The Role And Challenges Of International Monetary Fund In Global Economy

In executing these functions, the effectiveness of the IMF, like that of a football referee, depends on whether the players see it as competent and impartial.We will argue that the Fund’s perceived competence and impartiality, and hence its effectiveness, are limited by its failure to meet four challenges. Certain of these challenges are conceptual: the trusted advisor doesn’t always know what to advise. Others are practical: as a result of its organization, the IMF’s impartiality is called into question. All four of the challenges threaten the legitimacy of the institution and therefore its capacity to execute its core functions.

The first unmet challenge is how to organize the surveillance through which the IMF “monitors the economic and financial policies of its 188 member countries. . . highlights possible risks to stability and advises on needed policy adjustments” (IMF 2015a). The view of its founders was that the Fund should focus like a laser on the prerequisites for stable exchange rates and engage in ruthless truth-telling when those prerequisites were not met.

But over time, surveillance moved away from the exchange rate issues thatwere central to the Fund’s original mandate. Surveillance expanded to where it now encompasses virtually anything and everything with implications for economic
and financial stability. Blunt truth-telling, meanwhile, remains more the exception than the rule. It may be unrealistic to expect that the Fund should have anticipated and warned of the US subprime crisis, the global financial crisis, and the Greek debt crisis. But the IMF batted 0 for 3 on these three events, which suggests that its capacity to “highlight risks to stability” leaves something to be desired.

The role of International Monetary Fund controversial that is intervention into the global financial institutions provoke market reactions. Emphasizing on this issue it can be argued that there is an important role that is being executed by International Monetary Fund for supporting various countries in solving financial commitments, exchange incredible information and coordinating problems to significantly implicate stability of national economy as well as International Monetary system( Bahmani-Oskooee et al. 2015).

In order to execute such kind of functions IMF plays the role of football referee and it depends open the players who consider it to be competent as well as impartial. The paper highlights the fundamental aspects of International Monetary Fund that would help it to rejuvenate from positional prospective as a financial institution and ensure its effectiveness. The funds which are circulated within the global economy possesses competence as well as impartiality for which International Monetary Fund becomes restricted because of its inability to meet the major four challenges, namely, to maintain the quality of surveillance in case of individual countries or group of countries as well as.

the Global system, to maintain relevance of conditionality in loan contracts, maintaining efficient funding approach towards debt problems, the failure of funding approved the system of governance which provides appropriate voice to various stakeholders (Bhatti and Moosa 2016). These are the problems of legitimacy that are aspects of major concern as revealed by the people and at least in order to improve the situation of global economy as confronted by International Monetary Fund in the process of executing a more effective role in the 21st century.

Challenges

The role of IMF is not only to work as a trusted advisor to the government of different nations and ensure that the drawn funds are channelized to implement policies for economic development but also to raise awareness in spillover of cross border policies (McKinnon and Ohno 2016). IMF prevents persuasion of policies that may lead a government towards financial instability by working as the lender of the last resort and supporting cash strapped governments. Besides providing advice IMF also provides funds for strengthening national authorities for implementing stability followed by enhancing economic reforms (Woods & Eichengree 2018). However, to boost the capacity for executing core functions and its legitimacy by IMF there exists necessity to address the confronted challenges that can be put forty as follows:

• For the 188 member countries  it is necessary to implement surveillance over financial and economic policies
• Resolving confusion regarding the types of conditionality that are attached with the different kinds of IMF loans.
• Redefining the role of IMF in managing the sovereign debt crisis.
• The final concern is regarding the impartiality of the funds which is nothing but the authenticity regarding the fact that members do not have disproportionate influence upon the way of discharging responsibilities by IMF.

The first three aspects increases doubts about the legitimacy of output by IMF which is concerned with the quality of its performance. However, the final aspect is concerned with the input legitimacy of the fund allocated which emphasizes the process through which power is exercised and decisions are made.

Surveillance

Notably, after the collapse of Bretton Woods, the focus of IMF shifted towards a stable system of exchange rates. Whether the surveillance process is effective enough to monitor the financial, fiscal as well as monetary policies was considered with highest priority. This is because of the fact that it is next to impossible for national authorities to assess the risk associated with the financial stability.

Surveillance

The domestic authorities pursue micro prudential as well as macro prudential policies that are analogous to bilateral and multilateral surveillance as adopted by IMF. IMF requires much more analytics perspective in order to support the countries due to the reason that it was not capable of predicting the subprime crisis in US as it did not conducted any assessment upon the US financial sector. IMF also was unable to predict the sovereign debt crisis in Greece and the banking crisis in Ireland, Iceland where IMF gave an astonishing conclusion that the countries will be easily able to cope up with the economic slowdown or downturn in growth of the housing prices.

It is unfair to assume that IMF will be able to forecast on all crisis that may take place in the upcoming future though it can restrict the bias surveillance of powerful member countries along with focusing on channelization of its resources where the spill over is strongest, stability is a serious issue as well as information and commitment are at stake.

Conditionality

The condition that was imposed upon Indonesia during the financial crisis was criticized due to the reason that the government fell followed by social unrest. The implication of such phenomenon revealed that IMF is not tightly adhered with the areas that are subject to economic reforms and hence the policy implementation as well as allocated funds get compromised or gets siphoned off unethically. Thus the scenario becomes quite obvious to face political resistance and economic instability. IMF should focus on policy reforms based on the borrower’s ability to restore the growth and financial stability (McKinnon and Ohno 2016). This will ensure a more focused conditionality and disciplined design that will become more politically acceptable.

Sovereign Debt Crisis

The recent challenge that is faced by IMF is in understanding whether the nation’s debt is sustainable or it may hamper the economic decisions as well as financial stability of the country in the long run. IMF suggested not to restructure the debt in Greece by 2010 was controversial as it was rumored that Germany and France influenced the decision making of IMF as they were concerned about the debt restructuring in their own bank. However, IMF claimed that they insisted not to restructure the debt due to the reason that it may affect the overall financial market and global economic stability may get hindered. Only emergency finance was provided while delaying the process of debt restructuring which unfortunately made things tougher and the economy became weaker. The lesson that was learnt is that lending funds is not appropriate in countries where there is high probability of debt sustainability and financial instability.

Conclusion

IMF should focus upon small and open economies where the exchange rate has a significant impact on the macroeconomic factors like inflation, growth as well as financial market situations. It should also keep its attention upon the large economies where exchange rate policies are the major source behind cross border spillovers. Surveillance needs to be transparent in monetary union like Eurozone where no national instruments are there to regulate economic policies. IMF faltered when it took a step backward in the Greek Debt Crisis under the systemic exemption clause providing authorized exceptional access where there was prevalence of high systematic risks and doubt about the sustainability of debt.

Conditionality

Explain why PPP and IFE in theory makes derivatives unnecessary. 

The purchasing power parity talks about the fact that at equilibrium, the foreign currency future spot rate will differ from the existing spot rate by the amount which is equal to the inflationary differential within the foreign and home currency. Whereas the international fisher effect incorporates the fact that at equilibrium, the foreign currency future spot rate will differ from the existing spot rate in an amount which is equal to the nominal interest rate differential that prevails between that of the foreign and domestic countries (Bhatti and Moosa 2016).

Notably the theoretical basis of these theories reflects that when a country faces rise in inflation relative to another country then the decreased exports and increased imports lowers the currency of the high inflation country due to worsening of its current trade account balance. International fisher effect is based upon the purchasing power parity theory which attempts to quantify the relation between exchange rate and inflation. Hence, when PPP fails to interpret the abnormal changes in the financial market then Ife also fails to quantify them.

The extension of law of one price is an extension of absolute form of PPP that accounts for the fact that price of similar products in different countries should measure equal if estimated with respect to a common currency (Huang and Yang 2015). However, the relative form of purchasing power parity takes under consideration the market distortion due to transportation cost, quotas, taxes, tariffs, labor costs, etc. and suggests that the rate of the price changes are similar. The rationale of the PPP theory can be reformulated as follows:

Let, U.S. inflation> U.K inflation.

This implies the fact that,

↑U.S imports from UK and ↓ in exports from UK. Thus, U.S. current account ↓

Monotonically a downward pressure or depreciation of dollar takes place. This incorporates a shift in the US dollar depreciation which will continue till

In US: Price _{UK goods} ≥ Price _{US goods}

In UK: Price _{US goods} ≤ Price _{UK goods}

Assuming that PPP holds overtime, then it becomes a fact that when inflation occurs then the exchange adjusts itself to maintain PPP. This shows that, -

P_h1 Þ P_h0 (1 + I _h)

Where P_{h1 = after end of} one year the price index of home currency

I _h = the inflation rate of home currency for that particular year

P_f1 Þ P_f0 (1 + I _f) (1 + e _f)

Where, P_f = Price index of foreign currency

I _f = the inflation rate of foreign nation

e _f = % Ñ in the value of foreign currency

Considering the fact that PPP holds, then we have,

P_h1 = P_f1

The solution gives that,

e _f = (1 + I _h) (1 + I _f) – 1 ……………………………………… (1)

When, I _h > I _f  Þ e _f > 0, then appreciation in foreign currency takes place

And when, I _h < I _f  Þ e _f < 0, then depreciation in foreign currency takes place.

However, when the inflation differential is infinitesimally small then,

e _f = I _h – I _f

Sovereign Debt Crisis

The graphical representation of PPP can be shown as follows:

The actual inflation differentials and the spot exchange rate changes re plotted where if the points found to significantly deviate from the PPP line then PPP does not hold. Thus in the long run the relationship between inflation rate differential and that of the exchange rates will not remain perfect in the long run. The choice of base period affects the result and limits itself as a theory. In practical scenario so it makes the derivatives unnecessary. Due to confounding effect PPP is not found to occur consistently (Dominguez 2014).

This is nothing but the truth behind the fact is that the exchange rates are not only affected by the inflation rates only but also by the interest rates, government controls, income levels as well as expectation of future rates and many other parametric factors. If there exists lack of substitutes for tradable goods and if the real exchange follows a random walk it cannot be observed as a constant in the long run and this things makes the PPP not to hold in the long run.

The fisher effect on the other hand interprets the fact that the nominal risk-free interest rates consists of a real rate of return that anticipates inflation. If the investors require the same real return of the assets which possess similar maturity and risks, then the differentials within the interest rates occurs due to the differentials in the inflation expected. Thus currencies having higher interest rates will face depreciation due to the reason that greater nominal rates reveals greater inflationary expectation (Forbes 2016).

Thus investors who hope to capitalize on the higher foreign interest rate must earn a return which is greater than what they would have earned domestically. Thus the IFE theory is based upon the PPP theory which thus does not hold when PPP do not hold. It reflects the fact that there exists factors other than interest rate and inflation that affects the exchange rates for which the exchange rates are not found to always get adjusted with respect to only the inflation or interest rate differential. The comparison can be shown as follows:

Evaluate the differing ways in which derivatives can protect 
against the failings of IFE and PPP.

Movement in the exchange rates are majorly influenced by two variables. One is the relative prices of goods and services in two different countries which are foreign to each other and the other is the relative interest rate between the two countries. In order to anticipate the changes in the exchange rate only the inflation differential or the interest rate differential are not sufficient. Rather the role of derivatives are higher to neutralize the exchange rate risks. Thus PPP and Ife estimates the changes and puts forth the theory through which the frequent fluctuation in the exchange rates can be understood (Lo and Morley 2015).

However, there exist lot of other factors which influence the exchange rates between countries. This may be the upon several parametric factors like inflationary rates, interest rates, government controls, income levels as well as expectation of future rates. Derivatives on the other hand is the kind of financial instrument, the value of which is dependent upon other financial instrument termed as underlying asset. The wide range of financial instruments that are used in underlying assets includes the equity index, foreign currencies, fixed-income instruments, credit events, commodities as well as the derivative securities or collaterals.  Based on the kind of underlying asset, the value of the derivative contracts can get derived from their respective equity prices, exchange rates and probabilities of certain credit events, interest rates and commodity prices (Lothian 2016). The major four types of derivative contracts include futures, forwards, options and swaps. These provides user to cope up with the demand by rendering cost-effective protection against risks that is associated with uncertain fluctuations in prices of the underlying securities.

Conclusion

Emphasizing on this issue it can be incorporated that derivatives provides user the opportunity to hedge against movement in the interest rates, credit worthiness, commodity prices, equity and exchange rates. Precisely, derivative transaction includes transferring of risks from the entities that are unable to manage them in respect of entities that are able to manage them. Commercial banks, central banks, investment banks, insurance companies, fund managers as well as other financial organizations.

Though there does not exist any fine line of differentiation yet the classification of the participants in the derivative market are specifically made for this reason as speculators and hedgers. Hedgers prefers to take an entry in the derivative market with the perspective to render protection against adverse changes that takes place in their assets and liabilities. Any downturn in the values of the assets of the hedgers gets compensated by a substantial increase in the valuation of the derivative contracts (Gabaix and Maggiori 2015).

In contrast of this scenario, the speculators makes their attempt to enter the derivative market to make profit through anticipating the changes in the exchange rates, commodity prices or the credit events.  Hedging thus ensures risk reduction while speculation is risk augmentation in terms of return. However, both of this factors have the same objective on a certain sense which is to respond back to the market uncertainties and fluctuations based on not only mere theory like that of the purchasing power parity (PPP), international fisher effect (IFE) or interest rate parity (IRP), but considering the actual market scenarios. Moreover, apart from hedgers or speculators have other motivating factors in terms of the derivative market.

Notably, derivatives help to obtain better financing terms as for example the banks frequently offers more favorable financial situation to those organizations which have mitigated their market risks through activities like hedging.  Moreover, for achieving certain asset allocation of the portfolios, fund managers uses derivatives. Passive fund managers that are concerned with specific fund that tracks the index, uses derivatives in order to replicate financial exposures in some of the non-liquid assets. The foreign exchange exposures reflects the degree up to which the valuation of the firms are being affected by the changes that have took place upon the exchange rates.

The translational exposure, operational exposure, contingency exposure and the transactional exposure are the four channels of this foreign exchange exposure. In case of offshore enterprises the translational exposure occurs within the currency mismatch related to its assets and derived income 9Fornaro 2015). The operational exposure takes place when the market position of the firms varies due to change in the exchange rates in terms of competition in market demand, prices etc. of the products and services of the firm internationally.

Contingency exposure on the other hand occurs through the possible revaluation that arises upon the future liabilities and the transactional exposure takes place based on future cash flows in the form of trade contracts where the existing obligations are affected by the fluctuations in the foreign exchange rates. Thus the overall economic exposure is handled by the banks by the use of derivatives and foreign currency exposures are handled. Hedging helps commercial banks to tackle risks associated with foreign exchange rates though hedging itself poses additional risks to the commercial banks. Beside currency futures, currency options, currency swaps or currency forwards, hedging is also done off-setting positions against money markets and underlying assets.

Moreover, the risk that is adhered with the foreign exchange rates are managed through diversification of portfolios across the assets in various currencies. The cash flows of the portfolios are affected by the use of thee derivative securities. Hence, the derivatives are not only protective in hedging foreign exchange risk but also the information regarding currency derivatives makes the currency market more efficient.

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