12. International Financial Institutions – Fundamentals of International Business

CHAPTER 12

International Financial Institutions

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

  • Understand the need for International Financial Institutions in the global economy
  • Explain the role of the IMF as a regulator of global finance
  • Analyse the importance of the World Bank Group as a source of development finance
  • Distinguish between the objectives and functions of the IMF and World Bank
  • Examine the regional financial institutions in Asia and Africa

THE NEW BRICS BANK

The five BRICS nations—Brazil, Russia, India, China and South Africa had agreed to establish a development bank for the financing of infrastructure projects. It was christened ‘The New Development Bank’, and established with a corpus of USD 50 million contributed equally by all the members giving them an equal stake. The bank has its headquarters in Shanghai and had India as its first President, followed by Brazil and Russia. The members also signeda treaty to establish the BRICS Contingent Reserve Arrangement (CRA) with an initial corpus of USD 100 billion to be held as reserves of the member countries, as a safeguard against potential or actual balance of payment difficulties. It was scheduled to start lending in 2016 and remained open to membership by other countries, but the capital share of the BRICS cannot drop below 55 per cent.

The idea of a development bank by and for the developing countries was initially voiced by Indiain 2012. It was visualized as an alternative to the IMF and the World Bank which have often been perceived to have a developed nation slantin policy and functioning. The countries under BRICS represent slightly over 40 per cent of the world population, have a 17 per cent share approximatelyin world trade, contribute around 20 per cent to global GDP and are considered potential growth leaders. It has been viewed that the New Development BRICS Bank will accelerate economic growth through the much-needed financial intermediation for the infrastructure needs of countries like India and others in Africa using the surplus funds of China and other oil exporting nations which are currently being recycled through the capital markets of the developed world.

The Bank sanctioned its first set of loans worth USD 811 million in 2016, to be disbursed in tranches, for various renewable energy projects in Brazil, China, India and South Africa. The Indian loan worth USD 250 million was disbursed through Canara Bank.

The Bank has already received A++ ratings from the top global ratings agency S&P Global Ratings and Fitch Rating for its low risk profile and robust capitalization. The bank has also financed a significant number of green infrastructure projects in all its member countries.

The bank is considered to have strong risk management policies, mainly driven by self-imposed prudential rules on capitalization and liquidity. However, it has been cautioned to watch out against ‘concentration risk’, arising out of the relatively small number of countries in which it operates.

References: India to head the BRICS Bank for first five years, https://economictimes.indiatimes.com/news BRICS Bank announces first set of loans, http://thebricspost.com/brics-bank-announces-first-set-of-loans/; Fitch gives Brics’ New Development Bank its second-highest rating, https://www.businesslive.co.za, last accessed on 25 September 2018.

INTRODUCTION

A major development in global finance was the establishment of the IMF and World Bank at the Bretton Woods Conference in 1945.1 These institutions were visualized as the guardians of the international financial and monetary system with a clearly stated mandate. The IMF was established to provide the rules of the game and determine the code of conduct for the international monetary system. The World Bank, on the other hand, was set up to promote general economic development beginning initially with the reconstruction of war torn Japan and Europe. Over the years it has evolved into an agency that looks after the development needs of its member countries worldwide.

INTERNATIONAL MONETARY FUND (IMF)

The International Monetary Fund was established on 27 December 1945 at the Bretton Woods Con ference to promote international monetary cooperation, exchange rate staility and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment. It came into existence with an initial membership of 29 countries and has a present strength of 189 members.

 

The International Monetary Fund was established at the Bretton Woods Conference in 1945 to promote international monetary cooperation, exchange rate stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.

Objectives of IMF

The basic objectives of IMF are as follows:

  • To promote international monetary cooperation through a permanent institution that provides the machinery for consultation and collaboration on international monetary problems.
  • To facilitate the expansion and balanced growth of international trade, leading to the promotion and maintenance of high levels of employment, real income and the development of the productive resources of all members.
  • To promote exchange rate stability and 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 elimination of foreign exchange restrictions that hamper the growth of world trade.
  • To make the general resources of the Fund temporarily available to all members under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments.
  • To shorten the duration and lessen the degree of disequilibria in the international balances of payments of members.

Functions of the IMF

The IMF was established as a specialized agency of the UN system, and it seeks to fulfil these objectives by carrying out three basic operations, which are as follows.

 

The three main functions of the IMF are financial assistance, technical assistance and surveillance.

Financial Assistance

A core responsibility of the IMF is to provide loans to countries experiencing balance of payments problems. This financial assistance enables countries to rebuild their international reserves; stabilize their currencies; continue paying for imports; and restore conditions for strong economic growth. IMF lending usually takes place under an ‘arrangement’, in the form of an economic programme which contains specific macro-economic conditionalities. Unlike development banks, the IMF does not lend for specific projects.

The volume of loans provided by the IMF has fluctuated significantly over time. The oil shock of the 1970s and the debt crisis of the 1980s were both followed by sharp increases in IMF lending. In the 1990s, the transition process in Central and Eastern Europe and the crises in emerging market economies led to further surges of demand for IMF resources, which have largely been repaid as conditions improved.

Over the years, the IMF has developed various loan instruments, or ‘facilities’, that are tailored to address the specific circumstances of its diverse membership.

  • Low-income countries may borrow at a concessional interest rate through the Poverty Reduction and Growth Facility (PRGF) and the Exogenous Shocks Facility (ESF).
  • Non-concessional loans are provided mainly through Stand-By Arrangements (SBA), and occasionally using the Extended Fund Facility (EFF), the Supplemental Reserve Facility (SRF) and the Compensatory Financing Facility (CFF).
  • The IMF also provides emergency assistance to support recovery from natural disasters and conflicts, in some cases at concessional interest rates.

Except for the PRGF and the ESF, all facilities are subject to the IMF’s market-related interest rate, known as the ‘rate of charge’, and some carry a surcharge. The rate of charge is based on the SDR interest rate, which is revised weekly to take account of changes in short-term interest rates in major international money markets. The amount that a country can borrow from the Fund is called its ‘access limit’, and varies according to the type of loan, but is typically a multiple of the country’s IMF quota.

Technical Assistance

IMF provides technical assistance to support the development of the productive resources of member countries by helping them effectively manage their economic policies and financial affairs. The IMF provides technical assistance in its areas of core expertise: macro-economic policy, tax policy and revenue administration, expenditure management, monetary policy, the exchange rate system, financial sector sustainability, and macro-economic and financial statistics. In recent years the demand for IMF technical assistance has increased as the global economy is looking to strengthen the international financial system. Technical assistance is generally provided free of charge to any requesting member country, within IMF resource constraints. About 90 per cent of IMF technical assistance goes to low and lower-middle income countries. Post-conflict countries are also major beneficiaries. Apart from the immediate benefit to recipient countries, by helping individual countries reduce weaknesses and vulnerabilities, technical assistance also contributes to a more robust and stable global economy.

Surveillance

The IMF has been given the mandate of overseeing the international monetary system and monitoring the economic and financial policies of its 189 member countries in order to promote global economic stability. This activity is known as surveillance. IMF surveillance provides an expert assessment of economic and financial developments, both globally and in individual countries. It advises on risks to stability and growth and if policy adjustments are warranted. In this way, the IMF helps the international monetary system serve its essential purpose of providing a framework that facilitates the exchange of goods, services and capital among countries and sustains sound economic growth.

The IMF promotes international monetary cooperation, exchange rate stability and orderly exchange arrangements, and also encourages countries to adopt sound economic policies. These functions are critical, and aim at preventing various kinds of economic and financial crises in the world economy, for crises destroy jobs, slash incomes and cause great human suffering and misery.

Bird’s-eye View

The IMF is a multilateral financial institution aimed at promoting international monetary co-operation through the provision of financial and technical assistance and surveillance services to member nations.

WORLD BANK GROUP

The World Bank Group was created at the UN Monetary and Financial Conference, also called the Bretton Woods Conference, at New Hampshire, US in July 1944. It was originally known as the International Bank for Reconstruction and Development (IBRD) and later called the World Bank. It began formal operations in 1946.2 It is a family of five international organizations res ponsible for providing finance and advice to countries for the purposes of economic development and eliminating poverty. It functions through five major agencies:

 

The World Bank Group is a family of five international organizations responsible for providing finance and advice to countries for the purposes of economic development and eliminating poverty.

  1. International Bank for Reconstruction and Development (IBRD)
  2. International Development Association (IDA)
  3. International Finance Corporation (IFC)
  4. Multilateral Investment Guarantee Agency (MIGA)
  5. International Centre for Settlement of Investment Disputes (ICSID)

The term ‘World Bank’ generally refers to the IBRD and IDA, whereas the World Bank Group is used to refer to the institutions collectively.

The World Bank’s (i.e., the IBRD’s and IDA’s) activities are focused on developing countries, in fields such as human development (e.g., education, health), agriculture and rural development (e.g., irrigation, rural services), environmental protection (e.g., pollution reduction, establishing and enforcing regulations), infrastructure (e.g., roads, urban regeneration, electricity), and governance (e.g., anti-corruption, legal institutions development).

The IBRD and IDA provide loans at preferential rates to member countries, as well as grants to the poorest countries. Loans or grants for specific projects are often linked to wider policy changes in the sector or the economy. For example, a loan to improve coastal environmental management may be linked to development of new environmental institutions at national and local levels and the implementation of new regulations to limit pollution. The activities of the IFC and MIGA include investment in the private sector and providing insurance, respectively.

The World Bank Institute is the capacity development branch of the World Bank, providing learning and other capacity-building programms to member countries. All the 189 member countries of the World Bank are its shareholders, who are generally represented by the board of governors. The Board of Governors in the World Bank group and IMF meet once a year.

The World Bank’s two closely affiliated entities—the IBRD and the IDA—provide low or no-interest loans and grants to countries that have unfavourable financial sources or no access to international credit markets. Unlike other financial institutions, they do not operate for profit. The IBRD is market-based, and uses its high credit rating to pass the low interest it pays for money on to its borrowers—the developing countries.

IBRD lending to developing countries is primarily financed by selling AAA-rated bonds in the world’s financial markets. While IBRD earns a small margin on this lending, the greater proportion of its income comes from lending out its own capital. This capital consists of reserves built up over the years and money paid in from the bank’s 189 member country shareholders. IBRD’s income also pays for World Bank’s operating expenses and has contributed to the IDA and debt relief.

Loans

IDA is the world’s largest source of interest-free loans that grants assistance to the poorest countries, and is replenished every three years by 40 donor countries. Additional funds are regenerated through repayments of loan principal on 35-to-40 years no-interest loans, which are then available for re-lending. IDA accounts for nearly 40 per cent of World Bank’s lending.

 

There are two basic types of loans and credits offered by the World Bank Group through the: investment loans and development policy loans.

There are two basic types of loans and credits offered by the World Bank Group through the IBRD and IDA: investment loans and development policy loans.

  1. Investment loans are made to countries for goods, works and services in support of economic and social development projects in a broad range of economic and social sectors.
  2. Development policy loans (formerly known as adjustment loans) provide quick-disbursing financing to support countries’ policy and institutional reforms. IDA loans are interest-free.

During loan negotiations, the Bank and borrower agree on the development objectives, outputs, performance indicators and implementation plan, as well as a loan disbursement schedule. While the Bank supervises the implementation of each loan and evaluates its results, the borrower implements the project or programme according to the agreed terms.

IDA long-term loans (credits) are interest free, but do carry a small service charge of 0.75 per cent on funds paid out. IDA commitment fees range from zero to 0.5 per cent on undisbursed credit balances. The World Bank Treasury is at the heart of IBRD’s borrowing and lending operations, and also performs treasury functions for other members of the World Bank Group.

Grants

Grants are designed to facilitate development projects by encouraging innovation, co-operation between organizations and local stakeholders’ participation in projects. In recent years, IDA grants have been used to:

  • Relieve the debt burden of heavily indebted poor countries
  • Improve sanitation and water supplies
  • Support vaccination and immunization programmes to reduce the incidence of communicable diseases like malaria
  • Combat the HIV/AIDS pandemic
  • Support civil society organizations
  • Create initiatives to cut the emission of greenhouse gases
  • Analytic and advisory services

While the World Bank is best known as a financier, it also provides analysis, advice and information to member countries so they can deliver lasting economic and social improvements their people need. This is done in several different ways: through economic research on broad issues such as the environment, poverty, trade and globalization and through country-specific economic and sector work, where a country’s economic prospects are evaluated by examining its banking systems and financial markets, as well as trade, infrastructure, poverty and social safety net issues.

The Bank also draws upon the resources of its knowledge bank to educate clients so they can equip themselves to solve their development problems and promote economic growth. The analytic and advisory services of the Bank focus on the following issues:

  • Poverty assessment
  • Public expenditure reviews
  • Country economic memoranda
  • Social and structural reviews
  • Sector reports
  • Topics in development

The IMF and the World Bank often work together. While the IMF focuses on countries’ economic performance, the World Bank emphasizes longer-term development and the reduction of poverty. While the IMF makes short-term loans to help stabilize foreign exchange, the World Bank makes long-term loans to promote economic development.

Bird’s-eye View

The World Bank Group is a family of five institutions established for the purpose of global economic development and elimination of poverty through the provision of low cost loans and grants.

CHAPTER SUMMARY
  • The Bretton Woods Agreement of 1944 led to the creation of the IMF and the World Bank.
  • The role of the IMF was originally to extend short-term loans for development while the World Bank undertook longer term development loans.
  • The three main functions of the IMF are financial assistance, technical assistance and surveillance.
  • The World Bank Group consists of five organizations: IBRD, IFC, MIGA, ICSID and IDA. The term ‘World Bank’ generally refers to the IBRD and IDA, whereas the World Bank Group is used to refer to the institutions collectively.
KEY TERMS
  • IMF
  • World Bank
  • Financial assistance
  • Technical assistance
  • Surveillance
  • Loans
DISCUSSION QUESTIONS
  1. Discuss the role of the IMF and World Bank in fostering global financial cooperation.
  2. What are the basic objectives of IMF?
  3. What are the different forms of assistance that is available under IMF?
  4. Discuss the various sources of fund generation by the World Bank.
  5. What are the different types of assistance available to members of the World Bank?
EXAMINATION QUESTIONS
  1. Explain the structure, functioning and major objectives of the IMF. (15)

    [B.Com (Hons.), 2009]

  2. Explain the structure, functioning and major objectives of the World Bank. (15)

    [B.Com (Hons.), 2010]

  3. Compare and contrast the role of IMF and World Bank as global financial regulators. (15)

    [B.Com (Hons.), 2008]

  4. Examine the functions and role of the World Bank. (7)

    [B.Com (Hons.), 2017]

  5. Enumerate the objectives and functions of IMF. (7)

    [B.Com (Hons.), 2017]