The Big Fat Greek Debt Crowd‐​Out

May 20, 2010 • Commentary
This article appeared in The Wall Street Journal European Edition on May 20, 2010.

Europeans have long lectured emerging markets on the evils of fiscal profligacy and the virtues of prudence. But today, as amusing as it might be to see Europeans hoisted by their own petard, the Continent is no laughing matter. Emerging markets may soon worry that Europe is crowding them out of the International Monetary Fund’s limited lending capacity.

After global markets froze in 2008 and exposed the IMF’s lending capacity as insufficient, its members agreed in 2009 to triple its lending capacity to $750 billion (about €600 billion). But today, much of this money is being diverted to rich European countries. If the European financial crisis spreads to emerging markets — improbable but possible — the IMF may not have enough left for those very economies for whom it expanded its lending capacity.

Greece, Portugal, Spain, and Italy are all members of the IMF, and so are automatically entitled to its assistance. But while the IMF articles of association allow lending specifically for supporting countries’ balance of payments, the organization is not supposed to lend for fiscal support alone, and no developing country has ever received a loan to meet a purely fiscal problem. Greece, Portugal, and Spain have fiscal problems, but no balance‐​of‐​payments problems. So the rules of the IMF are being bent to accommodate the fiscal needs of European countries that together dominate its shareholding.

IMF apologists argue that fiscal problems can spill over into the balance of payments, so the two are related. But that was fully understood when the IMF charter was drawn up, and the distinction was nevertheless viewed as key. Besides, in the case of Greece and other euro‐​zone countries, the historical link between fiscal and balance‐​of‐​payments issues was severed by the creation of the European Central Bank. Even if the Greek government is in a fiscal crisis, Greek importers can get all the euros they need from Greek banks, which get euros from the ECB against pledged Greek bonds. The ECB was supposed to check fiscal recklessness by issuing euros only against European government bonds with an investment‐​grade rating. But when Greece lost its investment‐​grade rating, the ECB broke its own rule and pledged to keep issuing euros against Greek bonds. So, neither Greece nor any other European country faces a shortage of hard currency.

When Greece’s problems deepened in April, it initially declared that it would never accept a humiliating IMF loan. But by early May the fat was in the fire, and a European rescue package including an IMF contribution of €10 billion was proposed. As the Greek crisis deepened, the rescue package was expanded to €110 billion, with the IMF providing €30 billion. The markets were unconvinced, and financial contagion spread to Portuguese and Spanish bonds. So, a new trillion‐​dollar rescue package has just been announced. The IMF contribution will be roughly €250 billion.

So the IMF commitment to European countries has risen to a whopping €280 billion. This means Europe has pre‐​empted almost half the IMF funds raised last year, mainly for emerging markets.

It is only a matter of time before this rings alarm bells in those economies. Today, many emerging markets, especially in Asia, look sound and stable. But 2008 demonstrated that a Western financial crisis could suddenly reverse capital flows, and draw over a trillion dollars from emerging markets. Unlike in 1997, the 2008 crisis flowed not from the frailties of emerging markets, but from Western banks. Today financial storm clouds have again gathered over Europe, raising fears of another Western banking crisis followed by global contagion.

Greece would be better off defaulting; IMF assistance merely postpones that evil day. The IMF record in developing countries is highly flawed, and its loans are no panacea for unsound economies. But many emerging markets today face a risk of capital reversal not because they are unsound but because panic can drown all distinctions, as in 2008.

Brazil, Russia, India, and China — the so‐​called BRIC countries — have all contributed to the latest expansion of IMF lending capacity. India has also purchased IMF gold for hard currency. So, we are now seeing a significant cash transfer from emerging markets to Europe. But this change in balance between creditors and debtors is not reflected in voting shares. For years, there has been talk of IMF reform, with greater power going to emerging markets. That reform has now become urgent. The voting share of the BRICs must rise sharply, and that of imprudent Europeans must fall sharply.

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