International Monetary Fund
Lending Programs Allow for Negotiations and Are Consistent with Economic Literature
Gao ID: GAO-10-44 November 12, 2009
The International Monetary Fund (IMF) has significantly increased its total committed lending to countries from about $3.5 billion in August 2008 to about $170.4 billion in August 2009, as countries have been severely affected by the global economic crisis. IMF-supported programs are intended to help countries overcome balance-of-payments problems, stabilize their economies, and restore sustainable economic growth. Critics have long-standing concerns that the IMF has an overly austere approach to macroeconomic policy that does not sufficiently heed country viewpoints. To help address these concerns, the IMF recently stated that it has changed its policies, including by increasing its flexibility. GAO was asked to examine (1) the process for designing an IMF-supported program, (2) the IMF-supported programs in four recipient countries, and (3) the extent to which the findings of empirical economic studies are consistent with the IMF's macroeconomic policies. GAO analyzed IMF and recipient country documents; interviewed U.S., IMF, and foreign government officials, conducting fieldwork in four relatively large recipient countries; and analyzed published or widely cited empirical studies. GAO received written comments from the Department of the Treasury, noting its concurrence with the report's conclusions.
Designing an IMF-supported lending program involves a complex, iterative process based on projections for key macroeconomic variables; discussions between IMF staff and country officials regarding program goals, policies, and trade-offs; use of economic judgment; and IMF Executive Board approval. An IMF-supported program is intended to help countries achieve their objectives in the context of macroeconomic stability. Programs in low-income countries are broadly geared toward increasing economic growth and reducing poverty, and generally strive for low inflation and sustainable levels of debt. In middle- and high-income countries, programs generally aim to stem capital outflows, restore confidence, and stabilize the exchange rate by, for example, setting targets for budget deficits and international reserves. Trade-offs among the different combinations of objectives and policies allow for negotiations between the IMF staff and country officials, reflecting what is technically feasible and politically acceptable. IMF-supported programs in the four countries GAO reviewed--Liberia, Zambia, Hungary, and Iceland--include different sets of objectives, targets, and conditions that reflect country circumstances, based on negotiations between the IMF staff and country officials. In postconflict Liberia, the program focuses on rebuilding capacity and contains a target for maintaining a balanced budget with no borrowing. In Zambia--a country negatively affected by the recent economic crisis--the IMF-supported program is designed to increase economic growth, reduce poverty, and improve governance. Hungary, which faced a rising risk of default, has a program that focuses on restoring investor confidence while reducing debt and expenditures. A banking and currency collapse in Iceland precipitated the IMF-supported program, which contains some controversial approaches to monetary policy and banking reform. All four countries are making progress but face challenges in implementing conditions or achieving targets in their IMF-supported programs. The macroeconomic policies in IMF-supported programs are broadly consistent with the findings of the empirical literature GAO reviewed, although this literature lacks precise guidance for setting policy targets. For low-income countries, empirical evidence generally suggests inflation is detrimental to economic growth after it exceeds a critical threshold, which is broadly consistent with the inflation targets included in the IMF-supported programs we reviewed. For middle- and high-income countries, the literature identified specific policy weaknesses in advance of crises, including high inflation, high public indebtedness, and low international reserves. These weaknesses are consistent with the policies upon which the IMF focuses in the 13 programs in middle- to high-income countries GAO reviewed.
GAO-10-44, International Monetary Fund: Lending Programs Allow for Negotiations and Are Consistent with Economic Literature
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Report to the Chairman, Committee on Financial Services, House of
Representatives:
United States Government Accountability Office:
GAO:
November 2009:
International Monetary Fund:
Lending Programs Allow for Negotiations and Are Consistent with
Economic Literature:
GAO-10-44:
GAO Highlights:
Highlights of GAO-10-44, a report to the Chairman, Committee on
Financial Services, House of Representatives.
Why GAO Did This Study:
The International Monetary Fund (IMF) has significantly increased its
total committed lending to countries from about $3.5 billion in August
2008 to about $170.4 billion in August 2009, as countries have been
severely affected by the global economic crisis. IMF-supported programs
are intended to help countries overcome balance-of-payments problems,
stabilize their economies, and restore sustainable economic growth.
Critics have long-standing concerns that the IMF has an overly austere
approach to macroeconomic policy that does not sufficiently heed
country viewpoints. To help address these concerns, the IMF recently
stated that it has changed its policies, including by increasing its
flexibility.
GAO was asked to examine (1) the process for designing an IMF-supported
program, (2) the IMF-supported programs in four recipient countries,
and (3) the extent to which the findings of empirical economic studies
are consistent with the IMF‘s macroeconomic policies. GAO analyzed IMF
and recipient country documents; interviewed U.S., IMF, and foreign
government officials, conducting fieldwork in four relatively large
recipient countries; and analyzed published or widely cited empirical
studies.
GAO received written comments from the Department of the Treasury,
noting its concurrence with the report‘s conclusions.
What GAO Found:
Designing an IMF-supported lending program involves a complex,
iterative process based on projections for key macroeconomic variables;
discussions between IMF staff and country officials regarding program
goals, policies, and trade-offs; use of economic judgment; and IMF
Executive Board approval. An IMF-supported program is intended to help
countries achieve their objectives in the context of macroeconomic
stability. Programs in low-income countries are broadly geared toward
increasing economic growth and reducing poverty, and generally strive
for low inflation and sustainable levels of debt. In middle- and high-
income countries, programs generally aim to stem capital outflows,
restore confidence, and stabilize the exchange rate by, for example,
setting targets for budget deficits and international reserves. Trade-
offs among the different combinations of objectives and policies allow
for negotiations between the IMF staff and country officials,
reflecting what is technically feasible and politically acceptable.
IMF-supported programs in the four countries GAO reviewed”Liberia,
Zambia, Hungary, and Iceland”include different sets of objectives,
targets, and conditions that reflect country circumstances, based on
negotiations between the IMF staff and country officials. In
postconflict Liberia, the program focuses on rebuilding capacity and
contains a target for maintaining a balanced budget with no borrowing.
In Zambia”a country negatively affected by the recent economic crisis”
the IMF-supported program is designed to increase economic growth,
reduce poverty, and improve governance. Hungary, which faced a rising
risk of default, has a program that focuses on restoring investor
confidence while reducing debt and expenditures. A banking and currency
collapse in Iceland precipitated the IMF-supported program, which
contains some controversial approaches to monetary policy and banking
reform. All four countries are making progress but face challenges in
implementing conditions or achieving targets in their IMF-supported
programs.
The macroeconomic policies in IMF-supported programs are broadly
consistent with the findings of the empirical literature GAO reviewed,
although this literature lacks precise guidance for setting policy
targets. For low-income countries, empirical evidence generally
suggests inflation is detrimental to economic growth after it exceeds a
critical threshold, which is broadly consistent with the inflation
targets included in the IMF-supported programs we reviewed. For middle-
and high-income countries, the literature identified specific policy
weaknesses in advance of crises, including high inflation, high public
indebtedness, and low international reserves. These weaknesses are
consistent with the policies upon which the IMF focuses in the 13
programs in middle- to high-income countries GAO reviewed.
View [hyperlink, http://www.gao.gov/products/GAO-10-44] or key
components. For more information, contact Thomas Melito at (202) 512-
9601 or melitot@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Designing an IMF-Supported Program Is a Complex Process That Allows for
Negotiated Trade-offs Among Objectives and Policies:
Four IMF-Supported Programs Were Negotiated Based on Countries'
Circumstances:
Macroeconomic Policies in IMF-Supported Programs Are Broadly Consistent
with Findings of Academic Literature:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Countries Approved to Receive IMF Financial Arrangements
as of August 31, 2009:
Appendix III: Comments from the Department of the Treasury:
Appendix IV: GAO Contact and Staff Acknowledgments:
Bibliography: Empirical Studies Reviewed in the Inflation-Growth
Literature:
Bibliography: Empirical Studies Reviewed in the Crisis "Early Warning
System" Literature:
Tables:
Table 1: Number of Countries and Total Agreed-Upon Amounts of IMF
Funding by Type of IMF Lending Arrangements, as of August 2008 and
August 2009:
Table 2: Context, Circumstances, and Objectives of Four Current IMF-
Supported Programs:
Table 3: Inflation Targets in IMF-Supported Programs for 31 Low-Income
Countries, as of July 2009:
Table 4: Indicators of Crisis Vulnerability from the Academic
Literature:
Table 5: Countries Committed to IMF Financial Arrangements as of August
31, 2009:
Figures:
Figure 1: Elements of an IMF-Supported Program:
Figure 2: Liberia's Country Background:
Figure 3: Elements of Liberia's IMF-Supported Program:
Figure 4: Zambia's Country Background:
Figure 5: Elements of Zambia's IMF-Supported Program:
Figure 6: Hungary's Country Background:
Figure 7: Elements of Hungary's IMF-Supported Program:
Figure 8: Iceland's Country Background:
Figure 9: Elements of Iceland's IMF-Supported Program:
Figure 10: Relationship between Inflation and Economic Growth in Low-
Income Countries as Described in Empirical Literature:
Figure 11: Inflation Targets in IMF-Supported Programs Are within the
Estimates from Nine Studies:
Abbreviations:
EFF: Extended Fund Facility:
ESF: Exogenous Shocks Facility:
FCL: Flexible Credit Line:
G-20: Group of Twenty:
GDP: Gross Domestic Product:
HFSA: Hungarian Financial Supervisory Authority:
HIPC: Heavily Indebted Poor Countries:
IMF: International Monetary Fund:
NGO: nongovernmental organization:
NTSR: noise-to-signal ratio:
PRGF: Poverty Reduction and Growth Facility:
QPC: quantitative performance criteria:
SBA: Stand-By Arrangement:
SDR: special drawing rights:
SPC: structural performance criteria:
Treasury: U.S. Department of the Treasury:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
November 12, 2009:
The Honorable Barney Frank:
Chairman:
Committee on Financial Services:
House of Representatives:
Dear Mr. Chairman:
In response to the deepening global economic crisis, the International
Monetary Fund (IMF) has dramatically increased its lending to member
countries--from a total commitment under IMF-supported programs of
about $3.5 billion as of August 2008 to a record level of about $170.4
billion as of August 2009.[Footnote 1] Much of this new lending has
gone to middle-and high-income countries, facing balance-of-payments
crises or risking default on their external debt payments, to address
their short-term financing needs.[Footnote 2] About two dozen low-
income countries had longer-term IMF-supported programs focused on
increasing economic growth and reducing poverty, as of August 2009. To
help ensure that the IMF continues to have sufficient resources to meet
the increased demand, in April 2009, the Group of Twenty (G-20) world
leaders endorsed measures to make $1 trillion available through the
IMF.[Footnote 3] The $1 trillion includes the tripling of the IMF's
lending capacity to $750 billion, and an agreement to back the IMF in
effectively creating an additional $250 billion by issuing special
drawing rights (SDR).[Footnote 4] As part of these increased resources,
Congress had appropriated, in June 2009, additional funds for the IMF,
including making available up to about $117.5 billion for loans to the
IMF.[Footnote 5]
The IMF, after holding discussions and reaching agreement with country
authorities, provides member countries with financing that they have
not been able to obtain in private capital markets.[Footnote 6] IMF-
supported lending programs are intended to help countries overcome
balance-of-payments problems, stabilize their economies, and restore
sustainable economic growth. To help achieve these objectives, IMF-
supported programs identify key macroeconomic targets, such as economic
growth rates, using a macroeconomic framework.[Footnote 7] These
programs also establish conditions, the economic and financial policy
requirements to which recipient countries agree to receive IMF funding.
Furthermore, IMF-supported programs may involve financing from other,
often larger, creditors that link their funding to recipients'
performance on program conditions.
Critics have long-standing concerns that the IMF has an overly austere
approach to macroeconomic policy that does not sufficiently heed
country viewpoints, sacrificing potential economic growth and poverty
reduction in order to lower a country's inflation rate and government
deficit. For example, in October 2007, over 120 nongovernmental
organizations (NGO) expressed their concerns to the IMF that its
unnecessarily restrictive policies may undermine low-income countries'
ability to increase social spending. During the 1997-1998 Asian
financial crisis, as well as more recently, some NGOs also criticized
the IMF for imposing spending reductions and tight monetary policy on
middle-income countries that exacerbated already severe economic
stress. To help address these concerns, the IMF stated that it has
changed its policies in part to increase flexibility; however,
countries in crisis often have to undertake difficult reforms and cut
government spending to achieve macroeconomic stability. Researchers
studied these contentious issues, including the relationship between
inflation and economic growth, and between macroeconomic policy and
crises.
In response to your request, we examined (1) the process for designing
an IMF-supported program, (2) the IMF-supported programs in four
selected recipient countries, and (3) the extent to which the findings
of empirical economic studies are consistent with the IMF's
macroeconomic policies.
To address these objectives, we focused our review on IMF-supported
programs that provide countries with financial assistance. We reviewed
and analyzed IMF documents and data, including the IMF Articles of
Agreement; country requests for IMF-supported programs (letters of
intent[Footnote 8]); IMF consultation reports and assessments of
country progress under IMF-supported programs (including IMF's Article
IV consultation reports[Footnote 9]); program design papers; strategy
papers; policy documents; and IMF's Independent Evaluation Office
reports. Using the letters of intent and consultation reports, we
determined inflation goals in the 31 IMF-supported programs in low-
income countries and macroeconomic policy requirements in 13 IMF-
supported programs in middle-and high-income countries as of July 2009.
We also met with officials representing the IMF, U.S. Departments of
the Treasury (Treasury) and State, foreign governments, NGOs, and other
international organizations. We conducted audit work in Washington,
D.C., as well as Hungary, Iceland, Liberia, and Zambia, having selected
these four countries as case studies to illustrate the IMF-supported
programs in individual country programs. We selected these four
countries to ensure geographic diversity and to examine how IMF-
supported programs may differ in low-, middle-, and high-income
countries receiving relatively large amounts of IMF financial
assistance during the time of our review. Our choice of countries is
meant to be illustrative, not representative. Furthermore, using
published or widely cited empirical studies identified in economic
research databases including EconLit and Google Scholar, we identified
key relationships between macroeconomic policies and economic growth
and crises and compared them with macroeconomic policies in current IMF-
supported programs. Specifically, we reviewed two parts of the academic
literature relevant to the macroeconomic policy decisions in IMF-
supported programs, namely the literature that links inflation with
economic growth and the crisis "early warning system" literature that
identifies leading indicators of currency, banking, and debt crises.
We conducted our work from November 2008 to November 2009 in accordance
with all sections of GAO's Quality Assurance Framework that are
relevant to our objectives. The framework requires that we plan and
perform the engagement to obtain sufficient and appropriate evidence to
meet our stated objectives and to discuss any limitations in our work.
We believe that the information and data obtained, and the analysis
conducted, provide a reasonable basis for any findings and conclusions
in this product. Appendix I contains a more detailed description of our
scope and methodology.
Results in Brief:
Designing an IMF-supported financial assistance program involves a
complex, iterative process based on projections for key macroeconomic
variables; discussions between IMF staff and country officials
regarding program goals, policies, and trade-offs; use of economic
judgment; and IMF Executive Board (IMF Board) approval. The IMF-
supported program is intended to help countries achieve their
objectives in the context of macroeconomic stability. The IMF
macroeconomic framework provides the analytical basis for an IMF-
supported program and is designed to ensure consistency among the
projections for the various sectors of the economy while incorporating
country-specific circumstances. IMF-supported programs in low-income
countries are broadly geared toward increasing economic growth and
reducing poverty. These programs generally strive to achieve low
inflation and sustainable levels of debt by, for example, setting
targets for the size of the budget deficit and growth in the money
supply. In middle-and high-income countries, IMF-supported programs
generally aim to stem capital outflows, restore confidence, and
stabilize the exchange rate by, for example, setting targets for budget
deficits and international reserves. A range of possible targets can be
consistent with macroeconomic stability depending on the severity of
existing macroeconomic imbalances. Trade-offs among these different
combinations of objectives or policies allow for negotiations between
the IMF staff and country officials, reflecting what is technically
feasible and politically acceptable. Countries seeking IMF assistance
are already experiencing challenging and often severe economic
situations, and their available options usually require difficult
choices. For example, countries often have to sacrifice priority
spending to achieve macroeconomic stability, which includes a
sustainable debt burden and low inflation. Ultimately, IMF staff and
country officials reach agreement on the objectives and targets of IMF-
supported programs, which then require the IMF Board's approval.
IMF-supported programs in each of the four countries we studied--
Liberia, Zambia, Hungary, and Iceland--include different sets of
objectives, targets, and conditions that reflect the various
circumstances in each country, based on negotiations between IMF staff
and country officials. Although IMF staff and country officials
generally agreed on the areas that require reform, they sometimes
disagreed on the content and timing of specific policies for achieving
program goals. All four countries are making progress, but each has
encountered challenges in implementing conditions or achieving targets
in their IMF-supported programs. In the two low-income countries
(Liberia and Zambia), IMF-supported programs focus on achieving long-
term economic stability and growth.
* In Liberia--a country recovering from years of civil war and lacking
basic infrastructure, rule of law, and budget accountability--the IMF-
supported program is designed to help address the country's immediate
needs. Given Liberia's dire situation, IMF and Liberian officials
stated that Liberia has few options available for achieving its program
objectives. For example, under the program target to maintain a cash-
based, balanced budget, the government is precluded from borrowing to
finance additional spending. Officials stated that the typical trade-
off decisions--for example, between larger budget deficits and
increased public expenditures--are not as relevant under this
constraint.
* In Zambia--a country negatively affected by the recent economic
crisis--the IMF-supported program is designed to increase economic
growth, reduce poverty, and improve governance. Key elements of
Zambia's negotiations with IMF staff continue to center on fiscal trade-
offs, with the authorities preferring to use greater deficit spending
to stimulate economic growth, while IMF staff suggest restraint and
reform to guard against wasteful spending and maintain economic
stability.
For the middle-and high-income countries (Hungary and Iceland,
respectively), the IMF responded to sovereign debt or banking crises
with a goal of reestablishing economic stability.
* In Hungary, a rising risk of default and the central government's
unsustainable debt helped fuel the need for an IMF-supported program. A
key aspect of the program is to restore confidence by shrinking the
amount of government debt, largely through reduced expenditures. While
expenditure cuts are not expected to be popular with the general
public, Hungarian officials acknowledged that the spending cuts in the
IMF-supported program are necessary to stabilize the economy.
* Iceland is experiencing a crisis driven by the collapse of its
banking system and excessive private sector borrowing. Its IMF-
supported program contains controversial approaches to monetary policy
and banking reform that have yet to be finalized. For example,
authorities in Iceland would prefer to reduce high interest rates
earlier than IMF staff suggest to provide a stimulus for struggling
households and businesses. IMF staff caution against moving too quickly
due to the risk of currency depreciation, which would increase the cost
of the large stock of Iceland's foreign currency debt and could cripple
recovery prospects. In addition, determining how to restructure failed
banks, and particularly who will bear the losses, remains a contentious
issue for Icelandic authorities and the country's foreign creditors.
The macroeconomic policies in IMF-supported programs are broadly
consistent with the findings of the empirical literature we reviewed,
although this literature lacks precise guidance for setting policy
targets. Inflation targets are a prominent feature of IMF-supported
programs in low-income countries, but there has been considerable
debate about appropriate targets for these countries. For low-income
countries, empirical evidence generally suggests inflation is
detrimental to economic growth after it exceeds a critical threshold of
approximately 5 to 12 percent. This threshold is broadly consistent
with the inflation targets of 5 to 10 percent in the 31 IMF-supported
programs we reviewed. Reducing inflation below this critical threshold
produces no additional economic growth or may cause a country to
sacrifice some long-term growth benefits, according to the evidence we
reviewed. Although there are comparatively few systematic analyses, the
findings of the literature suggest a complex relationship between
inflation and growth that could vary across countries both in terms of
the optimal inflation target and the impact of higher levels of
inflation on economic growth. Given these findings and the differences
across countries at various stages of development, a uniform inflation
target applicable to all countries may not be appropriate. For middle-
and high-income countries, the academic literature identifies
weaknesses in macroeconomic policies that often precede economic crises
that are consistent with the policies focused on in the IMF-supported
programs we reviewed. We focused on this aspect of the academic
literature because middle-and high-income countries have sought
significant IMF financial assistance due to stress associated with the
global financial crisis. Economic crises may include one or more of
currency, banking, and debt crises, and can have severe negative
effects on the economy. The empirical academic literature identifies a
number of specific policy weaknesses in advance of crises, including
high inflation, high public indebtedness, and low international
reserves. These weaknesses are consistent with the policies upon which
the IMF focused in the 13 programs in the middle-and high-income
countries we reviewed. While informative for the development of
macroeconomic policy, the crisis "early warning system" literature
contains limitations, such as selections of countries in some studies
that may bias estimates of policy effects. For example, the amount of
international reserves necessary to guard against a crisis may be lower
for countries excluded from the analysis. As a result, this literature
provides qualitative rather than precise quantitative guidance.
The Department of the Treasury provided written comments on a draft of
this report (see appendix III), stating that it fully concurs with our
conclusions. Treasury and the IMF also provided technical comments,
which we incorporated as appropriate.
Background:
The IMF, an organization of 186 countries, provides surveillance,
lending, and technical assistance to its member countries. IMF
surveillance involves the monitoring of economic and financial
developments and the provision of policy advice, with key aims
including financial crisis prevention. The IMF also lends to countries
with balance-of-payments difficulties, including medium-to high-income
countries, to provide temporary financing and support policies to
achieve macroeconomic stability in the medium term. Its loans to low-
income countries are to assist policies designed to foster economic
growth and promote poverty reduction. In addition, the IMF provides
countries with technical assistance and training in its areas of
expertise.
Upon request by a member country, an IMF loan is generally provided
under a program that stipulates the specific policies and measures a
country has agreed to implement. As part of an agreement to receive IMF
financing, a member country may agree to implement policy measures,
known as conditions, designed to resolve its balance-of-payments
problems, overcome the problems that led it to seek financial aid, and
help ensure that it can repay the IMF. The IMF also conducts periodic
program reviews to assess whether the IMF-supported program is broadly
on track and the country has met established conditions, or whether
modifications are necessary to achieve the program's objectives. Based
on these reviews of a country's performance, including whether the
country has implemented conditions according to a specific timetable,
the IMF Board determines whether the country will receive subsequent
installments of IMF funding.[Footnote 10]
The IMF's resources are provided by member countries through quota
contributions, loan provisions to the IMF, and member contributions for
lending to low-income countries. When a country joins the IMF, the
country pays a quota to the organization, which may increase when IMF
members agree to increase the IMF's capital. Each IMF member country is
assigned a quota, based broadly on its relative size in the world
economy. A member's quota determines its maximum financial commitment
to the IMF and its voting power and has a bearing on the amount of IMF
financing a member can receive. The IMF also may enter into
multilateral or bilateral borrowing arrangements to increase its
resources. Moreover, resources for IMF-supported programs to low-income
countries come from funding outside quota resources, including member
contributions and the IMF.
In April 2009, the G-20 world leaders endorsed measures to
significantly increase the IMF's available resources to $750 billion
and also supported new SDR allocations of about $250 billion to
increase the international reserves of member countries. An additional
special SDR allocation of about $30 billion came into effect in
September 2009 under the Fourth Amendment.[Footnote 11] The source of
IMF's increase in resources includes both increased quota contributions
and a significant amount of borrowing from some member countries. Part
of these additional resources includes funding from the United States.
In June 2009, the U.S. Congress passed legislation that appropriated
about $7.8 billion for an increase in the U.S. quota to the IMF.
[Footnote 12] It also made available up to about $117.5 billion for
loans to the IMF.[Footnote 13] Congress set some provisions for the IMF
as part of the legislation, including language directing U.S. officials
to oppose loans to countries that have repeatedly supported acts of
international terrorism and to programs that would force developing
countries to cap spending on health care and education.[Footnote 14]
When signing the legislation, the President issued a statement stating
that certain provisions within the legislation would interfere with his
constitutional authority to conduct foreign relations and that he would
not treat these provisions as limiting his ability to engage in foreign
diplomacy or negotiations.[Footnote 15] In addition to the increase in
the IMF's overall resources, the IMF Board agreed in July 2009 to
measures that will boost the IMF's concessional lending capacity
available to low-income countries to $17 billion through 2014.
Since August 2008, the IMF has dramatically increased its commitment to
lend to member countries in response to the global economic crisis, as
shown in table 1. The table categorizes the number of countries and
amount of agreed upon IMF funding categorized by various IMF lending
arrangements, which are developed and tailored to address the specific
circumstances of its member countries. As shown in table 1, the number
of countries with Stand-By Arrangements, typically middle-and high-
income countries facing crisis and seeking to resolve their short-term
balance of payments problems, have significantly increased. See
appendix II for a list of the countries that have been approved to
receive funding under an IMF-supported program as of August 2009.
Table 1: Number of Countries and Total Agreed-Upon Amounts of IMF
Funding by Type of IMF Lending Arrangements, as of August 2008 and
August 2009 (Dollars (U.S.) in billions):
Type of IMF lending arrangement: Poverty Reduction and Growth Facility
(PRGF);
Key characteristics of IMF lending arrangement: Concessional (below-
market) interest loans to low-income countries eligible for PRGF
assistance;
eligibility based principally on the IMF's assessment of country's per
capita income; Loans carry an annual interest rate of 0.5 percent;
repayments made semiannually, beginning 5½ years and ending 10 years
after disbursement;
Number of countries and total agreed-upon amounts, as of August 31,
2008: 22; $1.8;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 22; $3.2.
Type of IMF lending arrangement: Exogenous Shocks Facility (ESF);
Key characteristics of IMF lending arrangement: Concessional financing
for low-income countries that are experiencing exogenous shocks but do
not have a PRGF arrangement; Interest rates and repayment terms same as
those under PRGF. Length of a loan is 1 to 2 years;
Number of countries and total agreed-upon amounts, as of August 31,
2008: 0;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 6; $1.1.
Type of IMF lending arrangement: Stand-By Arrangement (SBA);
Key characteristics of IMF lending arrangement: Nonconcessional loans
designed to help countries address short-term balance of payments
problems; Provision may be on a precautionary basis; countries may
choose not to draw upon approved amounts but retain the option to do so
if conditions deteriorate; Length of a loan is typically 1 to 2 years.
Repayment is due within 3¼ to 5 years of disbursement;
Number of countries and total agreed-upon amounts, as of August 31,
2008: 4; $1.2;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 18; $84.3.
Type of IMF lending arrangement: Extended Fund Facility (EFF);
Key characteristics of IMF lending arrangement: Use of nonconcessional
resources to help countries address longer-term balance of payments
problems requiring fundamental economic reforms; Interest rates and
repayment terms same as those under PRGF, however, disbursements may be
over a 1 to 2 year period under certain circumstances;
Number of countries and total agreed-upon amounts, as of August 31,
2008: 2; $0.6;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 0.
Type of IMF lending arrangement: Flexible Credit Line (FCL);
(Introduced in March 2009 to address the economic crisis);
Key characteristics of IMF lending arrangement: Accelerated financing
for borrower countries, useful for crisis prevention purposes. Large
and up-front financing to member countries meeting preset qualification
criteria. Criteria include having very strong fundamentals, policies,
and track records of policy implementation; Length of a loan is 6
months or 1 year. Repayment period is 3¼ to 5 years;
Number of countries and total agreed-upon amounts, as of August 31,
2008: Data not available because FCL did not exist;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 3; $81.7.
Type of IMF lending arrangement: Total[A];
Number of countries and total agreed-upon amounts, as of August 31,
2008: 28 $3.5;
Number of countries and total agreed-upon amounts, as of August 31,
2009: 49 $170.4.
Source: IMF data.
Notes: Some countries may have an IMF-supported program that combines
different types of arrangements. For example, Liberia had PRGF and EFF
programs as of August 31, 2008. For all types of IMF lending
arrangements, IMF's funding disbursements depend on performance of the
recipient countries. FCL arrangements are reserved for members meeting
preset qualification criteria and can be of 6 or 12 months in duration.
[A] Totals may not add up due to rounding.
[End of table]
Designing an IMF-Supported Program Is a Complex Process That Allows for
Negotiated Trade-offs Among Objectives and Policies:
The IMF-supported program is intended to help countries achieve
macroeconomic stability and contains objectives, targets, macroeconomic
policies, and conditions. The design of an IMF-supported program
involves a complex process, which includes the use of a macroeconomic
framework, economic judgment, and discussions between the IMF staff and
country officials regarding trade-offs among different objectives and
policies.
IMF-Supported Programs Are Intended to Help Countries Achieve Their
Objectives in the Context of Macroeconomic Stability:
An IMF-supported program consists of the objectives, targets,
macroeconomic policies, and conditions, to which the borrower and the
IMF agree. An IMF-supported program is intended to help a country
achieve its objectives while maintaining or restoring macroeconomic
stability. Although there may not be a distinct threshold between
macroeconomic stability and instability, IMF documents have specified
key characteristics that identify a country in a state of macroeconomic
stability. These include, for example, a prudent fiscal policy; a
sustainably financed trade deficit; low and stable inflation; and
rising per capita Gross Domestic Product (GDP) (see figure 1).[Footnote
16]
Figure 1: Elements of an IMF-Supported Program:
[Refer to PDF for image: illustration]
The figure is a series of concentric circles:
Conditions: including quantitative performance criteria (QPC) and
structural conditions:
Outer circle: Macroeconomic Instability:
High/rising inflation'
High and rising levels of public debt;
Large trade deficits financed by short-term borrowing;
Stagnant or declining GDP growth rate.
First inner circle: Macroeconomic Stability gray zone:
Low-stable inflation;
Rising per capita GDP;
Sustainably financed government deficit;
Sustainably financed trade deficit;
Second inner circle: Targets for key macroeconomic variables:
GDP growth rate;
Trade balance;
Budget deficit;
Exchange rate;
Government expenses;
Government revenue;
Foreign exchange reserves;
Inflation rate.
Inner hub: Macroeconomic policies:
Fiscal: Government spending, borrowing, and taxation;
Condition: Limit on new government borrowing (QPC).
Monetary:
* Money supply;
* Interest rate;
Condition: Ceiling on expansion of money supply (QPC).
External:
* Exchange rate;
* Foreign exchange reserves;
Condition: Floor on net international reserves (QPC).
Structural reform:
May include measures to:
* Strengthen banking supervision;
* Reform the tax system;
* Build up social safety nets;
Condition: Draft public finance law to legislature (structural
condition).
Source: GAO analysis of IMF documents.
[End of figure]
An IMF-supported program is defined by its objectives and the link
between those objectives and the macroeconomic policies used to achieve
them, with the specific content of a country's program reflecting the
country's characteristics and circumstances. For example, IMF-
supported program objectives in low-income countries are broadly geared
toward the long-term goals of increasing economic growth and reducing
poverty. In middle-and high-income countries, particularly those
experiencing acute crises, IMF-supported programs generally aim to stem
capital outflows, restore confidence, and bring about a recovery in the
short-to medium-term.
The macroeconomic framework used to develop the IMF-supported program
consists of the following elements as illustrated in figure 1:
* Targets for key macroeconomic variables: IMF-supported programs
include targets to help achieve a country's objectives. In low-income
countries, programs may include quantitative targets to limit the
growth of the money supply and the budget deficit to lower inflation
and maintain debt levels consistent with macroeconomic stability. In
middle-and high-income countries, an IMF-supported program may include
targets to stabilize the exchange rate, raise interest rates, and
tighten credit conditions to stem the outflow of capital and restore
investor confidence.[Footnote 17]
* Macroeconomic policies: Four types of macroeconomic policies--
monetary, fiscal, external, and structural reforms--may be used to help
a country achieve its objectives. Monetary policy is used to affect the
growth of the money supply and interest rate levels. Fiscal policy sets
the amount and composition of government expenditures and government
revenue to affect the size of the budget deficit. External policies
concern the size of the trade deficit and the exchange rate, which can
influence the amount of exports and imports and the buildup of
international reserves. IMF-supported programs also are likely to
include "macro-critical" structural reforms intended to help countries
establish sound financial sector regulatory systems.
* Conditions: IMF-supported programs may contain quantitative
performance criteria (QPC) and macroeconomic structural conditions,
which the country has agreed to implement to receive IMF
disbursements.[Footnote 18] Examples of QPCs that address macroeconomic
policy variables include (1) limits on government borrowing to curb the
public debt, (2) a ceiling on the expansion of the money supply to
manage the interest rate or contain inflation, or (3) a floor on
international reserves to stabilize the exchange rate and weather
shocks. According to the IMF, a country's performance criteria are
frequently revised during the course of a program as external
conditions evolve in a way not initially foreseen. Structural
conditions are measures that the IMF and country authorities consider
critical for the successful implementation of the program. Structural
conditions may include specific measures to strengthen banking
supervision, reform the tax system, improve fiscal transparency, and
build up social safety nets. Although structural conditions are no
longer used as performance criteria, the structural reforms that the
IMF sees as critical to a country's recovery will continue to be
monitored.
Various Combinations of Policies and Variables Are Consistent with
Macroeconomic Stability, Allowing for Negotiations:
Because of the extensive linkages among the various economic sectors
[Footnote 19] and the mutual dependence of policy instruments and
targets,[Footnote 20] designing an IMF-supported program is complex,
iterative, and requires economic judgment. The process of designing the
program begins when country authorities contact the IMF due to
impending or ongoing macroeconomic instability or crisis. The IMF staff
and country authorities establish the country's need for borrowing
based on the specific underlying macroeconomic problems to be addressed
and discuss program objectives and policies. Using a macroeconomic
framework as an analytical basis for the IMF-supported program, IMF
staff and country authorities use an iterative process to set targets
for key macroeconomic variables, such as real GDP growth, inflation,
and the budget deficit, and identify specific economic policies
intended to achieve these targets.[Footnote 21] The framework is
intended to ensure consistency of the target values for the
macroeconomic variables among the various sectors of the economy and to
align the IMF's macroeconomic and structural policy advice with the
program's objectives, while incorporating country-specific factors. For
example, the macroeconomic framework might be used to inform
discussions about how to achieve the target of a lower budget deficit
by weighing policy options that include reducing expenditures, raising
revenues, obtaining grant financing, or modifying the goal. The process
for designing the program usually culminates with country authorities
and IMF staff agreeing on the goals, targets, and policies for a
program that is both technically feasible and politically acceptable.
Then, they seek agreement on the conditions, including QPCs and
structural reforms, needed to complete the program. The IMF Board is
then asked to discuss and approve the program.
In designing an IMF-supported program, a government has to make
difficult trade-off decisions among different priority objectives and
policies consistent with macroeconomic stability. The trade-offs
required reflect the specific country circumstances and the severity of
the macroeconomic imbalances. According to an IMF/World Bank document,
there is a substantial gray area for a combination of levels of key
macroeconomic variables, including growth, inflation, fiscal deficit,
current account deficit, and international reserves that lies between
macroeconomic stability and instability, where a country could enjoy a
degree of stability, but where macroeconomic performance could clearly
be improved (see figure 1). This gray area allows for negotiation
between the country authorities and the IMF staff.
This process can be illustrated in the following hypothetical example.
A country can be adversely affected by the global recession in a number
of ways, including through declining export revenue as the price and
volume of exports fall. The decline in exports is likely to lead to a
rise in unemployment as private sector activity declines, contributing
to increased poverty. Any effort on the part of the government to
increase spending to counter this fall in aggregate demand is likely to
increase the budget deficit, especially in the context of falling
revenues. The increased spending also may contribute to inflationary
pressures.[Footnote 22] If the country, prior to the crisis, was
already experiencing a high debt level and an elevated inflation rate,
the way forward can be quite complicated. If the budget deficit were to
rise by too much, inflation could increase to a point where the country
would be at risk of macroeconomic instability, while insufficient
domestic spending could lower economic growth, worsening the
unemployment situation and increasing poverty.
Financial assistance through an IMF-supported program can help mitigate
the situation, but the government of the hypothetical country in this
example still faces a difficult policy trade-off--how to reduce the
impact of the recession on the poor without risking high inflation.
Within this overall context, the discussions between IMF staff and
government officials are likely to explore targets for the budget
deficit and inflation that attempt to balance these two concerns. While
the range of discussion regarding these targets is limited to what will
achieve or maintain macroeconomic stability, country officials and IMF
staff may have different perspectives on the risks of macroeconomic
instability, the degree to which spending cuts will harm the poor, and
the political feasibility of gaining parliamentary approval for
significant spending cuts. These different perspectives could provide
the basis for negotiation for the targets contained within the program.
Four IMF-Supported Programs Were Negotiated Based on Countries'
Circumstances:
IMF-supported programs in each of the four countries we reviewed
contain different sets of objectives, targets, and conditions that
reflect each country's individual circumstances, trade-offs, and
negotiations with IMF staff. The program in postconflict Liberia
focuses on rebuilding capacity, whereas the program in Zambia, a
country with significant natural resources, but substantial poverty,
centers on increasing economic growth. Hungary, a middle-income
country, faced a risking risk of debt default; thus, the program
concentrates on restoring investor confidence and reducing debt and
expenditures. A banking and currency collapse precipitated Iceland's
request for a program, which focuses on recapitalizing the banks and
stabilizing the currency. While IMF staff and country officials in all
four countries generally agreed with the programs and have made
progress in implementing the programs, each country has encountered
some challenges in implementing conditions or achieving targets.
Figures 2, 4, 6, and 8 show country background information for Liberia,
Zambia, Hungary, and Iceland. Table 2 summarizes the context,
circumstances, and objectives of the IMF-supported programs we
reviewed.
Table 2: Context, Circumstances, and Objectives of Four Current IMF-
Supported Programs:
Country: Liberia;
Context: Low-income, postconflict;
Circumstances: Economy and society devastated by years of civil war and
government mismanagement;
Objectives: Rebuild basic capacity, including economy, government, and
infrastructure.
Country: Zambia;
Context: Low-income, adversely impacted by global crisis;
Circumstances: Despite significant natural resources, including copper
as the mainstay of exports, substantial poverty remains;
Objectives: Increase economic growth, reduce poverty, and improve
governance.
Country: Hungary;
Context: Middle-income, risked defaulting on debt payments;
Circumstances: Years of over-spending and easy credit led to massive
debt accumulation;
Objectives: Restore investor confidence by reducing debt and
expenditures.
Country: Iceland;
Context: High-income, banking system and currency collapsed;
Circumstances: Economic meltdown, currency crash;
Objectives: Recapitalize banks, stabilize currency.
Sources: GAO review of IMF and country documents.
[End of table]
Liberia's Program Focuses on Rebuilding Basic Capacity after Years of
Devastation:
Figure 2: Liberia's Country Background:
[Refer to PDF for image: country map and related data]
Liberia: Country background:
Population: 3,441,790;
Estimated 2009 GDP growth: 4.9%;
Currency: Liberian dollars and U.S. dollar.
Sources: IMF and CIA World Factbook 2009.
[End of figure]
Liberian Government Is Working to Rebuild Devastated Capacity:
Although recovering from civil wars that spanned 1989 to 2003, Liberia
remains one of the world's most impoverished countries. Devastated by
past war and government mismanagement, the country suffers from minimal
basic infrastructure, limited health care, a largely unskilled labor
force, and a population with a low literacy rate. Liberia also has a
weak rule of law and widespread corruption, according to the documents
we reviewed and Liberian officials we interviewed. Liberian government
officials emphasized the need to address social issues, such as
building basic infrastructure and providing health care and education.
In the last 3 years, the country has made significant progress in
strengthening its economy and government. For example, the GDP has been
rising; the exchange rate remains relatively stable; and government
revenue has increased. In 2006, the government requested IMF technical
assistance to develop a program to support economic reconstruction,
begin building a track record of policy implementation, resolve its
arrears to creditors, and lessen its significant debt burden. Under
this IMF staff-monitored program, in which the IMF provided no
financial assistance, the IMF found that the Liberian government made
satisfactory progress. Specifically, the IMF reported that the
government has facilitated the rebuilding of public institutions,
restored credible macroeconomic management, and supported
implementation of important structural reforms to improve financial
management and the financial sector. In 2008, Liberia cleared its long-
standing overdue obligations, including obligations to the IMF that
initially precluded the country from IMF assistance, and met
requirements to begin receiving debt relief under the enhanced Heavily
Indebted Poor Countries (HIPC) Initiative.[Footnote 23] More than 100
IMF member countries participated in a fund-raising effort for Liberia,
securing sufficient commitments to finance the IMF's debt relief to the
country.
To make further reforms to help ensure a sustainable recovery over the
long term, the government received a new 3-year IMF-supported financial
assistance program in 2008. Figure 3 shows elements of the program,
including its overall objectives and the policies, targets, and
conditions intended to help achieve these objectives.
Figure 3: Elements of Liberia's IMF-Supported Program:
[Refer to PDF for image: illustration]
Liberia:
$391 million Poverty Reduction and Growth Facility program and $561
million Extended Fund Facility program approved March 2008;
Objectives are to:
* Achieve higher growth by maintaining macroeconomic stability;
* Attract private investment:
* Improve infrastructure and governance.
Macroeconomic policies, targets, and conditions:
Fiscal:
* Target: Maintain balanced budget;
* Condition: No new government borrowing;
* Condition: Sets a floor on government revenues.
Monetary:
* Target: Contain inflation to single digits;
* Condition: Sets a floor on the Central Bank's budget balance.
External:
* Condition: Rebuild foreign exchange reserves.
Structural reform:
* Condition: Reform judicial, agriculture, mining sectors;
* Condition: Improve public financial management, strengthen banking
supervision, improve national economic statistics, and implement
anticorruption strategy.
Source: GAO analysis of IMF documents.
Note: Program amount was the approximate U.S. dollar amount at the time
of program approval.
[End of figure]
Government Endorses Program but Questions Fiscal Constraints:
Liberian authorities and IMF staff said they generally agreed on the
program but continue to negotiate its fiscal constraints. Liberian
officials stated that they welcome IMF assistance, have open dialogues
with IMF officials, and have a sense of ownership of the program. When
the IMF began its support to Liberia in 2005, Liberia had significant
external and domestic debt. In addition, the country did not have the
financial resources to service any new debt, and its creditors sought
evidence that Liberia could control its fiscal position in advance of
providing comprehensive debt relief. Therefore, the IMF's focus was on
efficiently securing government resources. To accomplish this, IMF
staff said the program focused on the government achieving a balanced
budget, in which expenditures equal revenues. Given Liberia's dire
situation, the country has few options available for implementing its
program objectives, according to Liberian officials and IMF staff. For
example, under the program target to maintain a cash-based, balanced
budget, the country is precluded from borrowing to finance additional
spending. Both Liberian officials and IMF staff said that the typical
trade-off decisions--for example, between larger budget deficits and
increased public expenditures--are not as relevant under this program
target. Rather, policy decisions in Liberia generally centered on the
country's need to have a balanced budget, one of the program targets.
Some Liberian authorities we met with said that they preferred to have
more flexibility in spending to address some urgent needs, such as
increased public spending on roads, health care, and education. IMF
staff agreed with these views but recommended that the country
prioritize having a balanced budget to ensure that it would not incur
additional debt. IMF staff informed us that, while maintaining a
balanced budget, Liberian officials and not IMF staff determine the
composition of the country's expenditures.
Despite the existing program target of zero borrowing to maintain a
balanced budget, IMF staff made an exception to this target in response
to a Liberian government request. In May 2009, IMF staff supported the
Liberian request for limited, highly concessional--or below market-
rate--borrowing to invest in critical port infrastructure. According to
an IMF review, Liberia's main port in Monrovia was badly damaged during
the civil war, and further deterioration could have far-reaching
ramifications on economic growth through lower exports, import
shortages, and rising prices. The IMF review concluded that the
proposed borrowing would not undermine debt sustainability and is
directed at an urgent and important facility needed to increase trade
and economic activity. IMF staff stated that they accepted Liberia's
request in part because the government had thus far performed well
under its IMF-supported program.
Program Is on Track, but Challenges Remain:
In its June 2009 report, the IMF stated that Liberia's program remains
on track while noting challenges. The government met most of its
performance criteria and continued to advance structural reforms. For
example, the IMF concluded that Liberia's fiscal performance through
the end of 2008 was solid. The IMF said that Liberian officials remain
strongly committed to a balanced cash-based budget. Furthermore, the
Liberian government established an anticorruption commission that
became operational in December 2008.
The government continues to face some challenges that may affect the
progress of its reforms. Notably, the global recession has slowed
Liberia's economic recovery and may further pose risks to Liberia's
achievement of its program objectives. A sharper-than-projected
slowdown in global growth or a decline in world commodity prices could
reduce demand for Liberia's key exports, or delay investment activity
in these sectors, to a greater degree than projected. Liberian
officials also stated that the political process presents a challenge
in implementing reforms and legislation tied to the IMF-supported
program's goals. For example, Liberian government officials said they
plan to strengthen public financial management, a stated goal of the
IMF-supported program. However, the passage of legislation to improve
public financial management was delayed due to lengthy political
debates in Liberia's legislature. This legislation was submitted to the
legislature in December 2008 but not passed until August 2009.
Furthermore, the government encountered a 3-month delay in setting up a
functioning commission to address corruption due to late passage of the
law to establish it.
Zambia's Program Focuses on Increasing Growth and Strengthening
Governance:
Figure 4: Zambia's Country Background:
[Refer to PDF for image: country map and related data]
Zambia: Country background:
Population: 11,862,740;
Estimated 2009 GDP growth: 4.0%;
Currency: Zambian Kwacha.
Sources: IMF and CIA World Factbook 2009.
[End of figure]
Zambia Has Significant Natural Resources, but Substantial Poverty
Remains:
Zambia, a country endowed with natural resources, has performed well
economically, but poverty, aggravated by the global economic crisis,
remains widespread. The country's economy, afflicted by high debt and
inflation through the 1990s, grew strongly in the early 2000s. The
country's prior PRGF program, begun in 2004, identified reforms
intended to help Zambia achieve a sustainable level of debt and reduce
its 30 to 40 percent inflation rate, according to IMF staff. In 2005,
Zambia qualified for debt relief under the HIPC Initiative and has
begun to benefit from approximately $6 billion in debt forgiveness. As
of 2007, its economic growth was robust, inflation remained in the
single digits, the currency was relatively stable, and its strong
external position allowed a further increase in international reserves.
Zambia also benefited from the revival of mining in the wake of
privatization and the higher world prices of copper, the mainstay of
the Zambian economy. In 2008, copper accounted for an estimated 74
percent of Zambia's export earnings, according to an IMF document. The
IMF reported that Zambia's 2008 budget maintained the prudent approach
to fiscal policy of recent years. Despite increased spending, including
on capital projects, the fiscal position was expected to strengthen
with rising revenue from the mining sector.
Nonetheless, the lack of sufficient infrastructure--including power,
transportation, and telecommunications--impedes rapid economic growth
and development in Zambia. In addition, poverty has been reduced but
remains exceptionally high, especially in rural areas where 80 percent
of the population lives in poverty, according to an IMF document. To
address economic challenges, the Zambian government received a new 3-
year IMF-supported financial assistance program in 2008. Figure 5 shows
elements of the program, including its overall objectives and the
policies, targets, and conditions intended to help achieve these
objectives.
Figure 5: Elements of Zambia's IMF-Supported Program:
[Refer to PDF for image: illustration]
Zambia:
$79.2 million Poverty Reduction and Growth Facility program approved
June 2008;
Objectives are to:
* Boost economic growth;
* Reduce poverty;
* Maintain debt sustainability;
* Improve public financial management.
Macroeconomic policies, targets, and conditions:
Fiscal:
* Target: Aim for primary budget balance (excluding grants) of 7 to 8
percent in 2008-2010;
* Condition: Sets a ceiling on net domestic borrowing by the
government.
Monetary:
* Target: Reduce inflation to about 5 percent by 2009.
External:
* Target: Maintain flexible exchange rate regime;
* Condition: Build up foreign exchange reserves.
Structural reform:
* Condition: Improve public sector efficiency and accountability;
* Condition: Strengthen bank supervision.
Source: GAO analysis of IMF documents.
Note: Program amount was the approximate U.S. dollar amount at the time
of program approval.
[End of figure]
Government Generally Agrees with Program but Debates Spending Limits:
IMF staff and Zambian officials stated that they had reached agreement
on the initial and revised targets in the current IMF-supported
program. IMF staff and Zambian officials said that they maintain a
constructive relationship, which has improved during the implementation
of the current IMF-supported program compared with past IMF-supported
programs. For example, through negotiations with country officials over
the years, the IMF relaxed its targets related to government wages and
inflation rates. According to IMF staff, Zambia's government wages were
relatively high, causing the IMF to limit wages of Zambia's civil
service employees in an earlier IMF-supported program. From 2003 to
2004, some NGOs criticized the IMF's role in determining the budget
limits on the size of the Zambian government wage bill. The IMF advised
the Zambian government that such a high wage bill would not leave
sufficient room in the budget for spending to support the government's
poverty reduction strategy. After holding further discussions, IMF
staff reached agreement with Zambian officials about this issue. In
Zambia's current IMF-supported program, the IMF no longer sets targets
related to civil service wages. In addition, IMF staff and Zambian
officials discussed and revised the inflation target in Zambia's
current program. Zambian officials stated that they thought the
program's target of 7 percent inflation, set in June 2008 at the
beginning of the program and based on the IMF's projections, was too
ambitious. After some external factors that were out of Zambia's
control (such as food and fuel price increases) caused the country's
inflation rate to accelerate to 16.6 percent at the end of 2008, IMF
staff and Zambian officials deemed the initial inflation rate target to
be infeasible within the specified time frame. During the IMF's June
2009 review, the inflation rate target was revised to 10 percent by the
end of 2009, with a goal to further reduce the inflation rate to single
digits in 2010.
Significant elements of Zambia's negotiations with IMF staff have
centered on fiscal policy and the trade-offs between increasing
priority spending and reducing excessive debt. IMF staff and Zambian
officials stated that they discussed policy options, such as the extent
to which the government can undertake additional spending and what
recourse Zambia has without borrowing to finance the additional
spending. Zambian officials said that they would prefer to use greater
deficit spending to stimulate growth, particularly to address the
impact of the economic crisis. However, IMF staff suggested restraint
and reform to guard against wasteful spending and maintain
macroeconomic stability. According to IMF staff, the country faces the
ongoing risk of returning to its previous unsustainable debt levels if
the government does not spend effectively.
Program Was Broadly on Track, but External Shocks Have Slowed Progress:
In June 2009, the IMF reported that Zambia's program was initially
broadly on track, but slippages occurred later mainly due to three
factors that had an adverse impact on the economy. First, rising world
food and fuel prices early in 2008 pushed inflation to 16.6 percent,
above the program target of 7 percent for the end of 2008. Second, a
transition in political leadership delayed decisions on the budget and
structural measures central to Zambia's economic program. Finally, the
global economic crisis negatively affected the economy and exacerbated
poverty, most directly through the precipitous fall in the price of
copper, a commodity on which Zambia overwhelmingly relies for earnings.
The IMF review noted that copper prices have declined by about two-
thirds since they peaked in mid-2008. Export proceeds, government
revenue, and capital inflows have been reduced as a result. The slump
in copper prices will inevitably have a detrimental effect on Zambia's
economic prospects in view of the mining sector's central role in the
economy. As a result of these shocks, Zambia's real GDP is projected to
slow down, and its balance of payments position has weakened.
IMF staff noted that Zambian officials have responded appropriately to
these external shocks. For example, the IMF found that Zambia's fiscal
policy had struck the right balance between maintaining high-priority
infrastructure spending to promote medium-term economic growth and
safeguarding short-term macroeconomic stability by scaling back
investment and recurrent spending. IMF officials noted that spending
cuts have not reduced priority social spending. Furthermore, IMF staff
said Zambia's public debt sustainability outlook is favorable.
Specifically, Zambian officials have adopted a new public debt
management policy and strategy to help ensure that the amount of public
debt remains sustainable.
Hungary's Program Focuses on Reducing Debt and Expenditures:
Figure 6: Hungary's Country Background:
[Refer to PDF for image: country map and related data]
Hungary: Country background:
Population: 9,905,596;
Estimated 2009 GDP decline: -6.7%;
Currency: Forint.
Sources: IMF and CIA World Factbook 2009.
[End of figure]
Hungary Risked Defaulting on Its Debt Payments:
In fall 2008, Hungary's government secured financing from the IMF and
other creditors due to a rising risk of default and unsustainable debt.
Hungary was among the first emerging market countries to suffer from
the fallout of the global financial crisis. As financial difficulties
in advanced economies led to a decline in global liquidity and an
increase in investors' concern about the risk of their investments,
investors increasingly started differentiating among emerging markets.
Hungary's high debt levels negatively affected investor interest in its
assets. Hungary experienced an earlier short episode of financial
stress in March 2008, then its financing conditions deteriorated
sharply in mid-October 2008.
Prior to the crisis, Hungary's large fiscal deficits led to rising
government debt. The general government deficit averaged more than 8
percent of GDP from 2002 to 2006. As a result, public debt rose to
about 75 percent of GDP in 2008, the highest level of similar countries
in Eastern and Central Europe, according to the IMF.
With easy access to foreign currencies, foreign-owned and Hungarian
banks made domestic loans in foreign currencies, which carried lower
interest rates attractive to Hungarian borrowers. The rise in such
lending eventually resulted in about two-thirds of the lending to
Hungarian households and corporations being denominated in foreign
currency, according to the IMF. The risk of such loans is that a
reduction in the value of Hungary's currency, the forint, makes loans
more expensive for borrowers to repay. In March 2009, the currency
reached an all time low relative to the euro, according to the IMF. In
the 5 months between October 2008 and March 2009, the forint
depreciated by 26 percent against the euro.[Footnote 24] This reduction
stressed borrowers and translated into credit risk for banks that faced
difficulty collecting loans.
To address the increasing risks, the initial objectives of Hungary's
IMF-supported program focused on restoring investor confidence and
reducing government expenditures. Figure 7 shows elements of the
program, including its overall objectives and the policies, targets,
and conditions intended to help achieve these objectives.
Figure 7: Elements of Hungary's IMF-Supported Program:
[Refer to PDF for image: illustration]
Hungary:
$15.7 billion Stand-By Arrangement, in conjunction with $9.4 billion
support from the European Union and other creditors, approved November
2008.
Objectives are to:
* Improve long-term fiscal sustainability;
* Maintain adequate capitalization of banks;
* Underpin confidence.
Macroeconomic policies, targets, and conditions:
Fiscal:
* Target: Aim for budget deficit of 2.5 percent;
* Condition: Reduce government expenditure by 2 percent from 2008;
* Condition: Limit government borrowing;
* Condition: Passage of a fiscal responsibility law.
Monetary:
* Target: Keep inflation in target range of 2 to 6 percent.
External:
* Condition: Increase foreign exchange reserves over the medium term.
Structural reform:
* Condition: Provide bank support package;
* Condition: Strengthen bank supervision and regulation.
Source: GAO analysis of IMF documents.
Note: Program amount was the approximate U.S. dollar amount at the time
of program approval.
[End of figure]
IMF and Hungarian Officials Mainly Concur, but Spending and Banking
Challenges Remain:
IMF and Hungarian authorities generally agree on the elements of the
IMF-supported program, but determining how to achieve the deficit
target and support the banking system remain challenges. Country
authorities stated that they broadly concur with the goals of the
program and accept the need for reform due to the crisis. In addition,
they indicated that IMF staff are cooperative, helpful, and
unobtrusive, providing latitude for the policy response to be defined
and owned domestically.
Stabilizing the economy requires the Hungarian government to restore
investor confidence by decreasing the amount of government debt, mainly
by reducing expenditures and achieving the deficit target, according to
the IMF. While government officials said they plan to meet the deficit
target, they have yet to determine the necessary policy changes. Debate
in Hungary now centers on spending decisions for 2009. Because taxes
are already high to support a large government budget, increasing
revenue by raising taxes is not considered a viable option, according
to IMF staff. While spending cuts are not expected to be popular with
the general public, Hungarian officials acknowledge that the spending
cuts consistent with the IMF-supported program are necessary. However,
IMF staff and Hungarian authorities have disagreed on the target for
the budget deficit as a percentage of GDP, a key metric. In the
beginning, IMF staff called for a lower budget deficit than authorities
said was reasonable. Later, their positions reversed, with IMF staff
recommending a wider budget deficit target than the Hungarian
authorities' suggestion of 2.9 percent, a figure that would allow them
to stay within European Union guidelines.[Footnote 25] The latest
target, 3.9 percent, was reached after IMF, European Union, and
Hungarian officials agreed that deteriorating economic circumstances
merited a higher target. Moreover, if the recession lasts longer than
expected or if the government officials are unable to agree on
sufficient spending cuts, fiscal consolidation efforts could be
hampered.
Hungarian officials and IMF staff reached agreement in addressing the
domestically controversial area of regulatory oversight of the banking
system but expressed different views on how to proceed. Country
authorities indicated that a debate continues on formulating a new
approach to banking supervision. Currently, the powers of the agency in
charge of that responsibility, the Hungarian Financial Supervisory
Authority (HFSA), are limited, according to the agency's officials. The
HFSA must conduct on-site investigations, which take 45 to 60 days, and
can only recommend remedial action for individual banks. The HFSA
argues that it should be able to impose regulations in a more timely
fashion and on the entire sector. For example, it should be able to
issue binding regulations for the entire banking system, including on
capital levels. The HFSA also favors greater independence, suggesting
that it report to Parliament rather than the Ministry of Finance, as it
currently does. IMF staff support greater independence for the HFSA and
seek to strengthen and integrate weak and fragmented segments of the
financial supervisory structure. IMF staff outlined details in a paper
and provided technical assistance to explore options. The authorities
have decided to support the HFSA as an independent agency with the
right to issue regulations. However, implementing the change is
sensitive and requires political support that may or may not
materialize.
Regarding the stability of banks, according to Hungarian authorities,
initially IMF staff were concerned that banks did not have sufficient
capital and could be at risk of insolvency or collapse. As a result,
according to authorities, IMF staff argued for a preemptive bank
recapitalization that would provide additional capital to key Hungarian
banks. While IMF staff stated that preemptive recapitalization was not
the intention, banks were uneasy about the potential of greater
government involvement because recapitalization would occur through a
capital base enhancement fund established with government funds that
would purchase ownership shares of the banks. Although the IMF held
discussions with authorities to dispel concerns, Hungarian authorities
disagreed with the idea of preemptive capitalization, indicating that
the banks were healthy and well-capitalized. In addition, one bank
executive expressed concerns that preemptively and massively
recapitalizing the banking system would be overly cautious and
potentially harmful. He added that it could be counterproductive
because it would reduce return on equity for local Hungarian banks and
may put foreign parent banks in a situation where they would be unable
or unwilling to provide support, resulting in a banking collapse, the
very outcome the IMF seeks to avoid. In its June 2009 review of the
program, the IMF concluded that the banking sector was resilient during
the early part of the year, but that the possible need for additional
capital could not be ruled out. In September 2009, the IMF completed
its third review stating that, while policies are on track, continued
implementation of program policies remains essential to strengthen
macroeconomic stability.
Iceland's Program Focuses on Recapitalizing Banks and Stabilizing
Currency:
Figure 8: Iceland's Country Background:
[Refer to PDF for image: country map and related data]
Iceland: Country background:
Population: 306,694;
Estimated 2009 GDP contraction: -9.6%;
Currency: Króna.
Sources: IMF and CIA World Factbook 2009.
[End of figure]
Iceland Is Struggling to Address a Severe Banking Crisis:
Iceland's struggle to address a severe banking crisis led it to seek
financing from the IMF and other creditors in fall 2008. In the wake of
international financial turmoil, Iceland's economy faced a banking
crisis of extraordinary proportions. Triggered by a loss of investor
confidence and fueled by the financial sector's high debt and
dependence on foreign financing, the crisis led to the collapse of
Iceland's three main banks, accounting for around 85 percent of the
banking system. The economy continues to experience a deep recession
and a dramatic surge in public sector debt, reflecting the
unprecedented cost of restructuring the banking system.
In Iceland, an oversized banking system developed that significantly
outstripped the authorities' ability to act as a lender of last resort
when it ran into trouble. Banks increased their assets from slightly
more than 100 percent of GDP in 2004, after the privatization of the
banking sector was completed, to close to 1,000 percent of GDP. Iceland
was one of the first victims when declining investor confidence
intensified in fall 2008 because investors realized that the banking
system was too big relative to the economy's size and thus started to
pull assets out of Icelandic banks. Within a week, Iceland's three
primary banks collapsed, the króna's value dropped by more than 70
percent, and the stock market lost more than 80 percent of its value.
To address its significant banking crisis and plummeting currency,
Iceland's government, in fall 2008, received a $2.1 billion IMF-
supported program, which also depended on significant financing from
other creditors. Figure 9 shows elements of the program, including its
overall objectives and the policies, targets, and conditions intended
to help achieve these objectives.
Figure 9: Elements of Iceland's IMF-Supported Program:
[Refer to PDF for image: illustration]
Iceland:
$2.1 billion Stand-By Arrangement, in conjunction with $3.2 billion
support from the Nordic bloc countries and other creditors, approved
November 2008;
Objectives are to:
* Prevent further króna depreciation;
* Develop a bank restructuring strategy;
* Ensure medium-term fiscal sustainability.
Macroeconomic policies, targets, and conditions:
Fiscal:
* Target: Aim for budget surplus of 3 to 4 percent by 2012;
* Condition: Limit government borrowing and spending.
Monetary:
* Target: Raise interest rate to 18 percent.
External:
* Condition: Build up foreign exchange reserves;
* Condition: Phased reduction of capital controls.
Structural reform:
* Condition: Recapitalize banks;
* Condition: Assess regulatory and supervisory framework.
Source: GAO analysis of IMF documents.
Note: Program amount was the approximate U.S. dollar amount at the time
of program approval.
[End of figure]
In the short run, the IMF-supported program has been narrowly focused
on stabilizing Iceland's currency, the króna. Iceland has a significant
amount of debt that is either denominated in foreign exchange or
indexed to inflation. Therefore, when the króna depreciates, debt
servicing becomes much more expensive, which would likely lead to a
wave of defaults in the corporate and household sectors, further
harming the economy.
Government Generally Endorses the Program, but Some Critical Issues
Remain:
Country authorities said they generally endorse the IMF-supported
program and recognize the need for fiscal austerity. They said they are
fully committed to the program and acknowledge that economic reform and
reduced government spending will be painful but necessary measures that
must be taken to address the economic crisis. Government efforts are
under way to generate more revenue through higher taxes and to decrease
expenditures by freezing civil service wages and adjusting some social
services. Authorities said stakeholders, including unions, politicians,
and households, are involved in the dialogue on austerity, which is
critical because any retrenchment will be difficult and unpopular.
According to authorities, Iceland is a Nordic welfare state in which
its citizens have come to expect a high standard of living and generous
social benefits. However, due to the scale of the economic catastrophe,
traditional assumptions may be challenged as the government cuts
spending.
Regarding fiscal policy decisions, country authorities indicated that
IMF staff provide only broad direction and do not get involved in the
details, unless asked to provide expertise or input on a specific
measure. For example, IMF staff have not recommended cuts in certain
government transfers, such as unemployment or parental leave benefits,
or stressed that specific taxes be raised. Although budget choices and
priorities are left to the government, IMF staff emphasize the need for
changes that are durable over time and that will lead to a long-term
improvement in the fiscal position. In contrast to the perception that
the IMF always imposes fiscal restraint, Iceland's program was designed
to provide an increase in the budget deficit initially to mitigate the
macroeconomic shock and then to turn the focus to gradually reducing
the deficit over a period of time.
Country authorities also stated that relations with IMF staff generally
are cooperative, and negotiations involve a fair amount of give and
take. In addition, they said that IMF staff have been helpful overall,
particularly regarding fiscal and monetary policy, surveillance, and
technical assistance. Moreover, authorities said they own the program
and take responsibility for the crisis and the steps that must be taken
to resolve it. They acknowledged that asking for IMF support was
initially highly controversial, and many Icelandic citizens and some
members of Parliament still do not want the government to implement the
program.
Government authorities and IMF staff expressed different views on how
to resolve continuing interest rate, capital controls, and banking
issues. Authorities prefer earlier interest rate reductions than IMF
staff suggest. Although Iceland's interest rate is high by
international standards, IMF staff said the higher rate is necessary to
stabilize the króna and is normal policy in the context of a currency
crisis. However, a high interest rate is a drag on the domestic economy
because the elevated cost of domestic credit hurts some companies and
households. Authorities argue that the interest rate should be reduced
to relieve pressure on residents struggling to make payments on home
mortgages and business loans. IMF staff caution against reducing the
interest rate too quickly due to the risk that such action may lead to
renewed currency depreciation, which would increase the cost of the
large stock of Iceland's foreign currency debt and could cripple
recovery prospects. However, authorities contend that many residents
are already facing bankruptcy and question whether a high interest rate
does in fact help stabilize the króna. They suggest that interest rate
reductions so far have not resulted in significant currency
depreciation. Although IMF staff have not questioned the need to lower
rates eventually, they differ with the authorities on how quickly the
interest rate should be lowered. IMF expressed concern that if interest
rates come down too far too fast, Iceland may see excessive
depreciation in the exchange rate, which would be difficult to reverse.
IMF staff have warned that the current level of uncertainty
necessitates a slow and cautious approach.
Icelandic authorities imposed capital controls to restrict the movement
of financial assets between countries in October 2008 and maintained
them as part of the IMF-supported program approved in November 2008. In
addition, Icelandic authorities acknowledged that the controls were
necessary to stabilize the economy, at the time, due to the crisis but
view them as a drastic measure and favor loosening them as soon as
possible. Like a high interest rate, capital controls help limit the
outflow of money and reduce downward pressure on the króna. Icelandic
authorities view the combination of high interest rates and capital
controls as redundant--a "belt and suspenders" approach. In addition,
imposing capital controls was a shock to both the domestic and external
sectors. Moreover, capital controls created dual exchange rates, one
officially sanctioned by the Central Bank, and one determined by market
forces off-shore. This enabled foreign importers of Icelandic goods to
buy króna more cheaply in currency markets abroad, weakening the
system. As a result, authorities created a new rule to stop the
practice. International investors, traders, and business people
continue to try to identify loopholes and work-arounds, so efforts to
update and revise the capital controls structure continue.
Discussion of lifting capital controls is ongoing, but the details of
exactly when and how remain controversial. Bank industry
representatives we spoke with expressed frustration with capital
controls, criticizing them as a harsh measure. Authorities prefer to
loosen capital controls as soon as possible and assert that gradual
removal of the controls is an important step toward normalizing
economic conditions. Icelandic businesses view access to capital
markets, international funding, and investments as one of the main
preconditions for economic recovery. Both authorities and IMF staff
envision a gradual lifting of capital controls, but only when the
conditions are right. The concern is that billions of dollars worth of
króna-denominated bonds, amounting to about 60 percent of GDP, are held
by foreigners. Allowing sudden repatriation of those funds could lead
to a massive outflow and currency depreciation. Therefore, IMF staff
caution that confidence must be restored through fiscal consolidation
and banking sector reform before phasing out capital controls.
Differences also remain on a critical banking issue, particularly who
will bear the losses related to certain foreign obligations. Iceland's
collapsed banks had several overseas branches and subsidiaries, mainly
in other European countries. For example, "Icesave" is a vehicle in
which residents of the United Kingdom, Denmark, and other countries
deposited billions of dollars worth of savings. When Iceland's banks
failed, money to cover these deposits disappeared. Opinion in Iceland
about whether and how to ensure the value of the accounts is divided.
Critics argue that Icelandic citizens should not have to bear the
enormous cost of mistakes made by a few private bankers. However, two
IMF Board members, with a deep stake in the issue, argued that Icesave
deposits must be honored. While this was not an explicit condition of
the IMF-supported program, resolution of the Icesave issue was linked
to the provision of $2.5 billion in support from a bloc of Nordic
countries,[Footnote 26] a source of funding critical to, and in
addition to, financing provided by the IMF-supported program.
Originally scheduled for completion in early 2009, the first review was
delayed, in part to provide more time to address banking issues, and
was completed in October 2009. Following the delay in completing the
first review, the IMF Board granted the Icelandic authorities' request
to extend the program by 6 months (to May 2011), to allow time to
achieve objectives that will take longer than expected. The IMF review
noted that, in the context of Iceland's financial crisis, Iceland's
economy has shown some positive signs. For example, according to the
IMF review, inflation has decreased; the program's main objective,
stabilizing the króna, has been met; the financial sector restructuring
objective was achieved; and external financing has been secured.
Macroeconomic Policies in IMF-Supported Programs Are Broadly Consistent
with Findings of Academic Literature:
For low-income countries, empirical evidence suggests inflation is
detrimental to economic growth after it exceeds a critical threshold,
which is broadly consistent with the inflation targets included in the
IMF-supported programs we reviewed. Similarly, for middle-and high-
income countries, the academic literature identifies weaknesses in
macroeconomic policies that often precede economic crises that are
consistent with the policies in the IMF-supported programs we reviewed.
Empirical Evidence Evaluating the Complex Relationship between
Inflation and Growth Is Broadly Consistent with IMF-Supported Programs
in Low-Income Countries:
Empirical Research Suggests a Complex Relationship between Inflation
and Growth; Inflation Harms Growth above a Critical Threshold:
Inflation targets are a prominent feature of IMF-supported programs in
low-income countries, but there has been considerable debate about
appropriate targets for these countries. Some believe that the IMF may
have gone beyond the existing empirical evidence in targeting very low
inflation, potentially compromising economic growth. Although the
precise relationship between inflation and economic growth in low-
income countries remains uncertain, the empirical literature over the
past 10 years has reached consensus about some aspects of this complex
relationship. For example, there is general agreement about the
following in low-income countries:
* The relationship between inflation and growth varies depending on the
level of inflation and potentially on other country-specific variables.
[Footnote 27]
* Inflation is detrimental to medium-and long-term economic growth
after it exceeds a critical threshold, implying that inflation can
compromise growth if it is "too high."
* Inflation does not negatively affect economic growth at low levels--
in fact, the relationship can be positive for this limited range.
[Footnote 28] Reducing inflation below this critical threshold produces
no additional economic growth or may cause a country to sacrifice some
long-term growth benefits.
These findings are represented in figure 10, which provides an
illustrative summary of the impact of rising inflation on economic
growth in low-income countries. The central finding from the literature
is that relationship is nonlinear with a critical point (point 1) where
the relationship between inflation and growth changes significantly.
Figure 10: Relationship between Inflation and Economic Growth in Low-
Income Countries as Described in Empirical Literature:
[Refer to PDF for image: illustrated line graph]
Point 1: Inflation does not harm growth;
Beyond this critical point, the relationship between inflation and GDP
growth becomes negative;
Point 2 and 3:
As inflation increases, the negative impact on growth can increase
and/or decrease.
Point 4: Hyperinflation.
Source: GAO analysis of empirical research on inflation and growth in
lower income countries.
Note: Although based on the literature, the relationship depicted here
should not be considered definitive.
Inflation represents the rate of inflation beyond which inflation is
harmful to growth. Estimates for this critical threshold rate range
from 3 to 18 percent for low-income countries in the empirical
literature.
[End of figure]
To the left of point 1 in figure 10, inflation does not harm economic
growth and, in most cases, a positive relationship is established.
[Footnote 29] Beyond point 1, countries face a trade-off between the
short-term cost associated with lowering inflation to achieve higher
medium-and long-term growth and the cost of accepting higher inflation
and therefore lower future growth. Anti-inflationary policies in the
region left of point 1 can be counterproductive since the potential
costs of reducing inflation are not offset by increases in economic
growth or, at worst, can be compounded by declines in long-term growth
rates.[Footnote 30] However, as inflation rises and the critical
threshold is breached, the negative effects of inflation surface.
Beyond this point, any increases in the inflation rate result in
additional declines in economic growth. As points 2 and 3 show, the
marginal costs to long-term growth can either increase or decrease as
inflation rises, although empirical research does not reach a consensus
as to whether the relationship changes for moderate inflation rates. As
a country approaches hyperinflation (point 4), it likely faces a
complete breakdown in economic functioning.
However, examining the inflation-growth relationship under these
conditions generally goes beyond the scope of the literature we
reviewed.[Footnote 31] Earlier academic literature raised doubts about
whether moderate to high inflation was costly to economic growth, but
recent literature suggests that the cost of inflation was understated
because researchers failed to acknowledge the complex, or nonlinear,
nature of the relationship between inflation and economic growth.
Current IMF-Supported Programs Generally Target Single-Digit Inflation
That Is within the Bounds of the Existing Empirical Estimates:
Although not definitive, the empirical literature supports the focus of
IMF-supported programs on containing inflation in low-income countries.
Excluding those with countries in currency unions, or with currency
boards, IMF-supported programs in low-income countries consistently
target inflation in the 5 to 10 percent range.[Footnote 32] The 31 IMF-
supported programs in low-income countries, as of July 2009, are
designed to help the countries achieve and maintain macroeconomic and
financial stability, including targeting single-digit inflation to
avoid the risk that rising prices pose to economic growth. According to
IMF documents, inflation above 10 percent is generally considered
harmful to medium-term growth, while targeting inflation below 5
percent may not be appropriate given the potential benefits of modest
inflation on product and labor markets. Of the 31 IMF-supported
programs, the 20 programs that did not involve countries participating
in currency unions all targeted single-digit inflation at no less than
5 percent (see table 3). In some cases, we found shorter-term inflation
targets above 10 percent. For example, Sao Tome and Principe, and
Guinea both have short-term targets in low double digits as part of the
longer-term objective of gradually reducing inflation to the single
digits.
The 11 other countries with IMF-supported programs participate in
common currency unions (or operate a currency board) with inflation
targets of 3 percent or lower that are set indirectly by the choice of
exchange rate arrangements, not the IMF.[Footnote 33] Inflation targets
in the common currency unions in table 3 are driven by the decision to
maintain a fixed exchange rate that requires member countries to keep
the range of inflation close to inflation levels in the developed
country or area to which the common currency is fixed.[Footnote 34]
Almost all of the countries included in the lower half of table 3
belong to currency unions that peg their currency to either the euro
or, in the case of Grenada, the U.S. dollar. The only exception is
Djibouti, which is not part of a currency union but operates a currency
board tied to the U.S. dollar. As a result, the inflation targets for
these countries are largely independent of IMF inflation policy and
tend to approximate the inflationary experiences of the euro area or
the United States.
Table 3: Inflation Targets in IMF-Supported Programs for 31 Low-Income
Countries, as of July 2009:
Low-income country: Afghanistan;
Medium-term inflation target: 6%;
Type of IMF arrangement: PRGF.
Low-income country: Burundi;
Medium-term inflation target: 6%;
Type of IMF arrangement: PRGF.
Low-income country: Gambia, The;
Medium-term inflation target: 5%;
Type of IMF arrangement: PRGF.
Low-income country: Guinea;
Medium-term inflation target: 5%;
Type of IMF arrangement: PRGF.
Low-income country: Haiti;
Medium-term inflation target: 7%;
Type of IMF arrangement: PRGF.
Low-income country: Kyrgyz Republic;
Medium-term inflation target: Single digit;
Type of IMF arrangement: ESF.
Low-income country: Liberia;
Medium-term inflation target: Single digit;
Type of IMF arrangement: PRGF.
Low-income country: Madagascar;
Medium-term inflation target: Under 10%;
Type of IMF arrangement: PRGF.
Low-income country: Malawi;
Medium-term inflation target: 5%;
Type of IMF arrangement: ESF.
Low-income country: Mauritania;
Medium-term inflation target: 5%;
Type of IMF arrangement: PRGF.
Low-income country: Mongolia;
Medium-term inflation target: 9%;
Type of IMF arrangement: SBA.
Low-income country: Mozambique;
Medium-term inflation target: Single digit (7%);
Type of IMF arrangement: ESF.
Low-income country: Nicaragua;
Medium-term inflation target: 7%;
Type of IMF arrangement: PRGF.
Low-income country: Pakistan;
Medium-term inflation target: 5%;
Type of IMF arrangement: SBA.
Low-income country: Rwanda;
Medium-term inflation target: Single digit (7%);
Type of IMF arrangement: PRGF.
Low-income country: Sao Tome and Principe;
Medium-term inflation target: Single digit;
Type of IMF arrangement: PRGF.
Low-income country: Sierra Leone;
Medium-term inflation target: Single digit;
Type of IMF arrangement: PRGF.
Low-income country: Tajikistan, Republic of;
Medium-term inflation target: Single digit;
Type of IMF arrangement: PRGF.
Low-income country: Tanzania;
Medium-term inflation target: 5%;
Type of IMF arrangement: ESF.
Low-income country: Zambia;
Medium-term inflation target: 5%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Benin;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Burkina Faso;
Medium-term inflation target: 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Central African Republic;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Congo, Republic of;
Medium-term inflation target: 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Cote d'Ivoire;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Djibouti;
Medium-term inflation target: 3%-3.5%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Grenada;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Mali;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Niger;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Currency unions (or currency board): Senegal;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: ESF.
Currency unions (or currency board): Togo;
Medium-term inflation target: Below 3%;
Type of IMF arrangement: PRGF.
Sources: GAO analysis of recipient countries' letters of intent and
IMF's Article IV reports.
Note: For Mauritania, Mongolia, and Grenada, no clear target was
articulated, and therefore we have taken the long-term inflation
projection for the country as the implicit target.
[End of table]
Inflation Targets in IMF-Supported Programs Within the Bounds of the
Existing Empirical Studies:
The empirical literature we reviewed, consisting of nine studies,
provides estimates of the inflation rate (ranging from 3 to 18 percent)
beyond which inflation hampers long-term growth for low-income
countries. Inflation targets in IMF-supported programs, although at the
lower end of the 3 to 18 percent range, are generally consistent with
estimates in empirical studies. (See figure 11.)
Figure 11: Inflation Targets in IMF-Supported Programs Are within the
Estimates from Nine Studies:
[Refer to PDF for image: plotted point graph]
IMF inflation targets in low-income countries (5-10 percent).
Threshold inflation estimates from the empirical literature
(Percentage):
Estimates from studies ranging from 5 to 12 percent:
5%; 6%; 10%; 10%; 12%.
Estimates from studies outside the 5-12 percent range likely due to key
methodological issues or from an unpublished study completed in 2009:
3%; 17%; 18%.
Sources: GAO analysis of empirical research on inflation and growth in
lower income countries and IMF documents.
Note: Threshold estimates indicate the inflation rate where growth is
negatively and significantly affected by further increases in the
inflation rate. Figure 11 only includes threshold rates of inflation
that were estimated empirically using low-income, developing, or
nonindustrial countries.
[End of figure]
Eliminating the lowest and two highest estimates produces an
approximate range of 5 to 12 percent for the threshold, which is
roughly consistent with the inflation targets of 5 to 10 percent in the
31 IMF-supported programs for low-income countries we reviewed.
[Footnote 35] Across the studies, the estimated threshold is generally
found to be higher for low-income than for high-income economies,
providing some support for inflation targets in IMF-supported programs
that tolerate higher inflation in low-income countries. (The
bibliography for inflation-growth literature contains a full listing of
the studies.) While there is some disagreement on where the critical
threshold lies, there is consensus that it is lower than the level
suggested by some studies prior to 2000. These studies provided some
evidence that inflation did not significantly hurt economic growth
until it reached the 20 to 40 percent range, but these findings have
not proven robust for a number of reasons. Specifically, some of the
threshold calculations were based on judgment rather than empirical
estimation.[Footnote 36]
Flexibility in the Selection of an Inflation Target for a Particular
Country Is Prudent:
The complexity of the relationship between inflation and economic
growth uncovered by the literature indicates it may be inappropriate to
set a uniform policy target applicable to all countries. The empirical
literature illustrates that combining countries at different levels of
development can produce unreliable results both in the estimating of
the threshold in the inflation-growth relationship and the effect of
low and high inflation on economic growth. This calls for flexibility
in the implementing inflation targets in individual countries because
the "growth-maximizing" rate of inflation might be expected to differ,
at least somewhat, even across low-income countries at various stages
of development. For example, after increasing the sample of low-income
countries, some researchers found that the estimated inflation
threshold increased from 6 to 17 percent.[Footnote 37] Similarly,
another study found no clear-cut threshold for developing countries and
attributes this finding to the differences across countries grouped
under the "developing" country label.[Footnote 38] One interpretation
of these findings is that, even though the literature generally
supports inflation targets in IMF-supported programs, the gains from a
given reduction in inflation to single digits from somewhat higher
levels might be outweighed by the cost in some cases. As a result, the
relationships and trade-offs should be carefully evaluated for each
country.[Footnote 39]
Moreover, the methodologies and the validity of the estimates vary
across studies, and none should be viewed as definitive. Although
recent empirical literature is informative and addresses a number of
methodological issues that plagued earlier studies, other limitations
remain. Important limitations of the literature analyzing the
relationship between inflation and economic growth include (1)
potential biases due to the omission of important variables; (2) biases
resulting from the failure of some studies to address the fact that, in
addition to inflation impacting economic growth, economic growth may
also affect inflation; (3) issues with small samples and outlier
effects; and (4) technical issues related to the modeling procedures
employed. Moreover, the negative effects on the economy may extend
beyond the effects on economic growth. As a result, studies that
investigate only the impact of inflation on economic growth may
understate the total negative effects of inflation. Finally, there are
relatively few systematic analyses of the critical threshold beyond
which inflation hampers long-term growth; therefore, there is likely to
be continued disagreement on where the threshold lies.
Academic Literature Identifies Weaknesses in Macroeconomic Policies
That Often Precede Economic Crises, Consistent with IMF-supported
Programs:
Academic Literature Identifies Weaknesses in Macroeconomic Policies
Preceding Currency, Banking, and Debt Crises:
The academic literature identifies weaknesses in macroeconomic policies
preceding economic crises. We focused on this aspect of the academic
literature because, as previously noted, middle-and high-income
countries have sought significant IMF financial assistance due to
stress associated with the global financial crisis. Empirical academic
literature we reviewed, focused on anticipating and explaining economic
crises, attempts to identify leading indicators of crises, including
weaknesses in macroeconomic policies. This body of research is known as
the crisis "early warning system" literature. Economic crises include
in particular (1) currency crises, which involve a speculative attack
or large depreciation of a currency; (2) banking crises, which involve
the widespread failure of critical financial institutions; and (3)
sovereign debt crises, which involve the default or near default of a
government on its debt obligations. Economic crises can involve one or
more of the types of crises described above and often precipitate
moderate to severe recessions involving substantial losses of jobs,
income, and production.
By analyzing a broad history of crises--crises that have occurred in
dozens of countries over the last several decades--researchers have
tried to identify common precursors of crises that may provide "early
warning" that a crisis is coming. We reviewed 19 published or widely
cited studies, identified in economic research databases, or in
citations of other studies, written since 1998.[Footnote 40] For each
study, we documented the variables that were predictive of an economic
crisis. Across the studies, several macroeconomic policy variables (and
many variables unrelated to macroeconomic policy) consistently predict
currency, banking, or debt crises. These variables suggest a number of
specific policy weaknesses that make countries more vulnerable to
crises, especially high inflation, high public indebtedness, and an
overvalued currency. These vulnerabilities can represent unsustainable
monetary, fiscal, and exchange rate policies, such as (1) high money
growth, inconsistent with the government's commitment to a fixed
exchange rate or broad exchange rate stability; (2) large and
persistent budget deficits that significantly increase the stock of
public debt and jeopardize the ability of the government to meet its
obligations; or (3) a significant inflow of foreign capital without the
central bank accumulating a buffer of international currency to guard
against sudden capital outflows. Table 4 contains the specific
macroeconomic policy variables identified by the literature and the
nature of the related vulnerabilities.
Table 4: Indicators of Crisis Vulnerability from the Academic
Literature:
Indicator: Real exchange rate;
Nature of vulnerability: A high real exchange rate relative to
historical averages indicates that the currency may be overvalued and
the economy uncompetitive.
Indicator: M2/international reserves[A];
Nature of vulnerability: Low international reserves relative to the
supply of money indicates that the currency has only limited backing.
Indicator: Inflation;
Nature of vulnerability: High inflation can indicate monetizing the
budget deficit or monetary policy inconsistent with the exchange rate,
which may trigger a loss of confidence in the currency.
Indicator: Short-term debt/international reserves;
Nature of vulnerability: Low international reserves relative to short-
term debt indicates that the central bank only has limited capacity to
mitigate the effects of rapid capital flight.
Indicator: Measures of public indebtedness[B];
Nature of vulnerability: High public debt indicates that fiscal policy
may be unsustainable and that investors may lose confidence in the
ability of the government to meet its obligations.
Source: GAO analysis of academic literature.
[A] M2 is a measure of the money supply that includes currency and bank
deposits.
[B] Measures of public indebtedness in the literature include the
budget deficit and external debt/GDP.
[End of table]
Several factors unrelated to macroeconomic policy also often precede
crises, including external events (e.g., a crisis in a neighboring
country), private sector behavior (e.g., significant private sector
borrowing), and institutional or political factors (e.g., weak law
enforcement). Crises are not singularly caused by unsustainable
macroeconomic policies; there are often other factors or triggers that
increase the likelihood of a crisis. Nevertheless, crises do not strike
at random, poor macroeconomic policy management can greatly increase a
country's vulnerability to crisis.
While the crisis "early warning system" literature can inform the
development of macroeconomic policy, it has limitations and provides
qualitative rather than precise quantitative guidance.[Footnote 41]
Conceptually, the literature identifies certain costs associated with
loose macroeconomic policies that are important considerations to
include in the full accounting of the costs and benefits associated
with macroeconomic policies, but these are not the only considerations.
Furthermore, the literature has a number of methodological limitations.
Specific limitations that we identified during our review of the crisis
literature include selecting a sample of countries in a way that
overstates the predictability of crises, analytical approaches that
fail to account for multiple causes of economic crises, and crisis
definitions that may not correspond to severe economic consequences
(e.g., the inclusion of speculative attacks that did not result in
actual currency depreciation in the definition of currency crises). The
limitations we identified may introduce biases into estimates of policy
effects in studies where they are present. The exclusion of noncrisis
countries in some analyses may, for example, overstate the level of
international reserves necessary to guard against crises in some
countries. These limitations suggest caution in interpreting the
precise numerical results of the literature.
Macroeconomic Policies Are Focused on Critical Vulnerabilities in IMF-
Supported Programs in Middle-and High-Income Countries:
The central macroeconomic policy weaknesses identified by the
literature closely correspond to the macroeconomic policy areas upon
which IMF-supported SBA programs focus. The IMF-supported programs in
middle-and high-income countries we reviewed have macroeconomic program
requirements (generally QPCs) designed to limit money growth and
inflation, limit public debt, and accumulate international reserves.
Similarly, high debt, high inflation, and low international reserves
are important macroeconomic policy weaknesses that make a country more
vulnerable to crises.[Footnote 42] We reviewed certain quantitative
macroeconomic program requirements in all SBA programs in which
governments have drawn IMF funds, which included 13 countries for which
program documents were available as of July 2009.[Footnote 43] Because
SBA programs are for countries considered to have temporary balance-of-
payments needs, these countries are generally middle-or high-income
countries that have been adversely affected by the global financial
crisis. In each of the 13 programs, we found that quantitative program
requirements supported the broad goals of (1) limiting money growth and
inflation, (2) limiting public debt, and (3) accumulating international
reserves.[Footnote 44]
To support the broad goals identified above, IMF-supported programs
often used a variety of specific policy variables. To limit money
growth and inflation, SBA programs featured QPCs and other program
requirements for a number of macroeconomic policies. These included
ceilings on the net domestic assets of the central bank, inflation
consultations, and ceilings on the amount of credit the central bank
may extend to the government or the private sector.[Footnote 45] To
limit public debt, 11 of the 13 SBA programs had QPCs for the
government's budget deficit, and some had restrictions on the
government issuing new external debt, and short-term external debt in
particular.[Footnote 46] To accumulate international reserves, 12 of
the 13 SBA programs had floors for either net international reserves or
net foreign assets.[Footnote 47] With respect to our case study
countries, we have noted above that a large stock of public debt was a
key factor driving the crisis in Hungary. In Iceland, the IMF noted in
2007 that the króna was overvalued by 15 to 25 percent, and inflation
rose sharply before the banking crisis ensued. The focus of IMF-
supported programs on the central policy weaknesses should assist
countries in regaining investor confidence and addressing the
underlying crisis vulnerabilities.
Agency Comments:
The Department of the Treasury provided written comments on a draft of
this report, which are reprinted in appendix III. Treasury stated that
it fully concurs with our conclusions that IMF-supported programs are
shaped by negotiations with local officials in the context of country
circumstances. In addition, Treasury noted our finding that the
underlying economic literature on growth, inflation, fiscal and
external sustainability, and financial stability, drive IMF policy
advice in lending programs. Treasury also emphasized that it encourages
the IMF to work with low-income countries to increase spending in areas
such as health and education. Furthermore, we received technical
comments on a draft of this report from Treasury and the IMF, which we
incorporated as appropriate.
We are sending copies of this report to other congressional offices,
Treasury, and the IMF. The report also is available at no charge on the
GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-9601 or melitot@gao.gov. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. Other contacts and major contributors are
listed in appendix IV.
Sincerely yours,
Signed by:
Thomas Melito:
Director, International Affairs and Trade:
[End of section]
Appendix I: Scope and Methodology:
To examine the process for designing an International Monetary Fund
(IMF)-supported program, we reviewed and analyzed IMF's public
documents and data. These documents include IMF Articles of Agreement;
countries' letters of intent; IMF consultation reports and assessments
of country progress under IMF-supported programs, including the Article
IV consultation reports; program design papers; strategy papers; policy
documents; and IMF's Independent Evaluation Office reports. We also met
with officials representing the IMF and the U.S. Department of the
Treasury (Treasury) in Washington, D.C., to discuss the process of
designing of an IMF-supported program and the typical trade-offs
associated with the program's policy decisions. Specifically, we used
IMF policy documents and countries' letters of intent to identify the
primary objectives and key targets of low-and middle-to high-income
countries. We also reviewed the letters of intent provided to the IMF
by countries receiving current IMF-supported financial programs, as
well as updates of program reviews conducted by the IMF for these
programs, available as of July 2009, to obtain examples of
macroeconomic target variables, quantitative performance criteria, and
structural reforms. We utilized interviews with IMF officials, as well
as IMF policy papers, including IMF institute documents, to clarify and
explain the process of designing an IMF-supported program.
To examine the IMF-supported programs in recipient countries, we
selected four case study countries--Hungary, Iceland, Liberia, and
Zambia--and reviewed documents and interviewed officials regarding
these countries' IMF-supported programs. Our selection of these four
countries include criteria to examine how IMF-supported programs may
differ in low-, middle-, and high-income countries with geographic
diversity that had relatively large amounts of IMF financing as of
April 2009. Our choice of countries was meant to be illustrative, not
representative or generalizable to the population of IMF-supported
programs. Documents we reviewed include the letters of intent provided
to the IMF by these four countries; IMF reviews, reports, and press
releases regarding these countries' IMF-supported programs; and country
background documents provided by U.S. embassies in these four
countries. In addition, we interviewed IMF and Treasury officials in
Washington, D.C., to discuss the context of the four recipient
countries and the countries' IMF-supported programs. In Hungary,
Iceland, Liberia, and Zambia, we met with U.S. embassy officials, IMF
staff, officials representing foreign governments, academics, and
nongovernmental organizations to obtain their views about the IMF-
supported programs.
To examine the extent to which the findings of empirical economic
studies are consistent with the IMF's macroeconomic policies, we
reviewed IMF documents and empirical studies. Using published or widely
cited empirical studies identified in economic research databases
EconLit, Social Science Research Network, and Google Scholar, we
identified key relationships between macroeconomic policies and
economic growth and crises, and compared them with macroeconomic
policies in IMF-supported programs. Specifically, we reviewed two parts
of the academic literature relevant to the macroeconomic policy
decisions in IMF-supported programs, namely the literature that links
inflation with economic growth, and the crisis "early warning system"
literature that identifies leading indicators of currency, banking, and
debt crises. For the inflation and growth literature, we reviewed
empirical studies isolating the threshold level of inflation explicitly
for lower-income countries identified in economic research databases
and published since 1999. Due to the lag between publication and
submission, we also included working papers produced during the last 2
years. Although we found these studies to be reliable for the purposes
of identifying the range of estimates and comparing them with targets
in IMF-supported programs, their inclusion in this report does not
imply that we deem them to be definitive. (The bibliography contains a
full listing of the studies linking inflation with economic growth that
we reviewed.) To determine the inflation targets in all 31 IMF-
supported programs in low-income countries, as of July 2009, we
reviewed countries' letters of intent and IMF Article IV reports and
recorded the target for each country. To ensure the data were collected
consistently and accurately, each recorded target was independently
reviewed and verified. In a few cases where no clear target was
articulated, we used the long-term inflation projection for the country
as the implicit target. For the crisis "early warning system"
literature, we reviewed 19 published or widely cited studies,
identified in economic research databases, or in citations of other
studies, written since 1998. We chose 1998 as the starting year because
of the large volume of research explaining or predicting economic
crises that was performed after the Asian financial crisis. For each
study, we documented the variables that were predictive of an economic
crisis. Where possible, we used a conservative standard for identifying
key predictor variables. Under the signals method, we selected only
variables that had a noise-to-signal ratio (NTSR) of 0.5 or less (less
than 1 indicates more signal than noise). Noise indicates an incorrect
prediction while a signal indicates a correct prediction, so a NTSR of
less than 1 implies more correct than incorrect predictions. Under
traditional regression methods, we selected only variables whose
coefficients had p-values less than 0.05. (Several studies we reviewed
reported coefficients that were statistically significant at the 10
percent level.) (The bibliography contains a full listing of studies in
the "early warning system" literature that we reviewed.) Similar to our
identification of inflation targets in IMF-supported programs in low-
income countries, we determined certain quantitative macroeconomic
program requirements in all Stand-By Arrangements in which governments
have drawn IMF funds, which included 13 countries for which program
documents were available as of July 2009. We reviewed these countries'
letters of intent, determined and recorded the policies associated with
the macroeconomic program requirements for each country, then
independently verified that the requirements data were collected
consistently and accurately.
We conducted our work from November 2008 to November 2009 in accordance
with all sections of GAO's Quality Assurance Framework that are
relevant to our objectives. The framework requires that we plan and
perform the engagement to obtain sufficient and appropriate evidence to
meet our stated objectives and to discuss any limitations in our work.
We believe that the information and data obtained, and the analysis
conducted, provide a reasonable basis for any findings and conclusions
in this product.
[End of section]
Appendix II: Countries Approved to Receive IMF Financial Arrangements
as of August 31, 2009:
Table 5 shows the countries that have been approved to receive
financial assistance from the IMF as of August 31, 2009. The recipient
countries are categorized by type of IMF lending arrangement.
Table 5: Countries Committed to IMF Financial Arrangements as of August
31, 2009:
Type of IMF lending arrangement: Poverty Reduction and Growth Facility;
Countries approved to receive funding:
Afghanistan.
Burkina Faso.
Burundi.
Central African Republic.
Congo, Republic of.
Cote d'Ivoire.
Djibouti.
Gambia.
Ghana.
Grenada.
Guinea.
Haiti.
Liberia.
Mali.
Mauritania.
Nicaragua.
Niger.
Sao Tome and Principe.
Sierra Leone.
Tajikistan.
Togo.
Zambia.
Type of IMF lending arrangement: Exogenous Shocks Facility;
Countries approved to receive funding:
Ethiopia.
Kyrgyz Republic.
Malawi.
Mozambique.
Senegal.
Tanzania.
Type of IMF lending arrangement: Stand-By Arrangement;
Countries approved to receive funding:
Armenia.
Belarus.
Bosnia and Herzegovina.
Costa Rica.
El Salvador.
Gabon.
Georgia.
Guatemala.
Hungary.
Iceland.
Latvia.
Mongolia.
Pakistan.
Romania.
Serbia.
Seychelles.
Sri Lanka.
Ukraine.
Type of IMF lending arrangement: Flexible Credit Line;
Countries approved to receive funding:
Colombia.
Mexico.
Poland.
Source: IMF.
[End of table]
[End of section]
Appendix III: Comments from the Department of the Treasury:
Department Of The Treasury:
Washington, D.C. 20220:
October 26, 2009:
Mr. Thomas Melito:
Director, international Affairs and Trade:
Government Accountability Office:
441 G St., NW:
Washington, DC 20548:
Dear Mr. Melito:
I would like to commend the Government Accountability Office (GAO) on
the quality of the forthcoming report titled "International Monetary
Fund Lending Programs Allow for Negotiations and Are Consistent with
Economic Literature". The report distills the complex, iterative
process used by the IMF in its negotiations with country authorities
into a concise and accessible description of the factors that drive IMF
program design. The Treasury Department fully concurs with GAO's
conclusions that IMF-supported programs are shaped by negotiations with
local officials in the context of country circumstances and that
macroeconomic policies in IMF programs are consistent with empirical
economic studies.
As the GAO report highlights, the macroeconomic frameworks at the heart
of IMF programs naturally involve trade-offs between different policy
objectives. Local authorities' prioritization of any given issue may
impact other aspects of the macroeconomic framework. Striking an
appropriate balance between different priorities is not easy and
requires careful judgment. The IMF faces the added challenge that
governments often avoid requesting IMF assistance until imbalances are
clearly unsustainable and policy options are limited. Nonetheless, as
the report shows, the conclusions of the underlying economic literature
on growth, inflation, fiscal and external sustainability, and financial
stability drive IMF policy advice in lending programs.
Besides supporting broad macroeconomic stability and economic growth,
IMF policy advice and financing can also play an important role in
protecting the poorest, especially in low-income countries. The poorest
are often the most vulnerable to macroeconomic volatility like high
inflation or financing crises. We strongly encourage the IMF to work
with low-income countries to increase pro-poor spending (such as on
health and education).
Again, I thank GAO staff for its fine job in tackling this complicated
issue.
Sincerely,
Signed by:
Mark Sobel:
Acting Assistant Secretary for International Affairs:
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Thomas Melito, (202) 512-9601, or melitot@gao.gov:
Staff Acknowledgments:
In addition to the individual named above, Cheryl Goodman, Assistant
Director; Lawrance Evans, Assistant Director; Marc Castellano; Michael
Hoffman; Victoria Lin; and Roberta G. Steinman made key contributions
to this report. The team benefited from the expert advice and
assistance of Lynn Cothern, Etana Finkler, Joel Grossman, and Mary
Moutsos.
[End of section]
Bibliography of Empirical Studies Reviewed in the Inflation-Growth
Literature:
To examine the relationship between economic growth and inflation in
low-income countries, we reviewed the following academic articles. Our
review of the literature included academic studies, using data from low-
income countries, published from 1999 to 2009. Due to the lag between
publication and submission, we included working papers produced in the
last 2 years. The studies indicated with an asterisk (*) provided
empirical estimates of the threshold level of inflation for low-income,
developing or nonindustrial countries that serve as the basis for
figure 11 in the report. The list includes widely cited studies
published prior to 1999, although they either combine low-income and
high-income countries when estimating the threshold inflation rate or
determine the threshold on the basis of judgment.
Barro, Robert. "Inflation and Economic Growth," Federal Reserve Bank of
St. Louis Review 78 (1996).
Bruno, Michael and William Easterly. "Inflation Crises and Long-Run
Growth," Journal of Monetary Economics 41 (1998).
Bruno, Michael and William Easterly. "Inflation and Growth: In Search
of a Stable Relationship," Review of Federal Reserve Bank of St. Louis
78, no. 3 (1996).
*Burdekin, Richard C.K., Arthur T. Denzau, Manfred W. Keil, Thitithep
Sitthiyot, and Thomas D. Willett, "When Does Inflation Hurt Economic
Growth? Different Nonlinearities for Different Economies," Journal of
Macroeconomics 26 (2004).
Fischer, Stanley. "The Role of Macroeconomic Factors in Growth,"
Journal of Monetary Economics 32 (1993).
Ghosh, Atish and Stephen Phillips. "Warning: Inflation May be Harmful
to Your Growth," IMF Staff Papers 45 (1998).
*Gillman, Max, Mark Harris, and Laszlo Matyas. "Inflation and growth:
explaining a negative effect," Empirical Economics 29, no. 1 (2004).
Gylfason, Thorvaldur and Tryggvi T. Herbertsson. "Does Inflation Matter
for Growth?," Japan and the World Economy 13 (2001).
*Khan, Mohsin S. and Abdelhak S. Senhadji. "Threshold effects in the
Relation Between Inflation and Growth," IMF Staff Papers 48 (2001).
*Kochar, Kalpana and Sharmini Coorey. "Economic Growth: What Has Been
Achieved So Far and How?", in Hugh Bredenkamp and Susan Schadler (eds),
Economic Adjustment and Reform in Low-Income Countries (Washington,
D.C.: International Monetary Fund, 1999).
*Kremer, Stephanie, Alexander Bick and Dieter Nautz, "Inflation and
Growth: New Evidence from a Dynamic Panel Threshold Analysis,"
Sonderforschungsbereich Discussion Paper 649, Humboldt University,
Berlin, Germany (2009).
*Kremer, Stephanie, Alexander Bick and Dieter Nautz, "Inflation and
Growth: New Evidence from a Panel Data Threshold Analysis," Goethe
University Working Paper, Frankfurt (2008).
*Pollin, Robert and Andong Zhu, "Inflation and Economic Growth: A Cross-
Country Non-linear Analysis," Journal of Post Keynesian Economics 28,
no. 4 (2006).
Sarel, Michael. "Nonlinear Effects of Inflation on Economic Growth,"
IMF Staff Papers 43 (1996).
*Sepehri, Ardeshir and Saeed Moshiri. "Inflation-Growth Profiles Across
Countries: Evidence from Developing and Developed Countries,"
International Review of Applied Economics 18, no. 2 (2004).
*Vaona, A. and S. Schiavo, "Nonparametric and Semiparametric Evidence
on the Long-run Effects of Inflation on Growth," Economics Letters 94,
no. 3 (2007).
[End of section]
Bibliography of Empirical Studies Reviewed in the Crisis "Early Warning
System" Literature:
We reviewed the following empirical studies in the crisis "early
warning system" literature written since 1998. For each study, we
documented the variables that were predictive of an economic crisis.
Where possible, we used a conservative standard for identifying key
predictor variables. Under the signals method, we selected only
variables that had a noise-to-signal ratio (NTSR) of 0.5 or less (less
than 1 indicates more signal than noise). Noise indicates an incorrect
prediction while a signal indicates a correct prediction, so a NTSR of
less than one implies more correct than incorrect predictions. Under
traditional regression methods, we selected only variables whose
coefficients had p-values less than 0.05. (Several studies we reviewed
reported coefficients that were statistically significant at the 10
percent level.)
Berg, Andrew and Catherine Patillo. "Predicting Currency Crises: The
Indicators Approach and an Alternative," Journal of International Money
and Finance 18 (1999).
Borio, Claudio and Philip Lowe. "Assessing the Risk of Banking Crises,"
BIS Quarterly Review (December 2002).
Burkart, Oliver and Virginie Coudert. "Leading Indicators of Currency
Crises for Emerging Countries," Emerging Markets Review 3 (2002).
Bussiere, Matthieu and Marcel Fratzscher. "Towards a New Early Warning
System of Financial Crises," Journal of International Money and Finance
25 (2006).
Ciarlone, Alessio and Giorgio Trebeschi. "Designing an Early Warning
System for Debt Crises," Emerging Markets Review 6 (2005).
Davis, E. Philip and Dilruba Karim. "Comparing Early Warning Systems
for Banking Crises." Journal of Financial Stability 4 (2008).
Demirgüç-Kunt, Asli and Enrica Detragiache. "The Determinants of
Banking Crises in Developing and Developed Countries," IMF Staff Papers
45, no. 1 (1998).
Edison, Hali J. "Do Indicators of Financial Crises Work? An Evaluation
of An Early Warning System," International Journal of Finance and
Economics 8 (2003).
Esquivel, Gerardo and Felipe Larrain. "Explaining Currency Crises."
Harvard Institute for International Development (1998).
Hemming, Richard, Michael Kell and Axel Schimmelpfennig. "Fiscal
Vulnerability and Financial Crises in Emerging Market Economies,"
Occasional Paper 218 (Washington, D.C.: International Monetary Fund,
2003).
Kamin, Steven B., John Schindler, and Shawna Samuel. "The Contribution
of Domestic and External factors to Emerging Market Currency Crises: An
Early Warning Systems Approach," International Journal of Finance and
Economics 12 (2007).
Kaminsky, Graciela L. "Currency Crises: Are They All the Same?" Journal
of International Money and Finance 25 (2006).
Kaminsky, Graciela, Saul Lizondo, and Carmen Reinhart. "Leading
Indicators of Currency Crises," IMF Staff Papers 45 (March 1998).
Kaminsky, Graciela L. and Carmen Reinhart. "The Twin Crises: The Causes
of Banking and Balance of Payments Problems," American Economic Review
89 (1999).
Komulainen, Tuomas and Johanna Lukkarila. "What Drives Financial Crises
in Emerging Markets?" Emerging Markets Review 4 (2003).
Kumar, Mohan, Uma Moorthy, and William Perraudin. "Predicting Emerging
Market Currency Crashes." Journal of Empirical Finance 10 (2003).
Manasse, Paolo, Nouriel Roubini, and Axel Schimmelpfennig. "Predicting
Sovereign Debt Crises," IMF Working Paper WP/03/221 (November 2003).
Manasse, Paolo and Nouriel Roubini. "'Rules of Thumb' for Sovereign
Debt Crises," IMF Working Paper WP/05/42 (March 2005).
Shimpalee, Pattima L. and Janice Boucher Breuer. "Currency Crises and
Institutions," Journal of International Money and Finance 25 (2006).
[End of section]
Footnotes:
[1] For the purposes of this report, lending includes arrangements and
amounts that the IMF has committed to lend to recipient countries. The
recipient countries may not have drawn these committed amounts. Unless
otherwise noted, we use the August 31, 2009, U.S. dollar to SDR
exchange rate of 1.56606 to convert IMF-reported SDR values to 2009
U.S. dollars throughout the report. The currency value of the SDR is
determined daily by the IMF by summing the values in U.S. dollars,
based on market exchange rates, of a basket of four major currencies--
the euro, Japanese yen, pound sterling, and U.S. dollar.
[2] Balance-of-payments problems occur when countries have difficulty
obtaining the financial resources needed to meet their payments to
nonresidents.
[3] The G-20 is an organization of Finance Ministers and Central Bank
Governors representing industrialized and developing economies.
[4] SDR is an international reserve asset created by the IMF in 1969 as
a supplement to existing reserve assets, or quasi-currency that
borrowing nations can draw upon if needed.
[5] Supplemental Appropriations Act, 2009, Pub. L. No. 111-32, June 24,
2009. The legislation made available the dollar equivalent of up to 75
billion SDRs, but also included that if the United States agrees to an
expansion of its credit arrangement in an amount less than the dollar
equivalent of 75 billion SDRs, any amount over the United States'
agreement shall not be available until further appropriated. According
to the Department of the Treasury, there is an understanding between
the Department of the Treasury and the U.S. Congress, which is
supported by the administration's public statements, that the United
States would only commit up to $100 billion.
[6] Agreement on an IMF-supported program requires the IMF Executive
Board's approval. This board comprises 24 Executive Directors who are
appointed or elected by member countries or by groups of member
countries.
[7] We use the word target to mean a goal or objective of an IMF-
supported program, rather than a formal target or program requirement.
[8] Letters of intent are prepared by the member country. They describe
the policies that a country intends to implement in the context of its
request for financial support from the IMF.
[9] The Article IV consultation is an annual review of members'
macroeconomic circumstances. Typically, an IMF staff team visits the
country, collects economic and financial information, and discusses
with officials the country's economic developments and policies. The
staff prepares a report, which forms the basis for discussion by the
Executive Board.
[10] In May 2009, the IMF announced reforms to its policy on
conditions. For example, the IMF eliminated structural elements as
performance criteria. These structural performance criteria (SPC) are
changes in the underlying makeup of an economy, such as fiscal systems,
social safety nets, and measures to strengthen the financial sector.
Though eliminated as criteria, the IMF will continue to monitor
structural reforms as part of the overall review of country progress.
[11] The G-20 also called for urgent ratification of a long-pending
amendment to the IMF's Articles of Agreement. The Fourth Amendment was
proposed to enable all IMF members to participate in the SDR system on
an equitable basis and correct for the fact that countries that joined
the IMF after 1981--now more than one-fifth of the current IMF
membership--had never received an SDR allocation.
[12] Pub. L. No. 111-32. The legislation appropriated the dollar
equivalent of 4,973,100,000 SDRs.
[13] Pub. L. No. 111-32. The legislation made available the dollar
equivalent of up to 75 billion SDRs.
[14] These provisions are included in Pub. L. No. 111-32, Sections
1403(d) and 1404.
[15] Statement on Signing the Supplemental Appropriations Act, 2009,
June 24, 2009. The provisions noted in the signing statement included
Sections 1403 and 1404.
[16] The IMF identified these conditions for low-income countries.
Macroeconomic instability can be characterized by large trade deficits
financed by short-term borrowing, high and rising levels of public
debt, double-digit inflation rates, and stagnant or declining GDP.
[17] Limiting the budget deficit may also be crucial for middle-and
high-income countries, and stabilizing the exchange rate may also be
important for low-income countries.
[18] Conditions may also include prior actions, which are measures that
a country agrees to take before the IMF approves financing or completes
a review. Examples of prior actions include adjustment of a country's
exchange rate, elimination of a country's price controls, or formal
approval of a government budget consistent with the IMF-supported
program's fiscal framework.
[19] The key sectors of the economy are real (output growth), monetary
and financial (money and banking system), fiscal (government deficit),
and external (balance of payments).
[20] For example, the projections for GDP growth, inflation, and the
current account influence are influenced by monetary, exchange rate,
and fiscal policy instruments. GDP growth and inflation are thus
important inputs into determining government revenue and expenditures.
However, the size of the deficit has an effect on economic activity, as
well as the method of financing the deficit influences inflation and
interest rates.
[21] IMF staff use the financial programming model, which consists of
accounting identities, behavioral relationships, and economic judgment,
as a consistency check on the macroeconomic framework. This process
allows targets and policies to be adjusted and reformulated in light of
changing outcomes. The process may undergo multiple iterations as IMF
staff strive to ensure internal consistency across the various sectors
of the economy.
[22] If the increase in government spending is financed by borrowing
from the central bank, the effect on the price level may be
significant.
[23] In 1996, the World Bank and IMF launched the HIPC Initiative to
create a framework in which all creditors, including multilateral
creditors, can provide debt relief to the world's poorest and most
heavily indebted countries, and thereby help reduce constraints on
economic growth and poverty reduction due to the countries' debt
burdens. Countries begin receiving debt relief on an interim basis
until they complete the initiative, which Liberia may do in 2010.
According to IMF staff, Liberia has been receiving interim debt relief
from its main creditors, but full debt relief will only be secured when
it reaches the HIPC completion point. For more information, see GAO,
Developing Countries: The United States Has Not Fully Funded Its Share
of Debt Relief, and the Impact of Debt Relief on Countries' Poverty-
Reducing Spending Is Unknown, GAO-09-162 (Washington, D.C.: Jan. 26,
2009).
[24] Foreign exchange data obtained from Thomson Reuters Datastream, a
large financial statistical database.
[25] Hungary aspires to join the group of European countries that share
a common currency, the euro, in the future, which requires it to meet a
set of criteria, including a budget deficit of less than 3 percent.
[26] The countries included Norway, Denmark, Finland, and Sweden.
[27] In technical terms, this means the relationship has been found to
be nonlinear. This implies that the trade-off between higher inflation
and lower economic growth--or the marginal growth costs of inflation--
can differ as inflation rises.
[28] Theoretically, inflation can positively and negatively affect
growth through various channels. For example, high rates of inflation
reduce the value of savings and distort price signals, interfering with
the efficient allocation of resources and the functioning of the
financial system. On the other hand, at low levels, inflation can help
foster capital accumulation, contribute to labor and product market
flexibility, and make an economy less vulnerable to prolonged
recessions.
[29] While the relationship is found to be positive, in most cases it
is also statistically insignificant.
[30] IMF and other researchers suggest a need for caution in setting
very low inflation targets in low-income countries.
[31] Given that hyperinflation is clearly detrimental to economic
growth, the literature we reviewed focused on the effects of moderate
to high inflation.
[32] A currency union is a group of countries that adopt a single
currency and a uniform monetary policy. In the case of the currency
unions discussed in this report, the unions also peg the common
currency to the euro or the U.S. dollar. A currency board is a monetary
arrangement that pegs the currency of a country to a more widely used
and dominant currency and typically backs all currency in circulation
with international reserves.
[33] For example, the West African Economic and Monetary Union pact
sets a 3 percent inflation threshold as a convergence requirement for
participating countries. The Central African Economic and Monetary
Union pact has a similar convergence criterion. Grenada is part of the
East Caribbean Currency Union, which pegs to the U.S. dollar. Djibouti
operates a currency board tied to the U.S. dollar.
[34] If inflation were allowed to deviate significantly from the levels
in the developed country or area, the real exchange rate would become
increasingly misaligned and undermine the goals of the fixed-rate
currency system.
[35] Given the state of the literature, a 5 to 12 percent range is a
reasonable interpretation of the literature since two of the three
estimates outside the 5 to 12 percent range are likely due to
methodological issues and the remaining estimate (17 percent) is from a
June 2009 study that addresses a number of the methodological issues in
the existing literature but has not been peer reviewed. Of the
published studies, one estimates a 3 percent threshold using a
specification that is now used infrequently in the literature because
it allows a few outliers to drive the results. The other study
estimates a threshold of 15 to 18 percent using a simple nonlinear
model that may not accurately estimate the threshold inflation rate.
However, none of the studies should be interpreted as having identified
the exact inflation level beyond which inflation hampers long-term
growth, and this exercise is not meant to imply that literature is
conclusive.
[36] For example, two widely cited studies prior to 1999 impose
thresholds ranging from 15 to 40 percent. See Michael Bruno and William
Easterly, "Inflation Crises and Long-Run Growth," Journal of Monetary
Economics 41 (1998); and Stanley Fischer, "The Role of Macroeconomic
Factors in Growth," Journal of Monetary Economics 32 (1993). To the
contrary, the threshold models that dominate recent literature are
designed to estimate inflation thresholds as opposed to imposing them.
[37] See Stephanie Kremer, Alexander Bick, and Dieter Nautz, "Inflation
and Growth: New Evidence from a Dynamic Panel Threshold Analysis,"
Sonderforschungsbereich Discussion Paper 649, Humboldt University,
Berlin, Germany (2009).
[38] See A. Vaona and S. Schiavo, "Nonparametric and Semiparametric
Evidence on the Long-run Effects of Inflation on Growth," Economics
Letters 94, no. 3 (2007). It is important to note that this study
exploits techniques that have some positive methodological features but
are extremely sensitive to outliers.
[39] Even if inflation above 10 percent is believed to be harmful to
long-term growth in a country, there are still trade-offs to be
considered for negotiation. For example, if there is only a small
benefit to moving from 12 percent to 9 percent inflation, it may not
justify the potential cost of disinflation.
[40] See appendix I for our complete literature review methodology and
the bibliography for crisis "early warning system" literature for a
list of the studies reviewed.
[41] The lack of consensus in the crisis "early warning system"
literature as to the appropriate way to estimate the effects of
policies (and other variables) implies that it is difficult to obtain
precise quantitative guidance from researchers' estimates of policy
effects. This lack of consensus is reflected in the two different
methods, which we denote as (1) the signals approach and (2) the
marginal approach, which researchers have used to assess potential
leading indicators of economic crises. The signals approach assumes
that there are thresholds beyond which relevant indicators "signal"
that a crisis is more likely. The marginal approach assumes that
changes in relevant indicators increase or decrease the likelihood of a
crisis, irrelevant of particular thresholds. As an example of the
divergent predictions from the two approaches, consider the real
exchange rate. As discussed above, a higher real exchange rate can
indicate an overvalued currency, an uncompetitive economy, and an
increased likelihood of crisis. According to one study using a marginal
approach, a 10 percent increase in the exchange rate would increase the
likelihood of a currency crisis by approximately 3.6 percentage points.
According to a study using a signals approach, the real exchange rate
signals that a crisis is likely only when its value exceeds the 90th
percentile.
[42] Another leading indicator of crises, an overvalued currency, does
not correspond to common quantitative macroeconomic program
requirements in SBA programs. However, the crisis events that
precipitate IMF-supported programs are likely to involve a significant
depreciation of the currency. As a result, the likelihood of
overvaluation to be present once a crisis ensues is diminished.
[43] See appendix I for more information on our methodology.
[44] The IMF-supported program in Bosnia-Herzegovina did not have a QPC
or other program requirement to facilitate the accumulation of
international reserves. However, Bosnia-Herzegovina operates under a
currency board in which it must hold foreign exchange reserves not less
than domestic currency in circulation, under domestic law. Maintaining
this currency board is also a structural benchmark of the program, but
not a performance criterion.
[45] An inflation consultation is a program requirement that triggers a
meeting with IMF staff or the IMF Board if inflation falls outside of
certain bounds.
[46] Short-term debt has a maturity of 1 year or less.
[47] Net international reserves are a subset of net foreign assets. Net
international reserves are the foreign exchange reserves of the central
bank, less liabilities. Net foreign assets is a broader concept that
includes the foreign currency assets and liabilities of the banking
system.
[End of section]
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