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Recovery from Financial Crisis: Macroeconomic Policy
Alternatives for Equitable Growth

Speech to the North-South Institute
Jack Boorman
Director
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 debate:

  • Is the entire effort to globalize financial markets simply mistaken?

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:

  • 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.

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 that declaration:

    "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 Fund’s inception.

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 controls.

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.

  • 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.

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:

    —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 markets.

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 documented.

    —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.

    —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).

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.

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 country policies.

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:

  • 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.

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.

    —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 like;

    —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.

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.

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:

  • better regulation and supervision;

  • better macroeconomic policies to create the environment for better private sector decision-making;

  • improvement in the other tools for decision-making, especially credit risk assessment; this requires:
    • 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.

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.

There are other ideas around for further preventive action.

  • 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.

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.

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!

For example:

  • 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!

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.

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 system.

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:

  • 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 Indonesia; and

  • there will be much debate—and perhaps litigation—about the restructuring package put forward by Ukraine.

These cases remind us of two things:

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 them.

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

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