Notes on a proposal for a short term financing facility

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(1)Notes on a proposal for a Short-Term Financing Facility Roberto Frenkel 1995. Let me first make it clear that my comments are based exclusively on the version of the Short-Term Financing Facility proposal prepared by the Policy Development and Review Department and dated September 26, 1994. I am sure that there are better alternatives for helping the countries to stabilize the exchange markets in the present context of volatile capital flows, but those alternatives need to be envisaged and elaborated with a less constrained perspective than the IMF paper. When considered with a broader perspective, the target actually entails the main functions of the IMF in the present context. I have delayed sending my comments not only because I was very busy but because I had mixed feelings about the proposal. I did not have a strong argument against it but rather some points regarding its usefulness and practical implementation, together with a negative feeling about enhancing unnecessarily the role of the IMF staff. However, despite my caveats and skepticism, why should we argue against a proposal that could be useful under some circumstances? The Mexican crisis rescued me from this ambiguity because the case provides impressive evidence for discussing the ideas behind the proposal. In retrospective, the Mexican swap agreements signed in April 1994 with the United States and Canada seemed to be the ideal for similar arrangements to be developed in the IMF. Moreover, I do not know how the proposal was originated but I suspect that the Mexican swap agreements played some inspiring role. Anyway, the swap agreements have not performed their supposed function and have contributed in some degree to delaying the necessary adjustment of the Mexican external sector. Regarding the new facility proposal, two points follow.

(2) 1 immediately from the Mexican experience. First, the facility is useless when there is an intrinsic fragility in the external sector. Second, the IMF judgment about the robustness of the Mexican external sector was myopic, either because it was based on a mistaken diagnosis or it was motivated more by political considerations than by serious economic analysis. Both observations suggest to me that the facility seems to be neither useful nor convenient. Before developing the Mexican-based argumentation a bit more, let me first mention my pre-crisis view of the issue. As far as I understand it, the facility is intended to strengthen the country's defenses against a speculative attack on the reserves. It would operate in two ways. First, reducing the chances of a run by augmenting the amount of liquid reserves that could be sold to sustain the rate of exchange. Consequently, it would enhance the credibility of the rate of exchange policy. Second, because access to the facility had to be previously agreed upon with the IMF, the agreement itself could be considered as the Fund's seal of approval of the country's external sector sustainability and the exchange policy, and then operate as a stabilizing signal. The destabilizing potential of capital outflows depends on the relative magnitude of the flows vis-á-vis the amount of liquid reserves. So, to perform the first of the above-mentioned roles in a more or less relevant way, the facility would have to reduce significantly that ratio. Given the limited amount of financial resources that would have been apparently allocated to the facility, the first role would be operative only in some special cases: those where either reserves or capital outflows are relatively small with regard to the amount of the facility. Those cases were common in the financially rationed context of the.

(3) 1 eighties, but are less common now. For instance, the facility proposal would have been very useful to help the success of stabilization packages including the utilization of a fixed nominal rate of exchange as an anchor, as were the cases of Mexico (1987), Israel (1985), Argentina (1985), Brazil (1986) and others. Among these experiences, only the Israeli stabilization program received a reserves support that undoubtedly helped the program's success. In this case the support was reached through an agreement with the United States government. In the present circumstances, the facility would perform an analogous role in cases similar to those mentioned above, i.e. in the cases of countries relatively isolated from the recent massive capital flows, with limited availability of reserves, which need external help to sustain a stabilization program. But these cases are explicitly excluded in the IMF proposal. The argument is that these cases correspond to the normal operations of the Fund and should be treated in a normal way, i.e. by a stand-by agreement. According to the IMF paper, eligibility should be restricted to a country that previously requests access to the facility and which "was judged [by the IMF staff] not to have a fundamental balance of payments problem." To discuss both points it is helpful to divide the eligible countries into two broad categories according to the present situation of their external sectors. Let me utilize for exemplification the Latin American cases that I am more familiar with. The first category comprises the countries in which the balance of payments equilibrium is based on a structural balanced or nearly balanced trade account. Some cases in this category in L.A. are Chile, Colombia and Brazil. The second category comprises cases with a significant trade and current account deficit, financed in the nineties by massive capital inflows. Notable cases.

(4) 1 in this category are Mexico and Argentina. Economic policies in the countries in the first category have been fighting against both the destabilizing effect of capital inflows and the tendency to revaluation. In these cases the facility would be redundant. It can be taken for granted that these countries will not show any interest in the facility. The first point to underscore regarding the countries in the second category is the relative small amount of the facility and, consequently, its negligible above-mentioned first role. So, in these countries, the expected outcome of the facility would be restricted to the signalling effect of the agreement itself. If this is the case, all the IMF paper discussion about the possible secrecy of the agreement seems to be superfluous, at least. Reasonable doubts can be expressed about the positive or negative meaning of the signal, but anyway, the signal seems to be the only relevant effect. In the cases in which the fragility of the external sector results from the potential volatility of capital flows, the facility could have a stabilizing role given by the signalling effect of the agreement. But the agreement could alternatively have a negative effect on expectations and credibility. It seems to me that the sign of the effect would be country-specific. In the case of Mexico, the swap agreements with the United States and Canada, seen as complementary to the NAFTA agreement and showing a considerable involvement of concerned neighbors and partners, had a positive effect for some time, although it was not enough to compensate for the intrinsic fragility of the Mexican external accounts. The sign of the effect seems to be more doubtful in other cases. I am sure that it would be negative in Argentina, where the main arguments of the government to sustain the credibility of the rate of exchange is the full convertibility at a fixed rate and the one hundred percent backing of the monetary base, both guaranteed by law. In the Argentine case, any.

(5) 1 government gesture suggesting the need for additional reserves support would have negative effects on expectations. In all cases the agreement about the right of access to the facility would mean a consultation with the IMF staff. This implies risking a negative answer, with its consequent negative effects on expectations. It does not seem to be attractive to countries that do not have any current need for Fund support. The Mexican crisis confirmed my suspicions of the uselessness of the facility under the conditions of significant capital outflows and, more importantly, many people's pessimism regarding the sustainability of Mexican-type balance of payments structures. Mexico had been experiencing an increasing current-account deficit whose financing needed annual capital inflows amounting to over twenty billion dollars. Not one case of the econometric projections abundantly formulated at the time of the NAFTA agreement showed a significant improvement in the external balance in the foreseeable future. When asked about what could make a permanent capital inflow of that magnitude credible, most Mexican economists replied in either one or both of the following ways. Some mentioned structural reforms and fiscal surplus, spiced on occasion with references to the monetary theory of the balance of payments. Others with a more practical orientation made reference to the special commercial and political relationship with the United States. The facts showed again, as in the recent cases of Italy and Spain, that even the best designed signals and institutional arrangements cannot compensate for the intrinsic fragility of the balance of payments. The growth performance and the evolution of the current account had long shown that a reformulation of the program including a real devaluation was necessary. Moreover, the country had been experiencing reserves losses and rising interest rates for almost a year. It was in this context that the swap agreements.

(6) 1 with the United States and Canada were signed. Mexico missed the opportunity to make the necessary rectification when credibility and confidence were high and this is one of the reasons why the country again needs rescue operations and again lives under emergency conditions. One last point about the role of the IMF in the mentioned Mexican circumstances. According to the IMF paper, although the Fund has not been financially involved in the swap agreements, "management was consulted for its views by potential swap partners and by the Mexican authorities" on the occasion of the first swap agreement with the United States (November 1993). The involvement of the Fund in the April 1994 agreement is expressed by "the possibility that the participants in the agreement may request an assessment by Fund management of the requesting country's economic and exchange rate policies." We do not know if the Fund management was consulted again in April 1994, but we are informed by the paper that it actually expressed a judgment in November 1993. Given that the agreements were signed without alteration of the Mexican policies, we can be almost sure that Mexico was considered to fulfill the conditions the paper suggests for a country to be eligible for the analogous proposed facility, i.e. "(i) the member had a strong record of economic policies and performance and it was expected that policies would remain appropriate and (ii) the member was judged not to have a fundamental balance of payments problem.".

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Related subjects : Short-term Case and Agreement