The Role of the International Monetary Fund in Stabilizing Financial Crises

Introduction

International capital transactions are beneficial to both investors and borrowers. These benefits are achieved through portfolio diversification and intertemporal trade for the investors/lenders. However, international borrowing and lending do not always pursue financial gains, but there are recurrent financial crises that are hard to avoid. The rationale for this research paper is to provide a persuasive discussion that will analyze empirical reasons for the emergence of the international crisis and the role played by the International Monetary Fund in stabilizing the financial crisis.

International Capital Flows

It is worth noting that capital flows are investment and borrowing of all terms, including equity investment, short-term lending to long-term bonds, and currency holdings. In essence, currency outflows are denoted by lending and investment and indicated by a negative value. On the other hand, capital outflows include investment and borrowing indicated by a positive value. International capital flows are the financial part of international trade (International Monetary Fund, 2010). When a country imports goods and services, the exporter gives the importer a monetary payment, just as in the transactions in domestic settings. Hypothetically, if the total imports and exports are equal, the monetary transactions will have a net zero balance. As a result, the country would receive the same amount of financial flows as it paid out. However, such situation cannot happen because the trade balance cannot be zero.

The balance of trade that a country experiences during international capital flow through transfers, goods and services, and income receipts are known as its current account balance (Tille & Wincoop, 2008). Therefore, if a country experiences a deficit or surplus in its current account, an offsetting net financial flow consisting of security, currency, or other property ownership claims will exist. In fact, the net financial flow that exists is called the country’s capital account balance. If a country’s imports exceed its exports, there is a current account deficit. In this context, the foreign trading partner who enjoys the net monetary claims will continue to hold those claims as currency or monetary deposits. In addition, the partner may use the money to buy real property, equities (stock), and financial assets in the trade-deficit country. Goods and services trade claims, which give rise to the capital flow, move in the opposite direction. Therefore, a country with a deficit in the current account will have a capital account surplus (Tille & Wincoop, 2008).

In accounting terms of the balance of payment, the balance of the capital account reduces the current account balance, which is the total internationally traded services and goods. Therefore, the capital account reveals the total balance of claims that foreign and domestic investors have gained from the new financial investment, equity assets, and real property in other countries. In essence, all the counting terms are true by definition, but financial flows and international trade data are characterized by errors resulting from undercounting. Hence, the trade data and international capital make omissions and net errors (International Monetary Fund, 2011b).

The International Monetary Fund

The International Monetary Fund is an enduring institution that is an integral part of the creation of the worldwide financial market that supports the growth of developing countries. When a financial crisis occurs, the IMF provides assistance and advice to the affected country. The institution was established to curb economic crises like the effects of the Great Depression after World War II. The IMF is the largest lender of funds to the nations and a specialized agency with 186 members (Aiyar, 2011). The institution operates under the UN with its sister organization, the World Bank. The bank creates and maintains the international monetary system where international payments are settled. In addition, the bank provides a systematic mechanism for foreign exchange transactions, fosters investment, and enhances a balanced economic trade. The bank’s goals are to advise the macroeconomic policies within the country that affect the government budget, money and credit management, as well as exchange rate. More importantly, the bank offers financial assistance to correct the country’s balance of payment discrepancies. Therefore, IMF nurtures the country’s economic growth and maintains high levels of employment in the countries (Aiyar, 2011).

International Lending and Borrowing between Industrialized Countries

In this market setting, the lending and borrowing are well-behaved because even if one country dominates the lending, the borrowing country may have other areas that it dominates. Therefore, each country is afraid of instances of retaliation in other market structures. In addition, the market does not exhibit any default risk because the countries involved have a developed economic structure that will facilitate payment of any form of borrowing. In fact, developed countries will always struggle to have the best credit rating in the market, a strategy that makes them eligible for further borrowing. When developed countries borrow amongst themselves, it amounts to intertemporal trade where the lenders give up their resources and receive them later in more returns. On the other hand, the borrower will get more resources, which will generate more product in the future and share part of these resources with the lender.

International Lending by Industrialized Countries to Developing Nations

In this market setting, lending by industrialized nations to developing countries is different from lending between industrialized nations. The process is highly political, risky, and usually predatory. The developing nations are faced with many challenges that make them unable to service their debts. They sometimes default and fail to honor the loan agreements stipulated in the lending laws. Therefore, the lender stops any new lending, a situation that worsens the problems in the developing nation.

Reasons Behind the Asian Financial Crisis of 1997

Overlending and Overborrowing

The problem was brought about by weak government regulation of the banks. The banks borrowed from foreign currencies in large amounts, and then the funds were lent to risky borrowers. In addition, the export growth was declining, leading to weaknesses in the countries’ current accounts. Investors were attracted to this region because of the liberal trade policies, low inflation, budget surpluses, and rapid growth rate. Consequently, the high exchange rates affected the trade balances of Asian countries. In fact, Thailand’s stock and estate market were the first to collapse. The fear spread to other areas, including the Philippines, Malaysia, Korea, and Indonesia.

Exogenous Shocks

Many countries, especially in the low-income bracket, experience exogenous shocks, including natural disasters, volatile financial flow, export demands, and sharp swings in terms of trade. In fact, the frequency and magnitude of those shocks are higher in emerging market countries than in advanced economies (IMF, 2011). Negative shocks would imply a reversion to the steady income level, a growth bounce-back, and a a harmless transitory effect. However, the required resources, policy, and instrument buffers, which absorb and mitigate those shocks,,, are not available for weak economies or difficult to implement in weak policy and institutional environments. If the shocks are large, they induce breaks in the growth trend rather than cycle fluctuations, thus imposing welfare losses and steep output directly through succeeding growth slowdowns (Becker & Mauro, 2007).

Exchange Rate Risk

Financial crises are associated with substantial movements in exchange rates. In the process, both changes in the perceived risk of undertaking investment in certain currencies and the increasing risk aversion are reflected in the exchange rate. However, during the financial crisis of 2007 and 2009, the exchange rate movements were uncommon, unlike in earlier episodes of the Asian and Russian crises, where many countries, which were not at the focal point of the crisis, saw their currencies depreciate (Becker & Mauro, 2007). Those crises were caused by a ‘safe haven’ effect that went against the expected crisis-related flows. In addition, differentials in interest rates also explained the crisis-related rate of exchange in 2008-2009. In essence, amid the financial crisis of the past decades, the majority of the currencies depreciated even though they were not at the center of the crisis (Reinhart & Rogoff, 2004).

Large Increase in Short-Term Debt to Foreigners

The risk in this context is that short-term debts denominated in foreign currency cannot be rolled over or refinanced. According to International Monetary Fund (2000), the short-term debt that developing countries owed foreign banks increased from $ 176 billion to $454 billion in the period between 1990 and 1997. In fact, the rapid build-up of short-term debt was the main factor that contributed to the financial crises that took place in Mexico from 1994 to 1995, East Asia from 1997 to 1998, and Brazil and Russia in 1998 and 1999 (International Monetary Fund, 2011a). The growth of short-term borrowing accompanied faster growth, higher income, and openness to trade in many developing countries. However, the rise in borrowing reflected booms in speculative assets in some nations. In addition, the process increased the vulnerability of many nations, especially in the Asian region. They experienced a liquidity crisis because the short-term borrowing reversed during economic shocks.

Contagion

The other explanation of the financial crisis causes indicates that any country can experience a financial disaster. However, contagion indicates why a crisis in a particular country can spread to other countries. The contagion aspect can be interpreted as herding behavior demonstrated by the investors. In this context, investors may have incomplete information about other countries that might exhibit a similar financial crisis to those in their country. International financial contagion takes place in both developing and developed countries. Contagion is the crisis transmission across the financial markets for indirect and direct economies. However, in today’s financial system with large cash flows, such as large banks’ cross-sectional operations and hedge funds, the contagion occurs simultaneously in the countries and the domestic institutions (Kollmann & Malherbe, 2011).

Resolving the Crisis

Rescue Package

The effort used to resolve the financial crisis under the rescue package is often utilized by the facility of IMF (Collier & Goderis, 2009). It offers temporary compensation when private lending cannot be facilitated. The aim of IMF in offering rescue package is to restore the lender’s confidence and limit contagion. In addition, the process induces the borrowing government an attempt to improve its policies, such as macroeconomics. The rescue package was successful in assisting the Mexican crisis in 1994. However, the package did not offer much help in Asia because many countries were involved in the crisis, and the finances would not be sufficient. However, IMF managed to contain the situation by putting together many loan packages for the Asian countries involved. The rescue package increased the moral hazard to Mexican crisis since the lenders are eager to be assisted whenever there is a future financial crisis. However, in Russia, the moral hazard was reduced because the country did not receive any rescue package after the lenders lost substantial resources in the process of lending (Dedola & Lombardo, 2012).

Debt Restructuring

Debt restructuring is another financial aspect used to create a manageable stream of payments in the process of debt servicing. The process can be difficult because the lender has the incentive of the free rider, anticipating that other creditors will follow suit and restructure while requesting full repayment of its loans. The Brandy plan surmounted the free rider challenge to resolve the 1980s debt crisis (Perry, 2009). In the 1990s crisis, it was easy to restructure those debts owned by foreign banks. However, it is difficult to restructure the bonds since legal provisions give the power to resist restructuring to small numbers of bondholders.

Conclusions

When there is a financial crisis, crucial international efforts must be initiated to resolve the issue. The fragility and rigidity of the institutions at the center of the crisis, banks, cause these crises. In fact, the way to avoid future and existing crises are to establish stable institutions that will formulate policies regulating the market structure. It may not be possible for banks to retain their stability and maintain their essential functions. However, regulations should be initiated to make financial systems entirely stable by eliminating the need for the functions performed by the banks.

 

References

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