Understanding IMF bailouts

Context: The International Monetary Fund (IMF) last week confirmed a $3 billion bailout plan for Sri Lanka’s struggling economy. IMF officials are also in negotiations with Pakistan for a $1.1 billion bailout plan as the country faces a severe economic crisis marked by a falling currency and price rise.

Why do nations seek an IMF bailout?

  • Countries seek help from the IMF usually when their economies face a major macroeconomic risk, mostly in the form of a currency crisis. For instance in the case of Sri Lanka and Pakistan, both countries have witnessed domestic prices rise rapidly and the exchange value of their currencies drop steeply against the U.S. dollar
  • Such currency crises are generally the result of gross mismanagement of the nation’s currency by its central bank, often under the covert influence of the ruling government. 
  • Central banks may be forced by governments to create fresh money out of thin air to fund populist spending. 
  • Such spending eventually results in a rapid rise of the overall money supply, which in turn causes prices to rise across the economy and the exchange value of the currency to drop
  • A rapid, unpredictable fall in the value of a currency can destroy confidence in said currency and affect economic activity as people may turn hesitant to accept the currency in exchange for goods and services. 
  • Foreigners may also be unwilling to invest in an economy where the value of its currency gyrates in an unpredictable manner. 
  • In such a scenario, many countries are forced to seek help from the IMF to meet their external debt and other obligations, to purchase essential imports, and also to prop up the exchange value of their currencies. 
  • Bad luck can also contribute to a crisis. In the case of Sri Lanka, a decrease in foreign tourists visiting the country led to a steep fall in the flow of U.S. dollars into the nation.

How does the IMF help countries?

The IMF basically lends money, often in the form of special drawing rights (SDRs), to troubled economies that seek the lender’s assistance. 

SDRs simply represent a basket of five currencies, namely the U.S. dollar, the euro, the Chinese yuan, the Japanese yen, and the British pound. The IMF carries out its lending to troubled economies through a number of lending programs such as the extended credit facility, the flexible credit line, the stand-by agreement, etc. 

Countries receiving the bailout can use the SDRs for various purposes depending on their individual circumstances. 

Currently, both Sri Lanka and Pakistan are in urgent need for U.S. dollars to import essential items and also to pay their foreign debt. So any money that they receive from the IMF is likely to go towards addressing these urgent issues.

Are there any strings attached to an IMF bailout?

  • On giving loans to countries, the IMF makes the loan conditional on the implementation of certain economic policies. These policies tend to involve:
  1. Reducing government borrowing – Higher taxes and lower spending
  2. Higher interest rates to stabilise the currency.
  3. Allow failing firms to go bankrupt.
  4. Structural adjustment. Privatisation, deregulation, reducing corruption and bureaucracy.
  • The problem is that these policies of structural adjustment and macroeconomic intervention can make difficult economic situations worse.
  • For example, in the Asian crisis of 1997, many countries such as Indonesia, Malaysia and Thailand were required by the IMF to pursue tight monetary policy (higher interest rates) and tight fiscal policy to reduce the budget deficit and strengthen exchange rates. However, these policies caused a minor slowdown to turn into a serious recession with very high levels of unemployment.

What is the International Monetary Fund?

  • Its headquarters is in Washington DC.
  • Membership: 190 countries
  • The International Monetary Fund (IMF) is an international organization that:
  1. Promotes global economic growth and
  2. Promotes global financial stability, 
  3. Encourages international trade, and 
  4. Reduces poverty.
  • Origin: The IMF was originally created in 1945 as part of the Bretton Woods agreement, which attempted to encourage international financial cooperation by introducing a system of convertible currencies at fixed exchange rates.
  • Change in its role: Since the Bretton Woods system collapsed in the 1970s, the IMF has promoted the system of floating exchange rates, meaning that market forces determine the value of currencies relative to one another. This system remains in place today.

Functions of IMF: 

  1. The IMF collects massive amounts of data on national economies, international trade, and the global economy in aggregate and provides economic forecasts.
  2. One of the IMF’s most important functions is to make loans to countries that are experiencing economic distress to prevent or mitigate financial crises.
  3. The IMF provides technical assistance, training, and policy advice to member countries through its capacity-building programs. These programs include training in data collection and analysis, which feed into the IMF’s project of monitoring national and global economies.
  • The IMF gets its money through quotas and subscriptions from its member countries. These contributions are based on the size of the country’s economy, making the U.S., with the world’s largest economy, the largest contributor.
  • Quotas are a key determinant of the voting power in IMF decisions. Votes comprise one vote per SDR 100,000 of quota plus basic votes (same for all members). 
  • IMF Grants: These are given to charities in Washington D.C. and member countries. The grants are meant to foster economic independence through education and economic development.” The average grant size is $15,000. 
  • Note: Membership of the IMF is compulsory to be part of the International Bank for Reconstruction and Development (IBRD or World Bank). 

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