Institution

Institutions are humanly devised constraints that structure political, economic and social interactions (North, 1991).

Intsitution -2-

• Informal Constraints: Customs, Traditions, Codes of Conduct

• Formal Constraints: Constitutions, Laws, Property Rights• Eg. Institutions of Free Market Economy are:

Property Rights and Free Competition

• Institutions determine the choice set– Transaction and Production Costs

International Institutions

• Supra-national• Multi-lateral Agreements• Inter-governmental vs. Non-governmental• International Laws applied

International Financial Institutions

International Bank for Reconstruction and DevelopmentInternational Monetary Fund

Two Questions

• What is the role assigned to international financial institutions?

• How did this role change throughout the years since Bretton Woods?

The Bretton Woods Rationale

• Lessons from the Great Depression,• International corporation to avoid repetition

of the “beggar thy neighbour” trade policies and competitive devaluations,

• Countries devastated by the war required more investment than could be financed by domestic savings, therefore official capital flows became essential for reconstruction and development

Three Pillars of the Post-War System

• An institution to oversee exchange rate arrangements and to provide temporary finance when BoP difficulties did not result from “fundamental disequilibrium”,

• An institution to enable official capital flows to facilitate investment where private capital flows were inadequate,

• An institution to oversee trade relations among countries and to provide a framework for an open multilateral trading system.

Bretton Woods - 1945

• Agreed on an institutional framework for international economic cooperation

• IMF came into existence in Dec., 1945 with the aims of ensuring exchange rate stability and encouraging members to eliminate exchange restrictions.

• 29 members initially, but expanded to 184 countries as of June, 2006.

• Number of members increased esp. In 1960s and 1990s.

Twin Institutions of Bretton Woods

• IMF & IBRD• Aim => to help rebuilding war-ravaged

countries (i.e. Europe and Japan).• In 1960s: Newly independent and emerging

nations of Africa, Asia, L. America, Middle East.

• In 1990s: Transition countries of Central and Eastern Europe.

IMF & IBRD: Complementary Institutions

• IMF focuses on macroeconomic and financial sector issues.

• IBRD is concerned mainly with long term development and poverty reduction (i.e.infrastructure building)

• Countries must join the IMF to be eligible for IBRD membership.

IBRD & IMF

• Similar governance structures => shareholder based,– Memeber governments are the shareholders of

each institution,– Shares are in proportion to countries’ economic

importance,– Votes allocated to each countryare in proportion

to countries’ shareholdings,– Rich countries possess higher representation.

The IMF -1-

• Threat: DOMESTIC DEPRESSION and UNEMPLOYM ENT– Policies pursued to combat domestic

unemployment,– Beggar-thy-neighbour policies: shifting effective

demand away from imports onto domestically produced goods,• Tarriffs and Quotas on Imports,• Competitive Devaluations .

– Result: Exporting Internal Imbalances

The IMF -2-

• Role: To oversee exchange rate relationships in a fixed but, adjustable exchange rate system.– Members cannot alter their exchange rates without

approval of IMF,– It is only possible to alter the exchange rate when it

were determined that there was a “fundamental disequilibrium” in the BoP,

– When there was no “fundamental disequilibrium”, countries could borrow from the IMF to tide them over temporary imbalances.

Pusposes of the IMF are:(Article 1 of the Articles of Agreement)

• promoting international monetary cooperation; • facilitating the expansion and balanced growth of

international trade; • promoting exchange stability; • assisting in the establishment of a multilateral

system of payments; and • making its resources available (under adequate

safeguards) to members experiencing balance of payments difficulties.

Exchange Rate Stability

• Between 1945 – 71, member countries agreed to keep their exchange rates pegged at rates that could be adjusted only to correct a fundamental disequilibrium in the BoP, and only with IMF agreement.

• In 1971, U.S. Suspended the convertibility of Dollar into Gold.

• IMF members, since then, are free to choose any form of exchange arrangement (i.e. Free float, pegged sys.)

IMF had to develop new initiatives and reform its policies:

• New members, who are transition countries, exhibit different needs.

• U.S. abandonement of the par value system.• Oil price shocks in 1970s.• Latin American debt crisis in 1980s.• Crises in emerging financial markets in 1990s.• Argentina debt default in 2001.=> Institutional Restructuring!

IMF Activities

• Surveillance• Lending• Technical Assistance

Surveillance -1-

• Surveillance is the regular dialogue and policy advice that the IMF offers to each of its members.

• Once a year, IMF conducts in-depth appraisals of each member country’s economic situation.

• IMF monitors national, global, and regional economic and financial developments and advising member countries on their economic policies.

Surveillance -2-

• “Multilateral Surveillance” => IMF assessment on global and regional developments and prospects:

World Economic OutlookGlobal Financial Stability Report

Financial Assistance• A core responsibility of the IMF is to provide

loans to countries experiencing BoP problems• A member country may request financial

assistance if it cannot find sufficient financing to meet its international payments

• Precisely the oil shock of 70s, and the debt crises of 80s were followed by sharp increases in IMF lending, transition process in CEE, and the crises in emerging markets in 90s led to further surges of demand for IMF resources

Financial Assistance:Process of Lending

• Loan is provided under an “arrangement” stipulates the specific policies and measures a country has agreed to implement to resolve its BoP problem.

• Letter of Intent-Memoranda of Economic and Financial Policies are prepared by the member country, and describe the policies that a country intends to implement in the context of its request for financial support from the IMF

Financial AssistanceLoan Instruments -1-• Various “facilities” are tailored to address the specific

circumstances of diverse members.1. Poverty Reduction and Growth Facility=>to the poorest

members2. Exogeneous Shocks Facility=> Low income countries may borrow at concessional interest

Rates3. Stand-by Agreements=>short term BoP problems4. Extended Fund Facility=>BoP related to structural problems5. Compensatory Financing Facility=> Non-concessional

Financial AssistanceLoan Instruments -2-

6. Emergency Assistance: To support recovery from natural disasters and conflicts, in some cases at concessional interest rates

7. Supplemental Reserve Facility: large loans with short maturities, to countries going through capital account crises.

8. Trade Integration Mechanism: to developing countries, whose BoP suffers from multilateral trade liberalisation

General Terms of IMF Financial Assistance-1-

• All facilities, except PRGF &ESF, are subject to IMF’s market related interest rates = “rate of charge” + surcharge

• “Rate of interest rate” is based on SDR and revised weekly.

• A surcharge can be levied above a certain threshold to discourage countries from borrowing large amounts

General Terms of IMF Financial Assistance-2-

• The amount that a country can borrow from the Fund, its “access limit”, varies depending on the type of loan, but typically it’s the multiple of the country’s IMF quota.

• “Safeguards” on members’ use of IMF resources: IMF requires assessment of CB compliance with desirable practices, i.e. internal control, financial reporting, auditing

IMF’s Resources

• Most resources for IMF loans are provided by member countries, primarily through their payment of quotas.

• Each member of the IMF is assigned a quota, based broadly on its relative size in the world economy (i.e. İts GDP, current account transactions,official reserves), which determines its contribution to the IMF's financial resources.

Functions of Quotas

• Subscriptions => financial resources that the member is obliged to provide to the IMF.

• Voting Power: U.S. has 16.79% of total votes, Palau has 0.01% of total votes

• Access to Financing• SDR allocations=>A member’s share of general

SDR allocations is established in proportion to its quota

What is SDR?-1-

• The Special Drawing Right (SDR) was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system.

• A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase the domestic currency in world foreign exchange markets, as required to maintain its exchange rate.

What is SDR?-2-

• The international supply of two key reserve assets— gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial development that was taking place.

• => the international community decided to create a new international reserve asset under the auspices of the IMF.

What is SDR?-3-

• In 1973, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime.

• Today the main function of SDR is to serve as the unit of account of the IMF and some other international organizations.

SDR Calculation

• Initially, SDR was valued as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar.

• After the collapse of the Bretton Woods system, the SDR was redefined as a basket of currencies, consisting of the euro, Japanese yen, pound sterling, and U.S. dollar.

Borrowing Procedures

• Initial financing of the Fund came from members’ paid-in-capital,

• Payments made partly in gold, partly in convertable currencies, and partly in national currency,

• Members borrow from the Fund in “tranches”, which were in proportion to their capital subscriptions,

• Access to the first “tranche” was automatic, and equal to the gold proportion of paid-in-capital,

• Successive increases in “tranches” are subject to “conditionality.

Technical Assistance & Training -1-

• The objective is to help improve the design and implementation of members' economic policies, including by strengthening skills in institutions such as finance ministries and central banks.

Technical Assistance & Training -2-

• monetary and financial policies (monetary policy instruments; banking system supervision, and restructuring; foreign management and operations; clearing settlement systems for payments; and structure

development of central banks); • fiscal policy and management (tax and customs policies

and administration, budget formulation, expenditure management, design of

social safety nets, and management of domestic and foreign debt); • compilation, management, dissemination, and

improvement of statistical data; and • economic and financial legislation