IMF Managing Director Christine Lagarde shows thumbs up during a meeting of finance ministers in Luxembourg (AP Photo/Yves Logghe).
IMF Managing Director Christine Lagarde shows thumbs up during a meeting of finance ministers in Luxembourg (AP Photo/Yves Logghe).

Mohamed El-Erian had an interesting comment in last Friday's Financial Times calling on the G20 to protect the International Monetary Fund (IMF) from Europe. His point is that Europe, which is over-represented at the IMF, has weakened the conditions under which the Fund has lent to Greece, Ireland and Portugal. According to El-Erian, the Fund has supported programs that have little chance of restoring medium-term debt viability, are not fully financed and which risk the Fund's preferred creditor status.

These are important issues for the institution and its members.

The IMF is structured as a financial cooperative for the pooling of international reserves. Members agree to give other members access to their reserves under "appropriate safeguards" (that ensure that they are repaid). As a result, a member's financial contribution to the IMF through its quota subscription can be, and generally is, counted as part of that member's international reserves. If there is a possibility that the resources (i.e., borrowed reserves) might not be repaid, these reserves could be impaired.

In the world for which the Fund was designed, the fact that a member had access to a pool of reserves meant that it could smooth domestic 'absorption' (the sum of consumption, investment and government expenditures) in the face of a temporary negative external shock. This is critical because for its first forty years or so capital controls meant that a country with a balance of payments problem either required official lending from the IMF or a sharp contraction of domestic demand - with exchange rates fixed, the adjustment burden was typically borne through lower government expenditures or higher taxes. IMF financing did not eliminate the need for adjustment, but under "appropriate safeguards" spread the adjustment out over time and avoided the need for the draconian compression of absorption.

In this respect, while members chaffed under the conditions imposed by IMF programs, which were viewed as an infringement of national sovereignty (and the tenure of finance ministers was reduced by them), they had an incentive to adhere to the terms of  programs. IMF programs were 'incentive compatible.' And because the size of crises was small, reflecting differences in national savings and investment rates, the Fund had the resources to resolve them; it was viewed as both effective and credible.

In a world of (almost) perfectly-integrated capital markets, however, the IMF is in a much more difficult situation. With capital account liberalization, the balance of payments problems of the Bretton Woods era have become capital account crises of much greater size (it is no longer a problem of savings-investment flows, but of financing the flight of asset stocks). As a result, the IMF doesn't have the resources to fill balance of payments gaps. Instead, it tries to play a catalytic role in encouraging private capital to remain in the member.

This is the problem that worries El-Erian. If the IMF gets its analysis wrong, or is pressured into participting in support packages that have little chance of restoring medium-term debt viability, are not fully financed and which risk the Fund's preferred creditor status, it will be viewed as less effective and less credible. If it asserts its preferred creditor status, under which it is repaid before all other claims, private sector claims are subordinated - resulting in even larger haircuts.

It is little wonder then that El-Erian wants the G20 to protect the IMF from Europe. 

In the world for which the Fund was designed, the fact that a member had access to a pool of reserves meant that it could smooth domestic 'absorption' in the face of a temporary negative external shock.
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