ASSIGNMENT NO. 1

TOPIC No. 28: IMF’s Policies During World Recession

WHAT IS IMF?

The International Monetary Fund (IMF) is an intergovernmental organization that oversees the global financial system by taking part in the macroeconomic policies of its established members, in particular those with an impact on exchange rate and the balance of payments. The objectives are to stabilize international exchange rates and facilitate development through the influence of neolibral economic policies in other countries as a condition of loans, debt relief, and aid. It also offers loans with varying levels of conditionality, mainly to poorer countries. Its headquarters is in Washington D.C.

The International Monetary Fund was conceived in July 1944 originally with 45 members and came into existence in December 1945 when 29 countries signed the agreement, with a goal to stabilize exchange rates and assist the reconstruction of the world’s international payment system. Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances. The IMF works to improve the economies of its member countries. The IMF describes itself as “an organization of 187 countries (as of July 2010), working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty.”

RECESSION

In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way. Production, as measured by Gross Domestic Product (GDP), employment, investment spending, capacity utilization, household incomes, business profits and inflation all fall during recessions; while bankruptcies and the unemployment rate rise.

IMF’s ROLE AND POLICIES DURING RECESSION

Countercyclical macroeconomic policies

The International Monetary Fund (IMF) presented a response to CEPR’s latest paper, which looked at the macroeconomic policies of 41 countries that currently have agreements with the Fund. The paper had found that 31 of the 41 countries had implemented pro-cyclical policies, that is, either fiscal or monetary policies that would be expected to exacerbate an economic downturn, when such downturns were occurring in these countries.

This paper looks at the countries that have been hard-hit by the world economic recession, and have turned to the IMF for assistance. In the three Central and Eastern European (CEE) countries: Hungary, Latvia, and Ukraine, there were mistakes in economic policy that increased their vulnerability to external shocks. The governments’ responses to the downturn, along with IMF conditions for assistance, are also seen to have caused harm with pro-cyclical policies.

DESCRIPTION OF FLAWS IN THE IMF’s POLICIES

In Hungary, a surge of foreign borrowing allowed the country to run large current account deficits in 2006 and 2007 (7.5 and 6.4 percent of GDP, respectively), as well as a large fiscal deficit in 2006.

The current account deficits became much more problematic as foreign capital inflows dried up and then were reversed during the world economic slowdown. Private sector balance sheets were also hit hard when, in response to these reversals, the domestic currency depreciated sharply – since the private sector had borrowed heavily in euros. The response to the crisis, however, seems to have made matters worse than necessary. The IMF stand-by arrangement included measures to bring the government deficit, as a percent of GDP, down to 3.4 in 2008, and to 2.5 in 2009. This may not have been appropriate, given that Hungary is now projected to undergo a sharp economic contraction of 6.7 percent of GDP. This pro-cyclical fiscal policy has also been accompanied by pro-cyclical monetary policy.

The Fund’s forecasts indicate that it did not anticipate the severity of Hungary’s contraction, with its November 2008 projection of just -1.0 percent growth for 2009. Also, about a year before the crisis in Hungary’s financial sector, the IMF wrote in its 2007 report on Hungary’s economy that “the financial sector remains sound.”

Latvia also suffered from a large reversal of capital flows that was common to the CEE economies, following a boom fueled by foreign credit, which increased by 60 percent annually from 2002-2006. But here too, a combination of pro-cyclical fiscal and monetary policy – supported by an IMF agreement as well as funds from the European Union – appears to have worsened the contraction.

The decision by the Latvian government, in conjunction with the European Union and the IMF, to maintain Latvia’s pegged exchange rate with the euro, has made recovery much more difficult. With the currency fixed rate, the only way to reduce the country’s current account imbalance is through shrinking the economy, which reduces imports faster than exports and may also reduce real wages.

This is similar to the IMF-sponsored policies in the deep Argentine recession of 1998-2002, where a fixed, over-valued currency worsened and prolonged the downturn until the Argentine currency collapsed in 2002.

Ukraine was also hard hit by the world slowdown. There was a sharp decline in the price of steel (a major export) and, on the import side, a significant increase in the price of natural gas from Russia.

Like the other CEE countries, Ukraine also suffered from a reversal of capital flows, threatening liquidity in the banking system. From October 2008 to March 2009 the National Bank of Ukraine lost US$14 billion in reserves in an unsuccessful effort to defend the currency.

The Fund also prescribed fiscal tightening for Ukraine, where GDP is now projected to decline by 9 percent in 2009. The IMF stand-by arrangement approved in October 2008 provided for a zero fiscal balance. This was later relaxed to a deficit of 4.0 percent of GDP. Ukraine total public debt is low – just 10.6 percent of GDP, so it would make sense to borrow in order to finance an expansionary fiscal policy and reduce the severity of the recession. It is worth noting that the Fund also greatly underestimated the depth of Ukraine’s recession, with its December 2008 forecast of a decline of -3.0 percent of GDP for 2009. Ukraine has also pursued a pro-cyclical (contractionary) monetary policy under the IMF agreement.

CONCLUSION

We have analyzed the current situation of the countries that have been severely hit by the ongoing global recession, and have turned to the IMF in order to restore the normal operation of their economies. The policy recommendations derived from the IMF stand-by arrangements, however, are mostly pro-cyclical and will make it difficult for these governments to stimulate their economies.

In all of these countries, it would appear that there were more sensible responses to the crisis that would reduce the loss of employment and output, cuts in social services, and political instability that have resulted from the downturn. It is worth emphasizing that the main constraint for these countries pursuing expansionary fiscal and monetary policies, particularly in a time of falling inflation, is that they have sufficient foreign exchange to avoid a balance of payments problem. The IMF, especially with its vastly expanded resources, is capable of providing the necessary foreign exchange to allow for counter-cyclical policies – yet it has opted instead for pro-cyclical policies in these countries.

REFERENCES

1. www.cepr.net

2. The Wikipedia Encyclopedia

SUBMITTED TO:

Mr. GurDeepak Singh

SUBMITTED BY:

Isha Aggarwal

MBA- 1^st Sem(A)