The first of the International Monetary Fund Articles of Agreement provides for temporary liquidity support to its membership for stabilising a country’s external payments. There is no provision for providing such support to stabilise a member’s domestic debt. Why then is the IMF providing support to countries in the euro zone, whose problems are ostensibly fiscal?
While a country can of course choose to renege on both its external and domestic debt, a country need never be hostage to the markets for funding its domestic debt because of the unlimited central bank backstop, including the printing press, through which it can inflate a way out. This may trigger domestic macro-economic instability, but monetary and fiscal policies will not spill over externally, unless there is a large external demand for its domestic currency.
The central bank backstop however cannot insulate a country against unsustainable external imbalances, as it cannot print its way out to finance deficits denominated in reserve currencies. When a country loses market access to fund external liabilities it may need to turn to the IMF, the external lender of last resort, which provides liquidity support to countries as they adjust their external payments position towards the sustainable.
The distinction between external and domestic debt is of little relevance, however, in the case of the four freely convertible international reserve currencies (the US dollar, sterling, the euro and the yen) because their domestic currencies are also international reserve currencies with a large external demand that enables them to run large external and domestic deficits, both of which are denominated in the same currency, with apparent impunity. Thus, Japan’s high fiscal deficits and debt, and America’s large twin deficits have not had a commensurate impact on their borrowing costs or the values of their currencies.
In short, reserve-issuing countries have an additional policy lever in that they can use domestic monetary policy to finance external imbalances and also sustain higher levels of domestic debt. This lever has become increasingly potent on account of the proliferation in financial assets that now dwarf real economy flows. This is why these large economies, which account for over 50 per cent of global GDP at market exchange rates, do not turn to the IMF for liquidity support.
In recent years, large emerging markets that account for a substantial chunk of the remaining global GDP have accumulated huge international reserves. This self-insurance has made it unlikely that they would need to turn to the IMF for liquidity support in the foreseeable future.
The potential needs of the remaining countries are limited in size, as they account for a relatively small share of global GDP. This explains why the global firewall maintained by the IMF for combating crises was relatively small, at about $250 billion, prior to the global financial crisis.
The IMF’s resources have however been increased by almost five times over the last few years. This is primarily on account of the potential needs of the large euro zone, which accounts for almost a fifth of the global economy.
As pointed out, reserve currency countries do not ordinarily need liquidity support from the IMF. However, if a reserve currency-issuing area is a monetary union of independent sovereign states, the situation can change dramatically.
If such a monetary union were to have a common central bank that provided unlimited liquidity backstop to sovereigns there would be no problem. The problem arises when each country has its own central bank which cannot issue its own currency, over which the European Central Bank (ECB) has a monopoly. In such a situation the domestic debt of the government takes on the characteristics of external debt. This is precisely what has happened in euro zone countries, compelling them, inter alia, to turn to other euro zone countries, the ECB and the IMF for providing liquidity support for domestic adjustment as their fiscal deficits and debt ballooned out of control and they lost market access to their own currency.
There is no provision in euro-zone treaties for member countries or the ECB to bail out individual countries; they are expected to maintain the fiscal discipline necessary to enjoy continued market access to finance deficits. However, as the deficits and debt of some peripheral countries spun out of control, and they lost market access, member countries were compelled to bail them out through a hastily-devised temporary European Financial Stability Fund (EFSF), later expanded into the permanent European Stability Mechanism (ESM). The ECB was also constrained to lend to European banks to enable them to buy troubled sovereign bonds, assuming the role of the central bank backstop through its one-time Long Term Refinancing Operations (LTRO) to prevent a break-up of the euro zone. More controversially, the IMF has played a supplementary role by providing additional funds.
The recent increase in the European and IMF firewalls and the LTRO helped stabilise sovereign bond markets in the euro periphery. Markets are however turning nervous once again, pushing up the yields on Spanish and Italian sovereign bonds. Markets fear that these two large economies, with a cumulative public debt of about $3.5 trillion, are too big for the ESM and IMF to bail out through their recently enhanced aggregate “big bazooka” firewall of about $2 trillion. There is likely to be little appetite for continually increasing the size of this global firewall. The credibility of the bazooka is also in question because it may be difficult to meet the usual IMF conditionalities on the one hand — while most of the euro-zone firewall is a pie in the sky that would need to be raised from markets precisely when they are revolting.
If peripheral sovereign yields continue to widen, the ECB may be compelled to repeatedly intervene to maintain the integrity of the European Monetary Union and thereby become the de facto central bank backstop. The markets recognise that the ESM and IMF firewalls are mere field artillery, and the real “big bazooka” — the Big Bertha so to speak, with the unlimited capacity to fund sovereigns — is the ECB. The big question is whether, in the likely absence of commensurate economic growth and willingness of member countries to share the losses, much of the liabilities assumed by the ECB in the process would eventually have to be inflated away, as in the case of all unsustainable domestic debt, or whether the external demand for the euro would help cushion most of the losses.
The writer is a civil servant. These views are personal
