The International Monetary Fund

With the breakdown of the gold standard in 1930’s several difficulties cropped up in the sphere of international trade and finance.

A period of fluctuating exchange rates started. There were many instances in these years, of countries deliberately following policy of undervaluation of their currencies in order to encourage their exports. These efforts naturally led to resentment and retaliation.

Thus there was competitive depreciation of currencies and severe restriction of imports of goods and exports of capital.

One country after another adopted exchange controls not merely to check capital flight but also as a permanent measure to protect themselves for the adverse consequences of a depression elsewhere. Such a state of affairs led to a contraction of world trade and growth.

The Second World War started in 1939, which aggravated the economic misery of the different countries. Six years of war had shattered the economic and political relationships which has made up the world economy of 1939. The productive power of Europe had been destroyed or curtailed while that of United States had been enhanced.

The debtor-creditor relationships had been fundamentally altered. Direct controls on the passage of goods and the exchange of currencies had replaced the old regime of convertible currencies and the multilateral trade.

With the conclusion of the Second World War four important problems demanded world-wide attention.

(i) First, there was the immediate need of physical reconstruction and rehabilitation.

(ii) Second, there was the task of establishing and maintaining international payments equilibrium.

(iii) Third, there was the problem of stable employment.

(iv) Fourth, there was the problem of establishing a stable structure of world trade.

Flans for economic stability to follow World War 11 rested upon three pillars of 19th century liberal trade policy:

(a) Stable exchange rate,

(b) Large foreign lending and

(c) Relaxation of trade restrictions.

During the closing years of the Second World War most nations began to realize that international monetary problems must be solved by some kind of mutual agreement or some kind of an international monetary institution. With this realization experts of United States and United Kingdom began to prepare comprehensive plans for international monetary cooperation. Mr. Harry White of the U.S. prepared a plan which is popularly known as the White Plan. The author of the British proposal for world monetary cooperation was J.M. Keynes. The U.S. and British experts reached a compromise in this matter in Washington in April 1944.

In July, 1944 the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire in the north eastern United States, produced the most ambitious plan for the world economy which had ever been made. Three international institutions, namely, International Monetary Fund, International Bank for Reconstruction and Development and International Trade Organization, were conceived at the Bretton Woods Conference. Out of these three, only two were born but the I.T.O. was not born because the member countries of the conference did not ratify its scheme.

Thus, Bretton Woods created two international institutions, I.M.F. and I.B.R.D. The I.M.F. was to deal with payment restrictions and short run balance of payments disequilibrium of member countries. The I.B.R.D. was to deal with reconstruction of war-devasted economies and development of less developed countries. The I.T.O. (which was not established) was to deal with trade restrictions and to regulate and harmonies the commercial policies to promote free trade.

The basic principles of the Bretton Woods system are as follows:

(i) The exchange rate changes are a matter of international concern and that exchange stability is best achieved by a system of exchange rates which are fixed in the short run but may be varied from time to time to adjust fundamental changes in international currency. The system of managed flexibility is the compromise result.

(ii) That there must be some augmentation of national gold and currency reserves in order that countries are not forced to meet short run balance of payments deficits by disturbing domestic adjustments of income and employment.

(iii) That the interest of political harmony and economic welfare are jointly served by a system of unfettered multilateral trade and convertible currencies.

(iv) That a balance of payments disequilibrium is necessarily two- sided and its correction is the joint responsibility of both surplus and deficit countries.

(v) That international monetary cooperation is best effected through an international agency with defined functions and powers.

(vi)That monetary disturbances are frequently non-monetary in origin so that an international monetary agency must coexist with other agencies each responsible for such problems as employment stabilization and liberalizing of world trade.

(vii) That a high and sustained level of international investment is necessary for the stability of the international economy and that the flow of private international investment may be facilitated and increased by the creation of an international investment bank.

The I.M.F. and I.B.R.D. were brought into formal existence on 27th December, 1945 both with headquarters in Washington.

Purposes of the I.M.F:

The Fund’s purposes, according to the Articles of Agreement, included the following:

(i) To promote consultation on international monetary problems;

(ii) To facilitate the expansion and balanced growth of international trade and thereby to promote and maintain a high level of employment and income;

(iii) To promote exchange stability and orderly exchange arrangements and to avoid competitive exchange depreciation;

(iv) To help reestablish a multilateral system of payments and to eliminate foreign exchange restrictions which hamper world trade;

(v) To provide means whereby a country may correct maladjustments in its balance of payments without resorting to measures destructive of national or international prosperity; and

(vi) To promote measures which shorten the duration and lessen the severity of balance of payments disequilibrium.

More concisely three main tasks were to be undertaken:

(a) The Fund was to fix the initial par values of currencies following World War II.

(b) Thereafter, the Fund was to assist members in maintaining these rates of exchange by rendering assistance whenever required because of pressures arising from temporary balance of payments difficulties.

(c) Further, in the event of chronic difficulties in a member’s balance of payments (that is, going beyond short term), the Fund was to supervise changes in the rate of exchange without such action leading to a wave of competitive exchange rate depreciation. In other words, the Fund aimed to promote relative exchange rate stability, but nevertheless recognized the need for some degree of flexibility (actually “internationally controlled flexibility”) in exchange rates.

Structure and Management:

The membership of the Fund was held open to any country provided that it would subscribe to the Articles of Agreement. It started with 44 members but now it has increased to 186. The IMF is accountable to the governments of its member countries. At the top of its organizational structure is the Board of governors which consists of one Governor from each of its member countries. All governors meet once each year at the IMF World Bank annual Meetings.

It is the supreme authority of the Fund but in some reserved cases it has delegated its power to Executive Board. Twenty four of the Governors sit on the International Monetary and Finance Committee (IMFC) and meet twice each year. The day-to-day work of the IMF is conducted at its Washington D.C. headquarters by its 24 member Executive Board; this work is guided by the IMFC and supported by the IMF’s professional staff. The Managing Director is head of IMF staff and Chairman of the Executive Board, and is assisted by the three Deputy Managing Directors.

There are, perhaps, two main characteristics that distinguish the Fund from other international organizations with the exception of World Bank. The first is that the Executive Directors function in continuous session and meet not periodically but as often as Fund business requires.

Through the Executive Board governments exercise a closer control over the day to day activities of the Fund than is generally the case with international organizations with one or two exceptions such as the organization for Economic Cooperation and Development (OECD). The second distinguishing characteristic of the Fund, very rare among inter-governmental bodies is the system of

Authorization was to expire upon the Fund’s declaration that the currency in question was no longer scarce. The major assurance provided was in the form of the scarce currency provision which, when invoked, could serve to “legalize” exchange controls on the part of individual countries.

Capital Movements:

Exchange control was held a permissible practice, also when employed to prevent particular capital movements (whether or not these involved a currency declared scarce). In the wording of the Articles of Agreement, “a member may not make net use of the Fund’s resources to meet a large or sustained outflow of capital, and the Fund may request a member to exercise controls to prevent such use of the resources of the Fund”.

It was further provided that exchange control might not be exercised “in a manner which will restrict payments for current transactions or which will unduly delay transfers of Funds in settlement of commitments”. In other words, members were given no license under the Articles of Agreement to use exchange controls to regular ordinary capital movements either short term or long term.

The Fund’s provisions merely sanctioned control over “large” or “sustained” outflows of capital which, if unregulated, tend to create balance of payments difficulties and thereby force members to call upon the fund for assistance.

Chronic Balance of Payments Difficulties:

If a member experiences balance-of-payments deficit of more basic origin wherein the difficulty is both major and persistent (chronic), a different procedure applies: a change in the exchange rate, occurring explicitly under Fund supervision and limited in .scope to the member (or members) in question.

Actually any member is free, at its own discretion, to depreciate (or appreciate) by an amount up to 10 percent but any exchange rate change beyond that amount is to occur only upon request and following formal approval.

As respects such exchange rate changes, the Articles of Agreement provide that the Fund “shall concur in a proposed change if it is satisfied that the change is necessary to correct a ‘fundamental disequilibrium'”. In other words, in determining whether to approve depreciation by a member the Fund is to apply two tests-(i) does a fundamental disequilibrium exist in a member’s balance of payments? (ii) Is depreciation necessary in order to correct this fundamental disequilibrium?

What is Fundamental Dis-equilibrium:

While the Articles of Agreement left the term “fundamental disequilibrium” undefined, usage indicated that it referred to a situation of long term, deep-seated imbalance in a country’s balance of payments as distinct from a temporary disturbance.

According to Triffin, “A fundamental disequilibrium exists when there is a maladjustment in a country’s economy so grave and persistent that the restoration or maintenance of satisfactory levels of domestic activity, employment and incomes would prove incompatible with equilibrium in the balance of payments if not accompanied by extra-ordinary measures of external defence, such as a change in the exchange rates, increased tariff or exchange control, protection etc.”.

What conditions generally give rise to fundamental disequilibrium? First major cause rests upon price level distortions between countries. When one country’s price level rises more rapidly that that of others, it develops a deficit disequilibrium in its balance of payments. This deficit can be corrected by either imposition of exchange restrictions or through depreciation of its exchange rate.

A second major cause rests upon structural change as applied to individual countries or group of countries. Structural change stems from an unfavorable shift in world demand for particular world products or in the ability of a country or group of countries to produce for world markets.

How the IMF Promotes Global Economic Stability:

The IMF advises member countries in implementing economic and financial policies that promote stability, reduce vulnerability to crisis, and encourage sustained growth and high living standards. It also reviews global economic trend and developments and affect the health of the international monetary and financial system and promotes dialogue among member countries on the regional and international consequences of their economic and financial policies. The IMF helps countries to implement sound and appropriate polices through its key functions of surveillance, technical assistance and lending.

Surveillance and its Role Today:

Surveillance in its present form was established by Article IV of the IMF’s Articles of Agreement as revised in the late 1970s following the collapse of the Bretton Woods system of fixed exchange rates. Under Article IV, member countries undertake to collaborate with the IMF and with one another to promote the stability of the global system of exchange rates.

In particular, they commit to running their domestic and external economic policies in keeping with a mutually agreed code of conduct. For its part, the IMF is charged with:

(i) overseeing the international monetary system to ensure its effective operation; and

(ii) monitoring each member’s compliance with its policy obligations. To ensure that surveillance remains effective, the IMF is constantly reviewing its policy framework.

In June 2007, the policy framework of surveillance received its first major update since the 1970’s with the adoption of Decision on Bilateral Surveillance over members’ policies. The decision clarifies that country surveillance should be focused on assessing whether countries’ policies promote external stability. This means that surveillance should mainly focus on monetary, fiscal, financial, and exchange rate policies and assess risks and vulnerabilities.

It provides guidance to members on how to conduct exchange rate policies in way that is consistent with the objective of promoting stability and avoiding manipulation. The decision also emphasizes that surveillance should be collaborative, candid, evenhanded, and forward looking, adopting a multilateral perspective while taking into account countries, specific circumstances.

Surveillance needs to evolve with global economy. For example, the current financial crisis has shown the need for deeper analysis of the linkages between the real economy and the financial sector. Building on the Financial Sector Assessment Programme (FSAP), financial sector issues are receiving greater coverage under surveillance and analytical tools for integrating financial sector and capital markets analysis into macroeconomic assessments are being developed.

In their advice to individual countries, IMF staffs seek to leverage cross country experiences and policy lessons, drawing on the organization’s unique vintage point as a global financial institution. Spillovers of members’ policies on other members’ economies also receive particular attention in staff analysis, and the IMF has been sharpening its exchange rate assessments.

Even the best economic policies cannot completely eradicate instability or avert crises. In the event that a member country does experience financing difficulties the IMF can provide financial assistance to support policy programs that will correct underlying macroeconomic problems, limit disruption to the domestic and global economies, and help restore confidence, stability and growth. IMF financing instruments can also support crisis prevention.

International Liquidity and the IMF:

International liquidity refers to “all the resources that are available to the monetary authorities of the countries for the purpose of meeting balance of payments deficits”. It is composed of two elements, namely, owned reserves (unconditional liquidity) and borrowing facilities (conditional liquidity). “Owned reserves” in this context refers to official reserves which include the gold and foreign currencies in the possession of central banks. The borrowing facilities refer to those available from international financial institutions, drawing facilities available under swap arrangements with other central banks and the like.

Thus, international liquidity refers to the resources at the disposal of the national monetary authorities for meeting deficits in the balance of payments as well as the ability to borrow internationally for the same purpose. Growth of world trade necessitates the increase of international liquid resources at the disposal of countries so as to enable them to finance their international transactions.

There was an apprehension that the international monetary system created by the Bretton Woods Agreement would not be able to provide the required supply of international liquidity to finance the expanding volume of world trade.

This fear arose out of the world’s stock of, gold growing very slowly and the resources of the IMF being small as it was limited to a stock of gold and a pool of currencies. As such the IMF could not be a source of expanding liquidity. All these factors led the member countries to give the power to the IMF to create Special Drawing Rights.