The IMF: transmission impossible?

One central element of most IMF-supported adjustment programmes has historically been the preservation of free capital flows and freely floating exchange rates. It was only in exceptional circumstances that the Fund supported measures such as temporary capital controls (as was the case with the last Iceland programme).

That may now be changing. Another look at the costs and benefits of this principle and real-life evidence of preferred policies has led the IMF staff to alter this guidance. After working on a new policy framework for open economies, the staff concluded that smaller economies especially may benefit from currency interventions during periods of externally induced stress.

Similarly, measures that limit fast, uncontrolled flows of capital – implemented as macro-prudential tools, so tools combining regulation and risk management and introduced at times of market calm – can limit the build-up of vulnerabilities that would exacerbate external risk event (for example, elevated levels of foreign-currency debt or foreign borrowing, a problem that led Hungary and Romania to request an IMF programme in 2008, or aggravated the growth impact of the Turkish lira sell-off in 2018).

The IMF staff also argue that large currency depreciation – which usually accompanies adjustment programmes – does not offer much help with regaining competitiveness, especially for smaller, open economies that sell goods denominated in US dollars and import a lot of components.

Vigilantes versus vulnerabilities

This does not mean that the Fund would now recommend that countries close their financial accounts and eradicate all ‘bond vigilantes’. The IMF would still primarily insist on solid, free-market policies that prevent the build-up of vulnerabilities in the first place. But the design of new adjustment programmes – if the proposed changes are implemented – would recognise market imperfections and their costs.

What does this mean for economies that have to turn to the IMF for support? Essentially, the growth costs of adjustment programmes would be lower. Under more managed ‘emergency’ foreign exchange and capital-flow regimes, countries could cut policy rates faster, without fear of rapid capital outflows or currency depreciation or volatility. Fiscal adjustment could also be more gradual. Banks and importers/exporters would fare better under lower currency volatility too.

There are downsides, however. Without the strong ‘disciplining’ effect of the markets, commitment to reforms and policy predictability would be even more important. The risk of some form of market intervention would also add to liquidity premia.

Interventions may feature

What does this mean for investors? We can see both upsides and downsides. This change in guidance would limit shorter-term investment opportunities, for example when currencies overshoot at the start of adjustment programmes. It would also eliminate the moral hazard associated with such programmes, with the IMF being effectively a supporter of ‘hot money’ flows.

There are nevertheless also many positives: with lower costs for economic output from macro adjustments, countries would be able to restore growth faster than with fully open financial accounts. That would be positive for longer-term, ‘sticky money’ investors. The lower social costs of such adjustment programmes would also be a positive for investors with environment, social, and governance (ESG) mandates.

There is, of course, some uncertainty over whether these changes in policy guidance will be approved. After all, they alter the fundamental advice dispensed by the Fund since the era of free capital flows and exchange rates started.

But the proposals are not new, and the IMF has hinted at the potential changes before and discussed them at external fora. This indicates strong political support for modernising IMF guidance. These changes would still be up for a discussion on the Board, where the US has a blocking vote, so that support remains crucial.