The Need and Primary Obstacles to the Reform of the International Financial Institutions - Case Study Example

Why has reforming the International Financial s been proposed in recent years and what are the primary obstacles to proposed reforms? Two international organizations of significance emerged along with the United Nations, after the Bretton Woods conference in 19441. These were the International Monetary Fund (IMF) and the International Bank for reconstruction (IBRD). The prime objective of setting up these institutions was to ensure global financial security and to provide development aid to the needy countries. Through last 65 years of their existence these global institutions lectured the developing countries (who are the principle recipients of their aid) on the benefits of structural reforms. The idea was to promote world economies based on the model of capitalism, which were being practiced in the USA and other western countries who incidentally were also the main donors and the governing members of these two institutions. It seems that after so many years these very policies of the two institutions have come to haunt their mentors. The global recession which started with the bursting of the housing sector bubble has brought in significant implications on the economies of the developed countries. To deal with this situation the western economies are now paradoxically, following such policies which are totally in contrast to what has been suggested by the international financial institutions (IFI’s). Institutions like that of the World Bank and the IMF have always talked about liberalizing the trade barriers, reforming the labor market, to open up the country’s financial system, rein in budget deficits and subsidies and to go for privatization. In many cases these were made essential before any financial support was provided to these countries. On the other hand, post recession the developed countries all over the world are going for considerable government intervention, regulation of financial sector, coupled with an increase in social spending. (Act now on the G20 Summit: Messages to the leaders, 2008)  Failures of the IFI’s Failures of polices of the IFI’s has been experienced all over the world from the countries of Asia, Latin America and also in Africa. The East Asian crisis2 occurred mainly because of the liberalization of the financial sector which was carried out at the behest of the IFI’s. Such reforms were done even before establishing effective regulations on the financial markets. Government interventions in the markets were sufficiently reduced and excessive borrowings, speculation and unnecessary use of hybrid instruments was done in the private sector. In fact this kind of economic crisis arising out of the policies of the IFI’s was not new. It had already happened in countries like Mexico and later even reached Russia and Latin America.   Argentina was considered to be a model country as it had followed nearly all the instructions given by the IMF while granting loans. Paradoxically the same country suffered a severe economic crisis in 2001, which according to many experts have been a gift of the same economic policies of the IMF. These policies led to reduction in government expenditure, the direct effect of which fell on the country’s infrastructure. Also the deregulation in financial sector and rampant privatization led to the slipping away of governments control over the financial sector.    Another country which faced such severe economic crisis was Kenya. The IMF suggested that the Kenyan central bank must reduce its control on the inflow and the outflow of foreign currency. Although this had nearly no impact on the incoming foreign investment, but the corrupt government officials and politicians were able to siphon off billions of currency from the country, leaving the foreign currency reserve of the country in dire conditions.    Deficiencies in the IMF One of the main problems of delaying reforms in the IMF is that, the management of IMF is mostly in the hands of the donor countries. Although each member country can appoint a governor in the board of IMF, the day to day activities of the funds are governed by a Board of Directors consisting of 24 members. This executive board is made up of 24 directors among a total of 184 member countries. Although 8 industrially advanced nations get 8 positions, the rest of the 16 positions are distributed among 176 members on the basis of various quotas allotted to each group. Sub Saharan African countries that total 43 in number get only 2 seats. Although the constitution of IMF is akin to that of a credit cooperative, its functioning is not based on the same standards. Hence we see a clear differentiation between the status of the creditors and the debtors of the fund. Although most of the emerging market economies are the debtors of the fund, the decision making is in the hands of a few rich countries. Thus the needs and the opinions of the developing countries do not get reflected in the decisions of the funds. Hence the developing countries must be provided with greater representation in the management of these institutions. Also there is rule regarding 85% super majority for taking important decisions, like changing the articles of the fund. It is widely believed that this law had been introduced mainly to prevent other countries to take away the veto power of the USA. Incidentally USA is the only country which has such a power among all the members of the fund. (Park, and Wang, July 2001) IMF is widely regarded as a body which is responsible for stabilizing foreign exchange rates and promoting their development. In this context a major failure of the fund has been its inability to promote the SDR’s or the Special Drawing Rights as the international reserve currency. In the present scenario of using the currencies of the developed countries as reserve has led to a flow of money from the developing countries to the more industrialized ones. In the absence of SDR’s the increasing need for funds in the IMF had to be met by increasing the quota of the member countries. This approach has led to the further increase in dependence over the industrialized countries as it is they who provide the new funds by virtue of which their quota in IMF gets increased along with their voting powers. This was not the case during the early years, when each member country was allocated a basic quota and hence the voting power was much democratic. Now in the wake of the current global financial crisis, when there has been a major depreciation of investor’s confidence in dollar based assets, the demand of reinvigorating the SDR has been raised by countries like China and Russia. The developed countries claim that the lending activities of the fund are being largely financed from the money provided by them and hence they should enjoy more control of the activities of the fund. There is an inherent fault in this assumption. The reason being that now much of the funds used for lending come from the debt repayments made by the borrowing countries. Interest paid by these countries on their loans is used to meet the operating expenses of the fund and also to make further concessional lending.  Reforms undertaken at the IMF Due to the intense pressure from the developing companies and sustained pressure provided by the media and many NGO’s across the world, the developed world it seems now has accepted the need for structural reforms in the IMF3. During a reform plan presented in Singapore in September 2006, the US promised to look into how to reduce its voting share and to give the developing economies more share in the management. But US has also emphasized that along with it the European Union also has to reduce its influence on the working of the fund. (Samasuwo, 2005) The policy makers in the IMF have also understood that it is necessary to bring in change in their policies and to widen the reach of the fund. Soon after the East Asian financial crisis, two new facilities, namely the Supplementary Reserve Facility (the SRF) and the Contingent Credit Line (CCL) facilities were introduced by it. Under SRF, short term financial help is provided to such countries which are facing exceptional balance of payment difficulties. Under CCL monetary help is provided on a precautionary basis against any balance of payment crisis that may arise in the future. Thus now along with dealing with the financial crisis, the fund also wants to focus on the prevention of the same. (Griffith-Jones, and Ocampo, 2003) Development of codes and standards for preventing crisis in the debtor countries is one of the major successes of the fund. Progress has also been made in the macroeconomic surveillance done on the developing economies, in developing early warning systems and carrying out regular review of the economy. A step in this direction has been the formation of the Financial Stability Forums (FSF) to identify the risks, so as to gain control over them and ultimately develop similar regulations across the financial institutions of the world. FSF consists of “Compendium of Standards” that contains reference on the various economic and financial standards which are internationally accepted and are considered to be a must for a deep and well regulated financial market. FSF highlights three standards, in the fields of Macroeconomic Policy and Data Transparency, Institutional and Market Infrastructure, and Financial Regulation and Supervision. (Griffith-Jones, and Ocampo, 2003) What more can be done One of the most important reforms needed in the IMF is to change the voting structure of the fund. Voting power has to be allocated in such a manner, that the borrowing and the lending countries have same number of votes. This can be done by increasing the basic vote criteria which was envisaged in the 1944 Bretton Woods conference. The constitution of the executive board also has to be reformed so as to give greater participation to the developing countries in the functioning of the board. President has always been from the US while the MD from the European countries. Veto power and the need of 85% voting system should be removed. It has also been estimated that the majority of the staff working in the important departments of IMF, like the policy, research and external affairs department has degrees from the universities of US, UK and other western countries. This should be reformed and more globally trained and educated staff must be recruited so that they have local knowledge and are able to understand and deal with the problems efficiently (Caliari, and Schroeder n.d.) – “In September 2007, the Fund’s estimated forward lending capacity was $200 billion from regular quota resources and an additional $50 billion from established borrowing arrangements”. (Truman, January 2009) This needs to be increased in order to meet the growing demand of foreign exchange requirements among the member countries. Along with this the fund needs to increase its surveillance capacity so as to keep the members countries better informed about the market conditions. Lastly the fund must try to bring in more transparency in its working. World Bank World Bank or the IBRD was set up to provide long term funds to the developing countries which did not had the capacity to get such loan on their own in the international markets. The bank functioned by borrowing money from the market backed by the guarantee provided by the developed nations and lends them to such countries which had no access to these funds. At present the condition of this institution is not very satisfactory. The poor health of the World Bank can be gauged from the fact that, whereas the nations borrowed $14 billion in 1999 -2002, from the bank, they repaid $15 billion to the bank during 2003-05.   Recently it has been seen that there has been a marked indifference in the developing countries to borrow from the bank. The reason for the same is manifold. It was widely believed that the bank lends to those countries which do not get an easy access to financial market. But actually it has been found to lend only to those countries which are creditworthy. It has been found that 10 borrowing countries account for 90% of the bank loan. Also three fourth of the lending went to such countries which had A-rating for high yield. It was also perceived that bank lends where most of the world’ poor lives. This is also falsified by the fact that 10% of the clients who accounted for more than 50% of the loans had average per capita income of more than $8000. The bank holds the view that its lending is the only source which provides for long term financing facilities. But now the capital markets have become mature enough to supply loans of the duration of even 40 years, which is double to that of 20 years maximum prescribed by the World Bank. World Bank was further having the opinion that in case of any market crisis, the private lenders are the first to exit and the bank takes up the sole responsibility for bailing out the countries. But during the East Asian Crisis of 1997 and the Brazil crisis in 1998, both the countries were able to obtain significant financing from the capital markets with medium to long term maturities. The bank tried to prove that its lending to the developing nations generates profits in terms of the subsidy that it provides on the loans. But actually the costs like the technical ones, which are literally forced on the borrowing countries, drain the resources of the developing countries. It charges 0.50 percent as an annual charge on the loan along with 0.25 percent commitment fee and 1 percent up-front fee. The technical costs in some cases accounts to 3-4% of the total cost of the loan. (Lerik, 2006) Bank also bundles its projects in such a way so that the loans are used for such projects of which the developing countries do not have much use and which neither are revenue generating. This further increases the burden on the repayment schedule of the developing countries.  What needs to be done? Banks credibility has been stunted by the rise of private financial institutions and the growth of international financial markets. Hence the bank must try to adapt itself to the same. It should begin with proper targeting of the subsidies, so that the same is provided only to the needy countries and with the rest the bank can deal in a more professional manner. The bank to date has $40 billion in its treasury which is also interest free. The same can be lend and the surplus can be invested in the capital market to earn further income, the return on which can be again used for lending purposes. Other donor countries can also be asked to route their funds through the World Bank. Although a lot of discussions are underway but no reforms agenda for the IFI’s has yet been developed which can be acceptable to all. Financial markets across the world have become much integrated. An efficient IFI must be able to understand the dynamics of the same so as to advise the governments of the member countries on the same. Another important feature of such a system must be to create such standards which can be made universally acceptable. One such example is the banking sector norms presented by the Basle committee. These laws were first to be implemented by the government of the individual countries and later on same were brought together to meet the global standards. Along with an appropriate apparatus for providing development aid to the less developed countries, an efficient international financial structure should also be able to provide sufficient liquidity to meet all the requirements during an economic crisis. Present recession in the major economies of the world has provided a new opportunity to these institutions. Iceland has become the first western country in the last three decades to ask for help from the IMF. Both these institutions now should use all their expertise in leading the global efforts in dealing with the exigencies of the present situation.  References 1. “Act now on the G20 Summit: Messages to the leaders” (2008), Choike.org, available at: www.choike.org/bw2 (accessed on June 6, 2009) 2. Caliari, A. and F. Schroeder (n.d.) ‘Reform Proposals for the Governance Structures Of The International Financial Institutions’, New Rules for Global Finance, available at: http://www.new-rules.org/Docs/ifigovernancereform.pdf (accessed on June 6, 2009) 3. Griffith-Jones, S. and J. A. Ocampo, (2003) What Progress on International Financial Reform? Why so Limited?, EGDI, available at: http://www.egdi.gov.se/pdf/study/study2003_1.pdf (accessed on June 6, 2009) 4. Lerik, A. (2006) Has the World Bank Lost Control?, Rescuing the World Bank, Available at: http://www.aei.org/docLib/20060911_Lerrick_WorldBank.pdf (accessed on June 6, 2009) 5. Park, Y. C. and Y. Wang (July 2001) Reform of the International Financial System and Institutions in Light of the Asian Financial Crisis, G-24 Discussion Paper Series, United Nations, available at: http://www.unctad.org/en/docs/pogdsmdpbg24d12.en.pdf (accessed on June 6, 2009) 6. Samasuwo, N. (2005) Africa and the reform of the International Financial Institutions (IFIs), Available at: http://www.hollerafrica.com/showArticle.php?catId=1&artId=191 (accessed on June 6, 2009) 7. Truman, E.M.(January 2009) ‘The G20 and international financial institution reform: Unfinished IMF reform’, available at: http://www.voxeu.org/index.php?q=node/2896 (accessed on June 6, 2009) Read More