IMF ’softer approach’concerns bondholders

Bloomberg

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The International Monetary Fund, or IMF, may be so conscious of having handed out bad advice to needy countries in the past that it isn’t offering them enough guidance now.

The Washington-based lender is combating the worst financial turmoil in its 64-year history with more than $55 billion in loans for nations from Pakistan to Serbia. As the fund prepares to lend even more, it is retreating from its practice - carried out with adverse effects a decade ago in Asia - of demanding that governments overhaul their economic systems in return for aid.

The risk is that without more-stringent loan requirements, borrowers won’t reform their foundering economies, leaving investors to enforce the discipline - and delay recovery Ğ by shunning the nations’ debt and currencies. Among the economies whose markets may be most vulnerable are those in eastern Europe such as Latvia and Hungary, say Brown Brothers Harriman & Co. and Royal Bank of Scotland Group.

"The pendulum may be swinging too far," says Claudio Loser, former head of the fund’s Western Hemisphere department and now a fellow at the Inter-American Dialogue in Washington. "There was a strong perception that the IMF used to ask too much of countries. Now there is a major danger it’s moved too far in the direction of not setting enough conditions."

Little more than a year ago, the IMF lacked both relevance and resources. Now its lending firepower is being tripled to $750 billion by the Group of 20 nations. The G-20 also agreed to give the IMF another $250 billion in Special Drawing Rights, an overdraft facility for its 185 members.

"The IMF needs to adapt," Dominique Strauss-Kahn, the fund’s managing director, said in an April 16 speech. "Its lending must become more flexible and better tailored to country circumstances."

The Fund said last month it would set fewer goals for nations to commit to in return for aid and would place less emphasis on structural reforms such as overhauling banking or tax systems. It also eased terms for a credit line introduced in October that is now attracting interest from Mexico and Poland.

"There’s lots of money but little pressure for economies to adjust," says Kenneth Rogoff, former IMF chief economist. "It’s much more fun being Santa Claus than Scrooge."

Market rally
So far, aid packages from the IMF have buoyed markets in some emerging economies. Mexico’s peso strengthened 8 percent against the U.S. currency, and Poland’s zloty appreciated 1.1 percent versus the euro since the countries said they will seek IMF credit lines.

Ukraine’s equities and bonds have rallied since the IMF announced its $16.4 billion bailout in October, with the benchmark PFTS stock index gaining 47 percent, and the nation’s 7.65 percent U.S. dollar bonds due 2013 climbing 35 percent.

If governments don’t improve their fiscal policies, though, investors will deprive their economies of capital and punish their bonds, stocks and currencies, says Win Thin, senior currency strategist at Brown Brothers Harriman.

"We cannot see investors piling back into the emerging-market countries with the worst fundamentals, even if the global crisis continues to abate," Thin says.

Investors are demanding more than triple the yield they sought a year ago to own Hungarian bonds denominated in foreign currencies. Pension funds may pull out of Latvia after Fitch Ratings on April 8 downgraded its debt to junk, says Karlis Danevics, head of the Latvian credit department of Stockholm-based bank SEB.

Fitch said about half the countries in central and eastern Europe may face credit-rating downgrades. The ability of governments to stick with their IMF commitments will help determine the ratings, Fitch said.

Thin says ratings companies may still be too confident in the sovereign debt of Latvia, Hungary and Romania. ING Romania analysts say the country may exceed the budget-deficit target of 4.6 percent of gross domestic product that its government agreed on with the IMF. "IMF money helps resolve issues to do with liquidity, but is only one part of the process of overhauling economies with more fundamental problems, for example Latvia, Ukraine and Hungary," says Timothy Ash, head of emerging-market economics at Royal Bank of Scotland.

Economists from countries now receiving aid say the fund is missing an opportunity to force lasting reforms.

Missing opportunity
Zoltan Torok of Raiffeisen International Bank in Budapest says the IMF has been "very soft" on Hungary - first calling for the budget deficit to be reduced to 2.6 percent of gross domestic product from 3.4 percent last year, then settling for about 3 percent.

He says the IMF didn’t go far enough in pushing for cutbacks to Hungary’s pension system. Almost a third of the population of 10 million is retired, and their benefits account for 10 percent of GDP, according to the Organization for Economic Cooperation and Development.

In Serbia, Stojan Stamenkovic, head of the Belgrade-based Economic Institute, says the fund has suggested it "will accept any solution" from the government that cuts the 190 billion-dinar ($2.7 billion) budget deficit by 100 billion dinars. That’s not enough, given that Serbia’s economy is likely to contract 10 percent this year, he says.

The biggest test for the IMF’s new strategy may come in Turkey, where aid talks collapsed in January. Economic Minister Mehmet Şimşek said March 26, after the talks resumed, that he expected the fund to show more flexibility.