X Financial Programs and a Typical Negotiating Mission
- Marcello Caiola
- Published Date:
- August 1995
A country will require IMF assistance when it is having balance of payments difficulties or, in other words, when the normal inflow of external savings is not sufficient to finance its resource gap, which is defined as the difference between domestic savings and domestic investment. A country may supplement external savings by drawing down its international reserves, but once these reserves have been utilized, there is no other alternative but to adjust.21
Thus, a financial program of the Fund is usually aimed at “improving” the balance of payments, that is, reducing the current account deficit to a level that can be financed realistically and steadily by “genuine” external savings. A program must, therefore, also set the basis for attracting external savings and ensure that a steady flow of external savings will be provided to finance the resource gap. The level of investment will depend on this flow of external savings and on domestic savings. The larger the two, the more investment the country can finance.
Since all countries are interested, or should be interested, in higher economic growth and productive domestic investment, actions should be directed toward increasing domestic savings and the inflow of external savings. But “volatile” external savings, which can cause trouble in the future, are not desirable. To attract “sound” external savings and to retain domestic savings, domestic actions must be taken. A sustainable balance of payments will then require controlling inflation, removing price distortions, and reducing inefficiencies in the use of resources. These are structural adjustments.
External and internal factors are directly linked. However, authorities frequently put too much emphasis on foreign borrowing and tend to forget the importance of domestic savings. Realistically, a developing country cannot generate sufficient domestic savings to finance its development effort; it has to attract foreign financing. The amount and degree of steadiness of the foreign financing will depend on domestic policies, among other factors. The purpose of the foreign financing and its conditions (in terms of maturity, interest rates, etc.) are also important. A country that depends on foreign financing for consumption will soon be in trouble. Recent events have clearly demonstrated that too heavy a reliance on external savings is dangerous. Also, if this reliance is too great, domestic efforts will weaken, and soon external savings will be required to cover even negative domestic savings. Thus, a coordinated effort is needed on both fronts.
Emphasis is usually put on building up international reserves. Actually, international reserves are a safety cushion, as well as a guarantee to attract external savings and investment for the foreign investor, because he knows that he can get his money back and for the local investor, because he knows that there is enough foreign exchange to finance imported inputs.
The first step in preparing a program is to identify the causes of the imbalance (for example, fiscal deficit, excessive credit expansion, slow growth due to an overvalued exchange rate, need for structural reforms), keeping in mind that programs are not like over-the-counter medicines; they must each be tailored to the specific problems and circumstances of the country. The objectives, which depend on the circumstances of the country, must be defined. They can be a balance of payments target, an inflation target, or a certain GDP growth rate.
A program is based on subsequent iterative rounds of calculations, because of the need to take into account the impact of different policy decisions. One may start, for example, with a certain assumption about inflation and growth of GDP, but because of other elements of the program, the price and/or GDP projection may have to be modified, which, in turn, can lead to additional modifications.
Financial programming assumes that private savings are a function of income and that private sector financial assets are a large component of private savings. Hence, the creation of private sector financial assets depends on national income and on the desire of the private sector to retain its financial savings in the country. This last component is more difficult to estimate, as it depends on many factors, including social and political considerations and perceptions. As a result, bank credit expansion affects the level of the net international reserves through almost automatic adjustments of the import level or private capital movements. Basically, the only financial assets that will remain in the country are those that the private sector is willing to retain. If bank credit expands more than the level allowed by the accrual of private financial assets to the financial system, the excess credit will not result in a higher level of real financial savings. In these circumstances, one of two alternatives may occur:
A. If it is an open economy, pressures will develop on the balance of payments in the form of rising imports and/or capital outflows, with a consequent decline in net international reserves. Pressure will increase on the exchange rate as international reserves are depleted.
B. If it is a closed economy, demand will rise, exceeding domestic supply, with a consequent increase in domestic inflation. It is even possible that private sector financial assets would increase in line with the projection, but in nominal terms, whereas in real terms they may drop sharply.
The program includes also the following identity:
MO = NIR + NDA + FL, and
NIR = MO − (NDA + FL),
MO represents the private sector financial assets with the financial system;
NIR represents the net international reserves of the financial system;
NDA represents the net domestic assets of the financial system; and
FL represents the other (long-term) foreign assets and liabilities.
The program’s objective is a balance of payments target (such as NIR) combined with an inflation target. The principal instrument for achieving that objective is control of domestic credit (NDA). Since the value of MO is a function of private income (and of the desire of the private sector to retain its financial assets in the domestic financial system), the variation of NIR will depend on the program. The change in FL can be estimated, as it is a policy decision; the model thus calculates an expansion of domestic credit that is consistent with the other variables.
Basically, the financial program becomes an exercise in projecting financial flows to and from the financial system. This projection takes into account elements such as export estimates; expected and/or desired rate of economic growth and, therefore, imports and private and state investment; inflation; and availability and use of foreign loans.
The model is based on the assumption that economic units do not necessarily use all the income at their disposal or, in other words, that income and expenditure are not necessarily equal at the level of each economic unit or sector. Financial transactions represent intermediation between units that save and those that spend. This transfer of financial resources is done mostly through the financial system, which is also the only economic unit of a country that may extend credit in excess of the resources accrued or of that which the community desires to save.
The importance of the financial system in the economy now becomes clear; it is the main sector that can intermediate between the sectors that are saving and those that are spending financial resources. This function of the financial system makes the economy more efficient. At the same time, internal inflationary pressures may be generated at the level of the financial system; if the financial system and its intermediary functions did not exist, there would be no pressure on demand that could not be satisfied by the market.
While it is true that the model basically consists of projections of financial flows in the financial system, to make these projections information is required that goes beyond the purely financial system accounts. In order to project private sector financial assets accruing to the financial system, one needs information on the expected rate of economic growth, inflation, balance of payments prospects, and incomes policies, as well as on legislation and the sociopolitical environment. If this information were ignored and the monetary projections were prepared in isolation, the estimates could be meaningless. Similarly, to project credit demand, the financing needs of both the public and private sectors, and the extent of access to foreign borrowing (and its consequences) must be known. In addition, recent developments must be analyzed to identify the factors that have caused the financial difficulties of the country. Only after all those pieces of the puzzle are collected and analyzed can the stabilization plan be prepared.
A Typical Negotiating Mission
A typical IMF negotiating mission consists of a mission chief, three to four economists—depending on the complexity of the case and the familiarity of the staff with the country—and a staff assistant. Each of the economists is assigned a sector, such as the real economy, nonfinancial public sector, financial sector, or balance of payments. Interaction among the members of the mission is critical to ensure that the same information is being used in analyzing developments, as well as to obtain consistency between the different elements of the program.
The first stage of the mission normally consists of collecting the most recent economic indicators, together with information that would assist in preparing the program. Considerable time is spent either by the mission as a whole or by individual staff members in collecting and analyzing data, discussing the findings and clearing doubts, questioning local officials, and drawing conclusions. This preliminary work is needed to understand what is going on in the country and to understand the constraints that the authorities may face and the broad policies they intend to pursue. These findingsare invaluable in selecting the instruments to achieve the objectives of the program.
Assume that a mission visiting a member country at the beginning of 1985 requests, and receives, data on fiscal operations, balance of payments, monetary statistics, as well as information on the real economy, as shown in Table 11. This example exaggerates certain data and relationships, while at the same time presenting a reasonably simple and easy case of negotiations and adjustment program. After reviewing this information and discussing its findings with the authorities, the mission makes its preliminary assessment of the situation of the country.
|Fiscal operations||(In millions of local currency)|
|Foreign loans, net||250|
|Central bank credit||300|
|Balance of payments||(In millions of local currency)||(In millions of dollars)|
|Capital movements, net||150||30|
|Change in net international reserves (increase −)||500||100|
|December 31, 1983||Movement in 1984||December 31, 198 4|
|Monetary accounts||Total||Central Bank||Other Banks||Total||Central Bank||Other Banks||Total||Central Bank||Other Banks|
|(In millions of local currency)|
|Net international reserves||800||700||100||−500||−500||—||300||200||100|
|Public sector, net||2,000||2,000||—||300||300||—||2,300||2,300||—|
|Liabilities to the private sector||9,500||2,850||6,650||500||150||350||10,000||3,000||7,000|
|(In millions of dollars)|
|Net international reserves||160||140||20||−100||−100||—||60||40||20|
|Legal (and actual) reserve requirements: 10 percent of the liabilities to the private sector|
|Exchange rate: L/C 5 = $1|
|GDP rate of growth in 1984: Real terms−1 percent; Current terms−5 percent.|
In this particular case, the mission would conclude that the rate of growth of GDP has been rather modest (1 percent). The balance of payments has shown a sharp overall deficit ($100 million), which was financed entirely by use of the net foreign assets of the central bank. As a result, these net foreign assets dropped from the equivalent of about 14 weeks of 1984 imports at the beginning of 1984 to only about 4 weeks’ worth at the end of the year. The current account deficit could not be financed by net capital inflows, in spite of foreign borrowing by the public sector ($50 million) to finance government investment. Private capital movements showed a net outflow, but the mission concludes that this outflow did not necessarily represent capital flight related to a drop of confidence in the currency, because private sector claims on the domestic banking system rose at a reasonable rate. However, the mission wonders whether this private sector attitude would remain unchanged if stabilization measures were delayed.
The fiscal deficit has required substantial central bank financing in addition to the foreign borrowing. Monetary statistics reveal that private sector claims on the banking system (PSFA) grew by 5.3 percent, or slightly faster than nominal GDP. The distribution of these resources between the central bank (currency in circulation) and the rest of the banking system remained unchanged, with the central bank’s accounting for 30 percent of PSFA at the end of 1984, or the same as at the beginning of the year. However, credit expansion by far exceeded these resources (representing 10.5 percent of the stock of PSFA at the beginning of the year), which resulted in the above-mentioned decline in net foreign assets. An investigation of the credit expansion reveals that it was generated almost entirely by the central bank, which, in addition to financing public sector operations (L/C 300 million), had also financed the private sector either directly (L/C 100 million) or through the banking system (L/C 285 million). Banks had complied with legal reserve requirements but had made extensive use of central bank credit. Total bank credit to the private sector expanded by L/C 700 million, or by 11.3 percent, which was well above the rate of growth of nominal GDP. The economy is reasonably open, and domestic prices increased by 4 percent, which is considered to be in line with inflation in the neighboring countries and in the trading partners.
The mission concludes from this review that fiscal and central bank policies must be tightened if the situation is to improve. At this point, the second stage of the mission would begin. The staff would discuss with the authorities the broad lines of an adjustment program (Table 12), as well as review the constraints that could affect preparation of such a program. This stage would call for an initial round of discussions and the collection of background data needed to prepare the program.
|Real GDP||+ 1 percent|
|Prices||+ 4 percent|
|Liquidity preference||+ 1 percent|
|Balance of payments target (increase in net international reserves)||$20 million|
|Exchange rate||L/C 5 = $1|
There is general agreement that the program should have as the main objective a $20 million increase in the net foreign assets of the central bank. It is recognized that such an increase is modest, given the decline that occurred in 1984, but the authorities consider that a more ambitious target would not be realistic. At the same time, given the critically low level of net international reserves, the mission insists that the program should aim at a balance of payments overall surplus, if confidence in the currency is to be retained. This argument becomes even more important when the authorities state that, for political reasons, they cannot accept a devaluation of their currency.
As background information, the mission, together with the local staff, estimates that real GDP could increase by 1 percent in 1985. A faster rate of growth is considered to be inconsistent with the proposed balance of payments outcome (which is likely to call for a drop in imports) and restrictive fiscal and monetary policies. Prices are projected to increase by 4 percent. The mission also receives data on the proposed budget for 1985 (Table 13), which envisages a deficit of L/C 500 million, to be financed by a net use of foreign loans ($60 million, equivalent to L/C 300 million) and central bank credit (L/C 200 million). Revenue is expected to increase by 5.3 percent, and the authorities are not contemplating adopting new revenue measures at this stage. Expenditure is projected to grow by 2 percent. On the monetary side, the authorities are not considering modifying the legal reserve requirement structure; they are planning to extend L/C 200 million of credit to the banks for relending to the private sector in addition to the contemplated credit to the public sector. However, they are planning to abstain from new net direct lending to the private sector (new credit is expected to equal the recovery of credit). The mission estimates that private sector financial assets accruing to the banking system could increase by 6 percent in 1985, on the basis of the projected growth in nominal GDP and a possible strengthening of confidence following the adoption of an adjustment program. In the external sector, exports are projected to increase by 5 percent; the mission also receives projections on interest payments on the public and private sectors’ external debt.
|Fiscal operations, 1985||(In millions of local currency)|
|Foreign loans, net||300||($60 million)|
|Legal reserve requirements (10 percent)|
|Credit to banks||200|
|Credit to public sector||200|
|Central Bank credit to the private sector||—|
|Change in other accounts||—|
|Balance of payments||(In millions of local currency)||(In millions of dollars)|
|Loans to public sector, net||300||60|
|Change in net international reserves (increase –)||−100||–20|
The mission assembles the data received into a monetary program (Table 14), and it concludes that the data provided are not internally consistent. Assuming that the distribution of private resources between the central bank and the rest of the banking system remains unchanged (and so far the mission has received no indication that would justify a different conclusion), the central bank resources would increase by L/C 222 million, in the form of currency in circulation (L/C 180 million), and there would be an increase in legal reserve holdings (L/C 42 million). To be consistent with the programmed increase in net foreign assets ($20 million or L/C 100 million), central bank credit could expand by L/C 122 million. However, according to the authorities, credit demand was projected at L/C 400 million (L/C 200 million each to the public sector and to the rest of the banking system).
|Initial Projection||Final Projection|
|Total||Central bank||Other banks||Total||Central bank||Other banks|
|Monetary accounts||(In millions of local currency)|
|Net international reserves||1001||1001||—||1001||1001||—|
|Public sector, net||200||200||—||110||110||—|
|Liabilities to private sector||600||180||420||600||180||420|
|Fiscal accounts||Initial Projection||Final Projection|
|(In millions of local currency)|
|Foreign loans, net||300||300|
|Initial Projection||Final Projection|
|Balance of payments||L/C (millions)||$ (millions)||L/C (millions)||$ (millions)|
|Imports and net services||—||—||−2,4252||−4852|
|Change in net international reserves (increase −)||−100||−20||−100||−20|
|Flow of funds||Total||Public Sector||Private Sector||Banks|
|(In millions of local currency)|
|1985 Initial Projection|
|1985 Final Projection|
The mission concludes that central bank credit expansion should be limited to L/C 122 million to be consistent with the projected increase in net foreign assets, an inflation target of 4 percent, and the broad framework of policies (unchanged exchange rate and legal reserve requirements). These preliminary conclusions are presented to, and discussed with, the authorities. The mission also points out to the authorities that credit expansion could be higher, but in this case, one or more of the above assumptions would have to be modified.
Given the depletion of the net foreign assets of the central bank and the desire of the authorities to retain the present exchange rate, the balance of payments and inflation targets of the program are considered to be non-negotiable. It is, therefore, concluded that additional measures are needed to achieve the program objectives. At this stage, the mission would review with the authorities the different supply and demand management policy alternatives at their disposal, stressing the advantages and disadvantages of each instrument.
The mission reviews with the monetary authorities their credit plans. The mission points out that, under present plans, credit to the private sector would expand by L/C 578 million or by 8.9 percent—a credit expansion that would not be consistent with the expected growth of economic activity, and which would make it difficult to achieve the desired balance of payments objective. The central bank agrees to reduce its credit plans to the banks from L/C 200 million to L/C 160 million. To increase resources at the disposal of the central bank and to limit credit expansion to the private sector, the mission proposes, and the authorities accept, an increase in the legal reserve requirement to an average of 12 percent from 10 percent. Alternatively, the mission could propose open market operations, if such a market is already established. In this case, provisions should be made in the program for payment of interest on the central bank papers. The 2 percentage points increase in legal reserve requirements (from 10 percent to 12 percent) would yield L/C 148 million of additional resources to the central bank and could be achieved either by increasing legal reserves to 12 percent (on the basis of the stock of total bank deposits of L/C 7,420 million projected at the end of 1985), or by introducing a marginal reserve requirement of 35.2 percent on increases in bank private deposits in 1985 (or on L/C 420 million). Concomitant with this decision, the mission and the authorities agree to revise the interest rate structure to reduce private sector credit demand, encourage accrual of private sector savings to the banking system, and safeguard the financial viability of the banking system. The revised bank credit expansion to the private sector (L/C 390 million) would be about 6 percent, which would be consistent with the expected growth of economic activity. On the basis of these actions, the resources at the disposal of the central bank, and their expected use, are now estimated as follows:
|(Millions of L/C)|
|Currency in circulation||180|
|Increase in legal reserve requirements||190|
|Increase in net foreign assets||100|
|Central bank credit to banks||160|
|Central bank credit to public sector||200|
It is obvious that additional measures are still needed to achieve the objectives of the program. The mission would now review the fiscal plans, seeking to agree on a package of revenue and expenditure measures to reduce the fiscal gap by L/C 90 million. On the revenue side, tax measures and revision of state enterprise prices and tariffs are identified as capable of yielding L/C 70 million of additional revenue. This implies that public sector revenue would increase by about 9 percent in 1985. On the expenditure side, the authorities agree on some cuts, equivalent to L/C 20 million. Greater cuts are ruled out by the authorities on the grounds that the local counterpart for use of foreign loans and payments for interest cannot be reduced. On this basis, expenditure is projected to increase by 1.2 percent in 1985. This projected reduction of the fiscal deficit would allow for a reduction of central bank credit to the public sector by the needed L/C 90 million. On this basis, the monetary program can be finalized.
Regarding the balance of payments, the mission assumes that the expected limitation on credit expansion and the revision of the interest rate structure will result in neutral private sector capital movements. By assembling the available data, it appears that $485 million will be available for imports and net payments of other services, compared with $560 million in 1984.
The next task of the mission is to ensure that all the elements of the program are consistent with the main parameters—that is, to ensure that the projected level of imports, credit to the private sector, and tax and public spending policy are consistent with the anticipated 1 percent rate of real GDP growth. If the mission should determine that these projections are consistent with a lower rate of growth, all projections would need to be revised—or the program modified, if the authorities cannot accept a lower growth rate—to agree with the new, lower rate of GDP increase. Thus, in successive rounds of projections, the mission will ensure that the program is internally consistent.
The mission will also discuss the timing of the adoption and implementation of the agreed measures, as well as all other structural changes (such as import tariff revisions, improvements in tax administration, strengthening of bank supervision, control of the operation of state enterprises) that would be needed to ensure that the program can be delivered and achieve the desired objectives. Also, it is important to agree on several periodic checkpoints, to ensure that the program is on track and/or to provide early warnings for adoption of additional compensatory measures in the event that deviations should emerge or certain agreed measures should yield less than anticipated. The mission should endeavor to reach preliminary understandings with the authorities on the scope and nature of these possible additional measures.
The above example refers to a country that is facing an immediate crisis, such as a serious balance of payments deterioration, with a sharp drop in its net international reserves. In these circumstances (unfortunately, encountered too often), discussions with the authorities would emphasize measures that are aimed at addressing the immediate crisis. Several of those measures would be of an emergency type and, therefore, are likely to provide only a temporary respite. Nevertheless, if implemented, they would assist in overcoming the immediate crisis, while giving the authorities time to define and implement more lasting measures.
As mentioned in Section IX, such an approach would not be sufficient to solve the country’s imbalances, and the stabilization plan would need to be followed by a well-coordinated and comprehensive plan of action to consolidate, and to build on, the medium-term gains expected to be achieved under the stabilization plan. The mission should explain to the authorities the importance of such a longer-term view. This would call for understandings on the main financial variables over the medium term, as well as a definition of the policies to achieve these objectives. In this regard, identification of structural reforms, and of the timetable for their implementation, will play a key role.