International Monetary Fund: Lending Programs Allow for Negotiations and Are Consistent with Economic Literature
Released: 2009-11-12T00:00:00

Letter

Background

The IMF, an organization of 186 countries, provides surveillance, lending, and technical assistance to its member countries. IMF surveillance involves the monitoring of economic and financial developments and the provision of policy advice, with key aims including financial crisis prevention. The IMF also lends to countries with balance-of-payments difficulties, including medium- to high-income countries, to provide temporary financing and support policies to achieve macroeconomic stability in the medium term. Its loans to low-income countries are to assist policies designed to foster economic growth and promote poverty reduction. In addition, the IMF provides countries with technical assistance and training in its areas of expertise.

Upon request by a member country, an IMF loan is generally provided under a program that stipulates the specific policies and measures a country has agreed to implement. As part of an agreement to receive IMF financing, a member country may agree to implement policy measures, known as conditions, designed to resolve its balance-of-payments problems, overcome the problems that led it to seek financial aid, and help ensure that it can repay the IMF. The IMF also conducts periodic program reviews to assess whether the IMF-supported program is broadly on track and the country has met established conditions, or whether modifications are necessary to achieve the program’s objectives. Based on these reviews of a country’s performance, including whether the country has implemented conditions according to a specific timetable, the IMF Board determines whether the country will receive subsequent installments of IMF funding.

The IMF’s resources are provided by member countries through quota contributions, loan provisions to the IMF, and member contributions for lending to low-income countries. When a country joins the IMF, the country pays a quota to the organization, which may increase when IMF members agree to increase the IMF’s capital. Each IMF member country is assigned a quota, based broadly on its relative size in the world economy. A member’s quota determines its maximum financial commitment to the IMF and its voting power and has a bearing on the amount of IMF financing a member can receive. The IMF also may enter into multilateral or bilateral borrowing arrangements to increase its resources. Moreover, resources for IMF- supported programs to low-income countries come from funding outside quota resources, including member contributions and the IMF.

In April 2009, the G-20 world leaders endorsed measures to significantly increase the IMF’s available resources to $750 billion and also supported new SDR allocations of about $250 billion to increase the international reserves of member countries. An additional special SDR allocation of about $30 billion came into effect in September 2009 under the Fourth Amendment. The source of IMF’s increase in resources includes both increased quota contributions and a significant amount of borrowing from some member countries. Part of these additional resources includes funding from the United States. In June 2009, the U.S. Congress passed legislation that appropriated about $7.8 billion for an increase in the U.S. quota to the IMF. It also made available up to about $117.5 billion for loans to the IMF. Congress set some provisions for the IMF as part of the legislation, including language directing U.S. officials to oppose loans to countries that have repeatedly supported acts of international terrorism and to programs that would force developing countries to cap spending on health care and education. When signing the legislation, the President issued a statement stating that certain provisions within the legislation would interfere with his constitutional authority to conduct foreign relations and that he would not treat these provisions as limiting his ability to engage in foreign diplomacy or negotiations. In addition to the increase in the IMF’s overall resources, the IMF Board agreed in July 2009 to measures that will boost the IMF’s concessional lending capacity available to low-income countries to $17 billion through 2014.

Since August 2008, the IMF has dramatically increased its commitment to lend to member countries in response to the global economic crisis, as shown in table 1. The table categorizes the number of countries and amount of agreed upon IMF funding categorized by various IMF lending arrangements, which are developed and tailored to address the specific circumstances of its member countries. As shown in table 1, the number of countries with Stand-By Arrangements, typically middle- and high-income countries facing crisis and seeking to resolve their short-term balance of payments problems, have significantly increased. See appendix II for a list of the countries that have been approved to receive funding under an IMF- supported program as of August 2009.

Designing an IMF- Supported Program Is a Complex Process That Allows for Negotiated Trade-offs Among Objectives and Policies

The IMF-supported program is intended to help countries achieve macroeconomic stability and contains objectives, targets, macroeconomic policies, and conditions. The design of an IMF-supported program involves a complex process, which includes the use of a macroeconomic framework, economic judgment, and discussions between the IMF staff and country officials regarding trade-offs among different objectives and policies.

IMF-Supported Programs Are Intended to Help Countries Achieve Their Objectives in the Context of Macroeconomic Stability

An IMF-supported program is defined by its objectives and the link between those objectives and the macroeconomic policies used to achieve them, with the specific content of a country’s program reflecting the country’s characteristics and circumstances. For example, IMF-supported program objectives in low-income countries are broadly geared toward the long-term goals of increasing economic growth and reducing poverty. In middle- and high-income countries, particularly those experiencing acute crises, IMF-supported programs generally aim to stem capital outflows, restore confidence, and bring about a recovery in the short- to medium- term.

The macroeconomic framework used to develop the IMF-supported program consists of the following elements as illustrated in figure 1: Targets for key macroeconomic variables: IMF-supported programs include targets to help achieve a country’s objectives. In low-income countries, programs may include quantitative targets to limit the growth of the money supply and the budget deficit to lower inflation and maintain debt levels consistent with macroeconomic stability. In middle- and high- income countries, an IMF-supported program may include targets to stabilize the exchange rate, raise interest rates, and tighten credit conditions to stem the outflow of capital and restore investor confidence.

Macroeconomic policies: Four types of macroeconomic policies— monetary, fiscal, external, and structural reforms—may be used to help a country achieve its objectives. Monetary policy is used to affect the growth of the money supply and interest rate levels. Fiscal policy sets the amount and composition of government expenditures and government revenue to affect the size of the budget deficit. External policies concern the size of the trade deficit and the exchange rate, which can influence the amount of exports and imports and the buildup of international reserves. IMF- supported programs also are likely to include “macro-critical” structural reforms intended to help countries establish sound financial sector regulatory systems.

Conditions: IMF-supported programs may contain quantitative performance criteria (QPC) and macroeconomic structural conditions, which the country has agreed to implement to receive IMF disbursements. Examples of QPCs that address macroeconomic policy variables include (1) limits on government borrowing to curb the public debt, (2) a ceiling on the expansion of the money supply to manage the interest rate or contain inflation, or (3) a floor on international reserves to stabilize the exchange rate and weather shocks. According to the IMF, a country’s performance criteria are frequently revised during the course of a program as external conditions evolve in a way not initially foreseen. Structural conditions are measures that the IMF and country authorities consider critical for the successful implementation of the program. Structural conditions may include specific measures to strengthen banking supervision, reform the tax system, improve fiscal transparency, and build up social safety nets. Although structural conditions are no longer used as performance criteria, the structural reforms that the IMF sees as critical to a country’s recovery will continue to be monitored.

Various Combinations of Policies and Variables Are Consistent with Macroeconomic Stability, Allowing for Negotiations

Because of the extensive linkages among the various economic sectors and the mutual dependence of policy instruments and targets, designing an IMF-supported program is complex, iterative, and requires economic judgment. The process of designing the program begins when country authorities contact the IMF due to impending or ongoing macroeconomic instability or crisis. The IMF staff and country authorities establish the country’s need for borrowing based on the specific underlying macroeconomic problems to be addressed and discuss program objectives and policies. Using a macroeconomic framework as an analytical basis for the IMF-supported program, IMF staff and country authorities use an iterative process to set targets for key macroeconomic variables, such as real GDP growth, inflation, and the budget deficit, and identify specific economic policies intended to achieve these targets. The framework is intended to ensure consistency of the target values for the macroeconomic variables among the various sectors of the economy and to align the IMF’s macroeconomic and structural policy advice with the program’s objectives, while incorporating country-specific factors. For example, the macroeconomic framework might be used to inform discussions about how to achieve the target of a lower budget deficit by weighing policy options that include reducing expenditures, raising revenues, obtaining grant financing, or modifying the goal. The process for designing the program usually culminates with country authorities and IMF staff agreeing on the goals, targets, and policies for a program that is both technically feasible and politically acceptable. Then, they seek agreement on the conditions, including QPCs and structural reforms, needed to complete the program. The IMF Board is then asked to discuss and approve the program.

In designing an IMF-supported program, a government has to make difficult trade-off decisions among different priority objectives and policies consistent with macroeconomic stability. The trade-offs required reflect the specific country circumstances and the severity of the macroeconomic imbalances. According to an IMF/World Bank document, there is a substantial gray area for a combination of levels of key macroeconomic variables, including growth, inflation, fiscal deficit, current account deficit, and international reserves that lies between macroeconomic stability and instability, where a country could enjoy a degree of stability, but where macroeconomic performance could clearly be improved (see fig. 1). This gray area allows for negotiation between the country authorities and the IMF staff.

This process can be illustrated in the following hypothetical example. A country can be adversely affected by the global recession in a number of ways, including through declining export revenue as the price and volume of exports fall. The decline in exports is likely to lead to a rise in unemployment as private sector activity declines, contributing to increased poverty. Any effort on the part of the government to increase spending to counter this fall in aggregate demand is likely to increase the budget deficit, especially in the context of falling revenues. The increased spending also may contribute to inflationary pressures. If the country, prior to the crisis, was already experiencing a high debt level and an elevated inflation rate, the way forward can be quite complicated. If the budget deficit were to rise by too much, inflation could increase to a point where the country would be at risk of macroeconomic instability, while insufficient domestic spending could lower economic growth, worsening the unemployment situation and increasing poverty.

Financial assistance through an IMF-supported program can help mitigate the situation, but the government of the hypothetical country in this example still faces a difficult policy trade-off—how to reduce the impact of the recession on the poor without risking high inflation. Within this overall context, the discussions between IMF staff and government officials are likely to explore targets for the budget deficit and inflation that attempt to balance these two concerns. While the range of discussion regarding these targets is limited to what will achieve or maintain macroeconomic stability, country officials and IMF staff may have different perspectives on the risks of macroeconomic instability, the degree to which spending cuts will harm the poor, and the political feasibility of gaining parliamentary approval for significant spending cuts. These different perspectives could provide the basis for negotiation for the targets contained within the program.

Four IMF-Supported Programs Were Negotiated Based on Countries’ Circumstances

IMF-supported programs in each of the four countries we reviewed contain different sets of objectives, targets, and conditions that reflect each country’s individual circumstances, trade-offs, and negotiations with IMF staff. The program in postconflict Liberia focuses on rebuilding capacity, whereas the program in Zambia, a country with significant natural resources, but substantial poverty, centers on increasing economic growth. Hungary, a middle-income country, faced a risking risk of debt default; thus, the program concentrates on restoring investor confidence and reducing debt and expenditures. A banking and currency collapse precipitated Iceland’s request for a program, which focuses on recapitalizing the banks and stabilizing the currency. While IMF staff and country officials in all four countries generally agreed with the programs and have made progress in implementing the programs, each country has encountered some challenges in implementing conditions or achieving targets. Figures 2, 4, 6, and 8 show country background information for Liberia, Zambia, Hungary, and Iceland. Table 2 summarizes the context, circumstances, and objectives of the IMF-supported programs we reviewed.

Macroeconomic Policies in IMF- Supported Programs Are Broadly Consistent with Findings of Academic Literature

For low-income countries, empirical evidence suggests inflation is detrimental to economic growth after it exceeds a critical threshold, which is broadly consistent with the inflation targets included in the IMF- supported programs we reviewed. Similarly, for middle- and high-income countries, the academic literature identifies weaknesses in macroeconomic policies that often precede economic crises that are consistent with the policies in the IMF-supported programs we reviewed.

Empirical Evidence Evaluating the Complex Relationship between Inflation and Growth Is Broadly Consistent with IMF-Supported Programs in Low-Income Countries

Empirical Research Suggests a Complex Relationship between Inflation and Growth; Inflation Harms Growth above a Critical Threshold

Inflation targets are a prominent feature of IMF-supported programs in low-income countries, but there has been considerable debate about appropriate targets for these countries. Some believe that the IMF may have gone beyond the existing empirical evidence in targeting very low inflation, potentially compromising economic growth. Although the precise relationship between inflation and economic growth in low- income countries remains uncertain, the empirical literature over the past 10 years has reached consensus about some aspects of this complex relationship. For example, there is general agreement about the following in low-income countries: The relationship between inflation and growth varies depending on the level of inflation and potentially on other country-specific variables.

Inflation is detrimental to medium- and long-term economic growth after it exceeds a critical threshold, implying that inflation can compromise growth if it is “too high.”

Inflation does not negatively affect economic growth at low levels—in fact, the relationship can be positive for this limited range. Reducing inflation below this critical threshold produces no additional economic growth or may cause a country to sacrifice some long-term growth benefits.

These findings are represented in figure 10, which provides an illustrative summary of the impact of rising inflation on economic growth in low- income countries. The central finding from the literature is that relationship is nonlinear with a critical point (point 1) where the relationship between inflation and growth changes significantly.

To the left of point 1 in figure 10, inflation does not harm economic growth and, in most cases, a positive relationship is established. Beyond point 1, countries face a trade-off between the short-term cost associated with lowering inflation to achieve higher medium- and long-term growth and the cost of accepting higher inflation and therefore lower future growth. Anti-inflationary policies in the region left of point 1 can be counterproductive since the potential costs of reducing inflation are not offset by increases in economic growth or, at worst, can be compounded by declines in long-term growth rates. However, as inflation rises and the critical threshold is breached, the negative effects of inflation surface. Beyond this point, any increases in the inflation rate result in additional declines in economic growth. As points 2 and 3 show, the marginal costs to long-term growth can either increase or decrease as inflation rises, although empirical research does not reach a consensus as to whether the relationship changes for moderate inflation rates. As a country approaches hyperinflation (point 4), it likely faces a complete breakdown in economic functioning.

However, examining the inflation-growth relationship under these conditions generally goes beyond the scope of the literature we reviewed. Earlier academic literature raised doubts about whether moderate to high inflation was costly to economic growth, but recent literature suggests that the cost of inflation was understated because researchers failed to acknowledge the complex, or nonlinear, natur relationship between inflation and economic growth.

Current IMF-Supported Programs Generally Target Single-Digit Inflation That Is within the Bounds of the Existing Empirical Estimates

Although not definitive, the empirical literature supports the focus of IMF- supported programs on containing inflation in low-income countries. Excluding those with countries in currency unions, or with currency boards, IMF-supported programs in low-income countries consistently target inflation in the 5 to 10 percent range. The 31 IMF-supported programs in low-income countries, as of July 2009, are designed to help the countries achieve and maintain macroeconomic and financial stability, including targeting single-digit inflation to avoid the risk that rising prices pose to economic growth. According to IMF documents, inflation above 10 percent is generally considered harmful to medium-term growth, while targeting inflation below 5 percent may not be appropriate given the potential benefits of modest inflation on product and labor markets. Of the 31 IMF-supported programs, the 20 programs that did not involve countries participating in currency unions all targeted single-digit inflation at no less than 5 percent (see table 3). In some cases, we found shorter- term inflation targets above 10 percent. For example, Sao Tome and Principe, and Guinea both have short-term targets in low double digits as part of the longer-term objective of gradually reducing inflation to the single digits.

The 11 other countries with IMF-supported programs participate in common currency unions (or operate a currency board) with inflation targets of 3 percent or lower that are set indirectly by the choice of exchange rate arrangements, not the IMF. Inflation targets in the common currency unions in table 3 are driven by the decision to maintain a fixed exchange rate that requires member countries to keep the range of inflation close to inflation levels in the developed country or area to which the common currency is fixed. Almost all of the countries included in the lower half of table 3 belong to currency unions that peg their currency to either the euro or, in the case of Grenada, the U.S. dollar. The only exception is Djibouti, which is not part of a currency union but operates a currency board tied to the U.S. dollar. As a result, the inflation targets for these countries are largely independent of IMF inflation policy and tend to approximate the inflationary experiences of the euro area or the United States.

The empirical literature we reviewed, consisting of nine studies, provides estimates of the inflation rate (ranging from 3 to 18 percent) beyond which inflation hampers long-term growth for low-income countries. Inflation targets in IMF-supported programs, although at the lower end of the 3 to 18 percent range, are generally consistent with estimates in empirical studies. (See fig. 11.)

Eliminating the lowest and two highest estimates produces an approximate range of 5 to 12 percent for the threshold, which is roughly consistent with the inflation targets of 5 to 10 percent in the 31 IMF- supported programs for low-income countries we reviewed. Across the studies, the estimated threshold is generally found to be higher for low- income than for high-income economies, providing some support for inflation targets in IMF-supported programs that tolerate higher inflation in low-income countries. (The bibliography for inflation-growth literature contains a full listing of the studies.) While there is some disagreement on where the critical threshold lies, there is consensus that it is lower than the level suggested by some studies prior to 2000. These studies provided some evidence that inflation did not significantly hurt economic growth until it reached the 20 to 40 percent range, but these findings have not proven robust for a number of reasons. Specifically, some of the threshold calculations were based on judgment rather than empirical estimation.

Flexibility in the Selection of an Inflation Target for a Particular Country Is Prudent

The complexity of the relationship between inflation and economic growth uncovered by the literature indicates it may be inappropriate to set a uniform policy target applicable to all countries. The empirical literature illustrates that combining countries at different levels of development can produce unreliable results both in the estimating of the threshold in the inflation-growth relationship and the effect of low and high inflation on economic growth. This calls for flexibility in the implementing inflation targets in individual countries because the “growth-maximizing” rate of inflation might be expected to differ, at least somewhat, even across low- income countries at various stages of development. For example, after increasing the sample of low-income countries, some researchers found that the estimated inflation threshold increased from 6 to 17 percent. Similarly, another study found no clear-cut threshold for developing countries and attributes this finding to the differences across countries grouped under the “developing” country label. One interpretation of these findings is that, even though the literature generally supports inflation targets in IMF-supported programs, the gains from a given reduction in inflation to single digits from somewhat higher levels might by the cost in some cases. As a result, the relationships and trade-offs should be carefully evaluated for each country.

Moreover, the methodologies and the validity of the estimates vary across studies, and none should be viewed as definitive. Although recent empirical literature is informative and addresses a number of methodological issues that plagued earlier studies, other limitations remain. Important limitations of the literature analyzing the relationship between inflation and economic growth include (1) potential biases due to the omission of important variables; (2) biases resulting from the failure of some studies to address the fact that, in addition to inflation impacting economic growth, economic growth may also affect inflation; (3) issues with small samples and outlier effects; and (4) technical issues related to the modeling procedures employed. Moreover, the negative effects on the economy may extend beyond the effects on economic growth. As a result, studies that investigate only the impact of inflation on economic growth may understate the total negative effects of inflation. Finally, there are relatively few systematic analyses of the critical threshold beyond which inflation hampers long-term growth; therefore, there is likely to be continued disagreement on where the threshold lies.

Academic Literature Identifies Weaknesses in Macroeconomic Policies That Often Precede Economic Crises, Consistent with IMF- supported Programs

Academic Literature Identifies Weaknesses in Macroeconomic Policies Preceding Currency, Banking, and Debt Crises

The academic literature identifies weaknesses in macroeconomic policies preceding economic crises. We focused on this aspect of the academic literature because, as previously noted, middle- and high- income countries have sought significant IMF financial assistance due to stress associated with the global financial crisis. Empirical academic literature we reviewed, focused on anticipating and explaining economic crises, attempts to identify leading indicators of crises, including weaknesses in macroeconomic policies. This body of research is known as the crisis “early warning system” literature. Economic crises include in particular (1) currency crises, which involve a speculative attack or large depreciation of a currency; (2) banking crises, which involve the widespread failure of critical financial institutions; and (3) sovereign debt crises, which involve the default or near default of a government on its debt obligations. Economic crises can involve one or more of the types of crises described above and often precipitate moderate to severe recessions involving substantial losses of jobs, income, and production.

By analyzing a broad history of crises—crises that have occurred in dozens of countries over the last several decades—researchers have tried to identify common precursors of crises that may provide “early warning” that a crisis is coming. We reviewed 19 published or widely cited studies, identified in economic research databases, or in citations of other studies, written since 1998. For each study, we documented the variables that were predictive of an economic crisis. Across the studies, several macroeconomic policy variables (and many variables unrelated to macroeconomic policy) consistently predict currency, banking, or debt crises. These variables suggest a number of specific policy weaknesses that make countries more vulnerable to crises, especially high inflation, high public indebtedness, and an overvalued currency. These vulnerabilities can represent unsustainable monetary, fiscal, and exchange rate policies, such as (1) high money growth, inconsistent with the government’s commitment to a fixed exchange rate or broad exchange rate stability; (2) large and persistent budget deficits that significantly increase the stock of public debt and jeopardize the ability of the government to meet its obligations; or (3) a significant inflow of foreign capital without the central bank accumulating a buffer of international currency to guard against sudden capital outflows. Table 4 contains the specific macroeconomic policy variables identified by the literature and the nature of the related vulnerabilities.

Several factors unrelated to macroeconomic policy also often precede crises, including external events (e.g., a crisis in a neighboring country), private sector behavior (e.g., significant private sector borrowing), and institutional or political factors (e.g., weak law enforcement). Crises are not singularly caused by unsustainable macroeconomic policies; there are often other factors or triggers that increase the likelihood of a crisis. Nevertheless, crises do not strike at random, poor macroeconomic policy management can greatly increase a country’s vulnerability to crisis.

While the crisis “early warning system” literature can inform the development of macroeconomic policy, it has limitations and provides qualitative rather than precise quantitative guidance. Conceptually, the literature identifies certain costs associated with loose macroeconomic policies that are important considerations to include in the full accounting of the costs and benefits associated with macroeconomic policies, but these are not the only considerations. Furthermore, the literature has a number of methodological limitations. Specific limitations that we identified during our review of the crisis literature include selecting a sample of countries in a way that overstates the predictability of crises, analytical approaches that fail to account for multiple causes of economic crises, and crisis definitions that may not correspond to severe economic consequences (e.g., the inclusion of speculative attacks that did not result in actual currency depreciation in the definition of currency crises). The limitations we identified may introduce biases into estimates of policy effects in studies where they are present. The exclusion of noncrisis countries in some analyses may, for example, overstate the level of international reserves necessary to guard against crises in some countries. These limitations suggest caution in interpreting the precise numerical results of the literature.

Macroeconomic Policies Are Focused on Critical Vulnerabilities in IMF- Supported Programs in Middle- and High-Income Countries

The central macroeconomic policy weaknesses identified by the literature closely correspond to the macroeconomic policy areas upon which IMF- supported SBA programs focus. The IMF-supported programs in middle- and high-income countries we reviewed have macroeconomic program requirements (generally QPCs) designed to limit money growth and inflation, limit public debt, and accumulate international reserves. Similarly, high debt, high inflation, and low international reserves are important macroeconomic policy weaknesses that make a country more vulnerable to crises. We reviewed certain quantitative macroeconomic program requirements in all SBA programs in which governments have drawn IMF funds, which included 13 countries for which program documents were available as of July 2009. Because SBA programs are for countries considered to have temporary balance-of-payments needs, these countries are generally middle- or high-income countries that have been adversely affected by the global financial crisis. In each of the 13 programs, we found that quantitative program requirements supported the broad goals of (1) limiting money growth and inflation, (2) limiting public debt, and (3) accumulating international reserves.

To support the broad goals identified above, IMF-supported programs often used a variety of specific policy variables. To limit money growth and inflation, SBA programs featured QPCs and other program requirements for a number of macroeconomic policies. These included ceilings on the net domestic assets of the central bank, inflation consultations, and ceilings on the amount of credit the central bank may extend to the government or the private sector. To limit public debt, 11 of the 13 SBA programs had QPCs for the government’s budget deficit, and some had restrictions on the government issuing new external debt, and short-term external debt in particular. To accumulate international reserves, 12 of the 13 SBA programs had floors for either net international reserves or net foreign assets. With respect to our case study countries, we have noted above that a large stock of public debt was a key factor driving the crisis in Hungary. In Iceland, the IMF noted in 2007 that the króna was overvalued by 15 to 25 percent, and inflation rose sharply before the banking crisis ensued. The focus of IMF-supported programs on the central policy weaknesses should assist countries in regaining investor confidence and addressing the underlying crisis vulnerabilities.

Agency Comments

The Department of the Treasury provided written comments on a draft of this report, which are reprinted in appendix III. Treasury stated that it fully concurs with our conclusions that IMF-supported programs are shaped by negotiations with local officials in the context of country circumstances. In addition, Treasury noted our finding that the underlying economic literature on growth, inflation, fiscal and external sustainability, and financial stability, drive IMF policy advice in lending programs. Treasury also emphasized that it encourages the IMF to work with low-income countries to increase spending in areas such as health and education. Furthermore, we received technical comments on a draft of this report from Treasury and the IMF, which we incorporated as appropriate.

We are sending copies of this report to other congressional offices, Treasury, and the IMF.. The report also is available at no charge on the GAO Web site at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (202) 512-9601 or melitot@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Other contacts and major contributors are listed in appendix IV.

Appendix I: Scope and Methodology

To examine the process for designing an International Monetary Fund (IMF)-supported program, we reviewed and analyzed IMF’s public documents and data. These documents include IMF Articles of Agreement; countries’ letters of intent; IMF consultation reports and assessments of country progress under IMF-supported programs, including the Article IV consultation reports; program design papers; strategy papers; policy documents; and IMF’s Independent Evaluation Office reports. We also met with officials representing the IMF and the U.S. Department of the Treasury (Treasury) in Washington, D.C., to discuss the process of designing of an IMF-supported program and the typical trade-offs associated with the program’s policy decisions. Specifically, we used IMF policy documents and countries’ letters of intent to identify the primary objectives and key targets of low- and middle- to high-income countries. We also reviewed the letters of intent provided to the IMF by countries receiving current IMF-supported financial programs, as well as updates of program reviews conducted by the IMF for these programs, available as of July 2009, to obtain examples of macroeconomic target variables, quantitative performance criteria, and structural reforms. We utilized interviews with IMF officials, as well as IMF policy papers, including IMF institute documents, to clarify and explain the process of designing an IMF-supported program.

To examine the IMF-supported programs in recipient countries, we selected four case study countries—Hungary, Iceland, Liberia, and Zambia—and reviewed documents and interviewed officials regarding these countries’ IMF-supported programs. Our selection of these four countries include criteria to examine how IMF-supported programs may differ in low-, middle-, and high-income countries with geographic diversity that had relatively large amounts of IMF financing as of April 2009. Our choice of countries was meant to be illustrative, not representative or generalizable to the population of IMF-supported programs. Documents we reviewed include the letters of intent provided to the IMF by these four countries; IMF reviews, reports, and press releases regarding these countries’ IMF-supported programs; and country background documents provided by U.S. embassies in these four countries. In addition, we interviewed IMF and Treasury officials in Washington, D.C., to discuss the context of the four recipient countries and the countries’ IMF-supported programs. In Hungary, Iceland, Liberia, and Zambia, we met with U.S. embassy officials, IMF staff, officials representing foreign governments, academics, and nongovernmental organizations to obtain their views about the IMF-supported programs.

To examine the extent to which the findings of empirical economic studies are consistent with the IMF’s macroeconomic policies, we reviewed IMF documents and empirical studies. Using published or widely cited empirical studies identified in economic research databases EconLit, Social Science Research Network, and Google Scholar, we identified key relationships between macroeconomic policies and economic growth and crises, and compared them with macroeconomic policies in IMF- supported programs. Specifically, we reviewed two parts of the academic literature relevant to the macroeconomic policy decisions in IMF- supported programs, namely the literature that links inflation with economic growth, and the crisis “early warning system” literature that identifies leading indicators of currency, banking, and debt crises. For the inflation and growth literature, we reviewed empirical studies isolating the threshold level of inflation explicitly for lower-income countries identified in economic research databases and published since 1999. Due to the lag between publication and submission, we also included working papers produced during the last 2 years. Although we found these studies to be reliable for the purposes of identifying the range of estimates and comparing them with targets in IMF-supported programs, their inclusion in this report does not imply that we deem them to be definitive. (The bibliography contains a full listing of the studies linking inflation with economic growth that we reviewed.) To determine the inflation targets in all 31 IMF-supported programs in low-income countries, as of July 2009, we reviewed countries’ letters of intent and IMF Article IV reports and recorded the target for each country. To ensure the data were collected consistently and accurately, each recorded target was independently reviewed and verified. In a few cases where no clear target was articulated, we used the long-term inflation projection for the country as the implicit target. For the crisis “early warning system” literature, we reviewed 19 published or widely cited studies, identified in economic research databases, or in citations of other studies, written since 1998. We chose 1998 as the starting year because of the large volume of research explaining or predicting economic crises that was performed after the Asian financial crisis. For each study, we documented the variables that were predictive of an economic crisis. Where possible, we used a conservative standard for identifying key predictor variables. Under the signals method, we selected only variables that had a noise-to-signal ratio (NTSR) of 0.5 or less (less than 1 indicates more signal than noise). Noise indicates an incorrect prediction while a signal indicates a correct prediction, so a NTSR of less than 1 implies more correct than incorrect predictions. Under traditional regression methods, we selected only variables whose coefficients had p-values less than 0.05. (Several studies we reviewed reported coefficients that were statistically significant at the 10 percent level.) (The bibliography contains a full listing of studies in the “early warning system” literature that we reviewed.) Similar to our identification of inflation targets in IMF-supported programs in low- income countries, we determined certain quantitative macroeconomic program requirements in all Stand-By Arrangements in which governments have drawn IMF funds, which included 13 countries for which program documents were available as of July 2009. We reviewed these countries’ letters of intent, determined and recorded the policies associated with the macroeconomic program requirements for each country, then independently verified that the requirements data were collected consistently and accurately.

We conducted our work from November 2008 to November 2009 in accordance with all sections of GAO’s Quality Assurance Framework that are relevant to our objectives. The framework requires that we plan and perform the engagement to obtain sufficient and appropriate evidence to meet our stated objectives and to discuss any limitations in our work. We believe that the information and data obtained, and the analysis conducted, provide a reasonable basis for any findings and conclusions in this product.

Appendix II: Countries Approved to Receive IMF Financial Arrangements as of August 31, 2009

Table 5 shows the countries that have been approved to receive financial assistance from the IMF as of August 31, 2009. The recipient countries are categorized by type of IMF lending arrangement.

Appendix III: Comments from the Department of the Treasury

Appendix IV: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the individual named above, Cheryl Goodman, Assistant Director; Lawrance Evans, Assistant Director; Marc Castellano; Michael Hoffman; Victoria Lin; and Roberta G. Steinman made key contributions to this report. The team benefited from the expert advice and assistance of Lynn Cothern, Etana Finkler, Joel Grossman, and Mary Moutsos.

Bibliography of Empirical Studies Reviewed in the Inflation-Growth Literature

To examine the relationship between economic growth and inflation in low-income countries, we reviewed the following academic articles. Our review of the literature included academic studies, using data from low- income countries, published from 1999 to 2009. Due to the lag between publication and submission, we included working papers produced in the last 2 years. The studies indicated with an asterisk (*) provided empirical estimates of the threshold level of inflation for low-income, developing or nonindustrial countries that serve as the basis for figure 11 in the report. The list includes widely cited studies published prior to 1999, although they either combine low-income and high-income countries when estimating the threshold inflation rate or determine the threshold on the basis of judgment.

Barro, Robert. “Inflation and Economic Growth,” Federal Reserve Bank of St. Louis Review 78 (1996).

Bruno, Michael and William Easterly. “Inflation Crises and Long-Run Growth,” Journal of Monetary Economics 41 (1998).

Bruno, Michael and William Easterly. “Inflation and Growth: In Search of a Stable Relationship,” Review of Federal Reserve Bank of St. Louis 78, no. 3 (1996). *Burdekin, Richard C.K., Arthur T. Denzau, Manfred W. Keil, Thitithep Sitthiyot, and Thomas D. Willett, “When Does Inflation Hurt Economic Growth? Different Nonlinearities for Different Economies,” Journal of Macroeconomics 26 (2004).

Fischer, Stanley. “The Role of Macroeconomic Factors in Growth,” Journal of Monetary Economics 32 (1993).

Ghosh, Atish and Stephen Phillips. “Warning: Inflation May be Harmful to Your Growth,” IMF Staff Papers 45 (1998). *Gillman, Max, Mark Harris, and Laszlo Matyas. “Inflation and growth: explaining a negative effect,” Empirical Economics 29, no. 1 (2004).

Gylfason, Thorvaldur and Tryggvi T. Herbertsson. “Does Inflation Matter for Growth?,” Japan and the World Economy 13 (2001). *Khan, Mohsin S. and Abdelhak S. Senhadji. “Threshold effects in the Relation Between Inflation and Growth,” IMF Staff Papers 48 (2001). *Kochar, Kalpana and Sharmini Coorey. “Economic Growth: What Has Been Achieved So Far and How?”, in Hugh Bredenkamp and Susan Schadler (eds), Economic Adjustment and Reform in Low-Income Countries (Washington, D.C.: International Monetary Fund, 1999). *Kremer, Stephanie, Alexander Bick and Dieter Nautz, “Inflation and Growth: New Evidence from a Dynamic Panel Threshold Analysis,” Sonderforschungsbereich Discussion Paper 649, Humboldt University, Berlin, Germany (2009). *Kremer, Stephanie, Alexander Bick and Dieter Nautz, “Inflation and Growth: New Evidence from a Panel Data Threshold Analysis,” Goethe University Working Paper, Frankfurt (2008). *Pollin, Robert and Andong Zhu, “Inflation and Economic Growth: A Cross-Country Non-linear Analysis,” Journal of Post Keynesian Economics 28, no. 4 (2006).

Sarel, Michael. “Nonlinear Effects of Inflation on Economic Growth,” IMF Staff Papers 43 (1996). *Sepehri, Ardeshir and Saeed Moshiri. “Inflation-Growth Profiles Across Countries: Evidence from Developing and Developed Countries,” International Review of Applied Economics 18, no. 2 (2004). *Vaona, A. and S. Schiavo, “Nonparametric and Semiparametric Evidence on the Long-run Effects of Inflation on Growth,” Economics Letters 94, no. 3 (2007).

Bibliography of Empirical Studies Reviewed in the Crisis “Early Warning System” Literature

We reviewed the following empirical studies in the crisis “early warning system” literature written since 1998. For each study, we documented the variables that were predictive of an economic crisis. Where possible, we used a conservative standard for identifying key predictor variables. Under the signals method, we selected only variables that had a noise-to-signal ratio (NTSR) of 0.5 or less (less than 1 indicates more signal than noise). Noise indicates an incorrect prediction while a signal indicates a correct prediction, so a NTSR of less than one implies more correct than incorrect predictions. Under traditional regression methods, we selected only variables whose coefficients had p-values less than 0.05. (Several studies we reviewed reported coefficients that were statistically significant at the 10 percent level.)

Berg, Andrew and Catherine Patillo. “Predicting Currency Crises: The Indicators Approach and an Alternative,” Journal of International Money and Finance 18 (1999).

Borio, Claudio and Philip Lowe. “Assessing the Risk of Banking Crises,” BIS Quarterly Review (December 2002).

Burkart, Oliver and Virginie Coudert. “Leading Indicators of Currency Crises for Emerging Countries,” Emerging Markets Review 3 (2002).

Bussiere, Matthieu and Marcel Fratzscher. “Towards a New Early Warning System of Financial Crises,” Journal of International Money and Finance 25 (2006).

Ciarlone, Alessio and Giorgio Trebeschi. “Designing an Early Warning System for Debt Crises,” Emerging Markets Review 6 (2005).

Davis, E. Philip and Dilruba Karim. “Comparing Early Warning Systems for Banking Crises.” Journal of Financial Stability 4 (2008).

Demirgüç-Kunt, Asli and Enrica Detragiache. “The Determinants of Banking Crises in Developing and Developed Countries,” IMF Staff Papers 45, no. 1 (1998).

Edison, Hali J. “Do Indicators of Financial Crises Work? An Evaluation of An Early Warning System,” International Journal of Finance and Economics 8 (2003).

Esquivel, Gerardo and Felipe Larrain. “Explaining Currency Crises.” Harvard Institute for International Development (1998).

Hemming, Richard, Michael Kell and Axel Schimmelpfennig. “Fiscal Vulnerability and Financial Crises in Emerging Market Economies,” Occasional Paper 218 (Washington, D.C.: International Monetary Fund, 2003).

Kamin, Steven B., John Schindler, and Shawna Samuel. “The Contribution of Domestic and External factors to Emerging Market Currency Crises: An Early Warning Systems Approach,” International Journal of Finance and Economics 12 (2007).

Kaminsky, Graciela L. “Currency Crises: Are They All the Same?” Journal of International Money and Finance 25 (2006).

Kaminsky, Graciela, Saul Lizondo, and Carmen Reinhart. “Leading Indicators of Currency Crises,” IMF Staff Papers 45 (March 1998).

Kaminsky, Graciela L. and Carmen Reinhart. “The Twin Crises: The Causes of Banking and Balance of Payments Problems,” American Economic Review 89 (1999).

Komulainen, Tuomas and Johanna Lukkarila. “What Drives Financial Crises in Emerging Markets?” Emerging Markets Review 4 (2003).

Kumar, Mohan, Uma Moorthy, and William Perraudin. “Predicting Emerging Market Currency Crashes.” Journal of Empirical Finance 10 (2003).

Manasse, Paolo, Nouriel Roubini, and Axel Schimmelpfennig. “Predicting Sovereign Debt Crises,” IMF Working Paper WP/03/221 (November 2003).

Manasse, Paolo and Nouriel Roubini. “‘Rules of Thumb’ for Sovereign Debt Crises,” IMF Working Paper WP/05/42 (March 2005).

Shimpalee, Pattima L. and Janice Boucher Breuer. “Currency Crises and Institutions,” Journal of International Money and Finance 25 (2006).