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CIAO DATE: 8/01
Slow Progress in Prague
On The Issues
October 2000
The September World Bank and International Monetary Fund meeting in Prague produced important but incomplete reforms of IMF financial practices, continuing denial and confusion at the World Bank, and a seriously flawed proposal for debt relief for the poorest countries.
The real news from Prague was not the street protests but the International Monetary Fund's commitment to reform, a continuation of its evolution over the last year. The World Bank, in contrast, still seemed surprised by the intensity of its critics. James Wolfensohn, its president, offered many platitudes, numerous vague generalities, but little substantive progress.
IMF Reform
To increase global economic stability, the IMF will shorten the list of conditions that countries must meet to access emergency funds, emphasize crisis prevention and reform of financial systems, and encourage nations to forgo pegged exchange rates. The Fund has greatly increased publicly available information about its own actions and has encouraged its members to follow suit. Few changes are more important than helping markets make better decisions through improvements in the quantity and quality of timely information.
But one of the most contentious issues in the global financial system remains unresolved: how to "bail in" private lenders in a crisis. One group favors formal rules that specify creditor obligations to support countries experiencing large capital withdrawals. A second seeks more flexible arrangements, each case decided in the light of its circumstances. A third proposes that debtors and creditors resolve their differences without official intervention.
The issue arises because, in the past, the IMF has not distinguished between countries that behave responsibly and those that pursue profligate strategies leading to crisis. Reform cannot work under this nondifferentiating policy. The Fund's revised contingent credit lines (CCL) promise rapid and nearly automatic response for countries that institute sound strategies during good times. However, if all countries receive the same assistance in times of trouble, there is little incentive to enact the politically difficult decisions until the emergency arrives. The CCL cannot compete if its only advantage is a few percentage points of interest once the crisis occurs.
Global stability cannot be achieved unless individual countries and their creditors bear the consequences of their decisions. IMF crisis lending should be limited to two groups: nations that implement proper macroeconomic and financial preconditions and those that are harmed by failures elsewhere that threaten to produce systemic crises. This will create forces for stability by encouraging investors to reduce the flow and increase the cost of funds to nonqualifying borrowers.
Capitalism without losses is like religion without sin. It sounds wonderful but lacks proper incentives. The IMF must recognize that, if it does not "bail out" creditors, they are "bailed in" automatically. Without IMF funds, countries cannot support unsustainable exchange rates permitting investors to exit without loss. Allowing the currency to depreciate in an emergency forces lenders to pay a large cost for withdrawing their money. An additional excellent improvement is to permit foreign financial institutions to compete with local intermediaries. Argentina, Mexico, and Brazil have implemented this policy. The IMF must ensure that other countries open their financial sectors.
World Bank Muddle
By contrast, the Prague meeting only exacerbated the World Bank's problems. There is general agreement that its mission should be improvement of life in developing countries through economic growth and alleviation of poverty. The inability of the institution's leadership to define these goals in clear terms has led to the disappointing effectiveness of Bank programs.
Regrettably, the Bank has responded to the demonstrators and pressure groups by defining poverty and performance so broadly that few activities are ruled out and few results are measurable.
The G7 should insist on an independent audit of the effectiveness of Bank programs. The evaluation should report on results five years after a project has been completed, quantifying the costs and benefits.
The Bank directs $20—30 billion a year in aid flows. Donor countries and the recipient nations must clearly define its responsibilities and make it accountable for its results.
Debt Forgiveness
Debt forgiveness for the heavily indebted poor countries (HIPCs) appeared high on the Prague agenda, but the flaws in the current program were not corrected. The richest countries joined with the international financial institutions (IFIs—the IMF, the World Bank, and various regional development banks and lenders) in a pledge to staunch what Nigeria's President Obasanjo calls "the gushing wound of an ever-penetrating debt repayment lance."
The pledge has some bright spots and many flaws. Two-thirds of the total $125 billion in claims is bilateral. The rich countries agreed to write these off for countries that qualify by agreeing to reforms. The principal IFIs should do the same. Instead of using their ample reserves set aside for just this purpose, they have asked member governments to contribute $3.6 billion of new funds (the U.S. share is $1 billion). Instead of canceling their entire $45 billion HIPC debt, more than $30 billion will still be owed to the IFIs. If the four largest IFIs used half their reserves, they could cancel their entire debt. Instead of a permanent solution, the program is partial and temporary.
The original program identified forty countries. The current plan provides relief for only thirty-two nations. The General Accounting Office (GAO) recently reported to Congress that the continuing need for development financing by the HIPC economies is almost certain to require a new round of forgiveness in the next ten or fifteen years.
The GAO notes that the IFIs are wishing the problem away. To make the solution to the debt overhang appear permanent, the IFIs assume that annual growth of exports, GDP, and government revenues will average 7 to 12 percent in the HIPC economies in nominal dollar terms for the next twenty years. Past performance does not justify this optimism. In comparison to successful developing countries, they suffer by every measure—health, education, climate, infrastructure, civil order, government probity, and rule of law. Even with the best of intentions and effort, these deficiencies cannot be repaired quickly enough to sustain the assumed growth rates.
When pressed, proponents of the plan invoke China's dramatic achievements—a nation with a high savings rate, an established industrial base, considerable infrastructure, and an ability to attract capital from the developed world.
For the minimal $14 billion IFI relief plan for thirty-two countries, there is a $5 billion unfilled financing gap even after the $3.6 billion donor contribution. This deficit rises to $9 billion when four additional countries that will soon qualify are included. Funds will be exhausted within five years; thereafter, $700 million to $1.2 billion more will be required annually for the next two decades. A few years from now, there will be another desperate demand for more relief funding, possibly called by another name. Perhaps the development banks will seek "replenishments" for the International Development Association (IDA) arm of the World Bank and its regional counterparts.
The IFIs have positioned themselves as donors of last resort. But it is the taxpayers of the industrial world who will pick up the bill for as much as 70 percent of IFI losses, 84 percent of the HIPC initiative, and 94 percent of total debt forgiveness. Realism joins with humane concern in the Meltzer Commission's unanimous support for total HIPC debt relief if accompanied by reform. Effective default occurred long ago, and the debts are uncollectible. IFI lending that exceeds current payments of HIPC principal and interest simply serves to maintain a "no default" fiction while escalating debt burdens. But forgiveness of past obligations will be an empty gesture if new funds finance regional wars, presidential jets, rutted roads, or unfinished schools or end up in personal accounts of corrupt officials held abroad.
No Loans, No Debt
Reform must be real, not just a vague promise to support social and economic development. Governments must be held accountable, and so must the IFIs. Unfortunately, the World Bank is doing the opposite.
At the development banks, the free fall toward generalized lending must stop. The G7 governments have shifted to outright grants instead of loans. The Meltzer Commission proposed that the development banks do the same. Without loans, there is no debt and no future debt problem. Grants must be for specific purposes. The results of aid funds must be independently audited to assure performance.
The U.S. government has already contributed $7 billion to relieve bilateral debt burdens and $440 million to help the IMF meet its goal. The administration seeks an additional $600 million to reimburse the IFIs. A further $1.5 to $2.5 billion is waiting in the wings for 2005 and beyond.
Past efforts to relieve debt burdens have failed. Tough questions must now be answered: Is the current initiative enough to put the debt problem behind us? What reforms are needed by the countries and the IFIs to give the program a reasonable chance of success? What are the total funding demands, not the piecemeal contributions? Why shouldn't the IFIs be required to absorb the cost of their past mistakes as a first step in the reform of these institutions?
Allan H. Meltzer is a visiting scholar at AEI and Meltzer University Professor at Carnegie Mellon University. He was chairman of the U.S. government's International Financial Institution Advisory Commission, which issued its report earlier this year. Adam Lerrick served as senior adviser to the commission. Sections of this essay were published in the Financial Times on October 10, 2000, and the Washington Times on October 11, 2000.
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