The Euro-Area Crisis
Weighing the options for unconventional International Monetary Fund interventions.
What started in the fall of 2009 as a fiscal crisis in a smaller European economy -- Greece, which accounts for just 2 percent of the total euro area's gross domestic product (GDP) -- has evolved into a systemic crisis of the eurozone. This crisis now threatens not only to cause a meltdown of the entire European economy but also to destroy the social and political fabric that several generations of European leaders have worked to create over the last few decades.
While national governments are primarily responsible for the unfolding of the current events in Europe, the incomplete architecture of the euro area has created unprecedented scope for contagion by exposing each member of the monetary union -- albeit to varying degrees -- to the vulnerabilities of other members.
Italy is a case in point. The sluggish growth of its economy and its high (and increasing) stock of public debt are not new phenomena, but the crisis of the peripheral economies has provided the trigger for market investors to focus on Italy's long-run ability to service an increasing debt pile.
What started in the fall of 2009 as a fiscal crisis in a smaller European economy — Greece, which accounts for just 2 percent of the total euro area’s gross domestic product (GDP) — has evolved into a systemic crisis of the eurozone. This crisis now threatens not only to cause a meltdown of the entire European economy but also to destroy the social and political fabric that several generations of European leaders have worked to create over the last few decades.
While national governments are primarily responsible for the unfolding of the current events in Europe, the incomplete architecture of the euro area has created unprecedented scope for contagion by exposing each member of the monetary union — albeit to varying degrees — to the vulnerabilities of other members.
Italy is a case in point. The sluggish growth of its economy and its high (and increasing) stock of public debt are not new phenomena, but the crisis of the peripheral economies has provided the trigger for market investors to focus on Italy’s long-run ability to service an increasing debt pile.
Escalating market pressure has led to the formation of an emergency cabinet led by economist Mario Monti, charged with the task of pursuing an ambitious reformist agenda (see Box 1). Meanwhile, the 1.9 trillion euros of Italian public debt — equivalent to 120 percent of its GDP — serves as a harsh reminder to the finance ministries in Europe and abroad of the unpredictable consequences a potential fallout of a country like Italy could have on the global economy.
Given the sheer size of Italy’s debt, existing instruments — such as financial assistance programs via the European Financial Stability Fund (the European rescue fund) and the International Monetary Fund (IMF) — are inadequate as a financial backstop due to the limited lending capacity of both institutions. Acknowledging this limitation, EU leaders committed to "consider…the provision of additional resources for the IMF of up to 200 billion euros ($270 billion)" with the idea that the international community could provide matching funds "to ensure that the IMF has adequate resources to deal with the crisis."
Meanwhile the European Central Bank (ECB) has tried to address the crisis through a number of unconventional instruments, although it has fallen short of serving as a proper lender of last resort — a role outside of its mandate. At the end of June 2011, the ECB extended the liquidity swap arrangement with the U.S. Federal Reserve to provide U.S. dollar liquidity to euro-area banks unable to access the interbank dollar market. In October, the ECB announced that by year-end it would conduct two supplementary 12-month refinancing operations to keep liquidity abundant for a longer period, which were supplemented in December by the unprecedented introduction of three-year liquidity refinancing operations.
Following escalating market pressures in Italy and Spain over the summer, the Eurosystem reactivated the Securities Markets Programme in August by intervening for 206.9 billion euros (as of the week ending Dec. 2). Unofficial reports from trading desks suggest that approximately 65 percent has been spent to buy Italian government bonds, 30 percent to buy Spanish bonds, and the remaining 5 percent for Irish and Portuguese bonds. While the ECB has not disclosed how long it intends to continue the program, it is reasonable to assume that it may plan to do so until adequate safety nets are put in place.
Following the EU Summit of Dec. 9 (see Box 2), the strategy that the European leaders are using to stabilize the euro crisis can be articulated in three different layers: The first one is provided by the corrective measures to be enacted by euro area national governments in the context of sharpened EU surveillance and disciplining sanctions; the second layer, or line of defense, is offered by a potential financial firewall that a stepped-up IMF can erect around the vulnerable sovereigns of the euro area, such as Italy and Spain, through lending programs with conditionality; and the third and last line of defense would be the ECB itself, which would take the burden of any residual systemic pressures that the two previous layers would be unable to stabilize.
In light of these considerations, the aim of this paper is to review policy options that the international community could implement by strengthening the second line of defense, which hinges on an enhanced role for the IMF. These options all presuppose that the euro area as a whole will develop a credible and comprehensive strategy to address the systemic crisis effectively. However, given the credibility gap of European leaders in effectively resolving the current crisis, a quasi lender of last resort and a seal of approval by the international community would still be needed to stabilize markets and contain lingering uncertainty — even after a credible plan is eventually finalized. Following that, the options presented — admittedly, some are highly unconventional and require further technical and legal appraisal — could be leveraged to prevent contagion to the rest of the global economy and the international financial system.
This paper also aims to more broadly explore the role of the IMF in systemic financial crises in general by underscoring the need to better align the institution’s policy toolkit in the context of a truly global monetary and financial system. In this respect, the IMF’s current financial capacity offers an inadequate backstop against a systemic event that would prompt larger sovereigns such as Italy to request an IMF rescue package.
As of Dec. 1, the IMF’s forward commitment capacity stood at SDR (Special Drawing Rights) 251 billion — approximately $390 billion or 290 billion euros. However, in 2012 alone, Italy’s Treasury will need to rollover approximately 286 billion euros worth of debt set to expire throughout the year. Below we explore the institutional feasibility of various options that could be explored to enhance the IMF’s financial firepower while taking into consideration the accompanying risks and institutional constraints for the Fund and its members.
IMF Trust and Administered Accounts
In its 66 year history, the financial organization of the IMF has evolved to meet the ever-changing needs of the global economic and financial system. In doing so, the organization has offered a relatively wide spectrum of options in terms of risk and flexibility in the deployment of the financial resources made available by its international membership.
To date, the IMF’s financial organization includes three key departments: the General Department, the Special Drawing Rights Department, and the Trust and Administered Accounts Department. The majority of the IMF’s financial transactions with members are handled within the General Department, specifically the General Resources Account (GRA). The latter is financed mostly from members’ capital subscriptions to the IMF and is subject to the strictest safeguards in terms of the IMF’s own oversight. In case of default by a borrowing country, IMF-related claims would have privileged creditor status, while any residual burden would be shared by the membership in proportion to their quotas.
The Trust and Administered Accounts Department is the least well-known of the three departments. The establishment of an account in the Trust and Administered Department requires executive board approval by a simple majority. The legal authority for the IMF to establish such accounts is based on Article V, Section 2b, of the Articles of Agreement:
"If requested, the fund may decide to perform financial and technical services, including the administration of resources contributed by members that are consistent with the purposes of the fund. Operations involved in the performance of such financial services shall not be on the account of the fund. Services under this subsection shall not impose any obligation on a member without its consent."
As their financing includes voluntary resources that are independent on IMF capital subscriptions as well as the institution’s own resources, trust and administered accounts are legally and financially separate from the IMF’s General and SDR Departments. They provide for a wide spectrum of accounts, ranging from those involving heavier executive board involvement (trust accounts) to those preserving substantial discretion of contributors (administered accounts).
Up until now, trust and administered accounts are known mostly for their role in providing resources to low-income members of the IMF. Beginning in the 1970s, the institution recognized that these members needed financial assistance on a concessional basis. This led to the establishment of the first trust account-the Trust Fund — within the IMF, in 1976. The Trust Fund was financed solely from IMF profits generated from gold sales — providing $3.3 billion for concessional loans. The original Trust Fund terminated in 1981; however, over the past 30 years other such arrangements have been established to provide assistance to low-income countries or members with special needs with resources from both IMF profits and bilateral member contributions. Examples include the Poverty Reduction and Growth Facility Trust (1987-2009); the more recent Extended Credit Facility (2009-present); and the joint IMF-World Bank Heavily-Indebted Poor Countries debt-relief initiative (1996-present).
There are some key differences between trust and administered accounts. In the case of trust accounts, the executive board regularly overviews the allocation of their underlying resources. Typically, this entails board appraisal of a proposed lending program with its conditionality framework, as well as regular reviews of a member’s performance with respect to the latter.
Administered accounts involve a lighter role for the IMF’s executive board while preserving the greatest discretion to the contributors of the account. The first such account was created in 1989 following a request from Japan that the IMF set up a pool of resources to assist members with overdue financial obligations to the fund. The IMF acted as the trustee and the resources — made available by Japan and other countries — were distributed in amounts determined by Japan and the other members that Japan had identified.
In the context of the euro-area crisis, the creation of similar trust or administered accounts would provide a rapid response mechanism and increase the financial resources that could be mobilized under the IMF umbrella. By potentially providing unprecedented latitude, the IMF could use those resources in a highly precautionary manner, even by intervening in secondary markets to stabilize bonds prices, subject to the parameters set by the contributors to the trust and administered accounts.
The unparalleled flexibility potentially afforded by these accounts would allow the IMF to develop a full-fledged regional approach to the euro crisis by rapidly reallocating resources across national markets with the objective of stabilizing the euro area. The accounts could also be used as "equity" in a "vehicle," which would then be leveraged to increase its overall financial capability.
While the IMF would be serving as a coordinating agency for these accounts, this "pooling" function would be broadly consistent with the traditional catalytic role that the institution has been typically acknowledged to provide — albeit, in this case through highly unconventional instruments. Trust and administered accounts would also allow the contributing membership to leverage on the highly sought-after staff expertise of the IMF. In the case of trust accounts, this would include the fund’s immunities and privileges, including its status as a privileged creditor. To date, trust claims have been recognized as having preferred-creditor status by the Paris Club and other creditors, although that could conceivably change, particularly if a trust were to engage in lending decisions quite different from standard IMF programs.
In the case of administered accounts, however, any default risk would be borne out exclusively by contributing members. Related claims have, in fact, never been given preferred-creditor status, even when all they did was disburse resources alongside an IMF program — as in the case of the Spanish-administered account attached to the Argentina program in 2000-2001.
Special Drawing Rights (SDRs)
Special Drawing Rights were established in 1969 to support the then prevailing Bretton Woods fixed exchange rate system. The SDR is an international reserve asset and can be thought of as a potential claim on the freely usable currencies of IMF member countries. Since their creation, SDRs have played a limited role in the international monetary system. However, in the context of the current challenges facing the global economy, they represent a potentially useful policy option that warrants further examination.
SDR allocations have to be agreed on by a supermajority of IMF members representing at least 85 percent of the institution’s total voting power. Allocations of SDRs are typically in proportion to the quota held by each member country and are determined on the basis of a long-term global need to supplement existing reserve assets. Since their creation, the IMF membership has voted in favor of allocations just four times — the last two of which were in response to the 2008 global financial crisis. In August 2009, following a G-20 endorsement, a general allocation of SDR 161.2 billion or $250 billion was implemented. An additional special allocation for SDR 21.5 billion (about $33 billion) was also approved. Currently, the overall stock of SDRs issued totals SDR 204.1 billion or $322 billion, representing approximately 3.1 percent of total world non-gold reserves as of September 2011.
The IMF membership could decide on a general allocation of SDRs as a way to provide confidence and generate additional financing that could be partially mobilized toward the euro-area crisis. This would provide an important relaxation of the constraints currently complicating the financing of the European rescue fund — the EFSF. Since the rescue fund relies on guarantees provided by the euro-area member states through their respective treasuries, any step up in the guarantees to the EFSF triggers a corresponding increase in the contingent liabilities to be borne out by that member’s public-sector budget. For France, this could entail losing its AAA rating status.
If approved, the SDRs allocated to member countries through their fiscal agents — typically, national central banks — could be mobilized to this purpose, thus relaxing the constraint on the public-sector budget. Operationally, euro-area member countries could use their SDRs to provide a guarantee to an EFSF’s "vehicle," which could in turn leverage such guarantees in order to further expand its financial capability.
Such an arrangement, where euro-area members use their SDR allocations to guarantee a vehicle, would bear zero cost for the guarantors as long as the SDRs were not called upon. If the guarantee was triggered, and assuming the counterpart was a non-official sector entity, then the SDRs would need to be exchanged with assets denominated in any freely usable currency, such as the euro. The transaction would trigger an "open" position in SDRs for which euro-area members would bear a cost equal to the SDR interest rate, which is indexed to money market rates. For the week of Dec. 5-11, the SDR annual interest rate stood at 0.15 percent, while yields on Italian one-year bonds stood at 5.33 percent, on Spanish bonds at 4.17 percent, and on French bonds at 0.66 percent.
A general allocation would provide euro-area members with SDRs in proportion to their quotas (they together hold 23 percent of total IMF quotas), which could be used in the way described above. This would also allow some smaller, developing economies to increase their liquidity buffers as a protection against global liquidity shocks that might arise if market turmoil continued. Other members, in particular those with large reserve assets, could join a "pool of the willing" by exchanging their SDR allocations to buy euro-denominated bonds issued by the vehicle described above. These euro bonds would yield some percentage on an annual basis, which would be a multiple of the SDR rate charged on the "open" SDR position. To give an idea, currently EFSF bonds yield approximately 3.5 percent against the SDR rate of 0.23, which an IMF member would be charged in "opening" its SDR position. Moreover, assuming that such members would have diversified in euros anyway, they would not need to hedge against exchange rate exposure.
Yet such a special issuance would pose substantial redistributive questions within the membership of the IMF. It would also cause non-negligible procedural problems, as it would require an amendment to the IMF’s Articles of Agreement, for which a supermajority of "three-fifths of the members, having 85 percent of the total voting power" would be needed. To illustrate how arduous such a task would be, the latest quota reform package endorsed by G-20 leaders in Seoul in November 2010 and approved by the IMF board of governors one month later may not be ratified in time for the agreed-upon deadline of fall 2012. After almost a year, only slightly fewer than 25 IMF member countries have ratified the amendments embedded in the quota and governance reform package.
IMF’s Contingent Facilities — The "Expanded" New Arrangements to Borrow
For the IMF to be better equipped to handle the crisis in the eurozone, and more generally to fulfill its mandate to safeguard the stability of the global economy, its financial capacity must be enhanced.
In many ways, the IMF has been here before. Similar to today, the resources available to the IMF in the 1990s were considered inadequate to meet the challenges of the global economy. In response, the New Arrangements to Borrow (NAB) was established in 1998. Originally, the NAB was a credit arrangement between the IMF and 25 member countries in which supplementary resources would be made available to the fund in order to "cope with an impairment of the international monetary system or to deal with an exceptional situation that poses a threat to the stability of that system." When established, the NAB provided for SDR 34 billion (equivalent to about $51 billion) of available resources. However, in response to the 2008 global financial crisis, the "expanded" NAB came into effect on March 11, 2011, increasing the available resources to SDR 367.5 billion (approximately $580 billion). Participation in the expanded NAB was enlarged to 39 countries and institutions, including the large emerging markets of Brazil, China, India, Mexico, Russia, and South Africa.
The aim was to provide an immediate financial backstop, since a corresponding increase in the IMF’s permanent resources through quotas would take time to materialize. The NAB increase would be scaled back once the increase in the fund’s own resources would come into effect at the 2012 annual meetings. At that time, it is expected that the doubling in quotas from around SDR 238.4 billion to around SDR 476.8 billion ($767 billion) will kick in, assuming timely ratification by the membership.
In order to serve as a more effective crisis prevention tool, the expanded NAB allows for any type of GRA financing for all IMF member countries. Unlike in the case of resources entrusted to the IMF via a trust or administered account, NAB resources are a "loan" to the GRA. As such, the IMF and its full membership will bear any risks associated with their use, as well as the privileged-creditor status attached to those resources.
The enhanced NAB also provides more flexibility than the original arrangement, which could only be used on a loan-by-loan basis. As it now stands, the managing director of the IMF proposes an activation period — limited to a maximum of six months — and specifies the maximum amount of aggregate calls on the participants under credit arrangements. Activation only takes place when the IMF’s capacity to make commitments from quota-based resources is expected to fall short. The NAB is activated when: 1) it is accepted by 85 percent of the voting power of its contributing participants eligible to vote and 2) after which, it is approved by the IMF executive board.
Just over a month after the expanded NAB took effect, the IMF formally completed the process to activate the new borrowing arrangement for a period of six months in the amount of SDR 211 billion (about $333 billion), which was recently renewed.
To preserve a more substantial financial role for the IMF, consideration should be given to keep the size of the contingent facility at levels comparable to the current size. Such resources would need to be activated subject to the provisions set forth above.
The difficulties the Europeans are experiencing in handling the euro-area crisis highlight a potentially greater role the IMF can play. In line with its mandate as overseer of the international monetary and financial system, the IMF has a unique set of strengths to offer: Its staff has relevant crisis management skills that the Europeans lack; it has a surveillance mandate whose credibility is by far greater than the EU regional mechanisms; and finally, it has a lending role that is especially relevant given that that the euro area lacks a lender of last resort and the EFSF has a very limited financial capacity. Moreover, the IMF’s lending role generally comes with a "seal of approval" given to the policies that the institution intends to support by enhancing their credibility. As it stands, the IMF’s current credit capacity is, however, limited, but the institution boosts a global membership whose support and resources can be leveraged for the IMF to play a more effective role in this systemic crisis.
We have outlined a number of options that could boost the IMF’s ability to play a stabilizing role by increasing its financial size but also by broadening its range of instruments. A prerequisite to the feasibility of these proposals is for the Europeans to finalize a credible strategy that would offer comfort to the IMF membership. In turn, the IMF could exert an important role in clarifying the broader stabilizing framework in cooperation with the Europeans and in exchange for its financial interventions. At the current stage of the crisis, it seems extremely unlikely that the Europeans will be able to do without the IMF, given the relatively low credibility that financial markets attach to any further policy announcement or action coming from them.
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