will be intolerable stresses put on Brazil's currency system if it wanted a more inflationary policy to be run in comparison with United States. This also means that Brazilians would be able to buy US products at a cheap rate whereas US will have to spend excessive amount to buy Brazilian products.Within a short period of time, Brazilian government realised the very fact that it will be impossible to match monetary policy of the US. This realisation came after signs that American products were attracted to Brazilian people and there was very limited interest shown in Brazilian products worldwide as it would be much costlier. This, in a way, forced Brazil to adopt a crawling peg. This means that the exchange rate would be allowed to slide down within limits. The whole world received a message that that Brazil is making every effort to control the country's inflation. The inflation rate in 1994, the year of the Real Plan, was 900% but in 1998 the prices were going negative.
The overvaluation was not solved by the crawling peg and it made harder for Brazilian products as the consumers were unable to afford them, even Brazilian people become motivated to shop overseas.
Financial contamination, in simple terms, means that the investors move their money from one country in crisis to another country. Due to the overvaluation discussed above, Brazil started to suffer from this. During crisis in Asia (1997) and Russia (1998), investors reinvested their money from Asia, Russia and even Brazil in light of then recent developments in the respective countries. If this transfer of investment was allowed to occur, the government reserves of dollars would start to empty as the government would have to supply the dollars to maintain the ‘pegged' exchange rate. This forced Brazil to raise their interest rates simply to entice investors to keep investing in the country. The surge in the interest rate is shown in the Figure 1 below.
However, it was felt that these large increases in Brazilian interest rates did not assist Brazilian Government a great deal. As a result, Brazil had to release much of its foreign currency reserve for the good of the real. It should be noted that the Brazil's dollar reserves which were $70bn in early 1998 dropped by almost half in less than 12 months.
On a year to year basis, Brazil's primary deficit was not too large. However, the history of Brazil with debt did worry investors, and rightly so due to the ongoing crisis in Asia and Russia. However, a significant surge in interest rates made the overall deficit much greater which reached to 8% of Brazil's GDP. This resulted in debt holders being highly reluctant to hold the debt of Brazil and a direct impact on this was that the short term to total debt of Brazil increased significantly.
Although the President Cardoso announced a new budget plan to generate savings of $23bn, hopes started to fade badly due to a deficit reduced bill being voted down by his own coalition. Also, an effort to reform the pension system apparently failed. Meanwhile, in December 1998, the capital outflow rate reached as high as $350millions per day, causing further problems. The final punch to Brazilian economy was given by the new Governor of the Brazilian state of Minas Gerais. He conveyed that he would not continue with debt payments for few months.
Some well-known economists called for a devaluation of Brazil. When President Fernando Henrique Cardoso announced a new budget plan to generate savings worth $23bn, some economists forecast that primary surpluses will be generated in the next year if this budget and the plan succeeded. The IMF asked for deeper spending cuts in public sector. It can be argued that this could potentially seriously harm the country's growth and there was a possibility that the country could go into further crisis. Also, there remains a question as to why would IMF, or a wider community for that matter, support an overvalued currency (i.e. the Real).
Mary Smith, a financial advisor who represented the United States on the IMF's executive board during the Reagan Administration, believes the spending cuts in Brazil will have short term and long term effects. It is likely that there will be a slow down in Brazil's economic growth. As a matter of fact, it was noted that the unemployment went up from 6% in 1997 to 7.5% in 1998. This could worsen if public spending cuts are introduced without much thoughts or logic behind them.
Mary added that though the medium to longer term effects of these cuts will increase the country's growth in the following manner:
- The cuts will slow down country's public sector debt.
- The above will release some additional credit for private sector needs
- The cuts will help bring the interest burden.
Mary also said that the real is the Brazil's support. It is a way of avoiding market contamination that could spread to other countries. Brazil is reported to be devaluing its currency at 7.5% per year rate, this together will measures to bring the value of the real into linc with economic performance will provide a further boost to the overall economic growth.
Steven Radelet of Harvard Institute of International Development (HIID) reckoned it is typical IMF asking for spending cuts. These cuts were a centrepiece of IMF's original programmes in Asia which lead it into the recession. IMF did realise it as a mistake, however, being honest here, spending cuts are, in some cases, necessary particularly when the government is carrying large budget deficit over a few years period (e.g. Brazil). So, in Brazil's case, IMF would be correct to suggest strict cuts in public sector spending.
Steven carried on and suggested the Brazil should not have allowed an overvaluation of its currency and if IMF supports it, it does not solve this issue. The Government should solve this issue by itself by allowing the real to depreciate modestly to an appropriate level and to guard it against the possibility of an overshooting of the exchange rate by restructuring Brazil's debt.
Steven added that it is likely that Brazilian government and the IMF's basic approach would be to protect the currency that is with a combination of very high interest rate and a high amount of international loans. This approach is claimed to be not capable to solve the long-term problem of currency being overvalued, and does not provide that resolving or assuring stimulus for the exporters that they need to increase industry growth and avoid further recessional effects.
It is often argued that when IMF money goes into an economy, it appears to be passed out to the wealthy who invests the same money into the source countries.
Marcus Anthony Baptista of Natick questions that IMF do not suggest any mitigation measure if unemployment rise as a result of job cuts due to reduction in public spending, it would take years for the Brazilian economy to come back on track in order to be less immigration to the countries such as United States for the improved quality of life.
A delegation of Brazilian officials arrived in Washington D.C. on 17th October 1998 to discuss Brazil's financial situation based on then current policy assumption (including monetary policy) with a wider community at the IMF-World Bank Annual Meeting.
The discussions were primarily aimed at preparing solid grounds for the potential support from IMF for a multiyear financial programme to be announced by the Brazilian government that support the countries. It is argued that the IMF expressed the support in principle and in return the Fund asked for the Government of Brazil to propose, in detail, with a plan and policies (some new if required) that would help with the following:
On 13th November 1998, the managing director of IMF, Mr. Michel Camdessus received a formal request from the President of Brazil. As expected, the President included the proposed policies and objectives of the Brazilian Government for 1998 - 2001.
The Government of Brazil requested for the IMF for a support of $18million in the form of a stand by for a period of 3 years. Also, extra support in monetary terms was requested. On 2nd December 1998, the IMF Managing Director Mr. Michel Camdessus declared support to the Government of Brazil's ‘strong three-year programme of economic and financial reform'.He suggested that the Government of Brazil's plans contain sufficiently robust policies to achieve the targets of primary surpluses of 2.6% of GDP in 1999, 2.8% in 2000, and 3% in 2001.
He conveyed to the world that, as per IMF requirement as part of the deal, the Brazilian Government is committed to further ensuring the opening up of the economy, and maintaining the regime of current exchange rate. The IMF indicated that it would, together with potential multilateral or bilateral, would provide support totalling more than $41 billion between 1998 and 2001, of which $37bn will be available if needed over the next 12 months. This sort of commitment from IMF was a result of the Government of Brazil's sound programme which strongly appears destined to greatly brighten the economic prospects of the region as a whole.
The following facts illustrate the current (or fairly recent) status of Brazil as an economy and a country.
The IMF is considered as a lender's last resort for help of monetary terms. Some may argue that IMF exacerbates economic problems by imposing tough conditions and therefore does more harm than good (i.e. Asian Crisis of 1997). Also, it is a debatable issue whether the IMF's ‘one size fits all' way of using economic policy (i.e. blanket policies) work with each and every country.
The true reality, for Brazil anyway, is that the IMF programme did help it achieve economic stability. The Brazil has payments crisis, depreciating exchange rate, and high inflation. The IMF help in monetary terms together with all the policy reform that it imposed on Brazil have given the government of Brazil a chance to prosper once again, and it is there for everyone to see what Brazil has achieved since the year 1998.
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