First Deputy Managing Director Stanley Fischer and Research Department Director Michael Mussa inaugurated the IMF’s First Annual Research Conference on November 9–10. Fischer announced an informal contest for the catchiest acronym for the new conference, preferably something rivaling the mnemonic appeal of the World Bank’s ABCDE (Annual Bank Conference on Development Economics). Featuring presentations by academics and policymakers, the conference focused on issues debated daily in the IMF, including whether policy interest rates should be lowered at the onset of a financial crisis; whether IMF programs encourage risky behavior by investors; whether IMF and World Bank policies raise poverty and inequality; and what impact exchange rate regimes have on macroeconomic performance.
Interest rate response to crises
Financial crises tend to mutate and stay a step ahead of academic researchers. Participants at the conference noted that the Asian crisis of 1997–98, for instance, could not easily be explained by extant theoretical models of crises. These models stressed governments’ profligacy or inability to make credible commitments as sources of crises. An important feature of the Asian crisis, however, was the profligacy of the private corporate sector prior to the crisis (though implicit government bailouts and inadequate financial sector supervision played a role in encouraging this private behavior). With the onset of the crisis, the borrowing spigot was suddenly turned off; the resulting deterioration in corporate balance sheets played a big role, speakers noted, in the output collapse in the Asian crisis economies.
During the Asian crisis, Joseph Stiglitz, then Chief Economist at the World Bank, and others urged a reversal of the standard IMF prescription that a country facing a currency crisis temporarily raise its interest rates to stem currency devaluation and restore financial stability. Raising interest rates would worsen the condition of corporate balance sheets, these IMF critics argued, prompting further capital flight and weakening the currency. Hence, far from defending the currency, interest rate increases could have the “perverse” impact of further currency depreciation.
Results of the IMF strategy in Asia appear to suggest that these fears were not justified. Atish Ghosh of the IMF and Gabriela Basurto of the Inter-American Development Bank reported they found little econometric evidence that increases in interest rates depreciate a currency, leading them to conclude that “the perverse effect ... remains a theoretical curiosum.”
Despite this evidence, academic researchers are in the throes of constructing theoretical models in which a perverse effect is possible. In the model presented at the conference by Philippe Aghion of Harvard University, Philippe Bacchetta of Studienzentrum Gerzensee, and Abhijit Banerjee of the Massachusetts Institute of Technology, the main burden imposed by a financial crisis is that the currency depreciation raises the foreign currency debt obligations of the corporate sector. Consequently, in their model, limiting depreciation through increases in interest rates is—in most cases—good policy.
Lawrence Christiano of Northwestern University, Chris Gust of the U.S. Federal Reserve, and Jorge Roldós of the IMF were more agnostic about whether interest rate increases are the right policy. In their model, the answer hinges on whether the economy’s output can be maintained by substituting domestic resources, such as labor, for imported intermediate inputs, which become more costly as a result of currency depreciation. If substitution between labor and imported inputs is easy, interest rate cuts to maintain output may be a good option. If the economy is unable to adjust factors that are complementary to imported inputs—which may well be the case in the short run—then an interest rate cut could depress economic activity.
IMF lending, bailouts, and bail-ins
Evidence suggests that IMF lending improves the access of emerging market countries to private funds and the terms on which they obtain this access. But is this a good thing? Not according to critics of the IMF’s “rescue packages,” who see investor willingness to make more loans on better terms as an indication of the “moral hazard” fostered by IMF lending. Critics argue that investors make these loans because they believe the IMF will “bail out” countries (and, indirectly, investors) in the event of a crisis. Proponents of IMF lending, in contrast, take a very different view, linking the provision of an international financial safety net by the IMF and other agencies with a lower probability of financial crises and less severe crises when they do occur. This “catalytic effect” of official lending, proponents say, improves the access and the terms on which emerging market economies can obtain private funds.
It is not easy to discriminate between these two views, nor are they mutually incompatible. In the presence of moral hazard, events that make IMF rescue packages more likely should lower the interest rate at which investors are willing to lend to emerging market countries; more precisely, the spread between interest rates on risky emerging market bonds and U.S. government bonds (considered risk-free) should shrink. Such events should also weaken the link between interest rates and a country’s economic fundamentals as the higher odds of being bailed out make investors worry less about the particular characteristics of each country.
Finding such events poses an empirical challenge. Giovanni Dell’Ariccia of the IMF, Isabel Goedde of Mannheim University, and Jeromin Zettelmeyer of the IMF suggested that the Russian crisis of August 1998 was such an event. But the widespread expectation of market participants that Russia would receive a rescue package because it was “too nuclear to fail” turned out to be wrong, they observed. The sign that the international community was less willing to rescue emerging markets should have led investors to exercise greater caution in lending to these markets, thereby raising emerging market spreads and strengthening the link between spreads and economic fundamentals. The presenters found modest evidence that spreads did increase in the aftermath of the Russian crisis; moreover, investors appear to have started differentiating more among countries’ risks, as countries with sounder economic policies experienced a smaller increase in spreads.
But there is also some evidence of a catalytic effect. Using data on interest rate spreads for emerging market bonds issued over the 1990s, Barry Eichengreen of the University of California, Berkeley, and Ashoka Mody of the World Bank reported that IMF lending under Extended Fund Facility (EFF) programs improves terms of market access to private lending. This effect, however, appears to hold only for countries with intermediate credit ratings. The speakers interpret this to mean that lenders view compliance with IMF programs as unlikely in countries with low credit ratings (which tend to reflect concerns about a country’s policy environment). In these circumstances, they argued, the announcement of an EFF program has no effect. Likewise, countries with high credit ratings have already demonstrated a strong commitment to good policies, and IMF lending confers no further benefit in terms of market access. It is in the intermediate range, the authors suggest, that “the IMF can be seen as strengthening the commitment to reform,” and thus the announcement of an EFF program does enhance market access.
Regardless of the debates over the effects of IMF and other official lending, there was broad agreement at the conference that the private sector has a key role to play in providing capital to emerging market economies, in preventing and resolving crises, and in ensuring that the flow of capital to emerging markets is not subject to sudden stops. Nouriel Roubini (New York University) noted that while the overall framework for involving the private sector in crisis prevention and resolution is still being worked out, there has been an important shift in the tone of the discussions between the official and private sectors moving from the coercive-sounding “bailing-in” of the private sector to a policy of “constructive engagement”
IFI policies, poverty, and inequality
Few ailments of modern economies have not been blamed, at some time or other, on policies recommended by the international financial institutions (IFIs). One charge has been that structural adjustment programs hurt the poor. William Easterly of the World Bank found mixed evidence on the issue. According to his research, structural adjustment programs appear to have shielded the poor from some of the pain of economic contractions but to have moderated the income gains of the poor during economic expansions.
What explains these findings? Easterly suggested that adjustment lending has a greater impact on the formal sector than on the informal sector to which many of the poor tend to be attached. Hence, “the poor may be ill placed to take advantage of new opportunities created by structural adjustment reforms,” but they may also suffer less “from the loss of old opportunities in sectors that were artificially protected prior to reforms.” The inclusion of provisions to strengthen social safety nets in lending programs also cushions the impact of recessions on the incomes of the poor.
IFI lending and policy prescriptions are also often blamed for increasing inequality of incomes, particularly in transition economies that have undergone tremendous economic change over the last decade. However, Michael Keane of New York University and Eswar Prasad of the IMF challenged this conventional wisdom for one of the more successful transition countries, Poland. Using very comprehensive data on the incomes and consumption of Polish families, they found that the increase in income inequality during the transition had been quite modest, leaving Poland with income inequality “closer to those of Scandinavian countries than that of the United States.”
Though changes in income inequality were modest, earnings inequality did increase substantially during transition; however, transfers of income from some segments of the population to others mitigated the rise in earnings inequality. Keane and Prasad suggested that by directing the transfers of income to those who stood to lose the most from the transition, Poland may have been able to build political support for the reform process in the critical initial years of transition.
Effects of exchange rate regimes
With increasing experimentation among countries in the choice of exchange rate regimes, the issue of how regimes affect economic performance has remained critical. One immediate challenge for researchers is in deciding how to classify a country’s exchange rate regime, particularly because there is often a gulf between a country’s stated regime and the one it follows in practice. The IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) provides a detailed classification of countries’ stated regimes. Eduardo Levy-Yeyati and Federico Sturzenegger of the Universidad Torcuato Di Tella attempted an alternative classification based on observed volatility in exchange rates and reserves. A country with low volatility of exchange rates and high volatility of reserves, for example, is classified as a fixed exchange rate regime, regardless of its announced regime.
With this new classification, the authors found that intermediate exchange rate regimes tend to have higher inflation rates than either a fixed or a floating exchange rate regime. Levy-Yeyati and Sturzenegger also found lower output growth and higher output volatility in countries with fixed exchange rate regimes.
Two other papers at the conference investigated particular aspects of the choice of exchange rate regimes. Antonio Fatás of INSEAD and Andrew K. Rose of the University of California, Berkeley, studied whether fiscal policy differed more in “extreme” exchange rate regimes, namely, currency board or common currency areas, than in others. Rupa Duttagupta and Antonio Spilimbergo of the IMF tackled the puzzle of why exports of Asian crisis countries responded with a substantial lag to the large real depreciation of their currencies. They presented evidence that the near-simultaneous depreciation of these currencies neutralized the competitive advantage that any one country might have gained had its currency been the only one devalued.
From Mundell to Obstfeld
The conference also featured two special lectures. Nobel Prize winner Robert Mundell reviewed the history of the Mundell-Fleming model—the workhorse of international macroeconomic models and a product of Mundell and J. Marcus Fleming when both were members of IMF’s Research Department in the 1960s. And Maury Obstfeld offered a follow-up, “Beyond the Mundell-Fleming Model.” With Ken Rogoff, Obstfeld has played a critical role in developing the so-called New Open Economy Macroeconomics.