Poverty and Development Division
last updated : 20 December 1999
TOWARDS AN INTERNATIONAL FINANCIAL ARCHITECTURE
As stated at the beginning of this chapter, the Asian crisis has turned out to be deeper and more long-lasting than many analysts had predicted. Furthermore, the fallout of the crisis has engulfed a number of other countries outside the region creating a strong negative impact on global growth. In consequence, the crisis has prompted considerable reflection on policy measures to prevent such occurrences in the future. While no foolproof guarantee can be offered, it is evident that a wide range of actions are needed at the national, international and regional levels to minimize the possibility of future crises.
At the national level, there is general agreement that countries need to be more circumspect with regard to the speed and sequence of opening their capital accounts. Those with open capital accounts need to implement much more flexibly their domestic policies, such as monetary, fiscal and exchange rate regimes. Other issues that have to be dealt with at the national level are the institutional arrangements for financial sector supervision, enactment and enforcement of appropriate legislation and rules of behaviour by private business in both the financial and the real sectors, and transparency in corporate reporting systems.(12) It is incumbent on national authorities to remain perpetually alert to the potentially disruptive impact of large-scale capital movements and to make the best possible efforts to insulate their economies from such disruptions.
It would be wrong, however, to conclude that financial crises of the severity that have occurred in East and South-East Asia can be prevented exclusively by domestic policy or institutional measures. The fact that financial and exchange rate crises have become more severe in the 1990s, and loss of investor confidence more pervasive during these crises, suggests that the working of the international financial system also needs to be reviewed and reformed.
A number of ideas have emerged in various forums in response to these perceptions. While there is no strong evidence yet of a political consensus emerging around any one approach, there are several core issues that need to be dealt with. These fall within the general theme of reform of the international financial architecture and relate to the following: the need for a lender of last resort in international finance, improvements in the supervision and regulation of international capital flows, better definition of the role and responsibilities of foreign private investors and creditors in the maintenance of external stability and, finally, delineation of the scope for regional cooperation in preventing such crises in the future.
Lender of last resort
It is clear that adequate provision of liquidity is crucial for pre-empting crisis, minimizing contagion and mitigating adverse impact. At the moment, there is no true international "lender of last resort". As a body with a mandate to provide balance of payments assistance to its member countries, IMF has emerged as the de facto international lender of last resort. During the recent Asian crisis, IMF provided liquidity assistance after countries were hit by the crisis, subject to fulfilment of certain conditions. Also, owing to the paucity of resources at its disposal, IMF acted more as an organizer than as a provider of funds.
One set of arguments against the establishment of an international lender of last resort centres around moral hazard implications. There are two strands to the moral hazard argument. The first is that countries may pursue imprudent macroeconomic policies in the expectation that they will be bailed out in the event of any trouble. The second is that similar considerations would prompt foreign investors and lenders to take excessively risky positions with the expectation that they would be protected under the terms of any assistance package agreed upon between the lender of the last resort and the recipient country.
As regards the first strand, it is highly improbable that any sensible government would pursue irresponsible policies in the expectation of a bailout. The economic, social and political costs would serve as a strong disincentive against such motivation. In so far as IMF has been a de facto lender of last resort, the empirical experience is that most governments do their utmost to avoid seeking assistance from IMF and there is therefore no validity in the moral hazard argument with respect to national policy makers.(13) Moreover, it should be possible to design eligibility criteria to minimize any such possibility. Similarly, moral hazard implications for private market agents can be addressed through policy measures. Investors in equity markets do suffer losses when meltdowns occur. A range of options are available to minimize expectations of full-value maintenance of foreign loans and some of these are noted below.
It is argued that, in order to minimize moral hazard, an international lender of last resort would need to exercise a degree of supervisory authority that might not be acceptable to national policy makers. This is, however, not a convincing argument. It cannot be denied that IMF does play a significant role in the determination of macroeconomic policies of developing countries through its advice, which no country treats lightly. This is so not merely because access to IMF funding could be denied, but also because access to resources from other international financial institutions and private investors and lenders is often contingent on agreement with IMF. Very similar considerations would also apply with respect to an international lender of last resort.
A much more plausible argument is that, given the increased frequency and intensity of crises, it would be difficult to establish a very effective lender of last resort because of the inadequacy and uncertainty of the resources at its disposal. If the role were to be performed by IMF, there could be a number of ways to augment its resources. These would include expanding the scope of the General Arrangements to Borrow and the New Arrangements to Borrow, implementing the G-7 proposal for a new facility specifically to make liquidity support available at an early stage, allowing IMF to raise funds from the financial markets and creating additional special drawing rights. Similar provisions could be made, mutatis mutandis, for a new institution as well. It needs to be recognized that the world has suffered huge losses in foregone growth in recent years because of financial crises. The resource requirements for any institution that is able to be an effective lender of last resort and prevent such crises are likely to be small compared with those losses. What really matters is the political will.
The establishment of an international lender of last resort could yield a number of positive benefits. A country may be threatened with severe financial problems through no fault of its own. For example, a sudden drop in demand for its exports or changes in interest rates in capital exporting countries might cause large capital outflows and depletion of reserves. The provision of liquidity in advance could pre-empt a crisis caused by short-term investors and creditors moving out of a country together in a herd-like reaction. In the absence of a lender of last resort facility and given the frequency with which deep financial crises have occurred in recent years, there may be strong incentives for countries to adopt unduly restrictive measures against capital movements to the detriment of an efficient allocation of global resources. An additional consideration is that the existence of a lender of last resort facility might prevent rapid contagion from one country to another.
Supervision and regulation of international capital flows
The rapid pace of international financial integration has, to a large extent, overtaken the ability of national supervisory bodies to oversee the activities of financial sector entities with significant cross-border activities or exposure. Effective supervision has been further complicated by the proliferation of instruments and services on offer from the financial sector, referred to as "off balance sheet" activities, and the availability of tax havens and offshore centres with lax or nominal supervision. The activities of hedge funds, with their offshore domiciles and methods of incorporation, appear to fall outside the ambit of any reporting or regulatory system.
It is obvious that mere reliance on self-regulation or on market discipline is neither adequate nor satisfactory. In view of the severity of events that have engulfed countries not merely in Asia but in other parts of the world as well, improving international supervision and regulation through a new body requires careful and urgent consideration.(14) In this context, it should be noted that the United Nations Committee for Development Planning has proposed the establishment of a world financial organization. No consensus has yet emerged regarding the establishment of a new world body or its composition and functions, but the need for multilateral surveillance and regulation of the practices of a wide variety of financial institutions has been recognized in various intergovernmental forums such as G-7 and APEC.
International banks have been the principal players, both directly as lenders and indirectly as arrangers and underwriters of various forms of debt financing, in the international economy. In so far as their activities are concerned, the Bank for International Settlements provides a venue for the discussion of the problems that have come to the fore in recent months under the aegis of the Basle Committee on Banking Supervision and the Committee on Payment and Settlement Systems, which includes cooperation with the International Organization of Securities Commissions.(15)
The Bank for International Settlements, however, provides developing countries with little formal access or possibilities for participation, which is a major weakness. A new overseeing body for international capital requires a broader but specific mandate dealing with the monitoring, and eventual regulation, of all short-term cross-border flows to develop, as in the case of WTO, a rule-based system, rather than one dependent upon ex post facto disclosures by financial institutions. Private sector representatives might also be associated with it in some manner.
A rule-based system could allow countries to suspend repatriation of capital in the event of lower-than-expected export earnings or on account of an unforeseen bunching of outflows through herd-like behaviour. A close parallel in the trading sphere is provided by article XII of WTO. Under this article, countries can restrict the value or quantity of imports to forestall an imminent threat or serious decline in their reserves. The world financial organization could administer a similar article dealing with capital flows. A rule-based system of measures to moderate undesirable swings in capital flows would make all parties more conscious of the relative riskiness of their decisions without causing serious disruptions to these flows.
An overseeing body for capital flows could develop an early warning system for possible debt-servicing problems for the providers of capital. This could be combined with a system of declaring over-borrowed countries ineligible for new loans. The other functions of such a body could include monitoring the implementation of sound international principles and practices for accounting, payments and settlements, banking supervision, security market supervision, insurance supervision and supervision of financial conglomerates. In addition, it could formulate acceptable forms of international regulation for short-term capital movements to complement national measures, as well as formulate and apply international guidelines for short-term lending and borrowing by private creditors and borrowers. The competence of the world financial organization could be extended to include the development of rules for ensuring transparency and full disclosure of information relating to both financial and non-financial corporate sectors, as well as rules for the smooth functioning of international bankruptcy regimes.
Defining the role of private creditors
Private sector banks and investment funds have been by far the most important participants in the international financial system. Most of the capital inflow into Asian countries hit by the crisis came from private sources, particularly bank credits. The responsibility of private sector creditors, therefore, has to be clearly defined in resolving issues of indebtedness.
However, the resolution of debt issues is constrained by two considerations. First, there is a tendency on the part of private bank lenders and borrowers to play for time through a series of ad hoc measures and, even more important, to count on economic recovery as a means of resolving the debt problem. Second, all creditors, especially foreign bank creditors, tend to maintain the assumption of full value maintenance, that is, that the amounts owed to them will be repaid in full.
For any orderly, durable and equitable debt workout, it is important that a set of principles are internationally agreed upon to avoid placing the burden exclusively on debtor countries. In the absence of an agreed framework of principles, countries become bogged down in time-consuming discussions and negotiations. In these principles, bank debt ideally should not enjoy any seniority in claims compared with, say, bonds or debentures. It should be remembered that in the context of the current crisis many, if not most, borrowers are de facto bankrupt. If they were to go into liquidation, banks would recover only a small fraction of their original loan amounts and that, too, after a substantial delay. Equally, however, it is not in the interest of borrowers to go into bankruptcy as this would impair, perhaps fatally, their access to future credits.
In an orderly debt workout involving private sector banks, consideration would have to be given to a mutually satisfactory adjustment of claims. A number of formulas can be used: rollovers; conversion of debt into longer-term securities; reduction in its face value; lower interest rates; or, for example, a temporary standstill on debt servicing. Any standstill should be subject to validation by an international body, preferably the world financial organization, in order to avoid any harsh judgement by market participants and loss of confidence. The objective would be to enable debtor countries to adopt certain measures automatically without inviting an adverse reaction, rather than to rely on open-ended negotiations in which debtors and creditors might adopt extreme positions and a long time might be taken to find an acceptable via media.
Lack of liquidity, or even insolvency, is often the consequence either of exogenous circumstances or of commercial misjudgements by both borrowers and lenders. In either event, fairness demands that both should share in resolving the problems that result. One particular expression of unfair debt workouts is the provision of government guarantees and the consequent socialization of private debt. This happened on a large scale during the Latin American debt crisis of the 1980s and also in recent restructuring agreements of Indonesia and the Republic of Korea. One of the principles that should be internationally agreed upon is therefore the avoidance of public guarantees for private debt in the future.
There is a strong case for greater regional cooperation in the ESCAP region in the aftermath of the crisis. Issues of financial sector regulation, the establishment of common prudential standards for the industry and the development of early warning systems have been repeatedly mentioned in the context of regional cooperation for reducing the intensity of any future crisis and preventing contagion.
Financial market instability has been aggravated by a lack of reliable relevant information. This has arisen from the variability, as well as inadequacy, of standards of accounting, auditing and disclosures, and problems with corporate governance generally in the region. All economies need to make substantial improvements in these areas. In this context, the accord signed by several countries of the region with ADB for the conduct of surveillance is a welcome step.
Against this general background, the proposal for the establishment of an Asian fund could be an important initiative in the area of regional cooperation and merits serious examination. Its principal rationale is that it could reduce the probability and intensity of a future financial crisis. The Asian fund would be a source of additional liquidity to what is currently available to IMF. Its liquidity would help to improve market sentiment. It could be designed to be quick-disbursing in nature. Thus, it could help member countries in replenishing reserves as soon as signs of distress became visible and would thereby reduce the incentive for rapid withdrawal by foreign market operators. As of now, countries faced with debt problems have to negotiate financial rescue packages with IMF. The very news that such assistance is being sought can aggravate the loss of confidence and generate panic. By the time a rescue package is in its final shape, too much damage has been done and restoration of confidence takes a very long time.
The argument that the establishment of an Asian fund could increase moral hazard is not very persuasive. Countries are unlikely to pursue irresponsible policies simply based on the knowledge that they have access to some essentially limited amount of funds in the event of an emergency. Furthermore, a system of restraints could be built in to reduce the probability of moral hazard by, for example, levying progressively higher interest rates with the volume and frequency of drawings from the Asian fund.
Another argument cited against the Asian fund is that it could undermine IMF conditionalities and discourage countries from carrying out essential reforms. Once conditionalities are agreed upon, any release of subsequent assistance by the Asian fund could be made contingent upon compliance with the conditionalities. But the Asian fund should have a role in negotiating the conditionalities themselves. At present, negotiations take place between IMF and a country in distress and are often perceived as a one-sided process. Some degree of plurality of views in the determination of conditionalities would most probably add to their credence and promote wider acceptance, including in the recipient country.
In this context, it is worth noting that the ESCAP region's total foreign exchange reserves are about $800 billion. Only a small proportion would be needed to make a major impact were they to be deployed for establishing the Asian fund. An investment in the development of new institutions, such as the Asian fund, thus has a logical rationale. It needs to be examined dispassionately.
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The world has experienced several financial crises of great intensity with devastating impacts on the real economies and social fabric. To a great extent these crises can be attributed to major shortcomings in the international financial system. The financial markets have worked in a manner that gives rise to dizzying booms followed by catastrophic busts. The crises seem to have become unstoppably contagious, with developing countries and economies in transition becoming easy victims. The crises also reflect a fundamental contradiction in the world economy in that there has been a phenomenal explosion of cross-border financial transactions in a wide variety of forms with an ill-equipped institutional framework to oversee them. There is thus an urgent need for bold initiatives to reform the international financial architecture. The above discussion offers some thoughts in that direction.
12. National measures were discussed
at some length in Survey 1998, pp. 89-100.
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