Perspective

Cure or curse: Our perpetual dependence on the IMF

Updated Jan 17, 2017 08:11pm

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Photo courtesy: dawn.com
Photo courtesy: dawn.com

Moral of the story first: prolonged interaction breeds complacency and self-interest.

The latest International Monetary Fund (IMF) loan programme for Pakistan concluded in September 2016. It was deemed a success: the country’s economy is doing reasonably well after three years under it.

The state of the economy, however, may not have much to do with the programme. There is, in fact, a strong expectation that Pakistan may again seek help from the IMF if its finances become insufficient to meet its external trade and debt repayment needs.

Our relationship with the Fund (that is, dependency) can be better understood by looking at our past. The IMF is generally approached for help when a country faces a balance of payments problem. Although this remains the main reason for Pakistan requesting money from the Fund, the IMF programmes in Pakistan (and in other countries) since the 1990s have focused more on introducing comprehensive changes in the structure of the economy than just providing support for hard currency needs.

There is, in fact, a strong expectation that Pakistan may again seek help from the IMF if its finances become insufficient.

Since December 1988, Pakistan has had nine separate engagements with the IMF — three of them were double programmes. That means there have been 12 IMF programmes in Pakistan in the last 28 years. Only four of them – all initiated in the 2000s and 2010s – were completed successfully; all the rest were abandoned halfway in the 1990s.

The turning point came in 2000 when Pakistan was facing the possibility of defaulting on its foreign debts by the end of the year. One should recall that Pakistan had fallen out of favour with the West in May 1998 (when it conducted nuclear tests) and subsequently in 1999 (due to Pervez Musharraf’s military coup). Seeking help from the IMF was the only option available to Islamabad in those circumstances.

This constraint put the government in a situation where it had to accept and abide by the terms and conditions attached to the loan agreement with the IMF (signed in November 2000 and completed in September 2001).

Also read: Is Pakistan heading towards a serious debt problem?

A close look at the three remaining completed programmes reveals that two of them were clearly linked to positive external developments (positive shocks). The three-year programme that started in December 2001, for instance, was supported by debt rescheduling/write-offs and generous grants by the United States after 9/11; the three-year Extended Fund Facility programme initiated in November 2013 became irrelevant after the collapse of world oil prices in mid-2014.

The successful completion of an IMF programme, thus, clearly depends on political will within the government, as well as helpful external developments. This raises a question: what exactly does the IMF do to ensure the success of its programmes?

Doctor-patient parable

By the IMF’s own acknowledgement in 2002, Pakistan was third in a list of 51 countries described as “prolonged users” of its financial support. Our peers were the Philippines (#1), Panama (#2), Kenya (#7) and Argentina (#16). Pakistan continues to rank high on that list.

A parable may help illustrate Pakistan’s complicated relationship with the IMF.

The incentive for a doctor (IMF in this case) to maintain a relationship with a patient (the country receiving an IMF loan) is pretty straightforward. If the patient fully recovers, the doctor may feel professionally satisfied but he will also lose a customer.

The IMF was created as a lender of last resort for governments that cannot get a loan from any other source.

A ‘well-intentioned’ doctor will prescribe bitter medicine and demand behavioural changes – he will not allow the patient an easy way out – irrespective of the fact that this will lose him a client. A ‘self-serving’ doctor, on the other hand, will yield to the patient’s reluctance to change bad habits and prescribe milder medication; the doctor will also schedule regular visits to keep administering the palliative.

But after remaining bedridden for almost a decade, why doesn’t the patient (Pakistan) insist on a course of treatment that actually cures him? In our view, this is because the patient is under the charge of his aunt (the government). As with the doctor, we also assume the aunt is either well-intentioned (she wants the patient to recover) or self-serving (she wants to keep the patient weak so that she can continue living in his house).

Any doctor should be able to see through the motivation of the aunt. But it is not that simple — the doctor reports to a board which insists that the aunt has the final say (as the guardian of the patient). The issue is this: why does the doctor continue to treat the patient after eight failed treatments that have focused on the same illness? Why does the doctor not adopt a tough-love approach? Why does the aunt not demand a more effective treatment that will show results?

Game theory

Illustration by Essa Malik
Illustration by Essa Malik

Another way to look at this question is using a simplified game theory approach.

In this game, the doctor (the IMF) represents the board while the aunt (the government) represents the patient (the country). For a regular patient, the game is repeated; the ‘payoffs’ shown are what the two players (the aunt and the doctor) receive.

Quadrant 1 shows both the doctor and the aunt working for the betterment of the patient. In doing so, the doctor works himself out of the job.

In Quadrant 2, the doctor is well-intentioned but the aunt refuses a treatment that works. The patient suffers terribly (call it sovereign default) and the doctor is punished by his board. Both players are individually hurt in this worst-case scenario.

By the IMF’s own acknowledgement in 2002, Pakistan was third in a list of 51 countries described as “prolonged users” of its financial support.

Quadrant 3 shows a well-intentioned aunt and a self-serving doctor. The treatment fails but the doctor is assured of more work. The aunt is disappointed and hurt and the patient continues to suffer.

In Quadrant 4, both the doctor and the aunt are self-serving. The treatment obviously does not work but this serves the interests of the doctor and the aunt, as both know that another round of treatment will soon begin.

If the game is repeated and the doctor’s ‘dominant strategy’ is to be self-serving, irrespective of how the aunt behaves, he is better off playing selfish. If the aunt knows that the doctor will always be self-serving, she too will gain more from being self-serving. Hence, Quadrant 4 presents a stable equilibrium.

The IMF’s mandate

The IMF was created as a lender of last resort for governments that cannot get a loan from any other source — they are either on the verge of a sovereign default or have already defaulted. Since Pakistan often has insufficient dollar reserves, its ongoing relationship with the IMF is not surprising.

Broadly speaking, the reason for failed IMF programmes may be ‘exogenous shocks’ (for example, unanticipated floods, a sharp increase in oil prices, civil war etc), or a lack of ‘political will’ to make structural changes in the economy (meaning the unwillingness of the government to implement certain tax policies), or a combination of the two. As self-serving governments are more common than negative ‘exogenous shocks’, prolonged IMF user countries are highly likely to have governments that lack political will to change their economic systems.

International Monetary Fund Managing Director Christine Lagarde meets Prime Minister Nawaz Sharif at PM House | dawn.com
International Monetary Fund Managing Director Christine Lagarde meets Prime Minister Nawaz Sharif at PM House | dawn.com

The IMF’s willingness to accept half-hearted implementation of economic changes/reforms creates an incentive for the governments to show bad faith (that is, to promise changes/reforms they have no intention, or ability, to implement). Since bad faith (read bad behaviour) makes it more likely that the country will face a balance of payments problem in the future (which allows the IMF to offer another loan package), the Fund has to state that the previous programmes failed because of bad luck — which is to say that the reasons for failure were beyond the control of both the IMF and its client government. The failure cannot be ascribed to poor programme design/monitoring (by the IMF) or to bad faith (shown by the government).

The IMF’s inability to learn from the past is rooted in its bureaucratic structure that operates with its own internal incentives. If the IMF makes future engagement contingent with past performance, it risks losing its regular clients (prolonged users of its loans). This will reduce the IMF’s workload and a reduced workload will require a reduced workforce — all this goes against the mindset of a well-entrenched bureaucracy.

The IMF is, therefore, willing to return to countries even if they engineer their own problems. It cannot cite the lack of political will (by the government) as a reason for the failure of a loan programme, as an admission of bad faith will reveal poor operational practices within the IMF as well. The Fund, thus, remains ‘apolitical’, even though the hindrances to real economic reforms are always political.

Keen observers of the IMF are of the view that the institution is also a source of foreign policy leverage for the United States of America (which is the only member of its Executive Board with a veto). Having the final say on whether a country defaults on its external payments is a powerful position to be in.

The IMF’s willingness to accept half-hearted implementation of economic changes/reforms creates an incentive for the governments to show bad faith.

America does, at times, use its leverage to influence a country’s policy decisions. For instance, the IMF was very eager to support Pakistan’s economy immediately after 9/11; local media characterised the December 2001 IMF loan package – known as the Poverty Reduction and Growth Facility (PRGF) – as a reward for Pakistan’s joining of the American War on Terror. Although this programme became irrelevant after positive financial conditions prevailed for Pakistan post-9/11, the IMF was still enthusiastic about its ‘successful’ completion in late 2004 when Pakistan was in the midst of a credit-led consumer boom.

Pakistan’s outlook

Despite misgivings about falling exports and a slowdown in remittances, the outlook for Pakistan’s economy is upbeat. Even while direct tax collection perpetually misses its annual target, low interest rates have eased the cost of domestic debt servicing for the government, which has kept its fiscal accounts manageable. The financial space created by low oil prices is also likely to continue till 2020, which should keep annual inflation in the range of 4-6 per cent.

Another positive is the China-Pakistan Economic Corridor (CPEC). Although it raises many unanswered questions, the CPEC factors prominently in the bullish sentiments that many businessmen in Pakistan express. The booming stock market should help attract portfolio inflows in Fiscal Year 2016-17 and the foreign direct investment for CPEC-related projects should also help the external sector.

As we have discussed in a previous note (CPEC: The devil is not in the details), the CPEC cannot be allowed to fail — its failure would undermine China’s economic strategy for the 21st century. Just partnering with China, in this scenario, appears to be sufficient to promise a sustainable economic growth trajectory for Pakistan.

The Chinese flag flies next to Pakistan's flag on a sign along a road towards Gwadar | Syed Raza Hassan, Reuters
The Chinese flag flies next to Pakistan's flag on a sign along a road towards Gwadar | Syed Raza Hassan, Reuters

Conclusion Reforming a country’s economy is not just about changing policies or issuing official circulars. It is not even about securing parliamentary approval for sensitive policy change. Structural reforms are about changing people’s behaviour, especially the behaviour of those who feel political power gives them a licence to extract resources for personal gain. Changing such behaviour is not easy and this is why structural reforms are notoriously difficult to implement.

As we have argued, prolonged interaction between a government and the IMF can lead to second-best outcomes. Pakistan must now approach economic reforms with a completely different mindset if it wants to end its decades-long relationship with the IMF.

The CPEC may be a new character in our doctor-patient parable. If the CPEC is a no-nonsense ‘doctor’ who is able to help the patient become healthy enough to partner with China, the IMF programme that ended in late 2016 may be the last that Pakistan has.


Mushtaq Khan is Chief Economist at Bank Alfalah and holds a PhD from Stanford University.

Danish Hyder is a research associate at Bank Alfalah and holds a degree from Vassar College in New York.

These are the views of the authors and not the bank.