Is the IMF's European focus damaging its international credibility?

Not so long ago there was concern the International Monetary Fund (IMF) might become redundant as few countries were in trouble and its lending booking had dwindled.

Now, as the eurozone crisis grows bleaker and bleaker, new managing director Christine Lagarde is wondering whether the institution has sufficient resources to meet all the demands being placed on it.

“The question is, do we still have the resources that are now needed and appropriate to address… the crises? Maybe [the IMF] could do with more… In the not too distant future we will probably have to revisit this, ” she said at a Council of Foreign Relations event in New York, shortly after taking over her new role in July.

Growing grumbles

Raising more funds for the IMF, though, is not an easy task. There is opposition in the US, as well as among the major emerging markets who feel that the IMF has still not resolved its long-standing governance issue of giving them a say in the institution’s dealings more appropriate to their economic weight. 

In the US, opposition to increasing IMF funding will come from the Republican party, who have a majority in the country's lower house – and not only because of the recent US debt agreement that saw the country drastically cut spending to meet its debt obligations. Many Republicans are also loath to support multilateral organisations of any description and have already started proceedings to reduce existing US funding to the IMF as well as to the World Bank, the Inter-American Development Bank and all other regional development banks.

In emerging markets, the concern is that Ms Lagarde, as a former French finance minister, may not be as even-handed or as tough towards eurozone borrowers as a non-European might be.

Ms Lagarde dismissed such speculation as “rubbish” in a Financial Times interview recently. But it was also reported in the Financial Times that while some leading emerging market economies, such as Brazil, want the IMF to continue their involvement in Greece’s debt rescue plans in order to stem the spread of financial contagion, they are worried about the risks of the IMF lending even more money to Greece in a second bail-out package, when the consequences are uncertain. Currently about 57% of the IMF’s outstanding loans are in Europe.

Euro dominance

Questions also continue to be asked about the practice of always having a European at the head of the IMF – Ms Lagarde is the IMF’s 11th successive European managing director.

European countries have about one-third of the votes on the executive board, and the US holds 17%, making it possible to maintain an informal agreement of having a European as head of the IMF, and an American as president of the World Bank.

On governance reform (which is expected to be high on the agenda at the IMF and World Bank annual meetings in Washington, DC, this month), the G-20 endorsed a 5% shift in the IMF’s weighted voting system last November and according to this, China will become the fund’s third largest shareholder and the other BRIC )Brazil, Russia, India and China) countries will all be among the IMF’s top 10 shareholders by the 2012 annual meeting.

“Getting these reforms implemented as soon as possible is one of my top priorities,” Ms Lagarde said during her July 26 address at the Council on Foreign Relations event in New York. However, former IMF officials and economists think the reform does not go nearly far enough.

Charles Dallara, managing director of the Institute of International Finance (IIF) – a grouping of international banks and financial institutions – and a former US executive director on the IMF’s board, says despite the reforms over the past few years, European countries will still continue to have a “heavily over-weighted voting share relative to their current economic importance” in 2012, while the voting shares of major emerging markets, such as China and Brazil, will still be “grossly under-weighted”.

“The leadership of the fund has been unwilling or unable to adjust the voting shares to the new realities of emerging market economies. This needs to be definitively addressed” for the fund’s credibility, says Mr Dallara.

Losing influence

Ousmène Mandeng, a former senior IMF official and emerging market specialist at Ashmore Investment Management, now working at UBS, says that if governance issues (including voting shares, senior staff appointments and the way fund policies are formulated) are not addressed, there is a risk that the IMF will lose influence.

“Different emerging economies and member countries were disillusioned by the [IMF] when governance reforms started five years ago and I think that is as relevant today as it was then,” says Mr Mandeng. He adds that underestimating the problem can only lead to a fragmentation of the international system, with different parts of the membership preferring regional bodies and regional solutions, thus weakening the IMF.

“So long as the voting power is skewed towards Europe and the US, the staff will tend to discount IMF policies and advice and feel the IMF cannot be so transparent and open with regard to Europe and the US as it is to emerging economies and developing nations,” says Domenico Lombardi, a former IMF official now at Washington’s Brookings Institution.

Ms Lagarde is aware of the challenge. “Candour and even-handedness are essential for the IMF to be credible in its monitoring [ie: analysis and oversight] of [member countries'] economic policies,” she has said.

Meanwhile, another key challenge that is expected to be raised during the IMF’s annual meetings is the scope and traction of its crisis prevention work, and oversight which fell down badly in the years preceding the 2008 financial crisis, especially in the world’s largest and most systemically important countries, former IMF officials say.

The IMF's own independent evaluation office, in a review of IMF surveillance work from 2004 to 2007, concluded that the fund's ability to correctly identify the mounting risks was hindered by a high degree of group think among the staff, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely and an institutional culture that discouraged contrarian views.

Learning from the crisis

But since the 2008 crisis, the IMF has sought to improve its surveillance, filling gaps in its oversight – and in global financial architecture – with much greater coverage of the financial sector and financial regulation issues, and a better appreciation of systemic risks. For instance, IMF Financial Stability Assessment Programmes, previously carried out in developing countries, are now mandatory in all systemically important countries where the world’s top few large, complex, cross-border financial institutions are based.

Additionally, the IMF's financial sector expertise has been boosted, both by hiring more people from the private sector and by incorporating more financial sector analysis in its macroeconomic country work.

These improvements, former IMF officials say, are important in terms of raising the quality of the IMF's surveillance work, so that it is perceived as providing best practice advice in the financial sector, not only in the area of macroeconomic research, and in advanced economies as well as the developing world.

Filling another gap in its oversight, the IMF has stepped up its multilateral crisis prevention work, examining the impact of domestic economic policies, especially of systemically important countries in the G-20, on each other and on global stability. For instance, to promote stronger international policy co-ordination, the IMF added new 'spillover reports' to its latest assessments of five systemic economies – China, the eurozone, Japan, the UK and the US – to evaluate how their policies might affect regional and global stability.

To focus attention on the principal policy changes facing these economies, the IMF will present the lessons learnt from this additional work in an overarching report during its annual meetings in September 2011.

Anticipating some of the results, Ms Lagarde has said: “We found that a successful rebalancing of the Chinese economy – including a stronger social safety net, a liberalisation of the financial system and a stronger currency – would generate positive spillovers for the global economy. We also found that the adoption of a suitably ambitious [financial] regulatory and supervisory regime in the UK would strengthen the stability of the [financial] system as a whole.”

Reza Moghadam, director of the IMF’s strategy, policy and review department declared in a recent IMF online interview: “By shedding light on the impact of one country or region’s policies on others, we hope to facilitate the process of finding policies that serve both the national and the global interest.” 

Political dimension

But facts on the ground suggest, that as the world’s economy and the financial sector have become increasingly global and interconnected, economic policies and financial regulations have continued to be managed largely at a national level, responding to national electorates. “There’s fundamental incompatibility in that. This is the problem at the heart of it,” says Mr Dallara.

Mr Lombardi adds: “That is why it is really important for the new managing director [of the IMF] to recognise the political dimension of the institution, really playing a bridging role, really bridging the gap between the global dimension of the world economy and the national dimension of policy-making.” 

To this end, to bridge the gap and increase policy coordination, the IMF has been providing analysis and facilitating a dialogue between the G-20 leading economies, in addition to undertaking multilateral work of its own.

For instance, one small step forward in the G-20’s mutual assessment process, to strengthen global economic stability and growth, was an agreement earlier this year by the group on guidelines by which they could assess which G-20 countries should receive special scrutiny by the IMF.

The G-20 said the list would include all large and important economies and those that account for more than 5% of G-20 output. (That includes the US, Japan, China, France, Germany, the UK and the eurozone as a bloc.)

The IMF would examine the country or region and compare its public debt and fiscal deficit, as well as its external accounts with others in the G-20 to find out if policy action was required.

With such scrutiny – and the needed policy changes – the IMF hopes that potentially destabilising imbalances in the global system, which are now contributing to overheating in emerging economies and high unemployment in the developed world, can be adjusted or avoided completely.

But it remains to be seen what the major G-20 economies do, and how they will react, when the IMF actually does make its policy recommendations known, These recommendations are expected to be announced later this year.

Global priorities

In Mr Dallara’s view, the IMF needs to play “more of a leading role” in shaping this process of global economic policy and establishing an effective global framework and global adjustment mechanisms.

Improvements in the scope of IMF oversight have not removed a long-standing criticism of the consensus-governed institution. Developing countries have long complained that while the IMF frequently rebukes developing country borrowers over domestic policy choices, it has no ability to make non-borrowing rich countries or big emerging economies, which are also non-borrowers now (such as China, Brazil, India and Turkey), consider the external impact of their domestic policies.

Mr Lombardi says: “Clearly surveillance is an area where the IMF has a limited enforcement power and especially when it comes to dealing with systemically important economies.

“The only source of leverage with them is the quality of its analysis, the political ability of its managing director and the credibility of the institution as a whole in promoting a dialogue between the world’s biggest economies.”

But Mr Dallara at the IIF thinks the IMF can and should do more, not only to strengthen member countries' multilateral obligations, but also to make them accountable if they fail to uphold them. “You need a system of sanctions either through some public 'name and shame' or through financial sanctions, to encourage countries to pursue, broadly speaking, a globally compatible and coherent set of policies. The current approach is much too lackadaisical in my view, given the risks that can surround the global economy,” he says.

Simon Johnson, a former chief economist at the IMF and now a professor at the Massachusetts Institute of Technology, says it would be a mistake to expect too much from the IMF. “There’s no way that powerful countries are going to give up sovereignty over their economic policies and give that to an un-elected non-transparent body of technocrats like the IMF. Nor should they, by the way. And I don’t think that will change even with another crisis,” he says.