In March 2023, the US Federal Reserve expanded its balance sheet by $300 billion. Following the run on Silicon Valley Bank, the Fed provided emergency lending through a brand-new bank lending facility that accepted US treasuries at face value (higher than market value) as collateral against dollars, for cash-strapped financial institutions. The US central bank assured that even the uninsured deposits exceeding $250,000 at Silicon Valley Bank would be made whole. As the banking turmoil spread across the North Atlantic, the Fed reactivated its international dollar swap lines. Meanwhile, in Europe, the Swiss National Bank arranged a public liquidity backstop for UBS Group AG, which had agreed to absorb Credit Suisse. Swiss authorities wrote new amendments into law that enabled them to structure the merger’s terms and conditions.
This elasticity in liquidity and legal constraints contrasts sharply with the rigidity and discipline enforced in IMF loan programs. While expedited financing was provided to institutions in the North Atlantic, low- and middle-income economies face major encumbrances—the average length of time between a staff-level agreement on an IMF loan and the IMF executive board’s approval has increased from fifty-five days to 187 days. The interest rate on the Fed’s short-term lending swap-facility is typically twenty-five basis points above the benchmark OIS rate. IMF lending via its extended fund facility for middle-income countries can include additional fees that are 200 to 300 basis points over the market-determined Special Drawing Rights (SDR) interest rate. According to the IMF, these surcharges are “designed to discourage large and prolonged use of IMF resources.” Comprising almost half of its annual income at roughly $1.76 billion, these penalty fees have become the single-largest source of revenue for the leading multilateral lender of last resort.
If countries fail to meet the structural reforms spelled out in the IMF’s program review, lending can come to a halt. The Fund’s new policy on lending in “situations of exceptionally high uncertainty,” which has underpinned its recent $15.6 billion lending package to Ukraine, presents an exception to the IMF’s general rule against lending to countries whose debt is deemed unsustainable. However, it seems doubtful that this new allowance will reorient IMF lending away from fiscal consolidation, or in simpler terms, austerity. For now, IMF lending to Ukraine, a lower-middle-income country, appears to be in keeping with its stringent conditionalities for borrowing countries.
The recent American and Swiss bank bailouts fulfill Mario Draghi’s imperative to do “whatever it takes.” They insulate a bank whose clientele are primarily the financial elite from failing on the grounds that it would present a “systemic risk”—even though Silicon Valley Bank wasn’t a “systemically important” institution like Credit Suisse. In a frank if unwitting admission, a recent IMF report clarifies that “systemic debt crises” are ones that threaten the solvency of large and private creditors. In this framework, distressed low-income sovereigns simply don’t matter much.
Surveying the contemporary landscape of sovereign debt and IMF lending programs reveals pervasive inequalities in the Bretton Woods system. Barring fundamental reforms, these threaten the IMF’s future as the preferred lender for countries in crisis.
The North Atlantic bank turmoil may be understood as another aftershock of last year’s upheaval in the global economy. The energy-inflation triggered by the Ukraine war was followed by the Fed’s most aggressive interest rate hikes in recent memory. The upward march of the dollar, which topped a two-decade high, caused losses in balance sheets housing dollar loans and bonds across the globe. The counterpart of dollar appreciation is domestic currency depreciation—about ninety developing economies experienced exchange rate devaluations last year. In low-income economies, sharp currency depreciation leads to the exodus of finance capital. Faced with the threat of capital exit and double-digit inflation, central banks around the world have had to raise interest rates. Despite the efforts of monetary authorities to stanch the flow, there was an unprecedented exit from emerging market bond funds in 2022.
This liquidity shock is taking place in a context of rising debt burdens. The external public (and publicly guaranteed) debt of low- and middle-income (LMIC) nations stands at about $9 trillion. A third of this is owed by developing economies. Almost three quarters is issued by just eleven countries, including China. LMIC debt held by foreign residents has more than doubled in the last decade. Because they rely on short term loans, denominated in foreign currency, and issued largely from private creditors, indebted countries are vulnerable to interest rate shocks and subject to high debt servicing costs.
Dollar appreciation enlarged the value of dollar-denominated loans (in local currency terms) while high interest rates reduced the value of bond holdings and escalated debt servicing costs, requiring central bank portfolio managers to rebalance their dollar holdings. In some developing countries, central banks resorted to selling part of their dollar stockpiles to buy—and thereby bolster—their own currencies. Altogether, the foreign exchange reserves of developing economies fell by $379 billion.
Recently, IMF economists have criticized central banks that accumulate hard currency reserves to bypass interest rate hikes. But using foreign exchange reserves to purchase and thereby bolster the value of domestic currencies enables central banks to dampen some of the inflation. Given the inherent asymmetry in the international monetary system, hard currency war chests empower countries lower in the monetary hierarchy to cope with financial shocks. Over the course of the 2021–2022 dollar appreciation, countries that had larger ex ante reserves—especially in Latin America, the Middle East and North Africa, and sub-Saharan Africa—experienced lower ex post depreciations against the dollar.
Existing IMF lending policies
For many developing countries, the problem is not over-indebtedness per se. Though many borrowed heavily when low interest rates increased the appeal of their higher yielding bonds, the idea that most sovereign governments tend to be serial defaulters is erroneous. Most governments pay back their external loans, often at the expense of imposing austerity on citizens. Emerging market public debt to GDP ratios have yet to return to 1994 levels, just prior to the Highly Indebted Poor Country initiative, which restructured some of the sovereign debt overhang from the 1980s.
In fact, the problem that most sovereigns face today is a liquidity constraint. In this, they are not dissimilar from Credit Suisse. Prohibitively high interest rates make it difficult to access new financing and roll over existing loans. More than a fourth of all emerging market economies have effectively been cut off from international bond markets, with their interest rate spreads nine percentage points above US Treasuries. While Africa’s debt burden has doubled, its debt servicing costs have quadrupled. Balance of payments crises dot the “frontier economies”—low-income countries with thin bond markets and constrained borrowing capacity.
These circumstances prompt countries to seek IMF financing. Article I of the Fund’s Articles of Agreement calls for the use of general resources in the case of balance-of -payments disequilibrium. To receive a new loan program, indebted economies must first undergo a debt sustainability analysis. IMF staff assess a country’s projected GDP growth and calculate what percentage of sovereign debt could be written off (say, a “haircut” of twenty percent on existing loans and/or interest payments) to set it on a path of “debt sustainability.” Next, the Fund assesses the country’s financing gap—net payments it owes to creditors. Countries typically need short-term financing for a few years after defaulting. IMF loan programs are designed to fulfill part of this short-term gap.
Concurrently, the IMF encourages countries to seek financing from other creditors, including the World Bank and other multilateral development banks (MDBs), and also bilateral lenders like China or Saudi Arabia. Nations must then negotiate with both bilateral lenders and private bondholders on how much of their existing loans will be repaid and what proportion forgiven . The parameters of these negotiations are based on IMF staff assessments of how much the net present value of sovereign debt needs to decline in accordance with the IMF’s debt sustainability assessment. Typically, the government engaged in a debt workout must reduce public spending in order to receive an IMF loan.1
Despite renewed calls for a multilateral sovereign debt workout mechanism, the IMF Board has opposed uniform debt restructuring. ostensibly because of the differentiated nature of debt sustainability across countries. The distinction between market-access countries and low-income economies in its debt sustainability analyses, which precede debt restructuring, have made for unequal treatment. The recent restructurings of Sri Lanka and Zambia reveal this pattern. While Sri Lanka’s IMF loan program is flawed in its emphasis on fiscal restructuring, unaccompanied by substantive debt restructuring, Zambia, which is more reliant on financing at concessional terms from MDBs, has been tied down in attempts to secure financial assurances with its external creditors.
According to a former IMF official, the Fund’s new primary balance targets are even more onerous than previous ones. Back in 2013, the former IMF chief economist Oliver Blanchard found that IMF assessments of fiscal multipliers were too low, suggesting that IMF-imposed austerity mandates incur more damage to economic growth than previously calculated. In its latest World Economic Outlook report, the Fund also finds that, on average, fiscal consolidation does not lower debt-to-GDP ratios. In short, austerity does not promote debt sustainability, let alone growth.
Currently, IMF lending is at a record high, but its remaining loanable funds remain far below its trillion dollar monetary firepower. Global environmental sustainability will demand an estimated $4 trillion annually in investment. If the IMF doesn’t act more boldly in stabilizing the finances of countries in crisis so that they can address the bigger financing challenges of the energy transition, it risks jeopardizing its own place within the global financial hierarchy.
Despite the claims of its leadership, the IMF is no longer at the center of the global financial safety net. Standing at about $14 trillion in 2021, foreign exchange reserves far outweigh other forms of protection. Emerging markets and developing economies hold three-fifth of the world’s foreign exchange reserves: more than $7 trillion. While bilateral swap-lines,2 regional financial arrangements,3 and IMF funding have expanded ten-fold over the last decade or so, they only amount to $4 trillion altogether.4 In that same period, bilateral lenders such as China have dwarfed the IMF. The rise of alternative multilateral lenders such as the BRICS established New Development Bank may further diminish demand for conditionality-laden IMF loan programs.
Special Drawing Rights reform
In light of these developments, substantial reforms to the post-Bretton Woods lending system are pressing. Key among these is an expanded use of the IMF’s reserve asset, Special Drawing Rights (SDRs). Although SDRs are not currencies, they may be considered as claims on currencies. Using them outside of central banks for fiscal expenditures requires treating them as potential claims on hard currency like dollars and euros. They can be exchanged, typically for dollars or euros, at IMF facilities.5 Regularly issued as was originally intended under the 1944 Bretton Woods arrangement, SDRs can be an important source of financing the clean energy transition.
In 2021, the IMF issued an equivalent of $650 billion in new SDRs, its largest SDR issuance ever—yet only one percent went to low-income countries. Issuance is based on country quota shares at the IMF, which, in many cases, are grossly disproportionate to population.6 As forms of central bank liquidity, SDRs can serve many functions. As international reserves, they can reduce sovereign financing costs and help stabilize currencies. As equity, they can leverage more lending by MDBs. If rechannelled through the proposed Loss and Damage facility, they can provide much needed liquidity for countries facing disasters.
Building out the SDR system, which is idiosyncratic and opaque, should not be impeded by“originalist” interpretations of its reserve asset characteristic. While expanding SDRs beyond payments between central banks and prescribed holders would require changes in the IMF’s Articles of Agreement, the instrument’s scope can be broadened, as “no strings attached,” even without such changes. Under the Bretton Woods Agreement Acts, SDRs may be issued on a regular basis, aside from their special issuance in the face of exogenous global shocks. Given their current accounting designation as international reserve assets with matching liabilities, rechanneling SDRs from high-income countries (who have not used the bulk of their SDRs) to countries in need is a second-best solution compared to regular SDR issuance.7 Ideally, SDR issuance should be delinked from the IMF’s inegalitarian quota system. However, rechanneling SDRs from rich to developing countries via financial engineering in the form of SDR bonds are promising workarounds.
SDRs have already been pledged by donor governments to the IMF’s Resilience and Sustainability facility (RST) as well as its interest-free Poverty Reduction and Growth Facility (PRGT). Both facilities are loans- not grants- based. They have yet to be fully financed and their current capacity is orders of magnitude short of what is required by developing economies. Only countries that have an IMF loan program in place can borrow via the RST. Given the large number of countries facing debt and climate shocks, there is no need for such a conditionality. Japan, France, and China (among others) have committed SDRs to the two facilities, but up to $200 billion in European-held and $150 billion plus in US-held SDRs could be rechanneled.8
MDBs such as the African Development Bank have made plans to deploy rechanneled SDRs for climate mitigation and adaptation financing. The proposed Bridgetown Initiative includes a similar set up. Schemes to leverage SDRs into hybrid debt instruments to attract more public-private financing are gaining steam. It remains to be seen whether blended financing arrangements that seek to translate “billions into trillions” will provide funds at super-long maturity (fifty plus years) and on concessional terms. These factors will be key for the ability of low- and vulnerable middle-income countries to access, and equally importantly, manage new borrowing. Monetary authorities with limited fiscal capacity should not be coaxed into backstopping new green private investment; the IMF and other MDBs can take on that role. But that is only possible if the lending capacity of MDBs—which involves revising their capital adequacy frameworks while increasing their capital—is enhanced. While there seems to be growing consensus on the former front, efforts to increase capital appear stalled for now. At the Spring Meetings, the World Bank announced that it would boost its lending by about $5 billion a year for the next decade. Such modest efforts fall far short of rich countries’ pledges to re-channel $100 billion in SDRs to low-income economies for climate adaptation and balance-of-payments crises.
Modernizing the Bretton Woods institutions
A bolder IMF requires a bigger balance sheet. While the Fund, unlike the World Bank, does not have a credit rating to worry about, its resources have been stretched while its capital subscriptions, i.e. quotas, haven’t increased. Quotas aren’t just the capital-base of the IMF, they also determine member states’ voting shares, share of SDR issuance, maximum lending access and, crucially, the costs of borrowing. Both India and China punch way below their weight in terms of voting shares, with respect to population and GDP. The sixteenth review of quotas is underway and concludes in mid-December. Expanding quotas hangs in the balance. The last review in 2019 did not result in an increase in quotas because of a lack of adequate support for the measure. Those pushing for IMF reform in this review are advocating for rebalancing. Some of the key decisions on reforms, including quota increases, hinge on US support. The US holds 16.5 percent of the IMF’s voting shares, and changes in quotas, as well as the Articles of Agreement, require votes in favor by 85 percent of the body.
Much has changed since the initial drafting of the IMF Articles of Agreement in 1944. The Articles have been amended seven times, most recently in 2010. Shifts in the global financial system justify revisiting the Articles as a living document. The right to veto, which has been weaponized in debt holdouts by bilateral creditors such as China, should be eliminated. The IMF Board could be replaced with a voting-based system that involves all member-states. This twenty-first-century global institution still clings to the anachronistic “gentleman’s agreement” that IMF and World Bank leadership must come from Europe and the United States.
The IMF’s singular focus on structural adjustment for countries facing balance of payments crises runs contrary to the beliefs of one the key founding fathers of the Bretton Woods institutions: John Maynard Keynes. In Keynes’ view, countries running balance-of-payment surpluses, like the US at the time, also bear responsibility for equilibrating imbalances in the international financial system. The original Keynes-White plan, which was cut from the final IMF Article of Agreement, explicitly called for capital controls both on countries capital was fleeing from and to where capital was fleeing to—the destination today is mostly dollar and euro assets in offshore tax havens. In 2022, the IMF endorsed pre-emptive capital controls on financial inflows. But despite evolving IMF policy on capital inflows, capital can still flow out of developing economies when the global financial cycle takes a turn for the worse. While tax reform in developing economies is necessary, the onus also falls on advanced economies. US firms have contributed to half of the $250 billion in lost tax revenues across the globe—almost the size of the nearly $300 billion in new IMF loans since 2020.
An earlier version of this piece was published in Progressive International and can be read here.
Correspondence, IMF economist, January 12, 2023.↩
China has renminbi swap arrangements with thirty five countries. “Letter: Hesitant Fed Lets China Fill the Currency Swaps Void.” Financial Times. Accessed February 20, 2023. https://www.ft.com/content/7320e9b2-acca-46e4-ad58-12773912e5a6.↩
Such as the European Stability Mechanism and the Chang Mai Initiative Multilateralization↩
“Global Financial Safety Net-A Lifeline for an Uncertain World.” IMF. Accessed February 20, 2023. https://www.imf.org/en/Blogs/Articles/2021/11/30/global-financial-safety-net-a-lifeline-for-an-uncertain-world. Also see: “The Global Financial Safety Net during the Covid-19 Crisis: An Interim Stock-Take,” IMF Strategy, Policy and Review (Special Series on Covid-19).↩
The IMF has clarified that sovereign fiscal and monetary authorities have the flexibility to interpret these balance of payments guidelines. As they did, following the last major SDR issuance, fiscal authorities should continue to use SDRs (converted into hard currencies) for public expenditures.↩
More than $100 billion went to the US alone.↩
The sixth edition of the IMF balance of payments manual defines SDR as a “debt” instrument. Therefore, SDR allocation increases both the gross external reserves as well as the gross external long-term liabilities of a country’s external balance sheet. In the previous (fifth) edition of the manual, SDRs are likened to gold as reserve assets in country balance sheets “for which there is no outstanding liability.” As Andrés Arauz has pointed out, the latest IMF Balance of Payments manual (BPM) redefined the SDR from equity to a debt instrument—this has led to some confusion. If considered a perpetual liability as per the newer BPM guidelines, SDR allocation increases both the gross external reserves as well as the gross external liabilities of a nation. Holding SDRs earns countries interest payments while using SDRs involves paying an interest rate.↩
Rechanneling and/or issuing new SDRs has been stalled in the US because it requires bipartisan support in Congress. However, the US Treasury Secretary can sign off on new SDR issuance so long as it is $650 billion or less without Congressional approval. Across the Atlantic, the European Central Bank (ECB) president’s claim that re-channeling SDRs doesn’t cohere to ECB restrictions on monetary financing has likewise paused the re-channeling process.↩