News reports of the International Monetary Fund’s (IMF) activities abound in most countries across the globe yet there is little consensus in the literature as to the effectiveness of the IMF’s work. The purpose of this study is to provide a systematic review of the IMF literature that identifies the effects of IMF bailouts from the 1970s to the present. We investigate significant elements and consequences of the IMF’s bailout policies and implementation approaches such as bailout effectiveness, moral hazard, conditionality, leadership, governance and the sustainability of IMF policy. Based on our review, we develop the ‘Spiral of Doom’ framework and argue that the effectiveness of the austerity package attached to bailout funds is questionable because the design of the package overlooks the recipient country’s unique economic status and cultural background. We then propose financial engineering solutions as an alternative to IMF bailouts which it is envisaged may minimize the moral hazard problem associated with bailouts.
The International Monetary Fund (IMF) was established in 1944 to promote international economic cooperation and provide its member countries with short-term loans if they experience a financial crisis or a shortage of liquidity for international trading. In return, bailed-out countries are required to implement a series of economic reforms in line with IMF policy. Debates about the appropriateness of the IMF bailouts continue to thrive. Opponents of IMF bailouts argue that they make troubled countries further dependent on the IMF (Bandow & Vasquez, 1994; Corsetti, Guimaraes, & Roubini, 2006), while proponents claim that the liquidity supported by the IMF is crucial in preventing extreme financial consequences. Yet studies addressing the adoption of IMF bailouts are largely independent of those that address the effectiveness of the IMF. This lack of integration within the research could be fueling the inconsistencies in the literature addressing IMF bailouts.
The purpose of this study is to expand on the current literature by investigating several important, yet under-researched, elements related to the IMF’s bailout policies and implementation approaches, including leadership, governance and the sustainability of IMF policy. For example, IMF bailout policies typically have a short-term focus. Recipient countries are forced to implement economic reforms to return their budgets to surplus in a short period of time. However, in the long term, tough austerity packages may further deteriorate the weak economies of recipient countries. Additionally, IMF bailout policies are overly rigid as they fail to accommodate a recipient country’s economic status and cultural background as part of the bailout design and implementation process. In 2012, the Governor of the Malaysian Central Bank, Zeti Akhtar Aziz, stated that ‘The adjustment, the austerity and consolidation of the fiscal position has to be done gradually because any drastic prescription or conditionalities would drive the country into a new phase of economic recession and this would increase the cost to the economy and make recovery potentially more remote’. In this regard, indebted countries, such as Greece, should be given more time to implement reforms and clean up their finances; an overly stringent austerity drive could push such countries into a prolonged recession and make recovery even more unlikely (Chua, 2012). This is evidenced in Greece’s painful experience over the past few years, which has resulted in the country defaulting on its 1.6 billion euro debt payment to the IMF, which in turn will likely lead to its exit from the European Union (EU) zone and possibly even the EU. Consequently, the European Central Bank (ECB) has expended emergency funding to the Greek banks as the Greek people withdrew billions from their savings accounts.
In light of the above discussion, our research seeks to address the following research question: In what way, if any, do IMF bailouts contribute to a country’s financial recovery and stability?
The extant literature is inconclusive as to whether IMF bailouts are effective. This study reviews the critical issues related to IMF bailouts and offers constructive resolutions for the following four issues:
Issue 1: One of the key issues concerns the effectiveness of IMF bailouts and whether they significantly improve a country’s economic performance and financial stability.
Issue 2: The IMF is criticized for forcing recipient countries to adopt policy reforms without considering the difference in economic status, business environment and culture among countries. The short-term focus of the austerity package may damage the economic development of bailed-out countries in the long term. In addition, frequent bailout actions can lead to moral hazard.
Issue 3: Corporate governance plays an important role in economic development and investor protection. We posit that countries whose leadership adopts sound corporate governance systems are more likely to recover from an economic crisis and return to economic stability.
Issue 4: Evidence shows that financially stressed nations are bailing out other financially stressed nations with borrowed money. The IMF obtains money from various nations that are themselves drowning in debt. The five largest contributors to the IMF are the United States (16.75%), Japan (6.23%), Germany (5.81%), France (4.29%), and the UK (4.29%)—all of which, unfortunately, are in debt. So what happens when the contributor nation runs out of money and is no longer able to contribute? For how long can this situation continue before the entire system collapses? Such concerns add more credence to the argument that new ways and approaches to fund IMF bailouts are required.
To address the research question and four issues raised above, this study undertook an examination of research in the areas of management, finance, social science, government and the media that focused on the IMF’s financial assistance activities between 1970 and 2015. This involved a review of over 1300 academic studies and reports. Based on the criteria for the selection of papers examining the effect of the IMF aid programs, and to ensure the integrity of the research methodology, these papers and reports were reduced to approximately 700 academic studies and official reports drawn from various governments and the IMF. These documents then, progressed for inclusion in the second stage, entailing a category theme analysis (Aronson, 1995). Thematic coding was developed inductively and the studies were categorized by dependent and independent variables. The findings generated an understanding of the constructs and their relationships, which facilitated the development of the study’s framework.
The following sections focus on the effectiveness of IMF bailouts, the moral hazard issues surrounding IMF bailouts, the effectiveness of the conditionality of the IMF package, the corporate governance of IMF and debtor countries, and the financial engineering of IMF bailouts. Based on the existing literature, a bailout model is then developed. The final section provides a short summary of the research findings and suggestions for future research.
2. Literature review
2.1. The effectiveness of the IMF bailout
For decades, the IMF assumed the role of rescuer of financially troubled countries. However, it does not hold a convincing record of enabling countries to return to financial health and stability (Johnson & Sweeney, 1997; Bordo & Schwartz, 2000; Corsetti et al., 2006). Evidence suggests that IMF bailouts might lead to moral hazard, implying that debtor governments tend to have more aggressive economic policies, leading to a higher chance of receiving an IMF bailout in the future (Dreher, 2004; Corsetti et al., 2006; Lee & Shin, 2008). IMF programs have three components: financing packages, structural reforms and macroeconomic policies. These three elements are inseparable as together they form a single offer of assistance, known as an IMF-supported program.
The effects of an IMF bailout are well documented. However, the empirical evidence is varied and inconsistent. Empirical studies employ different methodologies, use a wide variety of samples spanning a number of time periods and ask different questions when examining how the IMF program affects the economic performance of indebted countries. The popular approaches to assessing the effects of IMF intervention are based on an examination of the economic performance of bailed-out countries before and after the IMF intervention or comparisons between countries that do and do not receive such assistance (Steinwand & Stone, 2008). Existing studies cannot provide a conclusive answer as to whether IMF programs influence the economic growth of indebted countries (Dreher, 2006). Mixed findings are reported in the literature, identifying positive and negative relationships, as well as no relationship, between the IMF bailout and the economic performance of bailed-out countries.
For example, in support of the benefits of IMF programs, Reichman and Stillson (1987), and Conway (1994), assert that the IMF provides significant benefits to a bailed-out country’s economic output. Based on data drawn from 69 developing countries during the period 1973–1988, Kahn (1990) reported that IMF programs have short- and long-term positive impacts on the performance of the current account, the balance of payment, and inflation. This finding is consistent with the conclusions presented by Bagci and Perraudin (1997) and Dicks-Mireaux, Mecagni, and Schadler (2000). Some studies found that the IMF bailout is effective when the debtor country makes the necessary policy adjustments (Morris & Shin, 2006). Moreover, various researches identified that the IMF intervention induces short-term creditors to roll over where IMF programs significantly increase the probability of local currency depreciation (Dreher & Walter, 2010).
In contrast, most studies find that the IMF bailout has a negative effect on the economic performance of recipient countries. For example, Bordo and Schwartz (2000) analyzed the annual data from 11 Latin American and 13 Asian countries for the period 1973–1998 and found that the performance of recipient countries was worse after they received assistance from the IMF. Analysing data from 98 countries over the period 1970–2000, Dreher (2006) found that the overall impact of an IMF bailout is negative. Such a negative impact might be due to either the provision of inappropriate advice by the IMF or the occurrence of moral hazard issue as a result of the IMF bailout. Drawing on data from 130 countries over the period 1975–1999, Barro and Lee (2005) also reported that the IMF bailout has a negative impact on the economic growth of bailed-out countries. In addition, they found that the IMF’s decisions on which countries will be given a loan are highly politically driven. Loans tend to be larger, and more frequent, if the recipient country: (1) has a bigger representation among IMF staff; and (2) is more politically and economically connected to the US and major European countries. More recently, analyzing data from 57 developing and emerging economies for the period 1975 to 2008, Jorra (2012) argued that an IMF program cannot improve the economic performance of bailed-out countries. Furthermore, his empirical evidence shows that IMF bailouts significantly increase the probability of subsequent sovereign defaults by approximately 1.5–2%.
However, a few studies identified no significant economic results attributable to IMF bailout interventions. For example, Donovan (1982) investigated the macroeconomic performance of countries associated with IMF programs during the period 1971–1980, and found that these countries experienced a significant balance of payments improvement, yet their economic growth rates were not significantly improved. Atoyan and Conway (2005) investigated the effectiveness of IMF programs in 95 developing countries for the period 1993–2002, and identified that IMF programs do not significantly improve real economic growth in participating countries in the short term. However, evidence of an improvement in economic growth in these countries was found in the years following involvement in a program. Similarly, Easterly (2005a,b) failed to find any remarkable economic growth associated with 56 IMF and World Bank adjustment loans to Argentina, Cote d’Ivoire and Ghana between 1980 and 1999. Evrensel (2002) found that the macroeconomic situations of recipient countries were worse after involvement in the program, and that the occurrence of moral hazard might be a major cause of program failure. Zwart (2007) claims that support from the IMF can be both positive and negative for recipient countries. On the one hand, financially troubled countries may access liquidity to address their budget problems in the short term and facilitate market functioning. On the other hand, support is always associated with conditionalities. In addition, timing is a key variable. When the IMF and investors act simultaneously, the liquidity effect means that the IMF is consistently successful since the negative signaling effect of the loan is necessarily absent. Similar findings are observed in many other studies (Hardoy, 2003; Nsouli, Mourmouras, & Atoian, 2005). Jorra (2012) concludes that debt crises would become less likely in a world without IMF intervention.
Perhaps the inconsistency in the literature is a key reason for the growing interest among researchers investigating the effectiveness of international official lending. This also includes the identification of an appropriate research methodology which to date, remains a significant challenge for researchers in this area. Dreher (2006) summarized the three popular methodological approaches employed in IMF bailout studies. The first approach is to compare the economic performance of bailed-out countries before and after their participation in an IMF program. However, participating countries are not exogenous, and are usually experiencing crises. Therefore, studies are more likely to observe negative findings. In the second approach, researchers employ control countries as external benchmarks to investigate the effectiveness of the IMF program. Ideally, for each program country there should be a control country with which it shares similar economic fundamentals. However, it is difficult to find a perfect match because the economic status of bailed-out countries normally differs greatly from that of non-recipient countries (Santaella, 1996). Even if the control group were carefully chosen according to economic indicators, the most important difference could not be accounted for: the decision to negotiate an IMF program in the first place (Dreher, 2006), which is an endogenous choice. Atoyan and Conway (2005) suggest that control countries be selected based on the probability of their participation in an IMF program. However, time is needed to evaluate the suitability of this approach. The third research approach uses regression analysis to assess the effectiveness of IMF programs, and has been more widely adopted in recent studies. However, this approach only functions effectively if control for the endogeneity of IMF lending variables is taken into account.
Steinwand and Stone (2008) argue that sample selection is a fundamental methodological issue in research addressing IMF bailouts. Previous studies ignore the fact that IMF programs and bailed-out countries are not randomly selected. Therefore, it is unfair to blame the IMF when bailed-out countries are vulnerable to financial disaster. In addition, even when IMF programs are ineffective, it is difficult to identify whether that failure is due to the program design, implementation approach or the vulnerabilities of bailed-out countries. Jorra (2012) points out that IMF programs might be detrimental to fiscal solvency if the bailed-out countries are associated with weak economic fundamentals, implying that we can blame either the IMF or the bailed-out countries for the failure of international financial rescue efforts. If it is the IMF’s fault, we need to re-examine the design, conditionality and implementation approach of the IMF rescue package. Otherwise the responsibility lies with debtor countries, due to their poor economic fundamentals.
2.2. Moral hazard
Moral hazard poses another major concern within studies in this field. Generally speaking, the term ‘moral hazard’ refers to the situation where in the provision of insurance leads to the insurant taking actions that increase the probability of an adverse outcome (Dreher, 2004). Similarly, Lee and Shin (2008) explain that a person in this situation has less incentive to maintain the insured asset properly, which might increase the probability of undesirable results. As a result, investors and governments treat financial support from international official organizations (such as the IMF or the World Bank) as a form of insurance against adverse shocks. Lee and Shin (2008) argue that repeated financial support from the IMF or World Bank encourages investors to lend excessive amounts to troubled countries with a low interest rate, which does not accurately reflect the underlying risks associated with those countries. In other words, financial support from international organizations actually indirectly encourages investors and governments to behave irresponsibly, which may lead to further future crises.
Moral hazard may be further divided into debtor moral hazard and creditor moral hazard. Debtor moral hazard, on the one hand, occurs when debtor countries receive IMF-subsidized loans with interest rates that are much lower than the market rate, which encourages the governments of said countries to adopt irresponsible policies. Creditor moral hazard, on the other hand, suggests that the recurring financial support from the IMF or World Bank provides strong incentive to investors to behave aggressively in the financial market. However, some studies argue that IMF support does not generate serious moral hazard because the IMF bailout package is relatively small compared to the creditors’ investment amount (Mussa, 2004; Jeanne & Zettlemeyer, 2004).
Empirical research investigating moral hazard generates a number of difficulties. First, it is difficult to quantify moral hazard, because the excessive risk-taking behavior of creditors and debtors cannot be directly observed and measured. Second, it is difficult to separate the effects of IMF intervention from those of other macroeconomic factors (Lee & Shin, 2008). For example, modern financial crisis can easily spread from one country to another, leading to investor panic or even crisis contagion. As a result, the increased investment risk will offset the reduction of bond spread of bailed-out countries due to the occurrence of moral hazard. Additionally, IMF bailout activities encourage investors and debtors to behave more aggressively, which leads to a radical change in market conditions and country economic fundamentals. In this regard, how to control for important market conditions and country economic fundamentals in empirical studies remains a challenge for researchers. In addition, IMF intervention itself is an endogenous factor that is dependent on the decisions of debtor countries and the IMF, as well as global economic and political circumstances. As a result, it is understandable that we cannot find many empirical studies in this field. Researchers normally employ the change in interest rates and bond spread as a proxy for moral hazard. Therefore, it is logical to assume that IMF intervention will reduce the potential for default among debtors’ and encourage investors’ irrational lending, and therefore reduce the borrowing costs of debtors.
Arguably, Zhang (1999) conducted the first empirical study to investigate the moral hazard associated with IMF programs. His study specifically addressed whether the IMF package triggered moral hazard among investors after the Mexican bailout in 1995. However, the relationship between the change in bond spread and the bailout dummy variable was insignificant, implying that the variation of bond spreads was mainly due to the change in international capital market conditions rather than the IMF bailout. Similarly, Kamin (2004), Noy (2004) and Lane and Phillips (2000) failed to find significant empirical evidence to support the presence of moral hazard.
Some studies, however, do argue for the occurrence of moral hazard among investors. For example, the empirical findings of Eichengreen and Mody (2001) support the existence of moral hazard, and these authors assert that the IMF rescue program significantly reduces debt countries’ bond spreads and increases the probability of bond issuance. Eichengreen and Mody argue that the IMF program is welcomed by the market, and is viewed as a commitment to reform by debtor countries. Dell’Ariccia et al., 2002 reported that sovereign bond spreads in emerging markets increased dramatically in 1999 and 2000 after the IMF decided not to bailout Russia in 1998, citing the risk of moral hazard. Examining 116 banks from 16 countries for the period July to December 1996, Lau and McInish (2003) identified that IMF bailouts had a positive impact on banks’ market performance in bailed-out countries. Lee and Shin (2008) further confirm the existence of moral hazard by using a dataset covering 18 emerging countries for the period 1998–2000.
To separate moral hazard from other factors that influence market spreads, alternative approaches are employed to measure investor moral hazard instead of changes in bond spread. For example, Haldane and Scheibe (2003) used the change in market valuation of creditor banks as a proxy for moral hazard. They found that market valuation of UK banks is positively and significantly associated with large-scale IMF loan packages, suggesting that investor moral hazard does exist, which is consistent with the findings reported by Gai and Taylor (2004). It is worth noting that Mumssen et al. (2013) examined the effects of short- and longer-term IMF engagements and found that longer-term IMF support (at least five years of program engagement per decade) assisted Low-Income Countries (LICs) maintain sustainable economic growth. In addition, short-term IMF engagement through augmentations of existing programs or emergency facilities is associated with a wide range of positive macroeconomic outcomes within LICs.
However, the findings are far from conclusive, which is primarily due to the flaws in the research methodologies used in these studies from our perspective. Dreher (2004) argues that using dummies to capture change in the degree of moral hazard is not a suitable approach because one of the key assumptions underpinning this approach is that the economic fundamentals of recipient countries remain steady during the crisis period—which is simply not the case. In addition, the economic fundamentals employed in the empirical analysis are exogenous because their fluctuation largely depends on the availability of IMF funding. Third, the selection of event window for IMF studies is not consistent and very subjective—ranging from a few days to several years. Moreover, the empirical findings of short- and long-term studies are inconsistent. Therefore, short- and long-term moral hazard needs to be further investigated. Fourth, it is worth noting that various studies examine the moral hazard issue by investigating the relationship between IMF bailouts and the political connections of bailed-out countries. In this regard, Barro and Lee (2005) found that the IMF’s lending decisions are highly politically driven. Similarly, Lee and Shin (2008) claim that moral hazard cannot be prevented by the IMF as long as the major shareholders of the IMF, such as the US, are in favor of bailing out countries that are more politically connected.
In short, with respect to moral hazard, the empirical evidence is far from conclusive. The mixed empirical findings are primarily due to methodological issues, such as the measure of moral hazard, and the choice of events and event windows. However, Dreher (2004) concluded that IMF bailouts do cause moral hazard among investors because the evidence from stock market studies is consistently positive and significant. Mussa (2004) and Jeanne and Zettlemeyer (2004) pointed out that empirical research in to moral hazard is not meaningful because lowering the borrowing costs of debtor countries is the expected consequence of an IMF bailout, and not proof of moral hazard. Therefore, examining the effects of IMF lending on capital flows or borrowing costs is not an effective strategy to test for IMF-induced moral hazard. In addition, bailed-out countries are expected to run more expansionary policies than countries that have not received support from the IMF. From the perspective of avoiding moral hazard, what matters is whether IMF interest rates are fair in the sense that they cover the risks faced by the IMF.
2.3. Bailout conditionality
The IMF provides financial assistance to countries only if they agree to implement a series of economic policy reforms to revive and maintain a sustainable economic growth rate in the long term. Debtor countries are normally reluctant to do so because they need to give up a certain level of solvency autonomy in order to receive external financial support. Typical economic reforms include devaluing currencies, lowering tariffs, encouraging foreign investment, privatizing state-owned enterprises, and reducing expenditure on the public sector. It is fair to say that these policy reforms are mainly free-market oriented.
Recently, the IMF was criticized for forcing recipient countries to take on policy reforms without considering the difference in economic status, business environment and culture among these countries. In addition, the tough austerity package attached to bailout funds has implications for leadership at the highest level and forces governments in recipient countries to sacrifice policy autonomy, cut public spending, increase tax and retrench staff, in order to return budgets to surplus in the short term. Unfortunately, these policy reforms often lead to inactive business investment, poorer government service, severe social instability and a higher unemployment rate—all of which may damage the economic development of bailed-out countries in the long term. For example, the IMF has been criticized for being one of the major causes of the recent Ebola outbreak in Africa, because its policy of prioritizing debt repayment over domestic spending has weakened the public health infrastructure in Sierra Leone, Guinea and Liberia who were hit hardest by the epidemic. This had direct implications for the coordination of health services across these countries, including a lack of effective communication coordination and information management. Furthermore, the enforced policy reform is criticized for being a ‘one-size-fits-all’ approach that lacks flexibility, and fails to acknowledge the significance of context such as local economic conditions, cultures and business environments in these countries.
Empirical research into conditionality normally investigates the effectiveness of IMF bailouts from functionalist, structural and public choice perspectives (Steinwand & Stone, 2008). From a functionalist perspective, conditionality is necessary because it forces debtor countries to adopt prudent economic policies to achieve the desired effects of the IMF program. However, it is observed that recipient governments may not be willing to follow the bailout conditions, and the IMF may threaten to cut off aid if recipient governments fail to cooperate. Therefore, Scholl (2009) argued, to achieve the desired bailout outcomes, self-enforcing conditional aid strongly stimulates the economy of recipient countries. However, Dreher and Walter (2010) claimed that the conditionality of IMF loans has no impact on the outcome of IMF intervention.
In determining how to rescue bailed-out countries, structural views represent the interests of the IMF’s major shareholders particularly in the US. This approach suggests that political connections play a critical role in fund allocation and conditionality. For example, Presbitero and Zazzaro (2012) concluded that political similarity with G7 countries is positively correlated with the probability of entering a loan agreement. In addition, the harsher the crisis and the exposure of foreign banks in the country, the larger will be the size of the IMF bailout. Similarly, in their investigation of 314 IMF arrangements with 101 countries over the 1992–2008 period, Dreher, Sturm, and Vreel (2015) identified temporary membership on the United Nations (UN)Security Council as representative of a country’s political importance. Specifically, that such country receives softer treatment from the IMF when negotiating bailout conditions. In return, major IMF shareholders, such as the US and major European countries, may exert more political influence over the Security Council.
From a public choice perspective, conditionality serves the institutional self-interests of IMF staff. For example, Dreher (2004) argues that the conditionality associated with IMF and World Bank loans gradually increased and became inseparable. The major objective of conditionality is to promote economic growth and reduce poverty yet bailed-out countries prefer to minimize conditionality. However, in reality the IMF normally has a stronger bargaining position. Stone (2008) reports that conditionality varies widely, and the IMF would like to maximize the scope of conditionality when countries are most in need of it said. Even when the conditions attached to IMF bailouts sound perfect, unfortunately their effects are often negative. Dreher and Vaubel (2004) found that the number of conditions are negatively associated with international reserves and positively associated with interest rates in the world capital market and monetary expansion in the borrowing market. However, overall the effect of conditionality was not found to be significant in their study.
Even if the conditions of an IMF loan are well designed, the effectiveness of their enforcement may be problematic. Lack of effective enforcement of conditionality can be viewed as one of the major reasons for the failure of bailouts, and may be attributed to the political pressure exerted by major member countries. For example, Stone (2004) argued that the IMF never seriously punishes countries that do not cooperate with bailout conditions if these countries are political allies of the US. In a similar vein, Kilby (2009) found that it is difficult for the World Bank to impose strict structural adjustment conditionality on countries that are friendly with the US. Similar findings are reported by Stone (2008) and Dreher, Jan-Egbert, and Vreel (2009).
Recently, performance-based aid was proposed as an alternative to the failed traditional conditionality approach. This would entail the IMF or World Bank, instead of committing fixed amounts of aid on a country-by-country basis, linking ‘the allocation and disbursement decision by committing the aggregate amount to a group of countries, but where the actual amount disbursed to each individual country depends on its relative performance’ (Svensson, 2003:384). The fundamental objective of this approach would be to strategically improve the overall effectiveness of the aid provided by international organizations. In addition, the IMF and World Bank could choose when and which country to assist based on favorable economic conditions for a bailout. Furthermore, competition among recipient countries might result in an overall improvement in the conditions in terms of supporting an effective use of aid (Öhler, Nummenkamp, & Dreher, 2012). This approach sounds idealin theory. However, empirical evidence of its effectiveness remains limited. For example, Scholl (2009) claimed that self-enforcing conditional aid strongly stimulates economic development by substantially increasing welfare in recipient countries. However, assessing the effectiveness of self-enforcing conditional aid is costly, particularly in ensuring enforceability of less benevolent political regimes which receive large aid funds in return for less stringent conditions. Öhler et al. (2012) found that the incentive to cooperate among recipient countries gradually weakens overtime when the timing and magnitude of aid are uncertain.
In short, the effectiveness of bailout conditionality is clear, and only 20% of loans were repaid in full in the period 2005–2009, based on are port published by the Development Assistance Committee of the Organization for Economic Co-operation and Development (OECD) (Öhler et al., 2012). In addition, as mentioned above, conditionality has multiple objectives rather than being purely economically driven. Vreeland (2006) and Dreher (2009) argued that IMF compliance is not straightforward because IMF agreements span many dimensions, which vary from agreement to agreement. Therefore, a new research methodology is required to clarify the issue. Furthermore, the IMF has never comprehensively reported on the non-compliance of recipient governments. Instead, it frequently waives its program obligations. Consequently, debtor countries have no motivation to implement the predetermined economic reforms or fulfill the conditions of their aid (Svensson, 2003). Thus, as Heckelman and Knack (2008) concluded, such aid may even slow policy reform.
2.4. Leadership and corporate governance
Globalization creates opportunities or challenges for countries, depending on their economic status. Leaders and policy-makers, through corporate governance, seek to adopt structures and institutions that promote economic and social dynamism (Weber, Davis, & Lounsbury, 2009). Leadership and corporate governance are intertwined in terms of their influence on accountability and regulation. The knowledge that leaders possess and disseminate to their boards is viewed as a key element in any country’s development and learning (Ellerman, 1999). This is due to the fact that leadership extends beyond policy and is embedded in the engagement between the state and its agencies, and in turn between the state and the population (Mayosi et al., 2012). Countries that come to the rescue of less fortunate countries via the IMF often do not have a good understanding of the recipient country’s status or the purpose of the IMF bailout package. In this regard, the characteristics of leadership are specific to each country’s context and hence corporate governance policy, procedure and practice. While the leadership literature is extensive, the corporate governance literature is limited in terms of an understanding of the governance structures and systems that enhance optimal organizational performance (Daily, Dalton, & Cannella, 2003).
To some extent, the role of corporate governance in financial markets is well documented (Shleifer & Vishny, 1997; La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998, 2000). The key objective of corporate governance is to provide good returns to investors on their financial investments (Shleifer & Vishny, 1997). The legal protection of investor rights is considered to be one of the key priorities within corporate governance, and countries with good corporate governance systems usually provide better protection to investors (La Porta et al., 2000). Drawing on financial crisis studies, Johnson, Boone, Breach, and Friedman (2000) argue that poor corporate governance had a significant effect on the extent of currency depreciation and stock market declines during the Asian Financial Crisis (AFC). Their findings indicate that countries with weak legal protection of shareholder rights and poor enforcement are more susceptible to a fall in asset values and a collapse of the exchange rate. The notion that a weak corporate governance system was one of the major causes of the AFC is supported by Eiteman, Stonehill, and Moffett (2001). The failures and weaknesses of corporate governance arrangements constitute one of the major causes of the 2008 Global Financial Crisis (GFC), as the existing corporate governance mechanisms failed to safeguard investors’ interests against excessive risk-taking in a number of financial services companies (Kirkpatrick, 2009). Financial firms with dominating shareholders performed worse during the 2007–2008 financial crisis (Erkens, Hung, & Matos, 2012), yet banks with sound risk management structure performed better during this crisis (Aebi, Gabriele, & Schmid, 2012). In relation to the country-level studies, Li and Moosa (2015) claim that countries with weak governance systems are more likely to be associated with greater operational losses in terms of both frequency and severity. It is argued that corporate governance systems serve as an effective enforcement tool for bailed-out countries to restore their economies and financial markets after bailouts. Countries with leadership evidenced in good corporate governance systems are more likely to recover from an economic crisis. In addition, IMF package recipient countries are required to implement a series of economic reforms in exchange for external financial assistance. The reforms attached to IMF packages normally include improving government efficiency and accountability, combatting corruption and privatizing state-owned enterprises, which leads to corporate governance reform. The dynamic change in the corporate governance system of recipient countries inevitably plays an important role in the bailout process.
Empirical studies investigating the effect of corporate governance on the success of IMF bailouts are limited. Only a few address one or two corporate governance variables, and seek to identify the link between corporate governance variables and the outcome of bailouts, instead of examining the overall impact of the corporate governance system. For example, Dreher (2006) identifies that a lower level of democracy and political stability actually increases the probability of a country requesting an IMF loan. In addition, he revealed that countries with an accountable legal system have a better chance of receiving larger IMF loans, and a lower probability of program suspension. Similarly, political instability is negatively associated with IMF loan approval and loan size (Lee & Shin, 2008). Additionally, Jorra (2012) finds that a high level of parliamentary democracy is negatively and significantly associated with the probability of sovereign default, implying that the general openness of political institutions has a significant impact on the effect of IMF bailouts. In contrast, Dreher and Gassebner (2012) found that countries with high levels of democracy are more likely to experience major government crises because parties in such systems can readily express their opinion on controversial policies and events, which may trigger a crisis. Corruption is one of the major barriers to the effectiveness of external aid, and recipient countries’ incentive to fight corruption is a key factor driving the success of bailouts (Öhler et al., 2012).
The importance of corporate governance to a country’s economic development is well documented in the literature. Therefore, we argue that the quality of corporate governance and the improvement in corporate governance systems, in particular, play important roles in determining the success of IMF bailouts. In addition, the implementation approach taken by the IMF needs to be further investigated, such as key persons involved in designing and implementing IMF bailouts, fund allocation channels, and the approach taken to combating corruption.
From the perspective of cultural theory, while the goals of the IMF and a recipient country may be similar, their respective interpretations of these may differ. The IMF would do well to adopt a cultural approach to management by seeking to understand each recipient country’s dominant culture. This is referred to as an ‘ambicultural’ approach to leadership and management, and provides a model for bridging cultures and organizations so that they may interact more effectively (Jer Chen & Miller, 2010). This model is increasingly having an influence on the mindset of IMF leadership across the globe, and increasingly being put into practice, evidenced in the organization’s greater consideration of the dominant values, attitudes and beliefs of recipient countries. This is resulting in superior models of governance, leadership and administration between the giving and recipient countries (Jer Chen & Miller, 2010), thus enhancing sustainable practices of mentorship, support and ultimately independence for the recipient country.
2.5. Financial and economic engineering
To date, borrowed funds are being used by penniless nations to bail out other penniless nations. The IMF obtains money from numerous nations that are in major debt themselves. To illustrate, the five largest contributors to the IMF are the US (16.75%), Japan (6.23%), Germany (5.81%), France (4.29%), and the UK (4.29%); yet it is well known that these countries are all experiencing major financial economic issues themselves. For example, the US has a debt-to-GDP ratio of over 100%, and Japan is associated with a significant debt-to-GDP ratio of over 200%. Thus, it is evident that these countries are funding the IMF with borrowed money. For decades, the IMF used money as a way to force developing nations to do what it wanted them to do. However, prior to 2009, this had mostly only been carried out among poor nations. But now an increasing number of previously wealthy nations are turning to the IMF for assistance. For example, in recent years we have seen Greece, Portugal, Ireland and Cyprus receiving bailouts that were partly funded by the IMF with Spain receiving a bailout for its banking sector. So what happens when the contributors run out of money and are no longer able to contribute? For how long can this situation continue before the entire system collapses? We need to find new ways and approaches to fund IMF bailouts.
As discussed above, doubt is cast on the efficiency and effectiveness of the IMF in managing international financial crises. To date, the empirical results of IMF bailout studies cannot provide conclusive findings on this issue. In addition, prominent economists such as Joseph Stiglitz and Jeffrey Sachs have publicly questioned the appropriateness of both the problem diagnosis and the assistance that programs provide, going so far as to charge the IMF with making the crises worse, deeper and longer than might otherwise have been the case.
The debate surrounding reforming the international financial architecture has attracted the media’s attention in recent years, particularly as previous financial rescue decisions have often been rushed and made without careful or constructive design. One notable example of an alternative to the bailout is the proposal for an international bankruptcy regime. Krueger (2001) claims that a new treaty is required to provide some bankruptcy-style protection to sovereign debtors. Stiglitz (2002) proposes the creation of a system similar to the Chapter 11 (US bankruptcy code 11) regime, to facilitate an across-the-board restructuring of private borrowers’ debts in the event of macroeconomic shocks. Sachs, Tornell, and Velasco (1995), Sachs (1998), Sachs, Radelet, Cooper, and Bosworth (1998), and Fisher (1999) argued that the IMF requires placing enough money on the table to ensure that it can stop capital flight from financially stressed countries. Others have suggested new binding rules to substantially scale back the amount of funds the IMF can provide to countries facing crises. The Meltzer Commission (also known as the International Financial Institution Advisory Committee—IFIAC, 2000) suggests that the IMF should exit the business of lending to countries that discover macroeconomic virtue only when they are close to default. Instead it ought only to lend large sums to countries with good policies that qualify in advance for extra protection—assuming that such policies could be defined. Lerrick, 2000 propose that the IMF should support the secondary market for a country’s sovereign bonds rather than lend directly to the country. However, to date, these calls for major reform have not significantly changed the international financial system. We witnessed the IMF bailout failure in Greece, and how its proposals failed to address the real underlying causes of the Greek crisis. Currently many of the IMF solutions have been impractical or inappropriate in resolving financial crises as they are unable to address essential factors such as culture and the economic and financial structures that are often specific to each country.
To reiterate, IMF programs comprise three inseparable components – financing packages, structural reforms and macroeconomic policies – within a single offer of assistance. In return for IMF financial assistance, the bailed-out countries commit to the reforms known as structural adjustment policies or programs (SAPs). These policies include, but are not limited to, increasing exports, reducing domestic demand, placing constraints on government spending, and encouraging privatization. Another broad view of SAPs describes the policies as involving a combination of short-run measures aimed at stabilization, and long-run structural reforms aimed at transforming heavily controlled economies into market economies. For example, IMF support normally includes privatizing industries and credit control, raising real interest rates, decreasing or ending subsidization, lowering tariffs and increasing imports, tightening fiscal policy (at least initially), opening up financial markets to foreigners, closing troubled banks and financial institutions, and undertaking a range of other structural reforms.
However, we observe many unsuccessful IMF-supported programs (in Greece and Indonesia, for example), where bailed-out countries have experienced severe capital outflows and currency depreciations, even after the programs were implemented. Un-successful results are due to a variety of factors, including the initial hesitation and policy reversals in program implementation. Examples are premature rollbacks of monetary tightening, and political uncertainties that cast doubt on prospective policies (as in the recent case of Greece). In addition, the overwhelming imbalances between reserves and maturing short-term debt are major contributing factors to market uncertainties over the IMF financing packages. Some bailed-out countries (such as Greece) have experienced much deeper recessions than projected, reflected mainly in a collapse in domestic spending, especially private investment. Greece underwent enormous current account adjustments, associated mainly with sharp drops in imports.
Here we make an argument for alternative solutions based on financial and economic engineering that address not only the country’s specific economic and financial structure but also its aspects of culture. Some of these innovations, which we designate here as financial and economic engineering, could lead to strong output growth generated by increasing private consumption, exports and new private investment. Furthermore, cutting inefficient infrastructure projects and public expenses, reforming the tax system and fighting corruption will all be critical to the success of bailouts and economic reform.
In addition, it is necessary for financially stressed countries to return their current accounts to surplus by reducing unnecessary imports and boosting trade surpluses. Implementing appropriate measures to increase international reserves will make a country less vulnerable to external shocks, which will eventually enhance financial market confidence. By preserving social stability through targeted subsidies, education and health programs, and employment creation, the risk of financial stress can be reduced. Finally, we believe that, by implementing certain strategic structural reforms such as closing down weak banks and other financial institutions, merging or restructuring debt, improving loan recovery, easing foreign ownership restrictions, and establishing higher standards of governance, such approaches to financial and economic engineering will assist a country such as Greece to achieve economic and financial prosperity.
2.6. Developing a bailout model
Based on the bailout literature, the following theoretical model is presented which identifies the connections among aspects of bailouts implemented by internationally recognized bodies and organizations. A typical IMF bailout process can be subdivided into four key stages, which are presented in Fig. 1. The first stage represents a situation of crisis around whether the government of a financially troubled country should seek assistance from international official organizations, and the potential outcomes associated with different decisions. The second stage is focused on whether international official organizations, such as the IMF or World Bank, agree to provide assistance after receiving a bailout request, and whether the country agrees to accept the rescue package (funds and conditionality) offered. It is clear that the government of the troubled country can reject the rescue package, as Malaysia did during the AFC. If two parties reach a deal, then the third stage of the bailout process commences. This stage involves fund injection and policy implementation imposed by the IMF or World Bank, which can be influenced by many macroeconomic and financial factors that have a direct impact on the economic outcome of bailouts. The fourth and final step in the process includes a review of the bailout.
A typical IMF bailout process: a ‘spiral of doom’
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Fig. 1. A typical IMF bailout process: a ‘spiral of doom’.
Realistic questions to ask about bailout activities are concerned with whether a country is willing to request assistance from the IMF/World Bank, and whether the IMF/World Bank agrees to issue loans to the financially troubled country. The answer to the first question (Q1) is based on an endogenous choice by the government, because the decision primarily depends on the degree of that government’s resilience. In such cases, a government realizes that it needs to give up a certain level of solvency autonomy in exchange for funding from the IMF or World Bank, which inevitably leads to an uncomfortable government situation. If a government is confident in being able to manage its problems alone, it will not seek assistance from international financial organizations, and internally driven economic reform will be conducted instead. In contrast, it can be expected that a government will request assistance from the IMF when all other options are exhausted, implying that this government is nearing default in terms of its financial situation. Once a country decides to seek assistance from the IMF, the first stage of the bailout process is completed.
The second stage depends on whether the IMF or World Bank will choose to provide assistance to the troubled country (Q2). The lending decision is complicated, and depends on the country’s current financial and economic fundamentals, its political connection to these international organizations, how closely its economy is engaged with the rest of the world, and the depth of foreign creditors involvement in the crisis (Barro & Lee, 2005; Lee & Shin, 2008). If the IMF or World Bank decides to decline the request, the market will react negatively and immediately. However, such an immediate rejection does not occur often due to the globalization of financial markets.
What will most likely occur is that the IMF or World Bank will agree to rescue the country. However, the conditions will be determined after a careful due diligence investigation of the country’s economic and financial fundamentals is conducted. This will, automatically trigger a negotiation process between the financial organization and the country. At this point, the country must decide whether it should accept the rescue package, and the associated negotiation process can be time consuming and tedious. A typical example is the case of Malaysia during the AFC. The Malaysian Government rejected the assistance and advice provided by the IMF. Consequently, it conducted a series of economic and financial reforms on its own initiative, such as tightening capital control and devaluing the local currency. In addition, the Malaysian Government increased government spending, in opposition to IMF policies. As a result of these measures, Malaysia suffered less severe economic challenges than did other countries embroiled in the AFC (Billington, 2004).
More recently, the Greek Treasury bond yield is highly dependent on whether the IMF and the ECB provide further financial assistance to the Greek Government. The re-elected Greek Government has demanded a debt reduction, implying that Greece’s nation-state creditors must write down and cover the investment losses by themselves. The EU and the ECB argue that treaties and agreements made with previous Greek governments should be honored. The re-elected leaders of the Greek Government argue that past agreements have only caused suffering and hardship for the Greek people due to the tough austerity package attached to these previous treaties and agreements. As expected, the market reacted negatively to the tension generated between Greece and its euro zone partners during their debt negotiations, and the situation stirred up anxiety about the solvency of Greek banks and fears that Greece might exit the euro zone bloc.
There is a unanimous agreement that Greece requires debt restructuring as it is impossible for the Greek government to service its debt as the bailout is designed to fail (Manasse, 2015). It is difficult to enter into re-negotiations with its creditors again without a convincing structural reform plan in advance, which leads to a dilemma. A realistic solution could be that Greece deals with an improved debt serving program specifically on lower borrowing cost, and longer terms of maturities. Principal reduction can be avoided in order to maximize creditors’ interests (Taylor, 2015). The effect of this new plan may avoid new market uncertainties, and enable Greece to pronounce a solution to its debt sustainability problem, which would eventually boost market confidence and reverse capital flows as the country implements its structural adjustment debt repay program overseen by an impartial body, such as IMF.
Alternatively, the solutions employed by the Malaysian Government during the AFC are worthy of consideration. Major reform policies employed by the Malaysian Government included devaluing the local currency, creating asset management companies, and tightening capital flow to stimulate the economic growth. However, not all approaches are practicable for the Greek Government. For example, it is impossible for the Greek Government to devalue the Euro because the monetary policies of ECB members are actually decided by ECB. If Greece adopts the Malaysian solutions, then Greece’s exit from the Euro zone would be highly anticipated, leading to an inevitable contagion effect. An alternative solution is for the IMF, EU, ECB or World Bank to agree to issue a special rescue loan to Greece. In this scenario, the probability of default would be reduced due to the liquidity injection from recognized international organizations (Lau & McInish, 2003).
Once the international official organizations agree to issue special loans to a particular country (the second stage), the third stage commences. The ultimate objectives of a bailout are to return the public sector budget to surplus in the short term and maintain sustainable economic growth in the long term. However, it has been widely observed that there are many factors that influence the bailout outcomes. For example, there is significant evidence in the literature on the impact of bailout conditionality and moral hazard. As discussed above, the design and enforcement of bailout conditionality mainly depend on the bailed-out country’s economic fundamentals, and its political relationship to international official organizations and to the key members of the IMF. However, the effects of bailout conditionality are generally disappointing due to the conflicts of interest between international financial institutions and major member countries (Öhler et al., 2012). On the one hand, countries can easily access the funds from international financial institutions if they are politically closely related to major member countries, and lax enforcement of conditionality can be expected due to such political connections. Similarly, Stone (2004) finds that countries that are politically important to the US receive lesser punishment if they do not comply with IMF bailout conditions. In relation to moral hazard, the empirical findings of previous studies are inconsistent—mainly attributed to issues associated with research design and methodology. Furthermore, the significance of the moral hazard phenomenon has been challenged. Mussa (2004) and Jeanne and Zettlemeyer (2004) observed that bailed-out countries tend to have lower borrowing costs and to adopt more aggressive economic policies after receiving financial assistance from international financial organizations. To avoid moral hazard, it is important that the loan interest rates reflect the underlying risks associated with those countries and the risk faced by the IMF.
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