Economics & Trade Relations
Washington File
14 February 2001
Byliner: Alan Meltzer on International Financial Institution Reform
(Article from February 2001 Economic Perspectives) (2336)
(This byliner was published in the February 2001 issue of Economic
Perspectives, an Electronic Journal of the U.S. Department of State.
Persons who intend to redistribute this byliner should give credit to
Economic Perspectives as the source.)
Reforming the International Financial Institutions: A Plan for
Financial Stability and Economic Development
By Allan H. Meltzer
(The author, professor of political economy and public policy at
Carnegie Mellon University, was chairman of the congressionally
appointed International Financial Institution Advisory Commission,
which submitted its report to Congress in March 2000.)
The world economy and the international financial system are now very
different from what was envisioned at the Bretton Woods conference in
1944, when the International Monetary Fund and the World Bank were
established. These principal international financial institutions have
responded to the many changes and crises in recent decades by
expanding their mandates and adding new lending facilities and
programs. New regional institutions, such as the Inter-American
Development Bank, the Asian Development Bank, and the African
Development Bank, have opened to serve the needs of regional
populations, but many of the activities of these agencies overlap with
those of the World Bank.
In addition, two major changes have occurred in the international
financial environment that require changes in the responsibilities of
the international financial institutions. First, the fixed but
adjustable exchange rate system adopted at Bretton Woods ended almost
30 years ago. Second, private financial institutions, corporations,
and individuals in the industrial countries now supply the largest
part of the capital flows to the developing world. The international
financial institutions' share is now less than 5 percent of the total.
Many of the poorest countries, however, remain dependent on the IFIs.
Major problems in the international financial system have followed
these changes. Some countries have grown to rely excessively on
short-term private capital inflows to finance long-term development, a
very risky approach that has caused crises throughout history.
Financial systems in developing countries too often have been used to
subsidize favored industries or individuals, weakening the financial
institutions, eroding their capital, and increasing risks of crises
and failures. Pegged exchange rates in many developing countries have
made them vulnerable to speculative attacks. All these factors have
helped create financial systems subject to frequent, severe crises.
Further, while the IFIs lend to governments, the institutions have
very little influence over how the funds are used. Often, projects are
not completed, funds are misappropriated, and promised reforms are not
implemented. Instead of improving their own performance, the
development banks have expanded their programs to overlap with the
IMF. The reverse is also true. The IMF, founded to deal with
short-term financial problems, now makes long-term loans for
structural reform and poverty alleviation. Some countries remain
permanently in debt to the IMF. Long-term lending should be left to
the development banks.
NEEDED STRUCTURAL CHANGES
To restore the IFIs effectiveness, these institutions must undergo
structural changes.
The proper role of the IMF should be preventing financial crises and
the spread of crises that do occur. Crisis prevention does not mean
that the IMF continues to "bail out" all lenders, or lends large
amounts to maintain pegged exchange rates, or dictates the policies to
be followed in client countries. The IMF should not lend to finance
the structural reform of the recipient country's institutions. The
Fund should give advice, but it should not tie the advice to
assistance.
The mission of the development banks -- the World Bank and the
regional development banks -- should be four-fold: promoting economic
and social development (including the reform of domestic
institutions), improving the quality of life, reducing poverty, and
providing global and regional public goods. These institutions should
not be banks in the traditional sense. Their job should not be to
increase the number and size of their loans or to lend to creditworthy
countries. It should be to advance development, not lending.
Reflecting this, the names of these institutions should be changed
from development banks to development agencies.
Steps also must be taken to address the "overlap" problem between the
World Bank and the regional development banks. The World Bank has
started to create field offices in loan-recipient countries. This is a
waste of resources by an overly large and ineffective bureaucracy. The
regional development banks already have offices in all of the relevant
countries. Many governments and their constituents have closer ties of
language, culture, and understanding to the regional agencies.
Effectiveness would be improved, and costly overlap reduced, if the
regional banks assumed sole responsibility for many of the programs in
their regions. The World Bank's direct role should be limited to
regions without a development bank and to Africa, where poverty
problems are most severe and difficult to solve, and where the
regional bank has less experience. The World Bank should continue to
supply technical assistance and promote knowledge transfer in all
regions.
PRE-CONDITIONS FOR IMF ASSISTANCE
The IMF needs to focus on four main tasks: crisis prevention, crisis
management, improved quality and increased quantity of public
information, and macroeconomic advice to developing countries.
Each of the serious crises since 1982 has its own special features and
some common features. Before the crisis breaks out, investors begin to
withdraw funds. The country often guarantees the foreign exchange
value of the funds in an attempt to forestall the emergency. This
postpones the crisis but does not prevent it. The IMF tries to help
the country maintain its exchange rate by lending foreign currency to
defend the exchange rate. The country may increase interest rates and
promise reforms, but investors see increased risk. If the financial
system depends on short-term capital inflow, it may collapse with the
exchange rate. The most damaging crises are of this kind.
Not all crises can be prevented. However, the frequency and severity
of crises can be reduced by reforming country and IMF practices to
increase incentives for policies and behavior that enhance stability.
The IMF should be a quasi lender of last resort, not first resort,
providing liquidity when markets close. It should work to prevent
crises, act to mitigate them, and leave structural reform and
development to the capital markets and the development banks.
When countries face a crisis that requires IMF assistance, they need
it quickly. To make this possible, countries should meet certain
pre-conditions to qualify for the IMF aid. Then, when needed, the
assistance should be provided immediately. This would end the existing
process in which countries that need assistance have to wait while
negotiators agree on a long list of conditions for structural,
institutional, and financial changes. Crises worsen during these
delays, and there is little evidence that conditions for disbursement
of aid, imposed after the crises have begun, have helped much in the
past.
The pre-conditions must be straightforward, clear, easily monitored,
and enforced. The four most important are that the nation's financial
system is adequately capitalized, that government financial policies
are prudent, that information on the maturity structure of foreign
debt becomes available promptly, and that foreign banks are allowed to
compete in local financial markets. Member countries of the World
Trade Organization have agreed to phase-in this last condition. I
would add a fifth condition: that the exchange rate system be either
firmly fixed or floating.
Countries would have strong incentives to meet and to maintain the
pre-conditions. IMF acceptance of the country as pre-qualified for
automatic assistance would serve as a seal of approval. The country
would be able to obtain more foreign capital on more favorable terms.
Countries that were not pre-qualified would get fewer loans and would
pay higher interest rates to compensate for the additional risk.
Pre-conditions would redirect private sector flows away from high-risk
borrowers toward those that pursue stabilizing policies. This would
reduce the risk in the entire system.
Third countries harmed by the collapse of a trading partner would
automatically receive assistance if they meet the pre-conditions.
Countries that do not meet the pre-conditions would receive IMF help
only in a crisis that affected the entire system.
Removing structural reform from the IMF's mandate is based on a
well-known proposition that money can solve liquidity problems, but
not real structural problems. In developing countries, structural
problems arise because of regulation, tariffs, inadequate financial
supervision, absence of the rule of law, and other impediments to
investment. As recent experience demonstrates, loans and liquid
resources often allow countries to delay reform.
The IMF can help sustain market discipline through the publication of
timely, accurate information on economic, financial, and political
developments. Accurate information permits lenders and investors to
make informed decisions. The IMF has a major role in improving the
quality and increasing the quantity and timeliness of country data.
Publication of reports of IMF missions and the IMF's recommendations
is a welcome development. Improved information reduces uncertainty and
improves lenders' decisions. Release of information encourages reform
and permits investors to make continuous marginal adjustments instead
of rushing to exit when anticipations change quickly. Further,
improving information and opening the economy to foreign banks reduces
reliance on renewable, short-term loans. Thus, it reduces one of the
major problems of development finance: excessive reliance on
short-term loans.
Another issue is "moral hazard," which arises in international lending
when governments or IFIs permit foreign lenders to believe that they
will be bailed out in a crisis. Part of the solution for reducing or
eliminating moral hazard lies in letting foreign financial
institutions compete in the local market. They would hold both assets
and liabilities denominated in local currency, so they would be less
exposed to exchange rate risk. An open financial system would
encourage foreign entrants with a long-term commitment, thereby
reducing reliance on short-term capital. And foreign banks would bring
expertise in risk management and act as relatively safe havens if a
crisis occurs.
A MORE FOCUSED MISSION FOR DEVELOPMENT BANKS
The development banks' main problems are that their programs lack
focus, are often loosely related -- or unrelated -- to their stated
goals, and all too frequently fail to accomplish their objectives.
After decades of programs, many of the poorest nations have lower
living standards than in the past. The fault does not lie totally with
the development banks, but they have not found ways around the
obstacles that some governments create. And they continue to lend
despite the obstacles and the resulting failures.
Countries that have made substantial progress are those that have
strengthened institutions and the role of markets; those that have not
made these reforms have made little, if any, progress. Most of the
very poor countries owe large debts to the IFIs that cannot be
serviced or repaid. These debts need to be forgiven entirely, but only
after countries implement reforms.
Changes to the development banks should focus on three broad areas.
First, the development banks should work to improve the quality of
life, even in countries where corruption and institutional
arrangements hinder or prevent economic development. In place of
loans, the development banks should offer grants paying up to 90
percent of the cost of approved projects. To increase achievement and
reduce waste, grants should be given after competitive bidding and
should require independent monitoring and auditing of results.
Payments should be made, after performance is certified, directly to
suppliers instead of to governments. This would give the suppliers an
incentive to assure that inoculations are made, potable water is
supplied, sanitation is improved, and literacy rates are increased,
and that these and other programs produce measurable results. Second,
long-term subsidized loans to develop effective institutions would
assist countries that willingly adopt and sustain the necessary
reforms. Here, too, independent auditors must certify that progress
continues. Third is the issue of global and regional public goods.
Many problems that prevent development or reduce the quality of life
are common to many different countries. The development banks have
maintained a country-specific focus. They have not tried to find
solutions to common concerns involving health issues, tropical
agriculture, and many other areas. Research is costly, and individual
market demand is too small to induce companies to do the research. By
bringing countries together and subsidizing their joint research
efforts, the development banks can close the gap between social and
private rates of return.
Scarce official financial resources need to be concentrated on poor
countries without access to alternative funds. Countries should
graduate automatically and regularly from the development banks'
programs. Graduation would release more money to help the poorest
countries. The development banks should continue to offer technical
assistance to countries that graduate, but these countries should
borrow in the market and be subject to market discipline.
A CALL FOR REFORM
The international economy has experienced several prolonged, deep
financial crises in the past 20 years. At the same time, economic
development has bypassed the poorest countries. Many of them are in
Africa, but extreme poverty can be found also in Latin America, Asia,
and southern and eastern Europe.
Reform of the international financial institutions is needed to
increase economic stability, improve the flow of information,
encourage economic development, support institutional reform, reduce
poverty, and support provision of regional and global public goods.
(Note: The opinions expressed in this article do not necessarily
reflect the views or policies of the U.S. government.)
(Distributed by the Office of International Information Programs, U.S.
Department of State. Web site: http://usinfo.state.gov)