How to equip the IMF for the crises of our time

by Lorenzo Bini Smaghi

Financial Times
January 26, 2012

After each major financial crisis, from Latin America in the 1980s to Asia in the late 1990s, the International Monetary Fund experienced several reforms aimed at strengthening its ability to deal with the new challenges. The most recent crisis in advanced economies, in particular Europe, does not yet seem to have triggered a comparable movement for reform. The main discussions so far have been focused on the need to increase the IMF’s financial resources and to reduce the conditionality for more rapid access to IMF financing. While these are certainly important issues, they may not be sufficient to equip the IMF better to restore stability in the current financial environment. This is especially significant in the face of shocks at the core of the system.

Recent events have shown that crises in advanced economies may develop in very different ways from those of past crises in developing or emerging economies. This suggests that the options available to the IMF may need to be rethought and updated, from several perspectives.

First, the time horizon of standard IMF programmes appears to be too short. As a rule, IMF funding is provided for three years, on the assumption that in the meantime existing imbalances will be corrected and access to capital markets fully restored. While this may be the case for small open economies with flexible exchange rates, recent experience suggests that more time can be required to implement a sustainable adjustment, especially for countries that are members of a monetary union and have accumulated large external deficits.

Second, and related to the above, the practice of taking countries in IMF programmes away from the markets for a few years and funding them entirely with official financing may not be appropriate for developed economies. The experience in Greece and now in Portugal shows that using all available official financing at the start of the programme may help solve the short-term liquidity problems but tends to raise doubts in the markets about countries’ ability to stand on their own feet at the end of their IMF programme – especially if the imbalances have not been sufficiently reduced. The fear that at that point no additional financing would be available raises the risk of debt restructuring and discourages private market participants through self-fulfilling expectations.

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