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Recovery from Financial Crisis: Macroeconomic Policy
Speech to the North-South Institute
Alternatives for Equitable Growth
Policy Development and Review Department, IMF
Ottawa, Canada, September 29, 1998
The events of the past year have generated a debate of enormous importance—one that
needs to continue and to lead to real action if the weaknesses in the global financial system
exposed by these events are to be properly diagnosed and corrected. Part of the process of
recovery—the theme of today’s session—must be an improvement in the system
to reduce the likelihood of such crises in the future. As you would expect, these issues are the
focus of increasing attention in the Fund and I would like to lay out today some of the more
specific ideas that are emerging and some of the policy changes that are already underway. But
before I do that, I would like to start by considering the most basic question underlying this
Over recent months there has been an increasing chorus of voices raising issues regarding the
wisdom and effectiveness of open capital markets. In recent weeks we have seen specific actions
reflecting these views:
- Is the entire effort to globalize financial markets simply mistaken?
The questions being raised are seen as a challenge to the long held view of the Fund - and others -
on the benefits of open markets. The view that open capital markets are beneficial lies at the heart
of the initiative to amend the Fund’s Articles of Agreement. The Interim
Committee’s "Hong Kong declaration" of last September proposed to make
the liberalization of capital movements one of the purposes of the Fund and, in the language of
- Malaysia has moved dramatically to close its markets, repegging the exchange rate,
making offshore holdings of ringgit illegal, forcing equity investors to remain in the currency for a
minimum period and many other measures—all of which are intended to isolate Malaysia
from what are seen as the arbitrary forces of international capital markets.
- Even more surprising, Hong Kong has taken to large scale official intervention in its stock
market in an effort to thwart the so-called "double play" initiated by speculators
simultaneously shorting equities and taking positions against the currency.
"to extend, as needed, the Fund’s jurisdiction through the establishment of
carefully designed and consistently applied obligations regarding the liberalization of such
movements, with appropriate safeguards and transitional arrangements."
In this manner, capital account transactions would be brought within the mandate of the Fund in a
manner similar to that through which current account transactions have been treated since the
This view held by the Fund seems at odds with the conclusions some seem tempted to by the
recent crises and by what appears at times to be something near chaos in capital markets.
Behind all of this there is a tension between two conflicting propositions which are at their heart
empirical, but on which the evidence is complex and disputed. The first proposition is that the
gains from a general and fluid movement of capital between countries and markets can be
enormous. Capital flows provide scarce investment resources, they encourage allocative
efficiency, and they can help effect a technology transfer that is beneficial to recipient countries,
especially developing countries. The alternative proposition is that the origins—or at least a
critical aggravant—of the recent crises in Asia and elsewhere lie in the openness of these
markets to the vagaries of unstable capital movements and that the costs being paid are too high.
In this view, the conclusion is that the regimes must be changed, perhaps dramatically, to prevent
such crises in the future.
Where is the truth? There are many anxiously waiting to see if Malaysia will succeed with its
approach. There are others who are convinced the downside risk from Malaysia’s
experiment is large—not just in the loss of capital inflows, but also in the loss of discipline
and incentives such flows can bring. Many wonder, for example, whether the incentives to deal
forcefully with the problems in the domestic financial system will not be weakened by these
One thing is clear: we won't get the issue right unless there is a careful diagnosis of the recent
crises that leads to the right lessons being learned!
And here I believe there is some reason for concern. Some seem tempted to conclude that open
markets are in and of themselves fundamentally flawed. So let me pose two questions.
Let me take the first question. The doctrine or paradigm from which the IMF and the international
community more broadly have worked is pretty clear in its generality:
- First, was it openness, per se, that led to or aggravated the recent crises; I will argue that
it was not, but that there were, and remain, vulnerabilities in the system—which are all too
obvious--that need correction. Which leads to my second question: what can be done to reduce
these vulnerabilities and to permit a better response if remaining or unforeseen vulnerabilities lead
to crises in the future.
—capital market liberalization should be orderly, properly sequenced and carefully
married to a strengthening of domestic financial systems;
If we ask whether that path was followed in many of the emerging market economies that have
faced crises in the markets, the answer is too frequently "no"!
Let's look at the Asian Crises countries! But let me make clear at the outset—I am not
involved in a finger-pointing exercise!
All participants—governments, the capital markets and, yes, the IFIs— made mistakes
at various points in run-up to or in dealing with the crisis. More importantly, the Thai and Korean
authorities, whom I’ll speak about below, have made courageous efforts to come to grips
with the problems this crisis has surfaced. But I want to illustrate some of the factors that lay
behind the turmoil in these countries—factors that are not inherent to open markets and
which—if corrected—could greatly lessen the risks that can accompany the opening of
First, take Thailand: there is a good deal of evidence of the weaknesses that had developed in the
Thai financial system—especially in nonbank financial institutions. But the story in Thailand
also has a dimension of very specific, but unfortunate, policy moves—policies that created
clearly the wrong incentives and distorted the flow of capital. During a period of already large
inflows of capital—feeding a current account deficit of near 8 percent of
GDP—measures were put in place that, through tax incentives and other means, further
encouraged inflows, and, most dangerously, inflows through the short end of the market. I refer
here especially to the creation of the Bangkok International Banking Facility. The result was a
predictable maturity mismatch and increased vulnerability—that encouraged a rush for the
exits that greatly weakened an already fragile financial structure.
Then take Korea. In this case too, a system was created that encouraged short-term borrowing
through the banking system, which, combined with active impediments to long-term funding of
the corporate sector through bond issues and equity, led again to over-exposure at the short end
of the market and a severe maturity mismatch. Korea opened its capital market alright--but
mostly at the short end and blocked inflows of more stable longer term financing. Again, when
pressure developed, the short term exposure dramatically increased the vulnerability of the
banking sector—and, ultimately, of the nonbank corporate sector.
A somewhat different, but equally troubling story can be told of Indonesia. There was no secret
regarding the weakness in the Indonesian banking sector. The Fund knew it, the World Bank
knew it and, most importantly, the monetary authorities knew it! But the supervisory system was
not up to the task of dealing with the problem—not that it wasn’t identified, but
rather that politically it could not be faced! The supervisors had neither the autonomy nor the
legal footing to do what they needed to do to protect the system, i.e., close institutions! With a
weak banking sector, the other problems that fell upon Indonesia had much larger repercussions
on the economy than might otherwise have been the case!
All of this points clearly, I believe, to weaknesses and mistakes that can be corrected—while
keeping to the view that capital markets can and should be opened in ways that help maximize
their potential benefits.
This is the critical lesson: open your capital markets, but do it carefully. Another lesson stems
from the fact that markets can be used—or, I should say, misused—in ways that
exacerbate their potential vulnerabilities. There is one particularly dangerous misuse of markets
that needs to be highlighted. This involves the creation of dynamically unstable debt structures by
governments themselves. A number of countries recently in crisis—not the least Russia and
Ukraine—financed unduly large budget deficits over an unduly long period of time in a way
that led to a level of short-term exposure that proved unmanageable. In Russia, for example, the
inability to roll over the very large stock of maturing GKOs in the weekly auctions played an
important part in the failure of the reform program that the Russian Government tried to
implement in July.
I don’t want to be misunderstood on this.
The establishment of short-term debt markets is a constructive step in the development of the
domestic financial system. It is perfectly sensible and desirable—providing liquidity to banks
and corporations, supplying signals and operating instruments to monetary policy makers and the
like. But, as in so many other areas of life, too much of a good thing can kill you. And there is no
doubt that too much reliance by governments on financing at the short end will result in a
structure against which markets can turn with a vengeance when attitudes and expectations
change—as, inevitably, they do. What is clear is that the margins for error in
macroeconomic, debt management and financial policy more generally are extremely tight in the
face of open capital markets and governments that overstep those margins, especially in the debt
structures they create, are inviting trouble. These mistakes are not unavoidable and the openness
of markets per se should not be blamed for the disruptions that result from misuse.
My final point on this issue is that this need for prudence extends to all participants in the markets.
There were many problems and weaknesses in the cases listed above that have been well
—the tendency of investors and debtors to put too much faith in fixed or nearly fixed
exchange rates and, thus, to take on unduly large, unhedged exposure in foreign currency.
These stories, too, are reasonably well known. But how to avoid these traps? There are
instruments that can reduce financing costs or promise a high rate of return under something like
normal circumstances, but which can go terribly wrong when pressures develop and lead to
self-aggravating processes that overwhelm otherwise reasonably healthy debtors. Thus, prudence
needs to be exercised by all those accessing markets. Sometimes this prudence needs to be
enforced and this can be done in various ways through supervisory and regulatory mechanisms.
But here, too, many countries have been found lacking and the international community needs to
organize a large and well-coordinated effort to assist governments in these areas.
—the purchase of instruments by sometimes inexperienced domestic financial institutions
that promised high returns in a stable environment, but which collapsed when the currencies fell
(puts, total return swaps, etc).
There are additional temptations for policymakers themselves when faced with fluid markets and
imaginative instruments which, if misused at times of stress, can quickly make a bad situation
worse. I refer here, by way of example, to the large-scale use of forward transactions by the Thai
authorities to defend the Baht and the misuse or misplacement of official reserves by a number of
countries that had the effect of severely limiting the room for maneuver when markets tightened.
Korea and Ukraine are unfortunate examples of the problems that can arise in this area.
My conclusion, then, is that it is not openness that is the issue or the enemy. It is rather (i) the
way in which markets are opened; (ii) the policy misuse of the opportunities created by more open
markets; and (iii) the failure to recognize the limits beyond which vulnerability can increase at a
startling pace. Each of these things can be corrected while still providing the opportunity to
exploit the real benefits that international capital flows can bring. I truly hope this will be one of
the operational lessons of the recent crises. It has important implications, not just for national
authorities, but for institutions like the Fund and the way we conduct surveillance over member
But if this diagnosis is generally correct, what should be done in response?
First, and obvious, is to try to correct and avoid the problems elaborated above. Here, some of the
requirements are clear:
On this last point, just a word of caution—or of realism. Some would like to suggest that a
country open its markets only after some specific set of prerequisites are put in place. This is,
unfortunately, overly simplistic.
- countries need to avoid creating perverse incentives—through tax policy and other
means—that encourage undue exposure, especially at short maturities;
- there needs to be better management of fiscal positions and of government debt; governments
need to resist the temptation to exploit every new instrument that comes along for deficit
financing as a means of avoiding needed fiscal adjustments;
- there needs to be much better supervision and regulation of banks and other financial
institutions, especially in emerging market economies;
- there needs to be better information—transparency—on the part of all players in the
markets—and better, more widely adopted standards to be used as benchmarks in the
provision of that information.
- finally, there needs to be a better alignment of the opening of capital markets with the creation
of the infrastructure needed to assure the effective supervision, use, and monitoring of the
resulting flows and of the exposure created by such flows.
—first, the so-called prerequisites are not so clear cut and precisely defined; they are
general and, in many instances, a matter of degree—such as the robustness or strength of the
domestic financial system, the capacity of the regulatory and supervisory authorities and the
The conclusion then is that a massive effort needs to be launched to assist countries in all these
areas. The international institutions and others who have the capacity to offer assistance in the
relevant areas need to be organized to assure the scope of this effort is up to the challenge.
—openness itself is also a matter of degree—it is not an either/or proposition;
—and, finally, the reality is that to a certain degree markets will continuously force greater
openness once the process begins. Thus, there is not much of an option to wait—and besides
the benefits are real and should be seized as soon as prudently possible—including when
political windows of opportunity open for genuine reform.
But what about the markets themselves? Are there ways in which the incentives and/or rules in
markets need to be changed. There is a great deal of discussion going on in this area under the
rubric of the Architecture of the International Monetary System. The issues that touch on the
private markets can be grouped under three headings: preventive, ex ante, and involvement at
times of crises. I would like to touch on each of these only briefly.
On prevention—much of what needs to be done I’ve already noted:
Here an aside. Free markets do not imply freedom to bring down the system. For example, if
private parties rely on government/official reserves to facilitate the ongoing inflow and outflow of
capital, the government or central bank as holder of these reserves has a responsibility to manage
them properly, but also the right—indeed, the obligation, to know what exposure the private
sector is taking on. That exposure represents potential claims against those reserves.
Governments—and not only in emerging market countries—need to be more
demanding of their financial and corporate sectors in this regard, and know on a timely basis the
kind of exposure—and, therefore, risk—to which they are subject. It may also be the
case that the international community needs to develop reporting requirements for hedge funds. I
believe that events of the past days strengthen the case for a move in that direction.
- better regulation and supervision;
- better macroeconomic policies to create the environment for better private sector
- improvement in the other tools for decision-making, especially credit risk assessment; this
- better data;
- better standards--accounting, disclosure, etc.;
- better transparency in policy-making;
- but it also means better monitoring by all concerned—especially of debt exposure.
There are other ideas around for further preventive action.
Besides better prevention, there are things that can be done to help involve the private markets at
times of pressure in the balance of payments—so-called "ex ante" measures.
Mechanisms are needed that could help limit the demands of private sector creditors at such times
or even to bring in the private sector to contribute some of the needed liquidity. Some new
devices to do the latter have already been put in place. Both Argentina and Mexico have entered
into agreements with commercial banks to assure the availability of liquidity at times of
stress—in the Argentine case in the form of swaps and in Mexico in the form of lines of
credit. The interesting feature of these facilities is that they do not contain the usual caveat about
drawing against them in the event of a "material change in circumstances." Thus, the
authorities are confident of their availability at times of stress.
- one idea is to increase the capital requirements on short-term lending and possibly to
differentiate such requirements depending on issues such as the compliance of the borrower with
certain international standards—such as accountancy, disclosure and the like. It may even be
possible to put capital requirements on the debtor side of the transaction—on the theory that
if intermediaries/banks fund their long-term lending at the short end because of lower interest
rates, supervisors may need to step in to increase the cost of such borrowing to reduce the
incentive to accept the resulting mismatch of maturities.
These are potentially useful mechanisms to help assure that private creditors contribute to the
solution rather than simply add to the problem at times of crisis. It remains to be seen, however,
how robust these mechanisms will prove when put to the test!
There are other interesting ideas that have been floated that would have an even more direct effect
of forcing a contribution from the private sector at times of crisis—a
"bailing-in", so to speak, of private creditors!
I hasten to add that these are, at best, only very tentative suggestions at this stage and much more
thinking and consultation would be required before anything practical could be made of them.
- it has been suggested that call options could be put into short-term credit
arrangements—including in interbank lines; this would be an interesting reversal of the put
options in medium-term credits that had the effect of accelerating payments due in the midst of
the Asian crisis—effectively converting medium-term loans into credits due and payable
immediately. This could lessen the pressure caused by an unwinding of short-term positions at
times of stress.
- more radically--various mechanisms have been suggested to provide for automatic
"haircuts" at times of stress—although, in this, I think there is little enthusiasm in
most circles—not least amongst the creditors themselves!
Notwithstanding the best preventive mechanisms, and devices to trigger automatically some
support from the private sector—there will be crises that demand more active means to
involve the private sector. The issue is straightforward: how to prevent an exit by private sector
creditors at the time the official community, including the Fund, is providing resources to the
country, i.e., how to limit one of the extreme manifestations of moral hazard—the
replacement of official money for private credit! This may be the most difficult area we are
wrestling with in this exercise of strengthening the architecture of the international financial
The issues here are complex, but also in need of urgent answers: The concrete cases dealt with in
the past year point clearly to the issues involved:
These cases remind us of two things:
- there has been endless debate about the timing of the call on creditor banks to roll over and
then restructure their exposure in Korea;
- there is obvious unhappiness with the Russian government’s handling of its debt and
the unilateral declaration of a moratorium;
- there is frustration over the time it is taking to deal with the debt of the corporate sector in
- there will be much debate—and perhaps litigation—about the restructuring package
put forward by Ukraine.
First, there will be—inevitably—extreme situations characterized by widespread
distressed debt; and
Second, the international community does not now have at its disposal the tools to deal with
If a country faces such a situation, our hope would be that through an early approach to its
creditors, in the context of discussions on its situation with the Fund, a cooperative, voluntary
restructuring could be arranged. This will require a realization on the part of creditors that their
interests are best served through such agreement. But it also requires mechanisms to assure some
order among the creditors. Here, such devices as sharing clauses and the like in international bond
contracts could help foster such order. Much greater efforts need to be made to develop the
mechanisms to encourage such outcomes.
But we have to face the extreme possibility—that is, a refusal by creditors that leads to
default, with all that that may entail: the triggering of cross default clauses, acceleration of
principal—making it due and payable immediately, and litigation to force creditor rights. The
Fund Board has already decided to extend the policy of lending into arrears under certain
conditions. However, under current rules, we cannot be sure creditors will not react litigiously,
threatening the attempt by the country to adjust. Such actions can pose a potentially serious issue
for members and for the international community and we need to think further about the question
of legal protection for debtors. Any such mechanism would, of course, have to be used with great
care and only in circumstances where the member is fully cooperating with the international
community through the Fund and where the community agrees that all other reasonable
alternatives have been exhausted. One possible means of providing this protection would be to
amend Article VIII, Section 2(b) of the Fund’s Articles of Agreement, as a way of
imposing a temporary stay on creditor claims when creditor action promises to disrupt a
member’s internationally supported adjustment effort. The analogy here, of course, is to
domestic bankruptcy law and the protection that the orderly processes of such law afford to both
creditors and debtors.
This is a most controversial area. Some see such a mechanism as unnecessary; others see it as
infeasible or undesirable. But the fact of the matter is that there is a problem out there and the
international community needs a way to resolve it. It is in no one’s interest to intensify the
stress and cost paid by countries beyond that involved in the adjustment process demanded at a
time of crisis. Orderly debt workouts are in everyone’s interest. But we must work to
develop the tools needed to increase the likelihood that such events can be more orderly.
IMF EXTERNAL RELATIONS DEPARTMENT