Wednesday, April 28, 2010

Adverse Selection at its best in Maldives…

I remember one of my professors explaining to me the difference between regulating a restaurant and a bank. He says that even if five restaurants closed down within a week, it doesn’t affect much to the macro economy; however, if even one bank was to fail each week, then it sure will impact the macro economy of the country. It is because of this reason, we need an authority (an effective one), to regulate, supervise, and monitor the activities of commercial banks and other financial institutions.

The under-developed financial sector of Maldives has six commercial banks, a leasing company, and a housing development finance corporation. The commercial banks mainly rely on their lending to the tourism sector for most of their profits. According to the published statistics from the regulating authority, MMA, 59 percent of the total lending of the banks is to the tourism sector, as at end of 2009. There is an outstanding amount of over $700 million (Rf 9 billion) lent to the tourism sector at the end of 2009. According to the website of MMA, the lending rates of the commercial banks in Rufiya ranges between 8 through 13 percent, and for US Dollars it is 5.5 through 13 percent.

The banks normally think that their profits will increase if they lend at higher interest rates; as high as 13 percent. However, what they don’t realize is that at such higher rates, there will come many borrowers who do not have the intention of repaying back. There will come many businessmen, with risky projects, having very high uncertainty of recovering the investments. The banks hence face the problem of adverse selection. This is exactly what has happened to some banks in Maldives. In order to record higher bank profits, the bank managers decided to lend huge amounts to very risky borrowers, when these risky borrowers did not have the intention of repaying back, in the first place. So, we can argue that with the increase in interest rate (lending rate), the probability of repaying back falls, and the profitability of banks fall.

Another very good example of adverse selection was seen in the tourism sector few years back, when the Ministry of Tourism opened several invitations to bid for new islands for resort development. Many parties proposed incredibly high rents, and they were awarded the island. What the government did not realize was; the probability of the investor making regular rent payments; and even the probability of the investor ever being able to develop the island and open the resort, decreases with every percentage increase in the rent proposed. In other words, by selecting the party with highest rent, the government is effectively selecting the party with the lowest probability of making the rent payments, and the party with the lowest probability of ever being able to develop the island. I think the evidence we see now supports this claim. There are still more than fifty islands unable to start their operations. And one of the main reasons they are unable to attract finance is due to the incredibly high rents that they need to pay the government.

Sunday, April 25, 2010

Greek and Maldives' economy

According to the data released on Thursday, the Greek budget deficit has reached to 13.6 percent of its GDP. The Greek Prime Minister, George Papandreou announced on Friday that his government was seeking to activate assistance from IMF and the European Union, totaling $60 billion as loan financing.

According to available statistics, Greece needs more than $13 billion to cover part of its debt coming due in May 2010. The total debt comes to about $400 billion, out of which $72 billion is due this year.

Because of the crisis in Greece, fellow eurozone members are worried, as a troubled Greek economy will surely pose problems to the euro economy, and the euro currency. Hence, it is in the best interest to all the member countries to salvage Greece.
We all have heard on the news that Greek authorities implemented a series of austerity measures; including tax increases, and wage cuts for government employees. This has led to demonstrations and unrest across the country. Civil servants conducted large demonstrations and strike in Athens.

All these sound familiar, right? The Maldives budget deficit was 26.1 percent of GDP in 2009, and is expected to fall to only 18.7 percent of GDP even this year. Maldives could be the country with the highest government deficit as a percentage of GDP in the whole world. We also could be the only country with the highest government wage bill as a percentage of GDP. We are spending about Rf 4 billion within a year to pay for salaries of all public employees; including civil servants, politicians, parliamentarians, and those in the independent institutions. Meaning we spend about Rf 400 million every month, only on salaries!

Our present government announced several austerity measures as well, including reduction of salaries, and reducing the number of civil servants. What followed is similar to what is happening in Greece. I say, there might come a time, when the international partners will abandon us, asking us to manage our expenses within our means. We are not Greece; there is no interest for the Europeans to save us. Our economy is insignificant to the region, and the world. Unless we manage our expenses and our economy, we will not be able to come out of this economic recession.

Tuesday, April 13, 2010

We need to reform IMF...?

Over the past 60 yeas, the world economy has become very inter-dependant. Due to globalization, development and crises have a contagious effect within regions. Further, as highlighted by Buira in his article, improvements in technology and communication , for example greater use of Internet and information technology has led to formation of an “international capital market".

The governing structure of IMF was formed in 1944 under the Bretton Woods Conference. However, a lot have changed since then in terms of size of economies, population of countries, share of world trade, reserves, and countries’ abilities to contribute to financial resources. Hence, it is evident that there is a need for reform of this important multilateral financial institution in order to achieve more effective financial global governance.
Here, I will highlight the main issues on the IMF Reform agenda put forward few years back.

The main reforms:

1. Making surveillance more effective
According to Article I of the Articles of Agreement of the IMF, one of the main purposes of the Fund is to ‘promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems’. In order to achieve this important mission, Article IV of the same Agreement stipulates that all member countries are required to collaborate with the Fund to assure orderly exchange arrangements and to promote a stable system of exchange rates.

However, recently the Fund has very much being criticized on its inability to influence the policies of powerful countries like USA, especially even when economies of such countries have a significant impact on the economies of developing countries.
One such criticism is that, “when the Fund consults with a poor and weak country, the country gets in line. When the Fund consults with a big and strong country, the Fund gets in line”.

As Ariel observed, ‘the world moves away from rules-based multilateral system to a power-based system’, whereby, larger powerful countries ‘go their own way based on their short term interests’ (Ariel 2005).

This was very much evident during the time when the United States Treasury responded to an IMF report, which highlighted the importance of the US current account deficit and the growing indebtedness, by stating that Treasury did not consider that a correction was necessary in its domestic policy (Ariel 2005).

In order to overcome this problem, the Managing Director’s Report 2005 recommended, ‘more incisive analysis of specific weaknesses and distortions that risk crises and contagion or hinder adjustment to gloabalization’. The Managing Director’s Report further describes various specific action plans that can be implemented to achieve the above mentioned recommendation; global surveillance, multilateral dialogue, financial market surveillance, having standards & codes, regional surveillance, country surveillance, and communications strategy.

2. Adapting to new challenges and needs in different member countries
The Managing Director’s Report outlines specific actions to be taken in terms of the Fund’s role towards the advanced, emerging and low-income countries.
With regard to advanced economies it is recommended that global implications are integrated into country specific policies.
Emerging market economies are characterized in the Report as the ones that need crisis prevention and resolution due to their high ‘risk of boom-bust cycles emanating from the volatility of capital flows’ (IMF 2005). Improving financial insurance in these countries is also on the agenda, with particular emphasis on helping member countries to ‘develop local financial markets and instruments’.
Finally, the role in low-income countries is recommended to be more focused, with more flexibility, more emphasis on the Millennium Development Goals, and having fewer procedures.

3. Helping build institutions and capacity
The Fund recognizes the need to further strengthen its ability to provide technical assistance to countries in the area of capacity building and improving institutions. The specific action recommended by the Fund is ‘to give area departments the central role in setting technical assistance priorities in the context of Article IV surveillance and Fund supported programs’. The Fund also acknowledges the need to enhance fiscal transparency and governance as they play an important role in the development of economic institutions.

Although the need for better institutions and capacity building is acknowledged and important, it is questionable how much overlapping and duplication is present in terms of providing technical assistance to member countries, between IMF and the World Bank. Hence, further reform in this area needs to consider this aspect and coordinate better with the Bank on matters relating to capacity building.

4. Prioritization and reorganization of work within a prudent medium-term budget
The Fund highlights the need ‘set priorities for the next few years based on a country-by-country analysis’.
The Fund also needs the reorganization which is necessary to implement the various components of the budget and hence recommends better organization of expert staff, departmental structure, management, executive board, and international monetary and financial committee.

5. Address the issue of fair quotas and voice
In order to achieve the mission of IMF more effectively, it needs to reallocate quotas and voting rights in order to reflect the changes that has taken place in the world economy during the past sixty years. The reallocation should be in such a way to reflect the interests and power of those countries whose share in the world economy has increased, and in general, in a way that the legitimacy of the Fund could be greater.

Concluding Remarks

The G-7 Finance Ministers and Central Bank Governors met in Tokyo on February 09th 2008 and discussed about IMF reforms, reaffirming their support on the IMF surveillance decision on exchange rate, fiscal and monetary policies. In their statement they expressed their support for the “proposal of the Managing Director to refocus the Fund’s operations on core priorities”. This is a positive message that reflects the commitment from the richest nations of the world, and is expected to have a significant impact on the reform agenda of the Fund.

The reforms outlined above are those highlighted in the Managing Director’s Report, 2005 and in addition to these, there are few other areas that need attention.
Some of them include, making the work of the Fund in the member countries more ‘demand-oriented’ taking into account the local circumstances and needs of the countries, rather than being ‘supply-oriented’ by the replicating what is being done in many other countries. In some countries, some of the new projects or policy recommendations are suggested and being ‘forced’ to be developed into loans, even though such loans are not diverted to the most efficient use or sector. In the meantime, there are many other areas that need special attention and assistance, but unable to attract the attention of the Fund or the Bank, as the officials of these institutions do not feel that they are important.

Finally, it has to be emphasized that rich and powerful countries need to be brought on-board in understanding the importance of global financial governance, and the relative effects of global integration, and thus adapting policies that can have positive impacts on the world economy.

In order to achieve ability to force corrective action on its members, the Fund needs reorganization and reallocation of its quotas and voting rights. Reallocation of quotas is also important in order to improve the legitimacy of the institution and hence, achieve the core objectives of the Fund.