Role of IFIs in Financial Crisis 1

Running Head: Role of IFIs in Financial Crisis

Role of IFIs in Financial Crisis

Sundas Jamil

BBA VI

2007-BBA-028

Fatima Jinnah Women University

 Role of IFIs in Financial Crisis 2

Table of Contents

Introduction:.....................................................................................................................................3
1.2 IFIs and Finnacial Crisis:...........................................................................................................3
1.3.1 Provider of Additional resources:.......................................................................................5
1.3.2 Lender of last Resort:..........................................................................................................6
1.3.3 Crisis Manager:...................................................................................................................7
1.3.4 Monitoring Exchange rates:................................................................................................7
 Role of IFIs in Financial Crisis 3

Role of IFIs in Financial Crisis

Introduction:

The International Monetary Fund (IMF) and the World Bank comprise the two major

international financial institutions (IFIs). The IFIs exercise enormous power over the workings of

the international financial system as reflected in the fact that half the world's population and two-

thirds of its governments are bound by the policies they prescribe (Reus-Smit, 2004). The World

Bank and IMF were essentially created in 1944 at the Bretton Woods Conference for the broad

purpose of coordinating and managing international monetary and financial matters. Although

united in achieving these general goals the two institutions were constituted to perform

distinctive but complementary functions. (Reus-Smit, 2004). The Bretton Woods system served

us well though not entirely as intended. It facilitated the postwar recovery without a large

number of economic and financial crises. There were a few, but they tended to be associated with

individual countries rather than the system as a whole. (Truman, 2009).

1.2 IFIs and Finnacial Crisis:

Today, We face a global economic and financial meltdown that may yet equal the Great

Depression. If national economic and financial policies are sufficiently focused and mutually

supportive, we can avoid the trade and financial protectionism and competitive exchange-rate

devaluations that exacerbated economic distress eight decades ago. The International Monetary

Fund (IMF), the World Bank, and what is now the World Trade Organization were established at
 Role of IFIs in Financial Crisis 4

the end of World War II to mitigate, if not prevent, recurrence of such destructive policies.

(Truman, 2009)

The international financial institutions have evolved with the globalization of our

economies. The global economy and financial system are in the center of a massive deleveraging

process. The increased globalization of the world economy and its financial system in recent

decades means that countries can run, but not hide, from this crisis or future crises. Every

country has been affected, and those with the weakest policies and the most precarious financial

circumstances have been affected first. The incidence and virulence of future crises may be

reduced by decisions taken in the wake of this crisis, but crises will not be prevented. What is

important now is to cushion the impacts of the global recession and to restore stability to

financial markets. (Truman, 2009).

1.3 Role of IFIS:

At the London summit in early April 2009, the leaders of the world’s twenty richest

countries decided that these international financial; institutions will be a major instrument to

respond to the financial and economic crisis. (Eurodad, 2009). One of the role thus, for these

interntional ifnancial instituitons was global economic governance positioned to help deal with

current economic and financial crisis. Unfortunately, the institution’s authenticity and

importance has decreased in recent years. Moreover, even in the best of circumstances, the

institutions can only be as successful as its principal members want it to be. As given by

Trumman (2009) in the near term, the institutions should:

• Lend to countries that have been adversely affected by the crisis

• Help to establish an agreed approach to global economic and financial recovery,

 Role of IFIs in Financial Crisis 5

• Monitor the implementation of national economic and financial policies, in particular

exchange-rate policies, to minimize the negative, spillover effects of one country’s

policies on other countries. (Truman, 2009)

1.3.1 Provider of Additional resources:

The UN summit outcome document recognises that "developing countries will need a

large share of additional resources" and calling upon the G20 "to further consider addressing the

financial needs of developing countries, especially low income countries". (Eurodad, 2009). The

document goes further than previous UN texts in recognizing that "international economic

relations have meant that the space for national economic policy, that is, the scope for domestic

policies, especially in the areas of trade, investment and international development, is now often

framed by international disciplines, commitments and global market considerations. We

recognise that these regimes, disciplines, commitments and considerations have presented

challenges to many developing countries seeking to fashion a national response to the financial

and economic crisis." However, The action agreement text is weaker than the above assessment

would indicate. It says governments commit "to provide sufficient developmental resources to

developing countries without unwarranted conditionalities". It calls for a "streamlining of

conditionalities" and says that "new and ongoing programs should not contain unwarranted pro-

cyclical conditionalities." (Eurodad, 2009)

Another option to create additional liquidity for developing countries is the issuance of

Special Drawing Rights (SDRs) by the International Monetary Fund (IMF). This was a decision

taken by the G20 which the IMF is now deciding how to implement. Civil society is calling to

use the SDRs to provide resources for the countries that need them the most. (Eurodad, 2009)
 Role of IFIs in Financial Crisis 6

1.3.2 Lender of last Resort:

Many writers have proposed having an international institution serve as an

International lender of last resort. The "Clinton proposal" offered at the October 1998 G-7

meetings is also very much in this spirit. In proposals of this sort, the IMF would offer a new

emergency line of credit, for which countries would have to prequali9 by meeting certain

macroeconomic and regulatory standards. The existence of this line of credit would stave off

speculative attacks, just as deposit insurance in the United States reduces the incidence of bank

runs, so that very few countries would actually ever have to draw on the facility. (Rogoff, 1999)

The obstacles to having an international "deep pockets" style lender of last resort are formidable.

The IMF today has lendable resources of roughly $200 billion. As a share of world GNP, this

amounts to less than a fifth of the resources the IMF had upon its creation at the end of World

War 11. All evidence suggests that the G7 is simply not prepared to put up the lund of resources

needed to preclude a broad-based attack on developing country debt. Moreover, a larger IMF

fund would probably encourage more risk-taking by banks in industrialized countries. G7

officials already have a hard time convincing their own banks that they will not bail them out in

the advent of default on developing country debt-especially since, in the past, they have

repeatedly done just that (Bulow, Rogoff and Bevilaqua, 1992).

Any plan for an international lending institution must also confront the fact that most

financial regulatory power will still lie in the hands of domestic author- ities. The creation of a

"deep pockets" international lender of last resort would almost certainly induce domestic

authorities to be more lax in their oversight. They will know that if domestic banks do run into

trouble, part of the cost will be passed on to other countries via the international guarantor. This
 Role of IFIs in Financial Crisis 7

problem could be mitigated by introducing a risk-based system for assessing country

contributions to the international lending institution, but how effective this would be in practice

is unclear. (Rogoff, 1999)

1.3.3 Crisis Manager:

Fischer (this issue) and Giannini (1999) argue that the main function of the lender of last resort

in most modern industrialized economies is that of "crisis manager," a role that does not

necessarily require vast amounts of capital. rises. By analogy, an international institution-say, the

International Monetary Fund-does not necessarily need deep pockets to play what is perhaps the

most essential role of a modern lender of last resort. (Rogoff, 1999)

1.3.4 Monitoring Exchange rates:

In a global recession, many countries are tempted to allow or to encourage their exchange rates

to depreciate. The problem is that all countries cannot depreciate their currencies at the same

time vis-à-vis the currencies of all other countries. Moreover, countries that are successful in

doing so in effect export their unemployment. This type of “beggar-thy neighbor” exchange-rate

policy, along with protectionist trade actions that were in part triggered by exchange-rate

policies, exacerbated the Great Depression and shredded international monetary cooperation.

Normally, one constraint on such competitive depreciation is the risk of igniting domestic

inflation. That constraint is largely missing at present. Most countries in the world either are
 Role of IFIs in Financial Crisis 8

experiencing low inflation or fear outright deflation. The exchange-rate policies of IMF members

remain central to the Fund’s mission. In the wake of the abandonment of fixed exchange rates in

the 1970s, the IMF Articles of Agreement, its charter, were rewritten. Members accepted the

obligation to “avoid manipulating exchange rates or the international monetary system to prevent

effective balance of payments adjustment or to gain an unfair competitive advantage over other

members.” However, The IMF’s enforcement of this obligation has been weak. Some of the

blame lies with the timidity of the IMF’s management and staff, but the major portion lies with

the general membership of the Fund.

Thus, in particular during this difficult period for the global economy, the international

financial institutions management and staff have a responsibility to call countries on the carpet if

their exchange rate policies are inappropriate. Members of the Fund, in turn, need to support

such efforts to curb exchange-rate movements that are disruptive to trading relations and

detrimental to the global economy (Truman, 2009)

 Role of IFIs in Financial Crisis 9

References

Eurodad. (2009). The UN conference on the financial crisis and development: outcomes

and follow-up prospects. Retrieved June 24, 2010, from Eurodad:

http://www.eurodad.org/whatsnew/articles.aspx?id=3738

Bulow, Jeremy, Kenneth Rogoff and Afonso Bevilaqua. (1992). "Official Creditor Seniority

and Burden Sharing in the Former Soviet Bloc." Brookings Papers in Macroeconomic Activity.

Giannini, Curzio. (1999) . "Enemy of None but Friend of All? An International Perspective

on the Lender of Last Resort Function." International Monetaq Fund Trorking Paper WP/99/10.

Rogoff, Kenneth (1992), “International Institutions for Reducing Global Financial

Instability”, The Journal of Economic Perspectives, Vol. 13, No. 4. pp. 21-42.

Truman,Edwin M (2009), The IMF and the Global Crisis: Role and Reform, Remarks

delivered to the Tulsa Committee on Foreign Relations on January 22, 2009 and to the Dallas

Committee on Foreign Relations on January 23, 2009, Peterson Institute for International

Economics