World monetary system and the role of IMF - Term Paper Example

?The role of International Monetary Fund in the world monetary system The International Monetary Fund plays a major role in evolution of international monetary policies and economic policies of the governments of the member countries. The policies relating to developing countries are largely influenced by the policies of IMF as they have to comply with the conditions of IMF while they demand for credit facilities. Also, there are resentments about the IMF’s interferences in the internal economic policies of the countries in matters related to opening up of industries to globalization, privatization of public sector companies, fiscal discipline, abolition of subsidies for narrowing down the budget deficits and reform processes. This paper seeks to review the role of IMF in world monetary system and the relevance of their policies under current developments in international economy. Since world monetary system is linked to world economy, the analysis covers its impact on world economy and the adequacy of the system to deal with the emerging challenges in relation to its objectives. Introduction “The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.” (IMF) In the backdrop of increasing globalization drive in various countries, technological developments, advent of internet and mobile telephony, the international trade has undergone significant changes over years. The world monetary system cannot ensure stability and achieve balanced economic growth among the world countries unless the causes underlying the imbalances in the countries as well as the world monetary system are effectively addressed. The self adjusting mechanism envisaged under floating exchange rate system has been rendered ineffective due to several factors such as trade restrictions of various sorts, exploitation of the economically weaker countries in the international trade and inability of the poor countries in using the available resources for development. The imbalances in the balance of payments situation call for actions in a concerted manner internationally to remove the underlying causes to pave way for smooth international trade. The adequacy of the international monetary system in dealing with these ground level changes has to be revisited with a view to realign scope of functioning of the IMF in tune with developments in world economy. Review of literature IMF extends credit facilities to the countries with a view to ensure stability and balanced economic growth among the world countries. The gold-standard system adopted at Bretton Woods Conference in 1914 with the aim of encouraging economic discipline through sound economic policies has failed. Devaluation of currencies after World War - I by many countries to make their exports competitive in the world markets and trade restrictions to protect their domestic economies have severely affected global economic growth. In order to prevent collapse of global economic system and provide monetary order, proposal for setting up of International Monetary Fund and a World Bank for Reconstruction and Development were mooted in the Bretton Woods in 1944. The US with huge gold reserves and with infrastructure not damaged by war had to play a crucial role in the IMF with the primary aim of providing credit to the countries with deficit in Balance of payments. However, the credit facilities were subject to conditions with regard to revamping of the economic policies of the countries to ensure stability and avoid any crisis in the future. The system of fixed exchange rates at par value of the currencies fixed in terms of dollar or gold worked well for some time, but defending the par values became increasingly difficult for countries. Currently, floating exchange rates governed by demand and supply are predominantly in force. IMF has played a pivotal role in world economy along with the process of its evolution from gold standard to floating exchange rate regime over years. Disbursements by IMF indicate that there has been steady increase over years until 2008, and the stagnation thereafter could be attributed to financial crisis in Europe and its impact on world economy. Disbursements are drawings by the borrower on loan commitments during the year specified. (Trading Economics?) DISBURSEMENTS ON EXTERNAL DEBT; LONG-TERM + IMF (DIS; US DOLLAR) IN EUROPE AND CENTRAL ASIA Long-term external debt refers to debt with a maturity of more than one year and IMF purchases are total drawings on the General Resources Account of the IMF during the year.  Government Debt to GDP (Trading Economics?, Annexure – I) in the case of South Korea (34) and China (25.8) are better than the developed European countries, Japan (211.7) and the USA (101.6). The debt includes external debt. IMF played a very crucial role in international economic development by providing credit facilities to various countries to overcome their balance of payments difficulties and maintain equilibrium. It is very important to note that the loans or documents relating to the loans cannot be treated as contracts and failure to abide by the obligations are not legally enforceable on any country. However, the IMF is in a position to exert pressure on the violating countries in various ways which include expulsion from the organization. IMF provides technical assistance to the member countries in areas that include fiscal policy, monetary policy, banking infrastructure, financial institution building and financial legislation. According to Feldstein “The IMF should provide technical assistance on how the debtors can improve their current account balances and increase their foreign exchange. It should act as a monitor of the success that the country is making in moving toward self-sustainable liquidity, providing its own funds as an indication of its confidence in the country's progress rather than as a bailout of international lenders and domestic borrowers. If the IMF can focus its attention on this narrower agenda, it can devote more of its scarce staff talent to the problem of crisis prevention.” The member countries are free to choose their own exchange rate system. According to the Article IV (3) a of IMF, the Fund shall oversee the international monetary system in order to ensure its effective operation, and shall oversee the compliance of each member with its obligations under Section 1 of this Article” Section IV (1) stipulates that “each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates.”  The efficacy of the surveillance of the IMF in the background of European financial crisis has become questionable. The IMF has been criticised for its structural conditions imposed on East Asian countries which has not only precipitated the crisis, but made the recovery process prolonged, though sovereign debt was under control. Khatkate (15) stated “The crisis also showed that the Fund needs to improve its surveillance role by looking beyond information provided to them by the authority. The way the East Asian crisis unfolded seemed to take the fund itself by surprise.” The international monetary fund’s ability to deal with the international financial problems should be assessed critically for taking meaningful actions to avoid yet another crisis. The European countries most affected in the financial crisis are Italy, Greece, Portugal and Spain. The Current Account balances (Trading Economics?) of these countries over years are depicted in the following charts. It could be observed that in all the four countries current account balances have been negative consistently for a very long period of time. The IMF could have intervened in the earlier stages and caution the countries to come out of their complacent behavior in dealing with the current account deficits. Sinns (3, 4) stated “The European Monetary Union is currently experiencing a serious internal balance of payments crisis that is similar, in many important ways, to the crisis of the Bretton Woods System in the years prior to its demise ... they increased rapidly, showing huge deficits in the GIPS countries (Greece, Ireland, Portugal, Spain). By the middle of 2011 (June), the sum of the accumulated balance of payments deficits (Target liabilities) of the GIPS countries had risen to 327 billion euros.” The accumulation of deficits in balance of payments over years and the failure of monitoring system by not intervening at the earlier stages are the causes that culminated into a full-blown financial crisis. The governments of these countries could not take effective steps for restoring proper equilibrium in the balance of payments position without the intervention and support of the European Union. IMF encourages the member countries to adopt floating exchange rate of the currencies. Free convertibility of the currencies is very important for the growth and development of international trade. Under Article VIII the member countries have undertaken the obligations imposed which facilitate adoption of floating exchange rate by the countries. These obligations include -Avoidance of restrictions on current payments (Section 2), Avoidance of discriminatory currency practices (Section 3), Convertibility of foreign-held balances (Section 4) and furnishing of information (Section 5). The resources for lending have been obtained through a quota system based on the strength of the member countries’ economy. The primary method for gaining resources is through the member’s quota. Quotas are considered important as they carry voting power and access to resources from IMF based on the size of quotas. “Reserve Tranche” enables the members to have automatic access to the prescribed portion of the funds. The IMF can also borrow to cater to the balance of payments needs of the member countries. The members purchase Special Drawing Rights (SDRs) or other currencies from IMF against their countries’ currencies, undertaking to repurchase their currency later. Dullien et al. (290) stated “quota is based broadly on the relative economic size of the member country, which determines its financial contributions as well as voting power within the IMF. It has been pointed out that this system results in most of the SDRs being allocated to countries that are unlikely to use them.” Both the IMF and the IBRD are involved in economic development of the member countries. But IBRD as an investment bank mobilizes resources from investors for extending credit facilities to developing countries aiming economic growth and poverty alleviation in various countries. On the other hand, the International Finance Corporation engages in development of private sector initiatives in lesser developed countries. Independent Evaluation Office of IMF (21) stated “The Fund needs to cultivate a culture that is proactive in crisis prevention, rather than primarily reactive in crisis response and management. It needs to take measures to prevent or mitigate future crises, as much as to address the weaknesses that were uncovered by past crises.” This view is also affirmed by Overseas Development Council’s report.  “The ODC Report identified the IMF's core competence as macroeconomic policy, and hence sees its central role as crisis avoidance and, when that fails, promoting speedy recovery from crisis” (Williamson). The international financial system is vulnerable to foreign debts and rise of deficit in current account balances. “Several of the sources explicitly endorse focusing attention on vulnerabilities in the financial system, foreign debt, the various areas in which international standards are being promulgated, and the exchange rate regime, and no one opposes going down that road.” (Williamson) Data and methodology The data published by IMF and World Bank are useful in research. Secondary data analysis involves collection large information relevant to the research after verifying for inconsistencies if any in the information gathered from different sources which include research papers published on journals, books and internet, official statistics from the government reports and reports from international institutions. Moreover, secondary data is more suitable, cost effective and less time consuming for the present research than other methods such as survey or interviews for collection of data. Since the purpose of the research is to analyze the role of IMF in the world monetary system, the evolution of the IMF, the efficacy of the organization in achieving its objectives, its impact on the world economy, criticisms leveled against its functioning or strategies and the current trends and the adequacy of the system have been analyzed carefully. While using secondary data for research the important factors such as validity and reliability of the data, personal bias and utility value of the content have been given due consideration. Main issues/findings The surveillance system in the IMF needs to be restructured for reacting to the impending signals alertly to avoid financial crises. However, in order to achieve the objective of the IMF namely, global monetary cooperation, financial stability, facilitating international trade, promoting high employment and sustainable economic growth, and reducing poverty around the world the organization has to look beyond surveillance. Economic growth by the underdeveloped countries of the world is stifled by their inability to import necessary technology or knowhow for gainfully exploiting the resources available in those countries. This could be partially achieved by helping them to improve their export performance by securing cooperation of the developed nations to this cause. Foreign direct investments in these countries not for just exploiting the natural resources available but also to manufacture and export value added products are essential. This will be useful for development of other industries by the local entrepreneurs to meet the increased demand consequent upon employment generation due to FDIs. For example, Athukorala (12) stated “China’s share in inflows to Asian developing countries increased from 11.4% during 1980-84 to 48.5% during 2000-06, and it has accounted for well over half of the total increment in FDI inflows to the region during this period” which is one of the important reasons for its economic growth. ‘Regional cooperation’ in international trade is a neglected area. The Asian, African and Latin American countries have several common features in the respective regions with similar economic and cultural background. However, bilateral trade among these nations has been hampered due to political differences, trade restrictions, border disputes and lack of infrastructure for bilateral trade. The IMF can focus in this area to improve trade relationships among these nations. This would reduce deficits in current account balances since variety goods and services can be exchanged among these nations and thereby avoiding imports from other trade blocs. According to Francis Ng and Yeats (37) “if goods that are increasing in importance generally have common characteristics like labor, capital or natural resource intensity in production, this could help focus regional efforts to reduce any transport, or other infra-structure constraints, these types of goods encounter.” The following table selectively shows total exports by regions and their share in the world trade. Total exports by regions and their share of world trade Total Exports ($billion) Share of World Trade (%) Group 1975 1985 1995 2001 1975 1985 1995 2001 European Union 325.3 711.6 1893.3 2194.8 39.2 36.0 36.9 34.3 Latin America 45.3 115.8 245.3 382.1 5.5 5.9 4.8 6.0 North Africa 13.4 29.4 33.9 49.3 1.6 1.5 0.7 0.8 South Asia 6.2 16.5 52.0 70.3 0.7 0.8 1.0 1.1 East Asia 44.5 186.2 839.0 1194.4 5.4 9.4 16.3 18.7 Source: Francis Ng and Yeats (3) It could be observed that share of world trade in the case of European Union has been stable considering the base effect and increasing over years in the case of East Asia. In North Africa, South Asia and Latin America the performance has been very poor. Considering the need for imports for the development of these economies, the balance of payments situation prevents growth in these countries. Increase in regional trade would lend flexibility in dealing with the current account imbalances. The potential for regional trade development should be explored by the IMF to promote economic development of these regions. The huge disparity in GDP per capita between even among the top economies of the world is a cause for concern. A nominal or negative growth in GDP will not affect the consumption pattern in the developed countries due to huge base effect. However, deceleration in GDP growth will severely affect economies in the case of developing countries. Any negative growth will be disastrous and can push the countries deeper into recession. For example, the countries at the bottom at ranks in terms of GDP per capita, India (837.75), Indonesia (1206.99) and China (2634.71) are the most populous and more vulnerable. GDP per capita: Top Economies TOP ECONOMIES LAST PREVIOUS HIGHEST LOWEST INDIA 837.75 822.76 837.75 180.86 INDONESIA 1206.99 1143.83 1206.99 194.43 CHINA 2634.71 2425.47 2634.71 72.32 RUSSIA 3052.15 2923.14 3052.15 1510.54 BRAZIL 4803.4 4716.61 4803.4 1448.14 TURKEY 5740.64 5348.57 5740.64 1556 NEW ZEALAND 14646 14629 15392.5 8042.68 SPAIN 15511.93 15458.21 16369.13 3715.88 SOUTH KOREA 16684.21 16372.5 16684.21 1109.86 ITALY 18935.05 18601.38 20000.52 5819.18 EURO AREA 21379.53 21096.43 21808.81 6264.2 FRANCE 23016.85 22884.95 23584.66 7482.07 CANADA 25933.29 25588.29 26192.94 9374.88 GERMANY 26080.52 25329.32 26080.52 11858.58 AUSTRALIA 27427.64 26693.71 27427.64 10449.84 UNITED KINGDOM 28032.79 27321.13 28928.94 10479.68 UNITED STATES 37691 37330 38699.01 14091.08 SWITZERLAND 38059.75 37666.39 38240.75 18970.15 JAPAN 39578.07 39309.65 40707 7117.79 Source: Trading Economics* Prolonged recessions in these currently growing economies and its markets will have serious repercussions on the international economy due to their increased exposure to FDIs. The role of IMF in averting balance of payments crisis assumes more significance to-day than before. Conclusion The purpose of surveillance will serve only if the IMF actively support a nation’s efforts to restore equilibrium in the balance of payments position at the earlier stages. If a country is allowed to slip deeper into deficit due to interest burden on the existing international loans from various sources including IMF and World Bank, the country’s contribution to the international trade diminishes drastically. Increasing deficit in the current account balances of the several developing and under-developed countries is a cause for concern since the people of these nations are excluded from enjoying the fruits of economic development. The IMF has to reorient the international monetary system for seamless integration of these economies into the international mainstream. References Athukorala, Prema-chandra. Trends and Patterns of Foreign Direct Investments in Asia: An Interpretative Survey. Research School of Pacific and Asian Studies Australian National University. Web. 28 March 2013 Dullien, Sebastian, Kotte, Detlef, J., Marquez, Alejandro and Priewe, Jan. The Financial and Economic Crisis of 2008-2009 and Developing Countries. United Nations Conference on Trade and Development, 2010. Feldstein, Martin. Refocusing the IMF. Foreign Affairs, Vol. 77, No.2, March/April 1998. Francis Ng and Yeats, Alexander. Major Trade Trends in East Asia. What are their Implications for Regional Cooperation and Growth? World Bank Policy Research Working Paper 3084, June 2003, SSRN. Web. 28 March 2013 Independent Evaluation Office of IMF. IMF Performance in the Run-Up to the Financial and Economic Crisis IMF Surveillance in 2004–07, 2011. Web. 28 March 2013 Read More