II Initial Conditions and the Setting of IMF-Supported Programs
- Charalambos Christofides, Atish Ghosh, Uma Ramakrishnan, Alun Thomas, Laura Papi, Juan Zalduendo, and Jun Kim
- Published Date:
- September 2005
In the archetypical IMF-supported program, a member faces external financing difficulties and external and internal imbalances, requiring stabilization measures. Under a fixed exchange rate regime, balance of payments difficulties reflect either an overheating of the economy that could also be associated with a loss of competitiveness, or an external shock—such as a deterioration in terms of trade or reduced net capital inflows. Correspondingly, under a floating regime, the external financing difficulties are manifested in a persistent depreciation of the real exchange rate. Either way, the problems stemming from current account imbalances can be exacerbated by net capital outflows.
Facing external imbalances, the member must either adjust, obtain financing from official sources, or restructure its external obligations. In the textbook case of a purely temporary disequilibrium, financing would be appropriate, while a permanent shock requires adjustment. More generally, some external adjustment and financing is required. The key objective in traditional IMF-supported programs, therefore, is to reduce the current account deficit to a sustainable level and to reconstitute reserves over a timeframe that complements the financing that the IMF is providing. Over the longer run, as confidence returns, capital inflows resume and the country is again able to finance its now sustainable current account deficit and replenish its international reserves.
Thus economic policies are intended to bring about the required external adjustment, while IMF financial support is intended to ease this adjustment by spreading it out over time, and to help reconstitute international reserves. In principle, the requisite external adjustment can be achieved either by raising aggregate supply or by reducing domestic demand. In practice, given lags in the supply response, the brunt of the adjustment falls on demand management with IMF financing provided to ease the adjustment burden while the country implements expenditure-switching and expenditure-reducing policies. Since a given adjustment can be achieved through different combinations of macroeconomic policies, making good policy choices naturally involves picking those alternatives that raise the likelihood of restoring external viability in the least costly way—avoiding “measures destructive of national or international prosperity” in the parlance of the Articles of Agreement—taking account of economic relationships and social and political realities.
The last comprehensive review of IMF-supported programs found that most programs were characterized by a classic external adjustment paradigm in which a member requests support from the IMF to deal with a continuing loss of reserves associated with current account imbalances, often in the context of poor macroeconomic performance such as high inflation or low growth (Schadler and others, 1995). The 1995 study documented an improvement in the country’s external position—its current account balance (new users) and its net international reserves, but the effects on inflation and growth were much less favorable.4 In cases where the balance of payments problem was precipitated by overheating of the economy, the country may have had rapid growth (and high inflation) prior to the emergence of economic problems, but the subsequent slowdown of capital inflows and financing, together with tightened macroeconomic policies resulted in a temporary slowing in economic activity. In other cases, the country’s growth performance in the runup to the authorities’ adjustment program may have been weak, but their program was associated only with growth returning to its historical average rather than with a marked increase in the long-term growth rate. In either case, despite generally tighter monetary policy (relative to the preprogram period), a discrete devaluation gave an additional fillip to inflation. The results of a study on ESAF-supported programs approved between 1986 and 1995 are similar, except for slightly greater emphasis on growth outcomes—see Box 2.1 for a summary of the conclusions of these reports.
Box 2.1.Conclusions from Previous Reviews of IMF-Supported Programs
Over the last decade, two studies have been undertaken to examine experiences in IMF-supported programs: a study of all stand-by and extended arrangements approved during the period 1988–91 (Schadler and others, 1995) and a review of the ESAF over the period 1986–96 (Bredenkamp and Schadler, 1999).
The study of experiences under Stand-By and Extended Arrangements notes an improvement in the external position of countries requesting IMF support but more mixed results in terms of other macroeconomic objectives (Table A). Specifically, the current account deficit fell during the program for all countries except for those with several previous arrangements. Moreover, about a third of the program countries benefited from large increases in capital flows and reserves rose from slightly over two months of imports in the year prior to a program to over three and a half months by the end of the program for all categories. In contrast, the record on inflation and growth was more mixed. Countries entering their arrangements with annual inflation rates above 10 percent saw significant reductions while other saw little change (or even small increases) in inflation rates. With regard to growth, countries with one previous arrangement bounced back rapidly during the program period, whereas for new users and for countries with several previous arrangements, the growth profile was comparable prior to and by the end of the program period, with a temporary dip at the beginning of the program.
|Current account deficit (in percent of exports)|
|Reserve cover (in months of imports)|
|Growth (in percent)|
|More than one previous arrangement||2.0||3.0||2.0||2.5||3.0||2.5|
|One previous arrangement||–3.5||–2.0||4.5||4.0||4.5|
|Inflation (annual; in percent)|
|Countries with initial inflation between 10% and 50%||23||302||17|
|Countries with initial inflation <10%||5||72||7|
t refers to the first program year.
Target of IMF-supported program.
t refers to the first program year.
Target of IMF-supported program.
The study of ESAF arrangements showed that the gap in per capita output growth between ESAF countries and other developing countries was eliminated by the mid-1990s, and that half of this improvement was associated with improved macroeconomic and structural policies (Table B). However, the study also documents a mixed record in attaining low inflation, even though the negative association between growth and inflation is robust.
|Per capita growth|
|ESAF excluding transition economies||–1.4||0.4||0.3||1.5|
|Non-ESAF developing countries||0.3||1.0||1.0||1.4|
|Low initial inflation||11.0||9.0||6.2||10.2||8.0||7.2|
|Intermediate initial inflation||15.8||16.2||20.2||16.3||15.1||11.7|
|High initial inflation||80.0||126.0||170.0||75.0||26.0||25.0|
Traditional IMF-Supported Adjustment Programs
The behavior of key macroeconomic variables in programs supported by the GRA—Stand-By Arrangements (SBAs) and Extended Fund Facility (EFF) arrangements excluding those with transition economies—show striking similarities to the predictions of the traditional model.5Figure 2.1 plots the key economic indicators.6 In particular, growth is V-shaped, falling during the program period, but recovering by the third year after the program.7 Inflation, which is usually on a downward trajectory prior to the program, increases slightly in the program year. The key characteristic, however, is the country’s external financing difficulties, which are manifested in the switch from an inflow of capital averaging 2 percent of GDP over the three years preceding the program to a net outflow of over 1 percent of GDP in the program year (before recovering to an inflow of about 1 percent of GDP two years later). The current account deficit narrows from 3 percent of GDP on average over the three years preceding the program to about zero in the program year. Adjustment of the fiscal balance, which improves by about 1 percent of GDP over the same period, explains less than half of the external adjustment, the remainder coming from the private sector.8 The current account improvement reflects both a decline in investment and a rise in domestic saving during the program period, but over a three-year horizon is driven entirely by a decline in investment with saving returning to its historical average.9 Foreign exchange reserves improve steadily once program implementation begins and this improvement is maintained.
Figure 2.1.Macroeconomic Performance Under GRA-Supported Programs (Excluding Transition Economies), 1995–20001
Of the 25 arrangements shown in Figure 2.1, 9 arrangements were treated as precautionary (36 percent). With the exception of real GDP growth—which rises during the program period—the behavior of other economic variables among members that had precautionary arrangements is similar to those for arrangements where the member made a purchase.10 In particular, both are characterized by sharp improvements in the fiscal and current account balances during the program and a corresponding buildup in reserves (Figure 2.2). Over the longer term, the main difference between the two types of arrangements is that the savings ratio rises among precautionary programs but remains flat in all other GRA-supported programs. These similarities between precautionary and nonprecautionary arrangements indicate that a common standard has been applied, but also suggests that IMF financing had little direct impact on current account adjustment where the member drew on IMF’s resources.
Figure 2.2.Macroeconomic Performance Under GRA-Supported Programs with Precautionary Arrangements, 1995–20001
Among the GRA sample, there are also programs whose primary focus is enhancing the credibility of macroeconomic policies rather than undertaking external adjustment—a group that is not as clearly defined as, but partly overlaps, the sample of precautionary arrangements considered in Figure 2.2. Members may request such an arrangement because they have achieved macroeconomic stability but still have a large structural reform agenda (for instance, some of the later programs in Estonia or Latvia); to reassure markets during election cycles or periods of political uncertainty (Peru, in 1999); or because they are trying to tackle a problem of high inflation or public debt sustainability (though they do not face acute balance of payments difficulties). Turkey’s 1999 Stand-By Arrangement is an example of the latter case: with the current account barely in deficit and readily financeable through private capital flows, the primary role of the IMF-supported program was to enhance the credibility of monetary and fiscal policies, which was essential to reduce inflation expectations and nominal and real interest rates. In Brazil’s 2002 Stand-By Arrangement, the credibility of the authorities’ commitment to generating the requisite primary surpluses was key to reducing spreads and to improving public debt dynamics.
Other Types of Programs
Capital Account Crises
The behavior of the main economic variables in capital account crisis programs mimics that in the traditional case, though the patterns are more pronounced. Indeed, in these capital account crisis programs the abruptness and magnitude of the reversal of capital inflows had pervasive consequences for economic performance and policy formulation and implementation (Figure 2.3).11 A sharper dip in growth and spike in inflation is observed when the crisis erupts (which typically precedes the arrangement’s approval date).12 Underlying these outcomes is the reversal from capital inflows to outflows. In the three years preceding the program, private capital inflows to these countries average over 5 percent of GDP, turning to a net outflow of more than 1 percent of GDP when the crisis erupts, before recovering to an inflow of 2 percent of GDP two years later. These movements force large swings in the current account balance which, on average, switches from a deficit of 4 percent of GDP to a surplus of 2 percent (and considerably more in some cases).
Figure 2.3.Macroeconomic Performance Under Capital Account Crisis Programs, 1995–20001 Box 2.2.Fiscal Adjustment in Capital Account Crises
Among the more controversial elements of program design in capital account crises is the stance of fiscal policy. In traditional adjustment programs, fiscal policy is typically tightened in order to reduce aggregate expenditure in relation to aggregate income and bring about the necessary external adjustment, especially when the public sector is seen as a major source of the external deficit.
Although the precrisis public sector deficits in the Asian crisis countries were not viewed as excessively large (with the possible exception of Thailand), the original program design in each of these countries called for at least some fiscal tightening. In particular, given capital outflows, there was a necessary improvement in the current account balance. Since the current account balance, in turn, equals the excess of public and private saving over investment, the greater the public sector’s share of the adjustment, the smaller the private share will need be.
While this is arithmetically correct, whether it translates into a smaller burden of adjustment on the private sector—in the sense of a smaller decline in private consumption or investment—depends upon the nature of the shock. If the country has suffered a shock to aggregate supply, then output is exogenous with respect to government spending, and an improvement in public saving will imply a smaller required adjustment of private consumption. Conversely, if the country has suffered a shock to aggregate demand, then the higher public saving, while still implying a smaller required increase in private saving, will be associated with weaker activity and lower income and private consumption—that is, the smaller required increase in private saving will take place not through a smaller decline in private consumption, but through a decline in income and a decline in consumption (see Ghosh and others (2002) and IEO (2003b) for a fuller discussion).
In the event, the programmed fiscal tightening in the Asian crisis countries was quickly reversed as it became apparent that the private sector was (over) adjusting and activity was collapsing. Fiscal policy in capital account crises has continued to be controversial, however. In particular, in the run-up to Argentina’s 2002 crisis, there were numerous slippages of the primary and overall deficit relative to program targets that were countenanced by subsequent waivers. Thus, the IMF-supported programs initially targeted too much fiscal adjustment in the Asian capital account crises but targeted (or at least achieved) too little adjustment in the case of Argentina.
|Coverage||Previous Year||Original Program||First Review||Second Review||Third Review||Fourth Review||Outcome|
The key difference between capital account crises and more traditional adjustment programs lies in the orientation of policies. In traditional adjustment programs, monetary and fiscal policies are intended to bring about external adjustment; in a capital account crisis the emphasis often shifts to mitigating the external adjustment that the member is forced to undertake in response to capital outflows. Whereas the fiscal balance improves by about 1 percent of GDP in traditional programs (Figure 2.1), in the capital account crisis programs the fiscal deficit widens by about 3 percent of GDP (Figure 2.3), though often this was not the orientation of policies in the original program (Box 2.2). Monetary policy is tightened, but the purpose of that tightening is less to dampen activity and promote adjustment than to attract capital flows through higher expected returns.
Transition and PRGF Programs
Another set of IMF-supported programs that differs from the traditional model consists of the GRA-supported programs with the transition economies and the PRGF-supported programs in low-income countries. As previously discussed, these countries form a diverse group, but examining these programs together is justified by their focus on structural reforms and efforts to promote growth and poverty reduction.
In the transition economies, although the need to maintain external viability acted as a constraint to some degree, the primary objective, at least initially, involved restoring macroeconomic stability following price liberalization and transforming centrally planned economies to those based on market principles. The growth picture differs considerably from the other GRA-supported programs mainly because of the abrupt transformation in the allocation of productive resources and of the disruption of existing trade linkages that the shift from central planning entailed (Figure 2.4). In terms of macroeconomic policies, on average, the fiscal deficit improved by 1 percentage point of GDP, while the current account deficit also improved. These policies and developments helped restrain money creation and lower inflation. Indeed, monetary policy was tightened, with a switch to positive real interest rates.
For programs supported by the PRGF, the primary objectives are its eponymous goals—raising growth and reducing poverty—rather than narrowing the current account deficit, though, again, the need to maintain external flow financing may act as a constraint.13 Not surprisingly, the most important difference between PRGF and more traditional adjustment programs lies in the behavior of output growth (Figure 2.5). Instead of the sharp V-shaped path in growth characteristic of traditional Stand-By or capital account crisis programs, IMF-supported programs in low-income countries in the 1990s have been associated with an increase in the longer-term growth performance. Inflation is on a downward trajectory prior to the program and continues to decline over the program period. The fiscal deficit improves by 1 percentage point of GDP during the early stages of a program, but this improvement reverses over time. In contrast, the current account deteriorates by about 1 percentage point of GDP in the first program year only to bounce back to its preprogram level (a deficit of 8 percent of GDP) by the third year of the program. While there is no secular improvement in the current account deficit over time, both domestic saving and investment rise by 1 percentage point of GDP, thereby enhancing future growth prospects. Indeed, the composition of inflows changes during IMF-supported programs with increased foreign direct investment. Moreover, a number of programs have included measures on liberalizing imports to foster future growth and put the balance of payments on a sustainable path, although these measures may adversely affect the current account balance in the short term.14 Real interest rates rise and money growth decelerates throughout the duration of these programs.