December 2, 2008
HP-1307

Deputy Assistant Secretary Sobel Remarks on the Global Financial Crisis and the IMF’s Response

Thank you for this opportunity to speak about the global financial crisis and the IMF's response. The IMF is also facing a critical juncture in implementing its agenda for institutional reform, and I would like to touch today on this subject as necessary changes underway in the IMF will require Congressional support.

The Evolving Role of the IMF

The IMF is a vital and necessary institution for international monetary cooperation.  The need for such cooperation and the rationale for the Fund's existence is every bit as strong today as it was in 1944, when the IMF was created in the aftermath of the Depression, protectionism and beggar-thy-neighbor currency policies, and World War II.

Throughout its sixty-year plus existence, the Fund has well served the global financial community.  It helped Europe and Japan achieve sustained growth and liberalization in the post-war period.  After the demise of the Bretton Woods System, it helped resolve the Latin American debt crisis of the 1980s, support economic transition in Eastern Europe and the former Soviet Union in the 1990s and address the Asian and emerging market financial crisis late in the 1990s and earlier this decade.   The Fund has supported low-income countries, and provided significant debt relief to the Heavily Indebted Poor Countries. 

This is a record of success and all along the way, through bipartisan backing in the United States, the IMF's efforts have been consistent with the U.S. interest in promoting strong macroeconomic and financial policies around the globe.  Recent events vividly demonstrate that the global economy has not outgrown the need for international monetary cooperation.  Instead, they remind us that the world needs a nimble and well-equipped IMF.

The Global Financial Crisis

We are in the midst of a deep global financial crisis, one that historians will analyze for decades to come.  Against this background, I will only focus on two points about the crisis in order to tee up my discussion about the Fund's role in it.

First, at the outset of the crisis, economic performance in many of the leading emerging market economies remained robust.  This remarkable performance was testimony to years of hard effort in many countries to put in place sound macroeconomic frameworks and institutions.  However, as global de-leveraging has accelerated in recent months with a significant retrenchment in risk appetite, on top of sharp declines in commodity prices, emerging markets have increasingly been impacted and in some cases significant weaknesses exposed.  Their outlooks for growth and trade have been substantially pared back and external financing has become increasingly difficult and stressed.  

Second, the recent Declaration of the Leaders of the Group of Twenty includes a blunt section on the root causes of the crisis.  It notes that amid a period of remarkable stability and large-scale capital flow earlier this decade, market participants reached for yield without exercising proper due diligence or comprehending the risks they were taking.  Financial firms also engaged in unsound risk management practices, products became more opaque and complex, and policy-makers, regulators, and supervisors failed to keep pace with these changes and the excessive leverage and risks building up in the system.  Global imbalances were an important backdrop with their correspondingly large build-up in foreign exchange reserves.    

The Role of the IMF in Response to the Current Crisis

These two points underscore that the IMF, given its unique role as a balance of payments lender and its global mandate for macroeconomic and financial surveillance has critical responsibilities in responding to the crisis.  Let me turn to each.

Crisis Lending

With the crisis increasingly affecting emerging market economies, the IMF is reprising its role as crisis lender and has moved quickly to use its existing tools creatively and flexibly, and to adopt new tools, when necessary.  This is to be welcomed.  It is important that the IMF help members facing legitimate needs, and the Fund should respond flexibly in doing so.

In Hungary, Ukraine, Iceland and Pakistan, concerns about large current account deficits and external sustainability predated the crisis.  As capital flows reversed in the current crisis, these vulnerabilities, particularly in Hungary, Ukraine and Iceland, translated into enormous balance of payments financing gaps.  The IMF responded in each case with lending through a Standby Arrangement, the Fund's workhorse financing tool that can be quickly implemented via "emergency procedures" and expanded in magnitude under certain circumstances via the Fund's "exceptional access policy."  Stand-by arrangements include a commitment by each country to undertake key policy measures necessary to address underlying vulnerabilities.

The Fund has worked in close consultation with a number of additional countries that are also susceptible to balance of payments pressures due to some combination of large current account deficits, inflexible exchange rate regimes, and large foreign exchange-denominated credit exposures.  The Fund has publicly indicated it has held discussions with Turkey, Belarus, Latvia and Serbia. 

Other countries have performed very well in recent years and are fundamentally sound, but they are now facing weaknesses due to tight liquidity conditions.  Such countries would not necessarily require the combination of financing and policy adjustment comprised by a traditional Standby Arrangement.  But they could need liquidity to tide them over for a several month period.  In anticipation of potential member needs along these lines, the IMF recently created a Short-Term Liquidity Facility, to provide such members with large-scale, three-month loans on the basis of preceding strong policy performance indicating the financing difficulties are not home grown.  

With the IMF now back in the lending business amid this deep crisis and after a lull in recent years, there has been some public speculation about whether the IMF might need a massive increase in its capital. 

A few months ago, the IMF had about $200 billion in loanable resources from its normal "quota-based" resources, plus an additional $50 billion as a backstop in times of need, for a total of $250 billion.  In addition, Japan has recently offered to provide a further $100 billion on a temporary basis to help ensure that IMF resources are adequate, consistent with the Fund's ability to borrow supplemental resources from its members. 

Prior commitments and those in recent weeks to Ukraine, Hungary, Iceland and Pakistan, total on the order of $50 billion, still leaving $200 billion for additional lending under Standbys or the new Short-Term Liquidity Facility.  There could be prospective commitments that are significant in the near term, perhaps of a similar order of magnitude, but the jury is out.  Potential demands on the Short-Term Liquidity Facility are difficult to gauge.

Our view is that the IMF is well positioned to meet prospective demands from its quota resources.  This is not to imply that we should be complacent.  History tells us that the unexpected happens and one must prepare contingency scenarios, especially for downward deviations from the baseline scenario.  In their Declaration, G-20 Leaders recognized that resource adequacy of the IFIs needs to remain under close review and that resources should be increased if necessary.  We completely agree.  If a need for additional resources is asserted, though, it will be important for the IMF's leadership to make a credible case to shareholders as to why more money is needed and for what purposes.  Further, should such a demonstrated need arise, we think there is a strong chance the need would be temporary, stemming from a once-in-a-generation financial crisis, and thus we think there would be a good case for relying on temporary funding rather than a permanent quota increase.  

Strengthening the Global Financial System

Another aspect of the IMF's crisis role revolves around global efforts to repair regulation and financial systems and the Fund's proper role.

For many years, the IMF has played an active role on this front.  The IMF's Financial Sector Assessment Program (FSAP) has provided invaluable insights to countries around the world with respect to their implementation of standards and codes, stresses faced by their financial systems, and other aspects of regulatory regimes.  Indeed, the United States agreed prior to the onset of the current crisis to undergo a FSAP.  It is expected to be undertaken in the run-up to the 2009-2010 U.S. Article IV review, and the United States is already in discussion with the Fund on the components.  The IMF's semi-annual Global Financial Stability Report is a flagship publication, offering insightful commentary on current conditions and vulnerabilities in the global financial system.  IMF Article IV bilateral surveillance reports typically cover financial sector issues.  IMF programs have often sought to tackle weaknesses in countries' financial system and ensure that they remain strong or are restored to health.  This is a rich and invaluable body of work. 

Regulation is a national activity, and sound regulation begins at home.  But today's markets are global in scope. Also, regulation is generally micro-prudential in nature, yet the sum of the parts of micro-prudential actions clearly can and does have macro-economic and systemic ramifications.  So, how does one square these circles?   One answer might be to have a new international treaty establishing a global regulator and supervisory body.  Yet, in a world in which the nation-state remains the dominant geopolitical actor, it is unlikely that countries would cede regulatory authority to a supra-national authority. 

Hence, there is a far greater need for international cooperation among national regulators and for strengthening our understanding of the interface between micro-prudential and macro-prudential issues.  Such cooperation is needed to ensure more effective and consistent regulation to protect against adverse cross-border developments affecting global stability and negative spillover effects from one country to another.

The good news is that there are many standard setting bodies (SSBs) where national regulators meet to advance international cooperation – the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, the International Association of Insurance Supervisors, to name just a few.  These groups work on micro-prudential regulation and they have intensified their work since the onset of the crisis. The Financial Stability Forum (FSF), created in the wake of the Asian crisis, also acts as an informal hub, pulling together much of the work of standard setting bodies. It has played a very strong role in advancing the international regulatory agenda, particularly since September of 2007, when the G7 countries set forth many tasks for the FSF to coordinate. 

The IMF, while lacking a mandate in regulating financial sectors, clearly has a leadership role in macroeconomics and financial sector surveillance and must contribute to making the global financial system stronger and more secure.  To that end, it is critical for the future of international financial stability that these micro- and macro-prudential perspectives are successfully woven together.  Against this background, the United States welcomes and supports the recent agreement between the IMF and FSF to enhance their collaboration and clarify their respective roles in this process, consistent with their mandates.  This agreement, in particular, underscores that:

• The IMF has the lead on surveillance of the global financial system through its important role in FSAPs, standards, and Article IVs.
• The elaboration of international financial sector supervisory and regulatory policies and standards, and coordination across standard setting bodies, is the principle task of the FSF, and the IMF participates in this work and provides input as an FSF member.
• The IMF and the FSF will together cooperate in conducting early warning exercises.

In short, strong IMF-FSF-SSB collaboration, teamwork and respect for individual mandates, is a pragmatic and sound answer for squaring the circle.  The IMF's role in this regard is absolutely vital.  Also, to enhance the global legitimacy of the FSF, its membership needs to be broadened on an immediate basis.

The recent Declaration of the Leaders of the Group of Twenty focused heavily on tackling regulatory weaknesses to minimize the chances of a repeat of another crisis.  There is much good work underway and much more to do. 

IMF Reform Agenda 

It is essential to the health and resilience of the global economy that the IMF adeptly carry out these crisis-related roles, but it is equally important that the IMF continue root-and-branch reforms to modernize itself and retain its relevance and legitimacy to the international system.  This point, as well, was underscored by the Leaders of the G20.

The United States has been a strong proponent of the IMF, but we have not shied away from insisting on vigorous institutional reform.  The Administration has sent legislation to Congress in order to implement reforms – reforms that the United States has strongly backed in international discussions – and I would like to take this opportunity to touch on this issue.   

Evolving its Mission

First, for the IMF to remain vital, its mission needs to evolve and not just on the global financial crisis.  

We well appreciate that exchange rate determination is an inherently complex subject and that exchange rates reflect a host of macroeconomic and microeconomic forces in an economy and the global system.  Over the years, the Fund has done an outstanding job in its surveillance work on fiscal and monetary policy issues.  Exchange rate analysis had not been conducted with the same vigor, yet it is one of the Fund's most basic tasks to exercise firm surveillance over a member's exchange rate policy.  Last year, the Fund recognized the need to intensify its efforts and updated its 30-year old exchange rate surveillance decision.  Since that time, the analytical quality, focus and depth of the Fund's exchange rate work has improved significantly.  But as stated in a Treasury report to Congress in August, the vital task of making tough judgments and increasing candor and clarity on external stability and exchange rate issues has not yet met with the same success.^[1]  The IMF itself echoed this finding in its recent Triennial Surveillance Review.  We look forward to further progress.

Another area where the IMF has sharpened the focus of its mission is on promoting global financial stability and openness to international investment through its work on sovereign wealth funds.  The recent agreement by the International Working Group of Sovereign Wealth Funds on a set of Generally Accepted Principles and Practices (GAAP) was an important and welcome step forward and a credit to the IMF's role as a facilitator. 

In addition, macroeconomic stability is a necessary but not sufficient condition for growth in low-income countries, and the Fund has a vital role to play in this regard through its policy advice, technical assistance, and lending as appropriate. The IMF has adapted its tools to better meet the needs of its low-income members.  It has strengthened its advice on policy responses to scaled up aid, and food and fuel price volatility.  And it has helped break the cycle of over-dependence on Fund lending by providing deep debt relief to highly-indebted poor countries, implementing a new Debt Sustainability Framework, and introduced a non-borrowing "Policy Support Instrument" to untie intensive policy engagement from IMF borrowing. 

Governance Structure

The second major area for reform is the IMF's governance structure. The United States has long recognized that the Fund's governance structure does not reflect the realities of today's global landscape and we have been a leading advocate for reforming the IMF's voting weights to reflect the rise of dynamic emerging markets. 

The quota reform deal secured last April, in which the United States played a key leadership role, is a useful first step, although we would have preferred to see greater ambition and change. 

• The reform package includes a new formula for determining country quotas.  It will give significantly more weight to GDP and thus better reflect countries' relative weights in the global economy. 
• The reform also includes a tripling of "basic votes" which will boost the voice of the poorest countries. 
• Finally, the package includes a targeted quota increase aimed at the most under-represented countries.  Under the reform, 54 under-represented countries will receive a combined increase of about 5 percentage points of total IMF quotas.

The U.S. quota share in the IMF is roughly 17 percent and this allows the United States to play a special role in influencing key IMF decisions such as quota increases, gold sales and charter changes.  With the United States representing roughly one-quarter of global GDP, the new IMF formulas would have indicated a much higher U.S. quota share.  In order to provide more room for quota increases for emerging market and developing countries, we decided to forgo the increase in voting power we would have otherwise been entitled to.  That said, we felt that keeping our voting share broadly constant was important to ensuring a strong and continued U.S. leadership position in the IMF. 

Yet, this leadership position would have been jeopardized by the increase in the nominal size of the Fund, if our nominal quota had not risen commensurately.  Accordingly, the U.S. nominal quota in the IMF will need to increase, on the order of $7½ billion.  In return for claims on the IMF, the United States receives an interest-bearing and liquid reserve asset, making IMF drawings on the U.S. quota part of our international reserve position.  Thus although Congressional authorization and appropriation are required for an increase in our nominal quota, IMF use of our quota line does not entail any net budgetary outlay. 

Our advocacy for governance reform is not limited to changes in voting weights.  In addition, we have sought changes to the Executive Board to make it more effective.  A recent analysis by the Fund's Independent Evaluation Office confirmed that the size of the Board is unwieldy.  The United States has called for a reduction in Board chairs from 24 presently to 22 in 2010 and 20 in 2012, without any reduction in the chairs of developing countries and emerging markets.  The IMF's Managing Director has appointed a panel of external experts to further study possible reform of the Board.  We hope this panel will seriously consider the U.S. proposal and develop other recommendations to improve Board effectiveness.

Financing Model

The IMF relies predominantly on lending income to finance not just lending-related activities but also its global, regional, and bilateral surveillance and technical assistance.  While the recent uptick in Fund programs will boost lending income in the short term, IMF lending is subject to wide fluctuations and is projected to be on a downward trend, making IMF finances no longer sustainable.  Crises and periods of high Fund lending will periodically occur, but generally stronger emerging market policies and institutions appear likely to put IMF lending (and lending income) on a permanently lower path over the long term. 

In response to the steep decline in Fund lending in 2006 and 2007, the Fund initiated a review of its long-term finances by a distinguished external committee led by Andrew Crockett.  The Committee had a mandate to propose alternate, sustainable sources of income to meet IMF administrative expenses.  At the same time, the United States, joined by others, insisted that the Fund undertake a comprehensive review of IMF administrative expenditures, with a view to significant cuts. 

On balance, estimates suggest that the Fund could face budget gaps on the order of $400 million per annum over the longer term. To address the vulnerabilities in the IMF's financing model:

• IMF Management has already carried out significant staff cuts -- over 380 positions, out of 3,000 total -- reducing expenditures by roughly 10 percent, for an annual savings of about $100 million. 
• The IMF agreed to conduct a limited sale of IMF gold, the proceeds of which would be placed in an endowment that would generate annual interest earnings and cover the bulk of the remaining gap. The IMF would minimize risk of market disruption by (1) pursuing off-market sales to central banks; (2) conducting sales over several years; and (3) coordinating with the European central banks in accordance with the Central Bank Gold Agreement to fit IMF gold sales into existing expectations for official gold sales.  Key global gold producers have indicated a willingness to go along with a sale, subject to these terms.
• Other Crockett Committee recommendations accepted by the IMF Board include a conservative expansion of the IMF's investment mandate to generate higher average returns over time. 

The Need for Congressional Action

These important governance and finance reforms have been set in motion, but cannot be completed without support from the U.S. Congress.  Changes in the U.S. quota and amendments to the IMF's Articles of Agreement to increase basic votes and expand the IMF's investment mandate require Congressional authorization for U.S. assent.  Likewise, U.S. assent to the sale of IMF gold to finance an endowment requires authorization by Congress.  In addition, a budgetary appropriation is needed for the approximately $7½ billion nominal quota increase, although no budgetary outlay would be involved.  Pursuant to the quota reform and IMF income negotiations, the Administration has submitted legislation to the U.S. Congress to gain the required legislative authorizations.

Conclusion

This is an important moment for the IMF and its future.  The IMF has a critical role to play in the global resolution of the financial crisis.  The proposed modernizing reforms will begin the process of making the IMF more representative of the global economy.  It is strongly in the U.S. interest that the Fund fulfills these responsibilities in order to retain its relevance and preeminent place in the international monetary system.  The need for a strong and effective IMF is all the more pressing in the challenging global economic environment we find ourselves in today. 

Thank you.