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Reforming the International Monetary System

Address by Mr. Alassane D. Ouattara
Deputy Managing Director of the International Monetary Fund
at the Academie de la Paix et de la Securité Internationale
Conference on Crises and International Security
Monaco, March 6, 1999

french

It is an honor and a great pleasure for me to join you as you weigh how best to reform the international financial system. We hear calls for a global currency and the creation of new supranational agencies—such as a global central bank, a global financial market regulator, a global debt insurance corporation, a global credit-rating agency, and a global bankruptcy court. We also hear calls for a return to broad capital controls, while many others think that capital markets should be left totally unfettered lest moral hazard govern the behavior of investors and borrowers.

Some of these ideas involve ceding national sovereignty and go some way toward the creation of a world government, while others ask policymakers to step back from cushioning the harsh realities of today's volatile and unforgiving markets. Are these ideas realistic? Is this really where we are headed? Speaking both as an IMF official and a former policymaker, my approach by nature relies heavily on pragmatism. After all, political economy—and that is what we are talking about—like politics itself is the art of the possible.

It is in that spirit that I would like to sketch out where there is consensus, where there are gaps to be bridged, and where the IMF fits in. But first a few words on the lessons we have learned from the recent crises and contagion. For it is these events that have generated the calls for change.

Cracks in the system

The crisis that consumed Thailand, Korea, and Indonesia was not spawned only out of profligate government policies, as was typical of balance of payments crises in the past. Rather, it stemmed from excessive credit expansion, latent cronyism, financial sector weaknesses, and other structural shortcomings. It then turned into a capital crisis, sparked by a massive outflow of funds from these countries. The three tigers were particularly vulnerable to the sudden change in investor sentiment because of their very large short-term debt exposures.

But the cracks that were exposed so brutally in Asia were not entirely homegrown. What we faced was a systemic problem, a crisis of the international financial system. The problem was that the system had not yet developed enough to reconcile the needs of all the participants—investors seeking new opportunities, emerging market economies seeking resources for investment, and governments seeking to ensure that markets were operating safely and efficiently.

In the end, the global economy managed to escape a seizing up of financial markets and a widespread credit crunch. But the close brush raised troubling questions about the dynamics of international capital markets. First, why was it that Russia's effective debt default in August triggered a massive global reassessment and repricing of emerging market risk?

We believe that more was at stake than the size of the losses on Russian exposures and positions. Far more important was the role of Russia's default as a defining event that challenged widely held views about default risks for all emerging market investments, and the willingness and ability of the international community to help countries in trouble. The situation may have been compounded by Malaysia's move to impose capital controls, heightening the risk that others might follow suit. So far, this has not proved to be the case. Rather, many emerging markets have been quick to underscore their commitment to open capital markets.

Second, why did the turbulence generate severe strains, sharp rises in interest margins on credit, and extreme price movements in some of the world's deepest financial markets—prompting a major central bank to facilitate the private rescue of a hedge fund? We believe at root was a problem of many investors attempting to rapidly unwind highly leveraged positions at the same time. And here, I would like to be clear, it was not just the hedge funds that had taken such positions. Although comprehensive data is lacking, proprietary trading desks of many of the large international commercial and investment banks appear to have been doing the same.

Of course, this raises another troubling question. How could very large leveraged positions be built up across a large number of financial institutions to the point where systemic risk was raised to extraordinary levels? We believe that lack of transparency, poor internal risk management, inadequate prudential supervision, and the moral hazard induced by anticipated bailouts in the event of bankruptcy, all came into play.

Mending the cracks

So what together can the international community do to modernize the system to catch up with the breathtaking developments in international capital markets? At this stage, and this is important, financial leaders have agreed on the seven basic building blocks. Where the debate lies, and it is a vigorous one, is among a range of proposals within each of these blocks. The overarching idea is to improve the way countries monitor and discipline themselves, improve the way banks and borrowers interact, improve the way financial markets behave, adapt the IMF better to the new environment, strengthen relations between the multilateral bodies, such as the Fund and the World Bank, in other words, improve what is often referred to as the architecture of the international monetary system. Here, I am reminded of a West African proverb: "The beginning of all wisdom is to get yourself a roof." In this case, the roof is the structure that we are trying to give the system to ensure that it is sturdy enough for today's globalized world. The hopeis to prevent the kinds of crises that we have seen over the past few years, and deal better with those crises that may inevitably still occur. Let me briefly review each one of these blocks.

First, better international standards. Many standards for financial practices already exist, but a lesson of the recent crises is that we need more effective standards. That means two things: sensitizing countries to what are universally regarded as good practices, whether in producing statistics, conducting policy processes, or designing supervisory regulations; and second, monitoring observance of these standards. That doesn't mean that national practices should be identical. But they will be judged according to their compliance with a common set of international standards. Along this line, a number of efforts are under way at the Fund.

  • One of the most important steps post-Mexico was the establishment in 1996 of standards to guide countries in publishing a regular and timely flow of economic and financial data—the so-called data standards. These standards are now being beefed up, especially in the areas of data on international reserves and public and private external debt.

  • Last year, the IMF adopted a code of good practices on fiscal transparency, which provides a benchmark for assessing governance. The aim is to make the policy environment less uncertain, and enable policymakers to respond earlier and more smoothly when economic problems emerge. This code is no mere "wish list" of government behavior, since it is backed up with a manual, a questionnaire, and other tools to help members.

  • The IMF, in conjunction with other institutions such as the Bank for International Settlements, is now working on a similar code on financial and monetary policies. It won't take a stance on specific financial and monetary policies, but rather will emphasize ways to make the formulation of these policies more transparent to the public and the markets.

  • Standards will also be needed in other key areas, such as accounting, auditing, asset valuation, bankruptcy, and corporate governance—although these will be primarily the responsibility of other agencies.
  • Standards, then, are the "stick." But what is the "carrot" to get countries to comply, and who will do all the monitoring? This brings me to the second block, greater transparency—a notion that applies to all the major players in the world economy: the public and private sectors, financial markets, and the multilateral institutions. Just think what might have happened if we had known, precisely on time, how quickly Mexico's foreign exchange reserves were being depleted in 1994. Or if we had known much earlier how fast the Thai central bank's forward transactions were accumulating in 1997. Or if we had known in time the amount of foreign exchange reserves Korea was lending to its commercial banks in 1997? Or even if we had had, at the time, a better idea of Indonesia's private sector indebtedness.

    Clearly, timely and detailed information can prevent the accumulation of problems by forcing governments to take appropriate measures at the right time. It encourages a more widespread discussion and analysis of policies by the public. It enhances the accountability of policymakers and the credibility of policies, thus contributing to good governance. It also facilities the orderly and efficient functioning of financial markets. For in a world of sizable, sometimes extremely volatile, private capital flows, financial markets must be able to respond more continuously and smoothly to economic developments if dramatic corrections are to be avoided. But here, one caveat. Just the existence of the information won't do the trick. It needs to be taken seriously in the analysis conducted by investment houses, financial institutions, and others. And that analysis must actually work its way through to the people who make the deals and to public policymakers.

    What can the IMF do? Besides establishing and refining standards, we have been releasing more information than ever before on the IMF's operations, policies, and processes, most of which can be accessed on our website—www.imf.org. But many groups, such as the G-22, would have us go even further. The G-22 is calling for the Fund-as part of its routine surveillance—to prepare reports that would assess the adequacy of transparency practices of member countries in critical areas. The problem is that some countries are less willing than others to divulge what they consider to be confidential information. Similarly, private or public companies may worry about disclosing what they consider to be proprietary information. Clearly, this is a major task and we are only just beginning to explore the possibilities. But whatever we can do, it will succeed only if the financial markets truly demand improvement on the part of those tapping the markets. That means there has to be a real reward for following the standards,—which should be reflected in the margins paid on borrowings.

    Third block, financial sector soundness. It is striking that around the world, for the past five years, every major financial crisis has been either caused, or exacerbated, by banking sector weaknesses. Moreover, almost three quarters of the countries worldwide have experienced domestic banking stress or crises in the past 15–20 years, including in a number of industrial countries. In recent months, the risks of highly leveraged types of international transactions have also come to the fore.

    So what can be done? The bottom line is that a sound international financial system must rest on sound and resilient national systems. And these must be monitored according to transparent and consistent standards. On this front, there is much activity. For some time, the Fund has been helping to disseminate a set of "best practices" in the banking supervision area—as developed by the Basle Committee—so that standards and practices that have worked well in some countries can be adapted and applied in others. We are stepping up our efforts to identify—and help correct—financial sector vulnerabilities with potential macroeconomic implications. We are looking into whether additional disclosure requirements or regulations are needed on the operations of institutional investors, including highly leveraged ones. And we are increasing our collaboration with the World Bank on financial sector issues.

    But even with technical assistance from the Fund and others, many developing countries have far too few supervisors monitoring fragile banking sectors—a situation that will exist for some time to come. This raises the possible need for interim safety measures on capital flows, which brings me to the next building block.

    Fourth, capital account liberalization. Open capital markets potentially bring enormous benefits to all-especially developing countries. They can supplement domestic savings, encourage the efficient use of scarce capital, and bring collateral improvements in knowhow. But the Asian crisis brought home the need for countries to take greater care in the way in which they liberalize, especially if they lack sound financial systems. It is clear that liberalization has to be done in stages, with due regard for the soundness of the financial market as a whole. A few examples:

  • Korea opened its capital market, but mostly at the short end, blocking inflows of more stable longer term financing. So when pressure developed, the unwinding of short-term exposures dramatically raised the vulnerability of the banking sector—and ultimately, of the nonbank corporate sector.

  • Thailand used tax incentives and other means to encourage inflows at the short end of the market, creating a predictable maturity mismatch and increased vulnerability. This permitted a rush for the exits that greatly weakened an already brittle financial structure.
  • In other words, it matters how markets open up. It matters if policymakers misuse the opportunities created by more open markets-with disastrous consequences. Policymakers must always be looking to minimize the vulnerability of their economies, because without this vigilance, vulnerability can increase at a startling pace. It also matters that creditors gauge risk better. So let us not blame liberalization for Asia's woes and choose to retreat.

    That being said, we do recognize that there may be circumstances when temporary capital controls could be called for—and this is a matter that we will be studying. Our main worry, however, is that any breathing space such measures might bring would be outweighed by long-term damage to investor confidence, the distorting effects in resource allocation, and the loss of discipline and incentives that capital flows can bring.

    Fifth block, private sector involvement in preventing and resolving crises. In all the recent crises, the initial pressures were severely aggravated by a rush for the exits by creditors, especially short-term creditors. How can such creditors be persuaded not to behave in this way? And, even trickier, how can they be encouraged to act in a way that permits a more orderly process of adjustment for the country involved—to the benefit of both the country and the investors and creditors? This notion of "bailing-in" investors and creditors is bound to be complicated. Indeed, it is the most complex and difficult of all the building blocks. The good news is that already a number of possible alternatives are being actively explored.

    Sixth block, equitable social policies. Reform of the international monetary system can only be complete if it is consistent with the social goals endorsed by the international community. That is why, in order to deal with the worsening recession in Asia, and its social cost, the IMF pushed for greater fiscal expansion to support the needed social programs. In all of the Asian crisis countries, the IMF-supported programs included subsidies on some essential consumer products. In Korea, we supported expansion of the unemployment compensation system, and in Thailand, we supported employment creation schemes in the public sector.

    But more needs to be done! When crisis strikes, whether it be from shocks emanating from the financial system, or from elsewhere, countries need to have automatic stabilizers and better social safety nets in place to help cushion the effects on the poor and the vulnerable-and we will work closely with the World Bank to this end.

    Seventh and final block, adaptation of the international financial institutions, and here I will stick to the IMF. As the world adapts to a new economic order, so must we, for the IMF plays a central role in the global economic and financial system. We are being asked to take on more and more responsibilities, and a natural extension of that would be to engage our 182 member countries in the decision-making process even more than at present. That is why we have suggested transforming the IMF's ministerial level advisory body—the Interim Committee—into a "Council" with decision-making, rather than merely consultative powers. This idea, along with others on stabilizing the international currency system—possibly moving to a tripolar system, with the euro, yen, and dollar; possibly providing for a lender of last resort—are also on the international reform agenda.

    * * * * *

    So where does this leave us? In some areas, we know what we want, but we aren't so sure how to get there. In other areas, we know how to get there, but we aren't so sure that the political will still exists. Rest assured that the IMF will do what it can to bring about the necessary insights and international consensus. For it is our job to ensure that the global economy is a more secure place, in which countries can flourish for the benefit of mankind.


    IMF EXTERNAL RELATIONS DEPARTMENT

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