In the News: Bringing the IMF Back to its Roots

International Monetary Fund. External Relations Dept.
Published Date:
October 2006
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On September 1, John Lipsky, a U.S. national, took over as IMF First Deputy Managing Director—the first person to hold the number two spot who has also worked in the rank and file (1974-84) and held a private sector job in the financial sector. Indeed, prior to rejoining the IMF, he was Vice Chairman of the JP Morgan Investment Bank and Chief Economist of both Chase Manhattan Bank and Salomon Brothers. He spoke with Laura Wallace of the IMF Survey about the role the IMF should play in a world characterized by a truly global financial and trading system and large cross-border private sector capital flows.

IMF Survey:With private capital flows growing by leaps and bounds, and the IMF’s available capital declining relative to those flows, is the IMF losing relevance?

Lipsky: Absolutely not! The IMF was established to provide the foundation for an international monetary and financial system that is nondiscriminatory, multilateral, and based on the rule of law. That role remains unique and highly relevant. There have, of course, been dramatic changes in the global economy over the past 15 years, and the Fund needs to adapt itself in a decisive way in order to fulfill its role comprehensively.

IMF Survey:How about the buildup of international reserves by emerging markets, especially in Asia? Is that further diluting the IMF’s traditional role?

Lipsky: The buildup of reserves suggests that many countries have decided, as a matter of policy, to try to self-insure against external volatility. If you thought that was the Fund’s traditional role, then the answer to your question might well be yes. The underlying reality is more complex, however. In particular, it appears that the buildup of reserves also in part reflects the sluggishness in investment growth after 1997-98 in many emerging market countries, as well as a deliberate policy choice. That said, I do think the reserve buildup is a symptom of uncertainty about the future stability of the international system and the efficacy of the existing instruments of crisis prevention and resolution. On balance, the reserve growth is more a sign of issues that need to be addressed than a dilution of the Fund’s role.

IMF Survey:The recent IMF-World Bank Annual Meetings gave the Fund the go-ahead to explore a new financial facility for emerging markets that might run into crisis—in effect, replacing the Contingent Credit Line (CCL), which was never used. In light of the large stockpiling of reserves, why would a new facility even be needed?

Lipsky: To begin with, it’s worth exploring why the CCL was never utilized, because it was a concept that seemed to find support. We should ask if there are aspects of the CCL that can be usefully modified in a new facility. And if we can develop a useful new tool, it’s possible that its existence would reduce countries’ perceptions about the desirability of large international reserves. Perhaps more to the point, I view the proposed new tool as a kind of placeholder while the IMF and its members undertake a much broader review of how they should adapt crisis prevention and resolution responsibilities to a world of large-scale, cross-border private sector capital flows. After all, it’s exactly the sharp growth in these flows that rendered the IMF’s traditional methods of crisis prevention and resolution dysfunctional to a certain degree.

IMF Survey:Does that mean the IMF could be dangerously ill equipped in the event of a major crisis?

Lipsky: Today, the Fund enjoys record liquidity, so there is no risk that the institution wouldn’t be able to respond to a new challenge. Nonetheless, it makes sense to take advantage of the favorable environment to rethink our approach to crisis prevention and resolution in a comprehensive fashion. You’re rarely seriously harmed by the dangers you’ve worried about. The biggest risks are the things you’ve taken for granted.

IMF Survey:You’ve said that the IMF needs to become a center of excellence in understanding the role of financial markets and their impact on the global economy. What specifically should it be doing?

Lipsky: We’re already taking action. We’ve created the Monetary and Capital Markets Department, merging the Fund’s work on international and domestic financial markets. The underlying message is that it’s no longer appropriate to view internal and external markets as separate. This new department will bolster the Fund’s direct knowledge of market developments. In addition, the Research Department will develop new insights regarding the critical interconnections between international trade flows and international finance while also addressing broad systemic stability issues. It’s probably not recognized to the degree that it deserves, but the IMF already has made substantial contributions to helping the international system adapt to the growth in private capital flows. This includes developing the data dissemination standards, the Financial Sector Assessment Programs, and Reports on the Observance of Standards and Codes. We need to ensure that the IMF’s knowledge about financial issues is incorporated adequately in the reviews of each member country’s economy through the Article IV consultations. To this end, we’re developing a financial template that will expand and standardize the basic information provided in regular country reviews.

“Both the United States and its trading partners are going to have to shift their sources of growth.”

—John Lipsky

IMF Survey:Given the growing importance of relatively unregulated financial institutions, such as hedge funds, how can the prospects of global financial stability be improved?

Lipsky: With the rapid changes in the magnitude and types of cross-border private sector financial transactions, it’s both natural and responsible for regulatory and supervisory authorities to make sure that their knowledge and practices are up to the task. Of course, a comprehensive and systemic approach is needed. The basic goal is to have as much oversight as necessary, but no more.

In the case of hedge funds, their capital in principle is provided by sophisticated investors who can bear losses, while most of their leverage derives from regulated institutions such as banks. Thus, it may be that the lessons learned in the wake of the Long-Term Capital Management (LTCM) failure in 1998 already have resulted in measures and practices sufficient to mitigate systemic risks. For example, the popular image is that the institutions that provided LTCM with credit simply weren’t able to understand the complexity of that firm’s position taking. It’s my impression that, in response to that painful and potentially dangerous incident, lenders are unlikely to finance anything close to the leverage that LTCM was able to obtain. It’s impressive that the recent spectacular losses by a few hedge funds have left underlying markets little affected. The principle of regulation isn’t to prevent individuals or firms from making losses, but rather to protect investors from fraud and to avoid systemic risks. Nonetheless, as markets change and evolve, regulators need to perform their own due diligence to make sure that they’re fulfilling their roles.

IMF Survey:In recent months, the IMF has initiated its first multilateral consultations—with China, the euro area, Japan, Saudi Arabia, and the United States—to try to resolve the hefty global imbalances. Is there a reason for the financial markets to believe that a way to unwind these current account imbalances in an orderly fashion can be found through such a mechanism?

Lipsky: Well, I’m hopeful that this initiative will be helpful. The base case scenario of the IMF’s World Economic Outlook is a benign one, and, in broad terms, financial markets seem to agree. Equity markets are nearing record heights, long-term interest rates are low, and exchange markets have been relatively stable. Moreover, the imbalances grew during a period that was far more positive than almost anyone had anticipated, with the fastest global growth and the lowest inflation in decades, and low volatility.

But there are good reasons to imagine that the coming few years will contain challenges and growing uncertainties—take, for example, the recent slowdown of U.S. economic growth. So it’s exactly the right time for the key economic players involved in the global imbalances issue to discuss whether there is something that can be agreed collectively to sustain private markets’ confidence that macroeconomic issues are going to be managed responsibly and successfully. What’s surprising is that the multilateral consultations represent the first time the key players have had a forum for that purpose. No one should expect miracles, but it’s not clear that miracles are needed to resolve the global imbalances, either.

IMF Survey:How much of the adjustment do you believe will need to come from U.S. fiscal policy and how much from a Chinese exchange rate adjustment?

Lipsky: It’s true that public discussion about global imbalances often seems to devolve into questions about U.S. fiscal policy and China’s exchange rate policy. This strikes me as far from adequate. The underlying cause of the increase of the global imbalances in recent years has been a sustained divergence in the pace of domestic demand growth among major economies. The U.S. federal budget deficit is less than 2 percent of GDP. This isn’t at all unusual by historic standards. What’s out of line with historical norms is the record-low U.S. household saving rate. Nonetheless, I’m confident that the long-term trend of a declining saving rate is at a turning point and that this rate will tend to “normalize” in the coming years, with or without policy action. The principal cause of the sustained drop in the U.S. household saving rate over the past decade has been the unexpectedly rapid increase in household net worth. Since the early 1990s, U.S. families as a whole have become wealthier faster than they expected, so they’ve concluded that they can save less out of current income. But the pace of asset price appreciation is likely to slow, with inflation no longer declining and productivity no longer accelerating.

For global growth to remain strong, even if U.S. domestic demand growth is likely to be somewhat slower than in the past few years, both the United States and its trading partners are going to have to shift their sources of growth. In particular, the United States will need to rely relatively more on net exports and business investment, while its trading partners will have to rely more on their domestic demand growth and less on net exports. In China, the authorities’ goal of strengthening domestic demand, including consumption, will depend on many more factors than simply adjusting the exchange rate. In Japan and the euro area, shifts in the sectoral sources of growth away from exports are also needed. And the current surpluses of the energy- and commodity-producing economies are assuming new importance.

IMF Survey:How do you think the IMF has changed since 1984, and where do you see it headed after this year’s Annual Meetings?

Lipsky: Certainly, the institution is much bigger. After all, its membership is truly global now, and the staff has consequently expanded. It’s also become much more transparent, partly because there’s more interest in the IMF’s work and partly because the IMF itself decided that it’s more effective if it tells people what it’s doing.

As for the future, there’s broad agreement that we need to take a leading role in adapting the international system to the new realities. The medium-term strategy (MTS) is the Fund’s specific response to this recognition. Encouragingly, the Annual Meetings provided an endorsement of all of the principal elements of the MTS. First, the Board’s proposal for quotas and voice reforms was endorsed. If this effort succeeds—and there’s a lot of hard work ahead—the Fund’s governance will become more representative of the current and future state of the global economy. Second, the Fund’s innovative multilateral consultation initiative was endorsed. This new tool potentially creates an appropriate and effective venue to address the key issues facing the Fund’s membership collectively—not to mention putting the IMF back in the center of debate, even among the largest economies. Third, the Fund got the go-ahead to review the basis for its mandated bilateral consultations with individual Fund members—including its approach to exchange rate issues—and, as we discussed, to explore a new financing instrument to better deal with crisis prevention and resolution. Finally, we are strengthening our engagement with our low-income members.

Thus, we have important challenges ahead, but we could hardly have hoped for a more positive result from Singapore—indeed, we’ve been offered the prospect of a newly energized role in the international system. Now we have to show that we deserve the role and that we can deliver. I’m enthused by all this, in part because it’s bringing the Fund back to its roots, and to its unique role.

IMF Survey:In what sense?

Lipsky: Today, the Fund has a mandate to rethink its operations in a fundamental way. The Fund’s Articles of Agreement were developed without any real precedent. They created the foundation for a multilateral, nondiscriminatory, international payments system based on the rule of law. The Fund staff and the Executive Board then constructed the new financial system virtually out of whole cloth, without a blueprint. That system represented a remarkable contribution to economic development, because it supported the hoped-for increase in international trade. It’s not by chance that the past 60 years have witnessed the greatest period of economic progress in human history. But there have been important recent developments that haven’t been fully incorporated into the system in any formal or coherent fashion. We have a mandate and a responsibility to make that happen and to set the stage for new progress.

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