When Dominique Strauss-Kahn appeared before the executive directors of the International Monetary Fund a year ago to pitch his candidacy for the top job, the former French Finance minister didn’t mince words about the challenges facing the institution. Years of robust global growth had dried up demand for IMF loans, and an outdated system of voting rights was undermining the Fund’s legitimacy in the eyes of emerging economic powers like China and India, he noted. “What might be at stake today is the very existence of the IMF as the major institution providing financial stability to the world, a global public good,” he warned.
Today, thanks to Strauss-Kahn’s energetic leadership as managing director and the deepening world financial crisis, the IMF is enjoying a new lease on life. The credit crisis spawned by the subprime mortgage debacle in the U.S. — which was just beginning to make itself felt when Strauss-Kahn talked to the IMF board — along with the decline of the dollar earlier this year and the high price of oil are threatening the stability of the international financial system. At the same time, the Fund’s readiness to tackle those challenges has been enhanced by Strauss-Kahn’s skillful implementation of reforms of the organization’s governance and finances.
As a result, member governments are only too happy to find new tasks for the 64-year-old institution. Already this year they have charged the Fund with drawing up a code of conduct for the investment practices of the world’s fast-growing sovereign wealth funds (see box) and with investigating the causes of the surge in oil prices over the past year. Strauss-Kahn has also bolstered his capital market department to aid the Fund’s efforts to help strengthen and reform the global financial system and serve as an early-warning system for future crises. Suddenly, questions about the Fund’s future and relevance — widespread in recent years — have vanished.
“The old saying is true in this case — if it didn’t exist, we would have to invent it,” says Clay Lowery, assistant secretary for international affairs at the U.S. Treasury Department.
John Lipsky, the IMF’s first deputy managing director, sees the Fund’s recent revival as just its latest evolution: The organization was created at the end of World War II to oversee the Bretton Woods system of fixed exchange rates, adapted itself to the shift to floating exchange rates in the 1970s and then became a bulwark against financial crises in developing countries in the 1980s and ’90s. “Setting the rules of the game in international financial relations, monitoring financial and monetary stability — this is the essential role or mission of the Fund,” Lipsky tells Institutional Investor. “How we go about it is inevitably going to evolve.”
Strauss-Kahn, who took office as managing director last November, moved quickly to adapt the Fund to its changed environment. He picked up on governance reforms drafted under former chief Rodrigo de Rato and won speedy approval from member governments in April to make a long-overdue adjustment of voting quotas for member countries, which will give added weight to major emerging economies to reflect their growing economic importance. He also addressed the IMF’s budget crisis by agreeing to slash its payroll by 13 percent and getting members to endorse the sale of some of the institution’s gold reserves to create an endowment to finance future spending.
“We’re already seeing results,” Treasury’s Lowery says of Strauss-Kahn. “He did succeed in getting governance reform, which nobody else had done. He brought the board together on the budget.”
Desmond Lachman, a fellow at the Washington-based American Enterprise Institute for Public Policy Research and a former deputy director for policy development at the IMF, says the new managing director is providing more-forceful leadership than his predecessors, Germany’s Horst Köhler and Spain’s de Rato. “Under Köhler and de Rato, very little actually got done,” he says. The IMF “was more in a cheerleading mode” as the globalization of financial markets appeared to buoy worldwide growth.
Strauss-Kahn is also following in de Rato’s footsteps in his effort to shift the Fund’s core mission from being a lender of last resort to developing countries to serving as a watchdog for the global financial system. The IMF has been refocusing its work on economic surveillance since the middle of this decade; in 2006, de Rato merged the Fund’s capital markets and monetary and financial systems departments and put them under the control of Jaime Caruana, a former Spanish central bank governor and chairman of the Basel Committee on Banking Supervision, which sets capital standards for global banks. “We want to be an early-warning system,” Caruana tells II. “Our objective is to raise awareness about risks significantly.”
The Fund’s record on that score is not without blemish, though. IMF economists warned frequently in recent years that financial markets and the international banking system were underpricing risk, but the Fund’s experts — like most other analysts — failed to foresee the fallout from the U.S. subprime crisis, says Edwin Truman, a fellow at the Peter G. Peterson Institute for International Economics and a former Federal Reserve Board economist. Senior fund officials acknowledge the criticism. “We did not realize how much leverage was in the system,” says Mahmood Pradhan, assistant director in the Fund’s Monetary and Capital Markets department.
To improve the policy analysis, Strauss-Kahn and his team are seeking to coordinate more closely the organization’s economic and financial market monitoring with the insights its experts gather from their bilateral consultations with the IMF’s 185 member countries. In particular, staff will use the Fund’s two benchmark reports — the semiannual World Economic Outlook and the Global Financial Stability Report — to pay more attention to the interplay between financial markets and the so-called real economy of manufacturing, trade and employment. “We want to link these two pieces of work to help us in understanding risks,” says Caruana. “There will be more cross-country analysis. We will study how others have dealt with similar problems. We don’t think there is just one solution to a problem.”
The Fund’s revised financial stability report, released in July, stressed that global financial markets remain fragile a year after the onset of the subprime crisis. IMF officials estimate that losses on U.S. mortgages and mortgage-backed securities could ultimately reach $565 billion, and that total credit losses — including everything from commercial real estate to credit cards — could hit $945 billion. Banks around the world have taken more than $450 billion in credit write-downs, so far, and raised capital equal to about three quarters of those write-downs, according to the report, but the IMF cautioned that losses could mount further. “Credit quality across many loan classes has begun to deteriorate with declining house prices and slowing economic growth,” the report stated. “Although banks have succeeded in raising additional capital, balance sheets are under renewed stress, and bank equity prices have fallen sharply.”
IMF officials have played a key role in the work of the Financial Stability Forum, a group of international regulators from a dozen countries created in the wake of the 1997–’98 Asian crisis. It is coordinating global efforts to deal with today’s credit crisis. According to Lipsky, the IMF brings to the table a global point of view, helping to represent all the parties and countries that don’t belong to the Forum. The Forum’s recommendations to the Group of Eight leading industrial nations, issued in April, echoed many of the themes in the IMF’s Financial Stability Report, including the need for banks to increase capital and improve risk management and disclosure.
Although officials welcome the Fund’s new activism, many analysts and policymakers remain skeptical about how effective the IMF or any institution can be in preventing new crises. The U.S. Treasury’s Lowery recalls that there was much talk in the wake of the 1994 Mexican peso crisis about the IMF’s serving as an early-warning system. “Yet here we are 14 years later and we still don’t have it,” he says. “Part of the problem is that you are always fighting the last war.” In addition, he says, many of the factors that contributed to the subprime crisis are regulatory issues, which by nature are specific to each nation, even if regulators are intensifying their international cooperation.
The IIE’s Truman says it is unrealistic to expect the IMF, which is not a regulatory body, to manage the global financial system. Rather, he suggests, the Fund’s role ought to be setting international standards and making sure that member countries live up to them.
Strauss-Kahn has shown a willingness to exercise the Fund’s recently enhanced authority to investigate the exchange rate policies of member nations — arguably the institution’s core mission — but it is much too early to tell whether he can improve the IMF’s effectiveness in this area. After years of prodding by Washington, which argued that a weak yuan was causing China’s massive trade surplus with the U.S., the Fund’s executive board toughened surveillance guidelines in June 2007, giving officials grounds to criticize exchange rate policies that produce external imbalances. China and some other developing nations opposed the move but were unable to prevent it. The People’s Bank of China said the change didn’t fully reflect the views of developing countries and argued that exchange rate adjustments were not the only means of reducing payments imbalances.
At the G-8 summit in July in Toyako, Japan, Strauss-Kahn told participants that the yuan remained undervalued despite its gains against the dollar over the past two years. The managing director last month proposed holding ad hoc consultations with member countries if the Fund has concerns about exchange rate policies.
Strauss-Kahn’s dilemma, like that of his predecessors, is that the Fund has little clout with economically powerful members, particularly big-surplus countries like China that have no need for IMF financing. Amid considerable fanfare, de Rato in 2006 launched a yearlong multilateral consultation on global imbalances involving the U.S., the euro area, China, Japan and Saudi Arabia. The talks provided a useful forum for exchanging information about national policies, according to participating officials, but they produced no real consensus or policy recommendations. The U.S. current-account deficit has declined from a peak of more than 6 percent of GDP in 2006 to an annualized rate of less than 5 percent currently, reflecting the impact of the dollar’s depreciation and faster growth in developing countries than in the U.S. But signs of a recent shift in Chinese exchange rate policy could put this issue on the front burner. Beijing authorities, worried that the yuan’s gains risked hurting exports, signaled in July that government policy would emphasize growth and employment. At the same time, the yuan’s steady rise against the dollar, which had seen it appreciate by 21.4 percent since July 2005, came to an abrupt halt.
Although the Fund has little leverage over a big-surplus country like China, the AEI’s Lachman welcomes Strauss-Kahn’s sterner line. “He’s definitely going in the right direction,” the analyst says. “He can sit down with them and say, ‘You’re not playing by the rules; you’re manipulating your exchange rate.’”
On another front, IMF officials have lately been sounding urgent warnings about global inflation. The Fund’s revised economic outlook, released in July, noted that high commodity prices and above-trend growth were aggravating price pressures in emerging markets, prompting the Fund to raise its inflation forecast for these economies by more than 1.5 percentage points, to 9.1 percent in 2008 and 7.4 percent in 2009. Consumer prices rose by an average of 6.4 percent in those countries in 2007. Fund economists upped their inflation forecast for advanced economies by 0.8 point, to 3.4 percent, in 2008; and by 0.3 point, to 2.3 percent, in 2009.
The Fund called on emerging markets to tighten monetary and fiscal policy to combat inflation. A slowdown in growth and containment of labor costs argue against immediate tightening in advanced nations, the Fund said, but it warned that authorities need to be prepared to act fast if commodity prices start pushing up wages. “Allowing the past decades’ gains in lowering inflation and inflation expectations to be lost would seriously undermine future economic prospects,” former IMF deputy managing director Lipsky cautioned in a July speech at the Brookings Institution.
At the behest of the G-8, the IMF is working with the International Energy Agency to investigate the causes of the surge in oil prices over the past year. Although the retreat of oil prices in recent weeks has taken some of the urgency out of this issue, policymakers and economists alike have been divided on what role speculation, as opposed to supply-and-demand factors, has played in determining oil prices. The Fund’s regional economic outlook for the Middle East and Central Asia, released in May, said the rise in oil prices seemed to exceed anything that could be explained by fundamentals and noted a close correlation this year between crude prices and gold, a speculative commodity. But Lipsky played down the impact of speculation in a speech at a June energy conference in Saudi Arabia. “While recognizing that financial factors have played a temporary role in the recent run-up of oil prices — let me mention here the drops late last year in real policy interest rates and the U.S. dollar’s earlier decline — it remains difficult so far to establish a lasting impact of financial commodity investment on oil price trends over the past few years,” he said.
In July the Fund warned in a report that rising food and energy prices were exacerbating the plight of the poorest countries. The inflationary effects of higher commodity prices should be “accommodated” by monetary and fiscal policies, the IMF recommended, but governments should seek to prevent those price pressures from spilling over into generalized inflation. Strauss-Kahn, meanwhile, pledged to use the Fund’s poverty reduction facility to help poor countries deal with the crisis. “We need to get food — or the money to buy food — to those most in need,” he said in an address at the High-Level Conference on Food Security in Rome in June.
To bolster the Fund’s oversight capabilities, Strauss-Kahn has moved to strengthen the institution’s pool of economists and financial market analysts even while paring staff numbers overall. A key recent hire was Olivier Blanchard, a French economist at the Massachusetts Institute of Technology, who takes over as chief economist this month. Blanchard has written widely on global payments imbalances, oil price shocks and asset bubbles, all key issues for the IMF. He regards the massive U.S. trade imbalance with China as a by-product of China’s high savings rate and the U.S.’s correspondingly low one and is skeptical about the need for coordinated policy moves to reduce the deficit. “Blanchard could provide the IMF with some intellectual firepower,” says the AEI’s Lachman. “He can generate ideas, credibility.”
Notwithstanding its new duties, the IMF stands ready to revert to its role as global lender of last resort, a prospect that looms larger as the credit crisis drags on. “If we get a serious downturn, many emerging-markets countries are going to be in a certain amount of difficulty,” notes Lachman. “I would not be surprised to see the IMF resume lending.”
Lipsky plays down the chances for a revival of the kind of massive bailouts that the Fund provided to Mexico, South Korea and Indonesia in the 1990s or to Brazil and Turkey early in this decade. Instead, he envisages the IMF’s financing serving as more of a standby credit. By conditioning such credits on an IMF-approved policy program, the Fund would seek to bolster market confidence and prevent difficulties from escalating into a crisis. “The idea is to anticipate a potential problem [and] to attest to the quality of the policies in place to deal with the problem.”
The combination of standby financing facilities and enhanced surveillance is enabling the IMF to adapt to today’s markets while fulfilling its original mandate, Lipsky contends. “The Fund doesn’t aspire to be the end-all and be-all,” he says, “but we have a unique mission — maintaining global monetary and financial stability.”
Rarely have those commodities been needed more.
Setting the Principles for Sovereign Funds When the U.S., Europe and Japan last year asked the International Monetary Fund to draw up a code of conduct for the world’s rapidly growing sovereign wealth funds, the prospects of success seemed uncertain at best. Many big reserve holders bristled at the very suggestion. At a testy January debate at the World Economic Forum in Davos, Switzerland, Muhammad Al-Jasser, who as deputy governor of Saudi Arabia’s central bank helps oversee the country’s $300 billion of foreign exchange reserves, criticized Western governments for trying to impose rules on sovereign funds that were bailing out major banks while resisting regulation of their own hedge funds and rating agencies. But after months of study and three rounds of talks among officials from 25 countries, Fund officials have allayed suspicions and reached a preliminary agreement early this month on a set of guidelines that are due to be unveiled at the IMF’s annual meeting in Washington, D.C., next month.
Sovereign wealth funds “took a positive attitude” and saw the merit of being “more proactive” in communicating their strategies to outsiders as their assets have grown, says Jaime Caruana, the head of the Fund’s monetary and capital markets department, who is overseeing the process. “They want to raise the bar in terms of practices,” he says.
Although the IMF is cochairing the negotiations, Caruana stresses that the sovereign wealth funds and their governments are in the driver’s seat. Indeed, the working group quickly rejected the term “code of conduct,” which many countries felt implied an imposition of rules, and instead defined its objective as “generally accepted principles and practices.”
Officials say that Hamad al Suwaidi, a director of the Abu Dhabi Investment Authority who cochaired the talks with Caruana, has played a key leadership role in the negotiations. In late March, al Suwaidi reached agreement with the U.S. and Singapore on a set of voluntary principles for sovereign funds — as well as countries receiving their investments — that are expected to serve as a template for the IMF guidelines. The U.S. accord commits sovereign wealth funds to making investments on commercial rather than political grounds, to improving disclosure of their strategy and performance, and to competing fairly with the private sector. The accord obliges recipient countries to avoid taking protectionist measures and to provide predictable and consistent investment frameworks.
The IMF-led talks have been modeled on the work of the U.K.’s Hedge Fund Working Group, which sought to defuse criticism of hedge funds by formulating voluntary standards of transparency and governance.
Officials from the 25 countries met at IMF headquarters in Washington in late April to formally establish the International Working Group for Sovereign Wealth Funds. The group reconvened in July in Singapore and in Santiago, Chile, at the start of September.
Clay Lowery, assistant secretary for international affairs at the U.S. Treasury Department, praises the IMF’s work on sovereign wealth funds. “They are playing a valuable role as what can best be described as an honest broker,” he says.
The IMF estimates that sovereign wealth funds control between $2 trillion and $3 trillion in assets, compared with nearly $6 trillion controlled by governments as official reserve assets and some $2 trillion managed by hedge funds. By comparison, institutional investors in developed markets control about $53 trillion.
The IMF identifies several broad categories of sovereign funds: Those set up primarily as stabilization funds, designed to even out national budgets over good and bad years; savings funds, aimed at preserving today’s wealth for future generations; and special-purpose funds, such as funds for infrastructure development or pension investment. What all of them have in common is an objective of maximizing returns on investment rather than ensuring liquidity for balance-of-payments purposes, as official reserves do.
In tandem with the IMF-led talks, the Paris-based OECD is shepherding negotiations among its developed-country members to formulate a set of principles for countries receiving investments from sovereign funds. Those principles, which are expected to emphasize the need for nonprotectionist and nondiscriminatory policies on incoming investment, are due to be finalized by next spring.
OECD Secretary General Angel Gurría delivered an initial report on this effort to the Group of Seven finance ministers in April and noted that the sovereign fund talks had become part of a wider OECD consultation on investment freedom. One key early agreement, he said, was that “recipient countries should apply the national security clause of OECD investment [agreements] with restraint.” — D.D.
