Today I want to talk about a new element in the international financial system, the IMF’s Contingent Credit Lines (CCL) Facility. This, I believe, is a potentially extremely significant innovation that will deploy the IMF’s financial resources more effectively to help prevent financial crises, rather than to help pick up the pieces after the damage has been done. The basic idea is straightforward: the IMF offers a precautionary line of credit to countries that have demonstrably sound policies but that nonetheless believe they may be vulnerable to contagion from crises elsewhere.
Volatility and contagion
The expansion of private international capital flows from $40 billion in 1990 to $290 billion in 1997 (after which they declined to $170 billion in 1999) has been one of the most spectacular manifestations of globalization in recent years. These flows have brought economic benefits to borrowers and lenders alike, but—as we have seen too often over the last six years—there is an important downside. Countries have been exposed to periodic crises of confidence when inflows of capital were suddenly reversed.
As international capital flows have increased relative to the size of national economies, so has the potential disruption threatened by their reversal. The need to maintain investor and creditor confidence generally serves as a useful discipline. It magnifies the rewards for good policies and the penalties for bad ones. But the capital account crises of recent years drive home the possibility that volatility and contagion can on occasion become excessive.
As a crisis spreads initially, most of those involved— particularly the affected countries—tend to blame excess volatility and contagion; in other words, they claim that they were innocent bystanders. This is in part a natural human reaction, in part a rational response to events. Eventually, the policymakers in the affected countries get down to solving their problems, and there is less talk about contagion and more talk about the weaknesses in the economy.
Photo Credits: Denio Zara, Padraic Hughes, Pedro Marquez, and Michael Spilotro for the IMF, pages 385-88, 391-92, 394-95, and 399; and Federal Reserve Bank of Philadelphia, page 400.
Still, which is it—contagion or weaknesses in the affected economy? The answer is both. Establishing the presence of excess volatility and contagion in the system is complicated by the fact that a crisis of confidence can push a country from a good to a bad equilibrium: to put it simply, when a country’s institutions and policies are subjected to massive pressure from a reversal of capital inflows, they may crack, thereby appearing to justify the reversal of flows that caused the crisis. Similarly, contagion does not spread randomly; rather, it hits weaker economies more quickly and more forcefully than stronger ones.
Focusing on prevention
One response has been to bolster IMF surveillance of national policies and international markets. We are concentrating more on potential weaknesses that might leave a country vulnerable to a crisis: poor macroeconomic policies; the exchange rate regime; unsound debt management; and weak financial sectors, to name but a few. Countries are also publishing more and better information about their own policies and economic developments. And a large and growing majority are choosing to publish the advice they get from the IMF. This makes it easier for investors and creditors to make better informed portfolio decisions; no less important, by making it necessary for policymakers to explain to the public what they are doing and why, transparency contributes to better policies.
The CCL is complementary to these efforts, providing an additional financial incentive to adopt good policies. In effect, the CCL allows countries that have met certain preconditions to augment—at low cost— the foreign exchange reserves they can draw on in a crisis. The knowledge that these resources are available may in itself serve to deter speculative attacks. In addition, by offering qualifying countries a public seal of approval for their policies, the CCL also makes it less likely that investors and creditors will succumb to herd behavior by pulling out their money when a crisis strikes elsewhere.
Extending credit lines to countries before problems break out means that the IMF’s lending capacity can be used to serve the cause of crisis prevention as well as crisis resolution.
Principles underlying the CCL
Traditionally, the IMF has offered financial support to countries already in trouble, typically when they are facing short-term balance of payments problems on the current account. When capital flows were restricted, the adjustment that a country needed to make to deal with a crisis was set by the scale of the external imbalance, rarely more than 5 percent of GDP. This was reflected in the rules determining how much a country can borrow from the IMF under a conventional Stand-By Arrangement—normally up to 100 percent of its quota, its contribution to the IMF’s capital base, in any one year, with a cumulative maximum of 300 percent of quota.
Capital account crises present more of a challenge. When a country confronts a crisis of confidence over its ability to repay its foreign creditors, the scale of its financing problem is set not by the current account deficit, but by potential capital flows, related to the size of its external debt and sometimes also to the scale of the internal debt. Of course, the official sector cannot and should not meet this entire financing need. But the official sector does play an important role in helping countries avoid the full burden of adjustment that would otherwise be needed. It can achieve this not only by providing money itself, but also—through its catalytic role—by restoring confidence among private creditors and lenders.
Like the Supplemental Reserve Facility (SRF), which the IMF established in 1997, the CCL is aimed at capital account rather than current account crises. As with the SRF, there is a recognition that relatively large sums of money may be needed, so there is no formal access limit. Given the threat that contagion could strike several countries at once, the IMF Executive Board agreed that the IMF’s overall liquidity position would be taken into account in deciding the scale of access in any particular case.
With both normal Stand-By Arrangements and the SRF, the IMF is picking up the pieces after an accident has happened. The CCL marks a clear departure from this model. Extending credit lines to countries before problems break out means that the IMF’s lending capacity can be used to serve the cause of crisis prevention as well as crisis resolution.
There is obviously a risk of moral hazard here. Countries have an incentive—in theory, at least—to run weaker policies if they have an extra financial cushion in place. Perhaps more important, investors have an incentive to lend to countries with weaker policies if they believe that the presence of an IMF credit line increases the chances that they will be repaid if things go wrong. To counter this problem, the CCL is aimed explicitly at members with first-class policies that face a potential loss of access to international capital markets because of contagion, rather than domestic policy weaknesses. The four eligibility criteria have been designed accordingly:
First, at the time the credit line is extended, the recipient country must not be expected to need to borrow from the IMF. This implies that over the medium term, the country should be expected to be able to finance its balance of payments comfortably, based on a realistic assessment of its access to private capital and a sustainable projected path for external debt.
Second, the IMF Executive Board must have made a positive assessment of both the country’s economic prospects and its progress toward meeting international policy standards.
Third, the country must both enjoy constructive relations with its private creditors and be taking appropriate measures to limit its external vulnerability.
Fourth, the country must outline to the Board the policies that it intends to pursue during the one-year period covered by the CCL.
One criticism of the CCL is that it would be very difficult to withdraw a country’s access to its credit line if the quality of its policies slipped after the CCL was in place. The assumption is that the IMF Board would be reluctant publicly to withdraw its stamp of approval, for fear of triggering a crisis that would then be expensive to resolve. Equally, countries might be concerned to enter a CCL for fear their access might later be withdrawn. However, this problem should not be exaggerated: it is unlikely that the markets would not have noticed the policy slippages that would cause withdrawal from the CCL; and we should also recall that there are many occasions on which negotiations on the renewal of an existing IMF program have been suspended and the market reaction has been relatively subdued.
Experience with the CCL
In the first year of the CCL’s existence, a number of countries discussed with IMF staff whether they should apply for one. But in the end, none did. Potential users pointed to several weaknesses in the original design. These were discussed in September 1999 by the Executive Board, which agreed to important changes to make the facility more attractive:
The Board has agreed in principle to lower the surcharge over the standard loan rate. The commitment fee countries pay when securing a CCL will also be cut. This will increase the financial incentive for countries to adopt sound policies.
Under the original rules, it was far from automatic that a country with a CCL would be able to get its hands on the money when contagion struck. In light of the strong track record required of countries that qualify, the Board has agreed to move in the direction of greater automaticity in the release of the first third or so of the resources committed under the facility.
The introduction of the CCL is potentially a highly valuable addition to the armory with which the IMF helps protect its members from the enormous economic and social costs of financial crises. I hope and believe that we will, in the coming months, see several countries enter the CCL facility—and that they and the world economy will be the better for it.