Journal Issue

The Fund’s Compensatory Financing

International Monetary Fund. External Relations Dept.
Published Date:
December 1969
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J. Keith Horsefield

MORE THAN 80 per cent of the Fund’s members are developing countries, and many of these are dependent for most of their earnings of foreign currencies on from one to four specialized crops or mineral resources. Coffee, cocoa, and sugar are prime examples of such crops; tin and copper of such mineral resources. All these are enormously important to the developing countries where they are to be found. Reliance on them makes the countries concerned very vulnerable to fluctuations in their earnings from exports.

A number of international agreements have attempted to alleviate the consequences of this dependence by controlling the sale of coffee, sugar, tin, and so forth. These agreements aim chiefly at holding the product off the market when its price tends to sag. One way to do this is to create buffer stocks to absorb surplus quantities, which can be released from these stocks in years when otherwise the price would go so high as to stimulate consumers to seek substitutes. A plan of this kind is now in existence for tin, but in general such plans encounter difficulties in realizing their objectives. For one thing there is too much temptation for countries with a relatively small stake in the particular product to refuse to participate in any agreement and to increase their sales when those inside the agreement are holding back. Thus, every few years the coffee producers, or the tin producers, or whoever it may be, experience a sudden drop in export earnings which may have disastrous results for their development programs, or for their monetary reserves, or both.

Difficulties of this kind have always been accepted as a sound justification for member countries to draw on the Fund, so as to tide themselves over a period of difficulty until good times return. But a few years ago it became clear to the Fund that some special assistance was needed, geared directly to shortfalls in export earnings of this kind, which would be available over and above the members’ ordinary rights to borrow from the Fund. Plans to provide this special assistance were therefore introduced in 1963 and revised in 1966. It is these plans for “compensatory financing of export fluctuations” that are the main subject of this article. Quite recently, however, the Fund decided to offer parallel facilities to assist in the establishment of buffer stocks, and a description of this new development is also given.

Limits to Compensatory Financing

The main idea of compensatory financing is simple enough. A member country suffering from difficulties in its balance of payments due to a shortfall in export receipts for reasons beyond its control can come to the Fund and draw an appropriate amount of foreign currencies in place of those which it would have earned had there been no shortfall. There are, however, two limits to this “appropriate amount.” One is related to the member country’s quota1: it may not draw more than 50 per cent of its quota in all, and except in very unusual circumstances it may not draw more than 25 per cent of its quota in any 12 months. The other limit is related to the size of the shortfall: the amount drawn may not exceed the difference between the member country’s actual earnings in what we may call “the shortfall year” and what it might have expected to earn had its output and the price received for it both been normal.

As regards the first of these limits, we need note only two things. For ordinary drawings there is a restriction, laid down in the Articles of Agreement, that a member country may not draw more from the Fund than would increase the amount of its currency that the Fund holds to more than twice (200 per cent of) its quota. Since normally a member subscribes, when it joins the Fund, one fourth of its quota in gold and three fourths in its own currency, the effect of this limitation is that its drawings may not total more than one and one quarter times (125 per cent of) its quota. This limitation is not absolutely firm, but it requires special action by the Executive Directors to breach it. The decision establishing the plan for compensatory financing took this special action for all drawings under the plan. As a result, drawings under the plan do not count toward the limit of 200 per cent. A member country may draw up to one and one quarter times its quota (so raising the Fund’s holdings of its currency to 200 per cent of its quota) and still draw under the compensatory financing scheme. Moreover, other drawings will be treated as if no compensatory financing drawings existed, thus reducing the stringency of the requirements which countries must fulfil to qualify for an ordinary drawing.

Measuring the Shortfall

The second limit on the amount drawn—the size of the shortfall—is much more tricky. Like other people, economists can never be sure what would happen if circumstances were different from what, in fact, they are; yet they must frequently try to prescribe for such happenings. Thus, the compensation of export fluctuations requires that an estimate be made of the shortfall which is to be compensated. This means, in turn, that an estimate has to be made of what the country’s export earnings in the shortfall year would have been if its output and the price received had both been normal.

The easiest solution, of course, would be an assumption that the country’s earnings in the shortfall year would have been the same as in the year before. But that is altogether too simple. For one thing, there may be a clear trend, upward or downward, in the value of exports, which might be expected to continue into the shortfall year. Alternatively, developments during that year may not be of a temporary nature but presage a change in the previous trend. Allowance must be made for both these factors.

There is a further point that has to be considered. The shortfall in the country’s earnings may point to a need for long-term measures to adjust the use of its economic resources in order to produce for export. For example, the pattern of production may be out of balance with the demand for the country’s products. Compensation which has to be repaid in a few years may provide immediate relief, but a lasting solution will require longer-term technical and financial assistance to effect the necessary technological changes. Again, the country’s costs may be too high because of serious domestic inflation; for such a situation the appropriate remedy is to check the inflation, or to devalue the currency, or both.

Search for a Solution

The problems of primary producers were extensively considered by several international organizations from 1959 onward, and a number of plans were produced to deal with them. Some of these plans provided for outright grants to countries suffering from shortfalls; others for loans to be repaid either at a fixed date or out of subsequent export earnings. Some of the plans would have related the assistance provided solely to the variation in the sums earned from the particular form of output hit by the shortfall; others would have looked more widely at the whole of the country’s balance of payments. Some would have fixed the amount of assistance given by applying a formula to the shortfall; others would have left it to the judgment of the body providing the assistance.

In 1960 the Fund itself began to explore the problem. If, as appeared reasonable, it was itself to be the agency giving the assistance, this would have to be a loan, not a grant; and, moreover, it would have to be repaid within five years, that being the maximum time that a member may wait before repurchasing a drawing from the Fund. Further, whatever assistance was given would have to take into account the member’s whole economic situation, just as is done with an ordinary drawing. Finally, it was essential to find a way to calculate the trend in exports as a basis for determining how large a drawing a member might make.

To meet this third requirement the Fund staff set out to find some means of discovering what would have been the normal value of a country’s exports in a shortfall year, had the shortfall not occurred. This normal value was defined as the average of the country’s export earnings over the shortfall year plus the two years preceding that year and the two years following it. In algebraic terms, this normal value for the shortfall year t is xt2+xt1+xt+1+xt+25, where xt represents the export earnings for the year in question.

However, data for future years would obviously not be available for the calculation, so a search was made for a formula, based only on the present year and past years, which would yield the closest approximation to the wanted figure. After testing 137 different formulas against the actual export earnings of 48 countries over a period of 13 years, the staff found that a good approximation could be obtained by using the following data: half the earnings in the shortfall year, plus one fourth of those in the immediately preceding year, plus one fourth of those in the year before that again. In algebraic terms, the normal value for the year t could be calculated as ½xt+ ¼xt-1+¼xt-2

Such a formula can, of course, only approximate to the answer required. A second approximation can be arrived at by economic forecasting. This method consists of considering one by one the likely outputs of the country’s principal exports, forecasting the state of the markets for them for two years ahead, and deducing from these forecasts what the country’s export earnings are likely to be in each of the two years following the shortfall. Once these estimates are available, the normal figure for the shortfall year can be found by taking a simple average of the data for that year, the data for the two preceding years, and the forecasts for the two following years.

The Fund’s Procedure

Since neither of the foregoing methods of estimating the normal value of exports in the shortfall year is wholly satisfactory the Fund has used both. In practice it has been found that the economic forecasting method is the more successful where (as has nearly always been the case) the country’s principal export products have been few enough to enable satisfactory forecasts to be made. The results obtained from the statistical formula have therefore usually been used only as a check on the forecast. However, in one or two instances where the forecast was unusually speculative, reliance has been placed on the formula instead.

Not all the drawings which have been approved under the compensatory financing procedure have been originally made under that plan; some have been ordinary drawings reclassified. The reason why a country may seek to reclassify an ordinary drawing is that it may find it more convenient to obtain balance of payments assistance through the use of its ordinary drawing rights until the exact size of a shortfall can be statistically determined. The Fund has agreed that if, within six months of making an ordinary drawing, the member country finds that its problems have been accentuated by a shortfall in export receipts, it may ask to have the drawing reclassified as a compensatory financing one (to the extent of the shortfall and subject, of course, to the limit of 25 per cent of quota for such drawings in any one year, and 50 per cent of quota in all). The advantage to the member of this procedure is that use of the ordinary facilities of the Fund is not impaired, because a drawing under the compensatory financing facility is not taken into account when comparing the country’s drawings with its quota.

However, the existence of an ordinary drawing made shortly before a request for a compensatory financing drawing produces a complication which has had to be dealt with. This is, that the earlier drawing may already have assisted the member country to overcome the problem which has now emerged as a shortfall in export receipts. If no account is taken of this previous assistance, the country’s problem might be doubly compensated, once by the ordinary drawing and a second time by the compensatory drawing now sought. If the member country seeks, when asking for the new drawing, to reclassify all its early drawings, the problem does not arise. But if the member does not wish to reclassify all its earlier drawings, the problem is more complicated, because ordinary drawings are not related to any particular deficiency in a country’s balance of payments; they are granted to deal with the country’s problems as a whole. Consequently, some conventional rule has to be adopted to decide how much of the current shortfall is to be regarded as having been covered by the earlier drawing.

The rule adopted assumes that the earlier drawing will have covered one half of the shortfall for that portion of the year ending at the date of the previous drawing which falls within 12 months of the date when the new drawing is sought. This difficult-sounding provision can best be explained by an example. Suppose that a member country made an ordinary drawing at the end of September 1969, and that early in January 1970 it seeks a compensatory financing drawing. It does not wish to reclassify the September drawing. The limit to the January drawing will be 25 per cent of the member’s quota or the calculated shortfall for the 12 months ended December 1969, whichever is the less. Suppose this calculated shortfall is $50 million. Suppose also that the shortfall for the 12 months ended September 1969 was $40 million. The part of the latter period which falls within the 12 months ended December 1969 is the 9 months January to September 1969. It may be reckoned that in these 9 months the shortfall was nine twelfths of $40 million, i.e., $30 million. Of this $30 million, one half ($15 million) is assumed to have been covered by the September drawing; this $15 million is deducted from the calculated shortfall which limits the January drawing, and the latter will then be either $35 million or 25 per cent of the member’s quota, whichever is the less.

Conditions for Compensation

There is one more consideration to be borne in mind. It will be remembered that the description given above of the way in which a shortfall might come about included the possibility that the shortfall was due partly to the policies of the country concerned. It may be suffering from the effects not of a crop failure or the collapse of its market but of inefficiency or inflation. Nonetheless its loss of export earnings may be real and serious, and the Fund would not wish to deny a member access to its resources even in these circumstances. The contingency is taken care of by two clauses in the Fund’s decision to provide compensatory financing. The first of these stipulates that the shortfall, to qualify for compensation at all under the scheme, must be “largely attributable to circumstances beyond the control of the member.” (If this does not apply, the member’s remedy is to seek an ordinary drawing.) The second clause in the Fund’s decision provides that the member will be expected to “cooperate with the Fund in an effort to find, where required, appropriate solutions for its balance of payments difficulties.” These two hurdles must be surmounted if a member is to obtain compensatory financing from the Fund.

Other clauses in the decision provide for the necessary repurchase from the Fund of the currency paid over by the drawing country in exchange for the foreign exchange that it needed. One of these clauses stipulates that the member country must undertake to repurchase its currency within five years. Another recommends (but does not insist) that in each of the first four years following a drawing the member country should use, to repay the Fund, half of any amount by which its actual export earnings for the year exceed the medium-term trend of these earnings.

From the inauguration of the compensatory financing plan in 1963 to the middle of 1969, 17 countries had drawn a total of $377,750,000 under the plan; 5 countries had drawn twice, so that there were 22 drawings. In 10 of these the amount drawn was limited to 25 per cent of the member’s quota, although the estimated shortfall was larger. Six of the other drawings were reduced by the provision for double compensation. Three countries made use of the reclassification procedure. In the same period, 7 countries repurchased the equivalent of $160,000,000, out of the $377,750,000 drawn.

Financing Buffer Stocks

In July 1969 the Executive Directors of the Fund introduced a plan, parallel to the foregoing, which will assist members to finance international buffer stocks. Any such new plan had, of course, to be kept within the framework of the Fund’s Articles of Agreement and working practices. As a result, it is subject to four important conditions: (a) finance can be provided only to individual members and not to any international organization controlling a buffer stock; (b) before a member can draw from the Fund under the plan it must have a balance of payments need to do so; (c) drawings must be repaid within three to five years, or earlier in the event of the buffer stock distributing cash to its members; and (d) the member country must agree to cooperate with the Fund in finding solutions, if required, to its balance of payments difficulties.

Subject to these conditions, the Fund is now willing to permit its members to draw on its resources in order to meet obligations that they have assumed under an international buffer stock scheme, provided that the scheme in question conforms to standards laid down by the United Nations. Drawings from the Fund would be confined to the reimbursement of contributions for financing purchases of stock and operating expenditure.

The amount which a member may draw under the buffer stock scheme will be limited to 50 per cent of its Fund quota; if necessary, this may be drawn in a single year. There will also be an overriding limit of 75 per cent of quota governing drawings under the compensatory financing scheme and the buffer stock scheme together. (One reason for the latter limit is that an effective buffer stock scheme may be expected to reduce export fluctuations, and so diminish members’ need to have recourse to the Fund under the compensatory financing provisions.)

Like drawings to compensate export fluctuations, drawings under the buffer stock scheme will not count toward the 200 per cent (of quota) limit on drawings; however, there is one minor difference between the effect of the two schemes in this respect. A member that has drawn under the export fluctuations scheme, but has made no other drawing, may automatically and without question draw from the Fund whatever amount is needed to increase the Fund’s holdings of its currency to 100 per cent of its quota. In Fund jargon, its rights to an automatic gold tranche drawing are unimpaired by the existence of a drawing under the compensatory financing scheme. This will not apply to buffer-stock drawings; if the member has drawn as much as 25 per cent of its quota for the purpose of financing a buffer stock, it will lose the right to an automatic drawing in the gold tranche. If it wishes to make an ordinary drawing, it will have to make a case for it in the same way as it would have to do if it were seeking to make a drawing which would increase the Fund’s holdings of its currency from 100 per cent to 125 per cent of its quota.

No experience has yet been gained with the buffer stock scheme, and it may well be a year or two before any substantial use is made of it. When approving it, however, the Executive Directors of the Fund expressed the belief that, like the plan for compensating export fluctuations which it supplements, this new provision would be of real assistance to member countries subject to sudden strains through the volatility of export earnings from primary products.

It may be added that the World Bank has also been considering how it would assist members in connection with commodity problems; a description of its plan will appear in a later issue of Finance and Development.

The quota is the equivalent expressed in U.S. dollars of the subscription that a member country pays into the Fund on joining it; the amount is related to the country’s economic strength.

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