INTERNATIONAL FINANCIAL INSTITUTIONS AND LIQUIDITY - INTERNATIONAL FINANCE

Notes 24 Pages

Bengaluru City University

Bachelor of Business Administration

Contributed by

Prajwal Hallale

INTERNATIONAL FINANCE
VI SEM BBA
SUSHMITHA V, ASST PROFESSOR, MES INSTITUTE OF MANAGEMENT
1

International Finance
Unit 5: INTERNATIONAL FINANCIAL INSTITUTIONS AND LIQUIDITY

THE INTERNATIONAL MONETARY FUND: (IMF)

The International Monetary Fund (IMF) is a post-war international monetary institution. The
breakdown of the Gold Standard resulted in vacuum in the field of international trade Then the
world nations felt the need for international co-operation in economic, trade and balance of
payments affairs. The United States Treasury in 1943 published a proposal for the establishment
of an International Stabilization Fund. The U.K. around the same time proposed the establishment
of an International Clearing Union. The USA's proposal is known as White Plan (Mr White is the
author) and the UK's proposal is known as Keynes Plan (author is Lord Keynes). A joint plan was
prepared in 1944 in the form of joint statement by experts for the establishment of International
Monetary Fund. This became the basis for International Monetary and Financial Conference at
Bretton Woods, New Hampshire during July 1-22, 1944. An agreement was reached to establish
International Monetary Fund by 44 nations in this conference.
Thus, the International Monetary Fund (IMF) came into being to promote
economic and financial co-operation among the member countries withh a view to facilitate the
expansion and balanced growth of world trade with effect from March 1, 1947. The number of
members of IMF increased from 44 in 1947 to 189 in 2019.
➢ OBJECTIVES OF IMF
• To avoid the competitive de valuation and exchange control.
• To establish and maintain currency con vertibility with stable exelange rates.
• To develop multilateral trade and payments.

The objectives of the IMF as stated in Article I of the Fund Agreement are as follows:
• To proniote international monetary co-operation through a permanent institution which
provides machinery tor consultation and collaboration on international monetary problems.
• To facilitate the expansion of balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income
and to the development of the productive resources of all members as the primary
objectives of economic policy.
• To provide exchange stability, to maintain orderly exchange arrangements among
members, and to avoid competitive exchange depreciation.
• To assist in the establishment of a multilateral system of payments in respect of current
transactions between members and in the climination of foreign exchange transactions
which hamper the growth of world trade.
• To lend confidence to members by making the Fund's resources available to them under
adequate safeguards, thus providing them with opportunity to correct maladjustments in
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their balance of payments without resorting to measures destructive of national or
international prosperity.
• In accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balances of payments of members.

The IMF performs various funcțions, in order to achieve these objectives.

FUNCTIONS OF IMF
The Fund sees that the provisions of the Agreement are observed by the member countries.
The Fund has amended its Articles of Agreement to make appropriate adjustments relating to
exchange rates which have become obsolete owing to intemational monetary events.
o The fund is regarded as, "the guardian of good conduct" in the area of balance of payments.
o IMF aims at reducing tnriffs and other trade restrictions by the member countries.
o IMF provides technical advice to its members regarding monetary and fiscal policies.
o IMF provides short-term financial assistance to its members to get rid of the balance of
payments problems/crisis.
o IMF provides machinery for the orderly adjustment of exchange rates.
o It functions as a reservoir of currencies of member countries and enables the members to
borrow the other currencies.
o It functions as a lending institution of foreign currencies.
o It provides a machinery for altering the par values of the currency of a member country, in
order to improve long-term balance of payments position of member countries.
o It also provides a machinery for international consultancy
o It conducts research studies and publishes the reports.
o It conducts short-term training courses on fiscal, monetary and balance of payments for
employees of member countries through its Central Banking Services Department, the
Fiscal Affairs Department, Bureau of Statistics and the IMF Institute.

ORGANISATION STRUCTURE
The IMF is an autonomous organisation affiliated to the U.N.O. The organization structure of
IMF consists of:
» Board of Governors
» Exccutive Board
» A Managıng Director
» IMF secretariat helps managing director in carrying out the activities
» Interim Committee
» Development Committee.

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Board of Governors: The Board of Govermors is the decision-making organ of the Fund, The
Board of Governors is the highest body. It exercises powers and takes decisions. The Board of
Governors consists of one Govemor and one Altemate Govemor appointed by each member
country. The member country appoints its Finance Minister or the Governor of its Central Banks
as the Governor. The Governor has the right to vote. The Alternate Governor participates in the
Board Meetings, but has voting right only in the absence of the Governor.
The Board of Governors meets once in a year and reviews previous year's activities of
the Fund. It also takes policy decisions) Any five member countries having 25 per cent of the total
voting rights can convene a special meeting However, power to make major decisions in the
following areas is delegated to the Board of Directors
• Access by the members to the Fund's resources.
• Charges and remuneration.
• Review of fund and consultations among its members.
The Executive Board:(The Executive Board, at present has 21 members. Five major members
of Fund are appointed by the countries having the largest quotas, viz., the USA, the UK, Germany,
France and Japan.
The Sixth Executive Director is appointed by the Kingdom of Saudi Arabia. The remaining 15
directors are clected by the remaining member countries. Articles of Agreement confer vast powers
on the Board and the Board of Governors also delegates the powers These powers include (All
fund activities including regulatory, supervisory and financial. To bring the major changes, 85%
of voting rights is essential. Thus, the Executive Board is an important organ of the IMF.

Managing Director: The Executive Directors elect the Managing Director, who is a politician
or an important international official. The Managing Director is a non-voting chairman of the
Board and the head of the Fund staff.

The Interim Committee: The interim committee, at present has 22 members. It was created
in 1974, The objectives of this committece are:
• To advise the Board of Governors on supervising the management
• To advise the Board of Governors on adaptation of the international monetary system with
a view to avoid disturbance.

The Development Conimittee: This committee was also established in 1974 and has 22
members. Its objective is to:
• advise and report to Board of Governors on all aspects of the transfer of real resources to
developing countries.

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The following figure presents the organization structure of IMF.

Board of Governors *Interim Committee
| *Development Committee
Executive Board of Directors
|
Managing Director
|
IMF Secretariat

VOTING RIGHTS
We have made a mention regarding the voting rights of the member countries and the requirements
of 8,5% of voting rights to bring about changes. The voting rights, are determined by the quotas.
Each member country has 250 basic voles irrespective of its quota. In addition to the
basic votes, member country has one voting right for every quota of SDR: 1,00,000. As such, we
shall now discuss the quotas.
» Quotas
The capital of the IMF which is represented by the General Account is contributed
by the quotas allocated to the member countries. The quota detemines:
• Size of the subscription of the member country to the IMF Capital/General Account.
• Voting power (or voting rights) of the member country, and
• the Drawing Rights of the member country,
Quotas of the member countries are determined on the lines:
i. 2 per cent of the national income of the member country.
ii. 5 per cent of the gold and US dollar reserve of the member country.
iii. 10 per cent of the average annual imports of the member country.
iv. 10 per cent of the maximum variation in annual exports of the member country.
v. the sum of (i), (ii), (iii) and (iv) increased by the percentage ratios of average annual
exports of national income.

Payment Method: At the time of the formation of the IMF, the members were required to
pay 25% of its quota in the form of gold or 10% of its net official holdings of gold and US
dollars whichever is less.
This method was modified under the second amendment This amendment came into force
from April 1, 1978. Under this amendment, the member country has to pay 25 per cent of its
quota in SDRs or hard currencies. The member can pay the remaining 75 per cent of its quota in
its own currency which can be deposited in its central bank. The Fund delinked the practices of
subscribing to its capital in the form of gold frem April 1978.
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» Revising the Quotas: The fund reviews and revises the quotas once in five years in order
to meet the growing demand for finance with a majority of 85 per cent of total voting rights.

FINANCIAL RESOURCES
As stated earlier, the capital of the Fund is contributed by the member countries in the form
of quotas. In addition, the Fund raises its funds by selling its gold reserves to its members. It further
borrows funds from the Governments, Central Banks and Private Financial Institutions of the
industrialised countries, the Bank for International Settlements (BIS) and from OPEC countries.

GENERAL ARRANGEMENTS TO BORROW
IMF also borrows from the. Industrialized member countries under the General Arrangements
to Borrow. This scheme came into being in October 1962. The original şize of the GAB was SDRs
6.4 billion and it increased SDRs 17 billion in December 1983. The GAB was renewed up to
December 1998.

Fund Lending: The fund provides loans to the member countries in the form of sale of foreign
currency. Member countries can get loans up to 25% of its quota freely as they contribute to the
General Account in the form of gold. The members can use this loan within 3 to 5 years. Members
can use this loan for mitigating the disequilibrium in the balance of payments position. Thus, the
Fund provides loans to overcome the problems of balance of payments on current account.
However, the members receive the loans very continuously, based on the situation.

The shortfall of the member's currency with Fund over its quota is called 'Reserve Tranche.'
The member country can draw 25% of its reserve tranche automatically from the Fund. No interest
is charged bn such drawings, but the menmber country has to repay such loans withi a period of
five years.
Credit Tranches: The remaining balance of quota, after drawing 25% of reserve tranche is
called Credit Tranche. Members have to adopt viable programmes for drawing from the credit
tranche. Hence, drawing from the credit tranche is conditional. Now the member countries can
draw up to 300 per cent of their new quotas on the total net use of the Fund's resources. The
drawings under Buffer Stock Financing Facility, Extended Fund Facility, Supplementary
Financing Facility, Structural Adjustment Facility and Compensatory and Contingency Facility
are excluded from the 300% loan limit.

Approval of Stand-by Facility and Extended l'inancing Facility are now under the powers
of Executive Board. The Fund created a number of facilities in order to help the member
countries. These facilities include:
Buffer Stock Facility, Extended Fund Facility, etc. The loans under these facilities are excluded
from tranches and, are for longer periods.
Now, we discuss the loans under these facilities, briefly.
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Buffer Stock Facility: IMF created buffer stock Financing Facility for Financing buffer
stock by member countries in 1969. The assistance was provided to the member country
equivalent to 30 per cent of its quota.

The Extended Fund Facility: The Extended Fund Facility was provided in 1974 in order
to provide credit to member countries to meet the balance of payment deficits for longer
periods. Under this facility members are allowed to get the loan facility equal to 100 per
cent of their quota. The duration of this loan would be for 10 years. This loan is mostly
utilised by the developing countries.

The Supplementary Financing Facility: The IMF created the supplementary/facing the
serious problem of balance of payments, which is larger in relation to their quotas. This
facility is meant for developing countries. The IMF created subsidy account in 1980 to
make subsidy payment to member countries.

Structural Adjustment Facility: Under Structural Adjustment Facility, IMF provides lọans
to the poorer countries to solve the problem of persistent balance of payments problem
and to carry out macro-economic and structural adjustment programmes. The IMF created
this facility with Special Drawing Rights (SDR) 2.7 billion.

Enhanced Structural Adjustment Facility: In order to provide medium term finance to
the low income countries, IMF created the Enhanced Structural Adjustiment Facility, with
SDR 6 billionn December 1987. Eligible members receive a great deal more assistance

Compensatory and Contingency Financing Faciligy (CCFF): The IMF, in order to provide
timely compensation for temporary short falls or excess in cereal import costs created this
facility.

OTHER OPERATIONS OF THE FUND
Exchange Stability: At the early days of functioning of IMF, gold played important role in
delennining the relative values of the member currencies. Members were required to declare the
par values of their currencies in tenns of gold or US dollars. This provided the basis for determining
the exchange rate between the currencies of any two countries.
Whenever, there was a feeling of disequilibrium in the balance of payments
position of a member country, they may propose a devaluation. IMF allows devaluation only for
the purpose of correcting the disequilibrium in the balance of payruents position.
The member countries should not adopt a multiple exchange rate system, i.e., they should not
have more than one exchange rate.
- Exchange Control Operations: According to the Fund, there should not be restrictions
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in ordinary trade and other current account transactions. However, the Fund allows exchange
controls and other restrictions in order to control international capital movements in case of scare
currencies announced by IMF and during the transition periods.
-Bank for the Central Banks: The fund acts as a bank for central banks as it collects
resources from various central banks in the lines of a central bank which collects cash
resources from commercial banks.

TRAINING AND TECHNICAL ASSISTANCE
IMF offers advices to the member countries regarding the formulation and' implementation of
their economic policies The Fund, on the special request of the poor countrica, provides training
on ‘Economic Management. ' The Fund provided the training course on 'Financial Analysis and
Policy', Fiscal Policy etc. It also provided training on 'Balance of Payments Methodology,' Public
Finance, Central Banking Services, organisation and administration of central banks.
» Extension Programmes: The IMF conducted extension programmes in various countries on
‘Technical Assistance.' It sends teams of experts to various developing countries in order to
provide training, formulation of draft legislation, conducting surveys, formulation of monetary
policy, etc.
» Expansion of Global Trade: The Fund helps for the expansion of global trade in the following
ways:
• Provides credit facilities to the member countries.
• Reduces the need for import quotas and resorting to exchange controls.
• Helps the countries to overcome the problem of temporary disequilibrium in their balance
of payments.
• Facilitates multi-lateral payments and trade.
• Simplification of imultiple exchange system.
• Introduction of more liberal credit policy.
• Granting developmental loans.
• Granting loans for structural adjustments of member conuntries.
Infact, IMF provided loans to a number of member countries for economic structural
adjusimenis that helps the countries to produce export-oriented goods and render services that
are demanded by foreign countries.

CRITICISM OF IMF
The IMF has also been evaluated for its lack of accountability and willingness to lend to
Countries with bad human rights record.
1. Conditions of Loans
On giving loans to countries, the IMF makes the loan conditional on the implementation of
certain economic policies. These policies tend to involve:
a) Reducing government borrowing- Higher taxes and lower spending

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b) Higher interest rates to stabilize the currency.
c) Allow failing firms to go bankrupt.
d) Structural adjustment. Privatization, deregulation, reducing corruption and bureaucracy.
The problem is that these policies of structural adjustment and macroeconomic intervention
make the situation worse.In 2001, Argentina was forced into a similar policy of fiscal restraint.
This led to a decline in investment in public services which perhaps damaged the economy.

2. Exchange Rate Reforms
When the IMF interfered in Kenya in the 1990s, they made the Central bank remove controls
Over flows of capital. The consensus was that this decision made it easier for corrupt politicians
to transfer money out of the economy (known as the Goldman scandal). Critics argue this is another
example of how the IMF failed to understand the dynamics of the country that they were dealing
with insisting on blanket reforms.

3. Devaluations
The IMF has been criticized for allowing inflationary devaluations.

4. Neo Liberal Criticisms
There is also criticism of neo liberal policies such as privatization. Arguably these free mar
policies were not always suitable for the situation of the country. For example, privatizations.
oreate-lead to the creation of private monopolies who exploit consumers.

5. Free Market Criticisms of IMF
Other criticisms of the IMF for being too interventionist. Believers in free markets argue
it is better to let capital markets operate without attempts at intervention) They argue attempt
influence exchange rates only make things worse it is better to allow currencies to reach
market level. There is also a criticism that bailout countries with large debt create moral hazard.
Because of the possibility of getting bailed out it encourages people to borrow more.

6. Lack of transparency and involvement
The IMF has been criticized for imposing policy with little or no consultation with affected
countries. Jeffrey Sachs, the head of the Harvard Institute for International Development sain
Korea the IMF insisted that all presidential candidates immediately "endorse" an agreement which
They had no part in drafting or negotiating, and no time to understand. The situation is out of hand.
It defies logic to believe the small group of 1,000 economists on 19th Street in Washington should
dictate the economic conditions of life to 75 developing countries with around 1.4 billion people.

7. Supporting Military dictatorships
The IMF has been criticized for supporting military dictatorships in Brazil and Argentina_
as Castello Branco in 1960s received IMF funds denied to other countries.
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RESPONSE TO CRITICISM OF IMF
1. Crisis always leads to some Difficulties
Because the IMF deal with economic crisis, whatever policy they offer, there is likely
difficulties. It is not possible to deal with a balance of payments without some painful
readjustment.
2. IMF has had Some Successes
The Failures of the IMF tend to be widely publicized. Criticism tends to focus on short term
problems and ignores longer term view.
3. Confidence
The fact there is a lender of last resort provides an important confidence boost for in
This is important during current financial turmoil.
4. Countries are not obliged to take an IMF loan
It is countries who approach the IMF for a loan. The facts so many take loans suggest there
must be at least some benefits of the IMF.
5, IMF Easy target
Sometimes countries may want to undertake painful short-term adjustment but there is a lack
of political will. An IMF intervention enables the government to secure a loan and then pass the
blame on to the IMF for the difficulties.

DIFFERENCE BETWEEN IMF AND WORLD BANK

International Monetary Fund

World Bank

1.Oversees the international monetary system.
1.It seeks to promote the economic development of
the world's poorer countries.

2.Promote exchange stability and exchange
relations among members.

2. It assist developing countries through long
term financing of development programs

3. Has staff of 2300 drawn from 182 member
countries.

3. Has staff of 7000 drawn from 180 member
Members countries

4.Draws its financial resources from the quota’s
subscriptions of its member

4. Acquires most of its financial resources by
borrowing on the international bond market
countries.

5. Has at its disposal fully paid in quotas now
totaling SDR 212 billion (about $ 300 billion)
5. Has an authorized capital of S 184 billion of
which members pay in about 10 percent

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INTERNATIONAL LIQUIDITY AND SPECIAL DRAWING RIGHTS

Central banks of the countries maintain the imernationally aceptable asseis like bullion
international borrowings, commercial credit operations, hard currencies, foreign securities,
and SDRs in order to settle the deficit balance of the balance of payments position. The
aggregate stock of such assets of all the central banks in the world is called, "international
liquidity" or International reserves
The international liquidity assets may be owned or borrowed. If a country has excess
foreign reserves after meeting the import obligations of both current and capital account, such are
treated as owned assets. The gold reserves of the country are also owned reserves.
The borrowed assets include the borrowings from other countries, and borrowings
from the international financial institutions
The international liquidity may be conditional or unconditional. Unconditional liquid reserves
include country's gold, foreign exchange surplus, SDRs and private holdings of international assets
The country has unconditional right to use these reserves. Most of the borrowed funds are
conditional assets, as the country has only conditional right in using these assets regarding the
nature of use.

COMPONENTS OF INTERNATIONAL LIQUIDITY
Under the present international monetary order, among the member countries of the IME. the
chief components of international liquidity structure are taken to be:
1.Gold reserves with the national monetary authorities’ central banks and with the IME
2.Dollar reserves of countries other than the U.S.A.
3.E-Sterling reserves of countries other than U.K.
It should be noted that items (2) and (3) are regarded as 'key currencies' of the world and
their reserves held by member countries constitute the respective liabilities of the U.S. and
U.K. More recently Swiss francs and German marks also have been regarded as key
currencies.
4.IMF tranche position which represents the 'drawing potential' of the IMF members and
5.Credit arrangements (bilateral and multilateral credit) between countries such as swap
agreements and the Ten of the Paris Club.
a) Of all these components, however gold and key currencies like dollar today entail greater
significance in determining the international liquidity of the world.
b) It is difficult to measure international liquidity and assess its adequacy.
c) This depends on gold and the foreign exchange holdings of a country, and also on the
country's ability to borrow from other countries and from international organizations. Thus, it
is not easy to determine the adequacy of international liquidity whose composition is
heterogeneous.
d) There is no exact relationship between the volume of international transactions and the
amount of necessary reserves. In fact, foreign exchange reserves (international liquidity) are
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INTERNATIONAL FINANCIAL INSTITUTIONS AND LIQUIDITY - INTERNATIONAL FINANCE

INTERNATIONAL FINANCIAL INSTITUTIONS AND LIQUIDITY - INTERNATIONAL FINANCE

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