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Managing the International Monetary SystemStanley Fischer
First Deputy Managing Director
International Monetary Fund
Given at the
International Law Association Biennial Conference
London, July 26, 2000
Mr. Chairman. Ladies and Gentlemen.
It is a great pleasure to join you here today and to be able to discuss the reform of the international monetary system at such an opportune time — after the storms of the emerging markets crisis of the last decade have subsided, and with the world economy growing faster than it has in a decade. Of course, the unofficial motto of the IMF, "complacency must be avoided," applies both to the global economic situation and to the need to intensify efforts to reform the system — including, with the new Managing Director taking charge of the Fund, the IMF itself.
You will probably not be surprised to hear that when the original Articles of Agreement of the IMF were drawn up at Bretton Woods, legal practitioners were strongly represented on the American side of the negotiating table. But this did not impress John Maynard Keynes, Britain's principal negotiator. "This plan," he once complained, "seems principally designed to make a paradise for the lawyers. [They] seem to be paid to discover ways of making it impossible to do what may prove sensible in future circumstances."
I want to talk today about the evolution of the international monetary system. The framework established at the end of World War II was designed to revive international trade in goods and services — and it succeeded brilliantly. The growth of international trade has been one of the prime forces behind economic growth in the post-World War II period, as many countries have availed themselves of access to global markets to grow at historically unprecedented rates. In real terms world GDP rose by 4.3 per cent a year on average between 1950 and 1999, driven and outstripped by growth in world trade averaging 5.7 per cent a year.
Changes in the international financial system have been driven largely by the even more rapid growth of private international capital flows, which first overwhelmed the Bretton Woods fixed exchange rate system, and since the 1980s have had especially strong effects on the emerging market countries. Increasingly the discretion of national policymakers is constrained by international capital markets, which magnify the rewards for good policies and the penalties for bad policies. But markets may on occasion overreact, by responding late and excessively to changes in underlying conditions.
The international financial system has had to adapt to the increasing role of private capital flows. That process was evident in the shift towards flexible exchange rates among the major currencies three decades ago, and it continues today, as we absorb and react to the lessons of the emerging market crises of the last decade. The evolving system poses several challenges, of which I want to touch later on two. First, the need to safeguard the legitimacy of the institutions that are involved in managing the system. And second, the need to find ways of working constructively with the private sector in both crisis prevention and crisis response.
2. How the international monetary system has evolved
Today's international financial arrangements were inspired by the Great Depression and a lesson hard-learned in the 1930s: namely, that economic policies that might seem logical from the viewpoint of an individual economy, such as protectionism, can have a devastating effect when pursued by all. The determination to learn and apply this lesson after World War II laid the foundations of an increasingly open and market-oriented world economy. This in turn delivered spectacular increases in living standards for billions of people over the last 50 years.
In joining the IMF, and accepting its Articles of Agreement, our 29 founder members signed up to a treaty laying out clear rules for the operation of the international monetary system. These rules included a commitment to work towards currency convertibility and formal procedures to ensure the orderly adjustment of pegged but adjustable exchange rates.
In return for accepting these obligations, member countries were entitled to come to the Fund for temporary financial assistance if they found themselves in balance of payments difficulties. This made it less likely that they would resort to policies with damaging spillover effects — trade barriers, competitive devaluation or draconian contraction of domestic demand. A further cushion was introduced in 1969, when the Fund was given the power to alleviate shortages of international liquidity by providing countries with extra reserve assets in the form of Special Drawing Rights.
The Bretton Woods system came under mounting pressure as the post-war growth of international trade was complemented by an even more dramatic expansion of cross-border capital flows. These starkly revealed the "impossible trinity" of a fixed exchange rate, an open capital account, and a monetary policy dedicated to domestic economic goals. With the leading countries unwilling to subordinate domestic policies to maintenance of the exchange rate, the fixed exchange rate regime among the major economies gave way.
The Articles of Agreement of the IMF were amended in 1978 to reflect this new reality. Given the greater freedom for countries to pursue domestic economic goals, there was a need to constrain the types of policies that would be followed. In Article IV of the amended charter, IMF members promised to eschew competitive devaluations, to guard against "erratic disruptions" and, more generally: "To direct economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability." These promises were to be monitored through IMF surveillance over country policies, by regular discussions of economic and financial policies between the Fund and each of its member governments — the so-called Article IV consultation, presented by the staff to the Executive Board of the IMF, representing all the membership.
The growth of international capital flows has continued apace in the quarter century since then. But as their volume grew, the potential effects of reversals became larger, and countries dependent on such flows — particularly short-term flows — became increasingly vulnerable to crises of confidence, akin to runs on banks. And contagion, the spreading of crises from one country to another, has also become more powerful and complex. That was evident not only in the Asian crisis, but more dramatically in the contagion to Latin America and even the industrialized countries of the Russian devaluation and debt default in 1998.
Countries can react in two ways to the potential power of capital flows. The first is to seek to strengthen their economies — their economic policies and their economic institutions, especially the financial system, both to reduce the likelihood that capital flows will reverse, and to ensure that the effects of reversals, should they occur, are minimized. Alternatively, and perhaps as well, they can use capital controls to exclude or regulate international capital flows.
There is a lively controversy over whether and how countries benefit from being open to international capital flows. I will not enter that debate in detail today, but note that all advanced countries have liberalized international capital flows, and that despite the crises of the last decade, almost all emerging market countries have kept their capital markets open. The revealed preference of policymakers is to participate in the international capital markets. That is not to say, however, that countries should open their capital accounts prematurely: rather they need to ensure that their economies and their financial systems are sufficiently strong; and they may particularly want to avail themselves for some time of controls on short-term capital flows.
Nonetheless, we are bound to live in an international financial system in which private capital flows play an increasing role. How can the official sector contribute to economic stability and growth in such a system, one in which we can envisage more and more countries reaching emerging market status?
We have to help strengthen both individual economies and the international system in which they interact. In particular, the emerging international system requires:
Transparency is one of the keys to the effectiveness of these efforts. This not only helps ensure better-informed citizens and investors, but also provides encouragement to policymakers to strengthen their policies and institutions. There has been a sea-change in IMF transparency during the past few years. In Fund surveillance, for example, the great majority of countries now publish the conclusions of their annual policy discussions with the Fund, and a growing number also release the IMF staff analyses on which these discussions are based. A pilot scheme is also under way to build up Reports on the Observance of Standards and Codes for individual countries, pulling together information on many policy areas.
Peer pressure and encouragement from international organizations has so far been the main stimulus for participation in these initiatives. But if the system is to operate effectively, the discipline will in the future have to come as much from investors and other financial market participants. At the moment it appears that the private sector is often unaware of publicly available information and analysis — and this needs to be remedied.
The IMF's Contingent Credit Line facility provides a further stimulus to good behavior. It provides a precautionary line of credit to countries which have demonstrably sound policies, but which are nonetheless vulnerable to contagion from crises elsewhere — and by being available it can make countries less vulnerable to contagion. No country took advantage of this facility in its first year of operation, and we are working now to make it more user-friendly and financially attractive.
3. The Legitimacy of the System and Reform of the Fund
It is notable that while the international system has evolved, the principles of good economic citizenship underlying the system have remained the same. This is evident from the fact that the fundamental purposes of the Fund — laid down in Article I of the Articles of Agreement — have remained unchanged since 1944. They include facilitating international monetary cooperation; promoting trade, employment and growth; encouraging exchange stability and offering financial help to members confronting balance of payments problems.
If the international system is to operate effectively, then it is essential that the institutions involved in maintaining it enjoy a widely-accepted legitimacy. The Fund, for example, must not only operate in the interests of the international common good, but be recognized to do so by the public, by national authorities, and by the private sector too.
This point has been emphasized by the Managing Director of the IMF. He has established a task-force within the Fund the re-examine the reform process. It is still premature to say what will be concluded, but some themes are already clear:
If the system is to work effectively and enjoy legitimacy, it is also important that the overall institutional infrastructure is as clear and simple as possible. We must avoid having too many fora or institutions with vague or overlapping mandates. This is difficult in a world of cross-cutting policy concerns — and history suggests that it is much easier to create new institutional structures than to eliminate outdated ones. But the system needs to be coherent and we should therefore try.
4. Constructive Engagement with the Private Sector
So far I have talked largely about the roles of government and international institutions. But what about the role of the private sector, in particular investors and financial institutions? How should they contribute to ensuring the smooth running of the international monetary system, preventing financial crises where possible and helping to resolve them where necessary?
In normal times, countries with market access can rely on the continuation of that access provided their policies remain strong. The more successful of the emerging market countries devote a great deal of effort to keeping their investors informed of their intentions and economic developments, both through direct contacts and through the regular provision of comprehensive data. Countries that maintain constructive relationships with their creditors in good times, will be better able to draw on those relationships to help resolve difficulties should they occur.
The same principle of constructive engagement applies to relationships between the international institutions and the private sector, particularly between the Fund and the private financial sector. By strengthening its relationships with the private financial sector, the Fund should not only be able to carry out its normal tasks of surveillance more effectively, but also be able to make the process of crisis resolution more efficient and somewhat less painful for all concerned.
In the domestic context, the central bank can act as a crisis lender and manager when banks get into trouble by acting as a lender of last resort. In the international context, the Fund cannot act as a textbook lender of last resort because its resources are limited by its inability to print money. And if the Fund or another institution were to be able to act as an international lender of last resort, it would have to operate with rules that limit moral hazard. Otherwise institutions would be tempted to lend with an irresponsible lack of regard for the underlying risk, secure in the knowledge that they would be bailed out if things went wrong. Some critics have argued that the Fund's financial support for Mexico in 1995 encouraged irresponsible lending to Asia. The evidence does not support this, although a stronger case can be made that moral hazard was indeed a factor in capital flows to Russia which some investors wrongly assumed to be too big and too nuclear to fail.
On most occasions when a country runs into balance of payments problems, a combination of strong reform efforts and limited financial support from the IMF will be sufficient to catalyze a restoration of access to private capital. But if a country faces a severe liquidity problem (a large short-term financing requirement and little hope of an early return to the capital market) or a solvency problem (an unsustainable medium-term debt burden) then the resolution of the crisis may require a concerted contribution from the private sector.
While contributing to crisis resolution is in creditors' collective interest, each individual creditor has an incentive to block the settlement for their own gain. The problem was nicely illustrated in the movie Waking Ned Devine, as Steven Schwarcz of Duke Law School has pointed out. A man with no heirs wins £6.7m in the Irish national lottery and promptly dies of shock. The remaining 52 residents in his village decide that one of them should pretend to be Ned, claim the money and share out £130,000 of the prize money to each of them. Everyone else simply has to vouch for the fake Ned to the lottery inspectors. Unfortunately — well it all depends on whose side you're on — one villager holds out for a much larger share, threatening to expose the fraud if her demand is not met.
Concerted private sector involvement has been necessary in a number of countries in recent years, with the precise mechanics differing from case to case. In examples where bank debt has predominated, the coordination of lenders has varied from a light touch in Brazil to a more heavy-handed approach in Korea. Dealing with bond debt is inherently more difficult as the holders are more numerous, more diverse and more difficult to identify. Fears of disruptive litigation proved unduly pessimistic in Ukraine and Pakistan, in part because the presence of collective action clauses in some bond contracts that limit the power of rogue creditors.
Investors are understandably frustrated that the rules of the game are unclear. To some extent this is inevitable, given the many factors which determine the appropriate approach in a given case. Clarifying the situation is made no easier by differences of opinion among our leading shareholders, some favoring clear rules determining when the private sector is to be "bailed in" and others arguing for constructive ambiguity.
In a paper to be published by the Centre for Economic Policy Research in the fall2, Barry Eichengreen draws a clear distinction between the approach to fundamental solvency problems and liquidity problems arising from investor panics.
In the case of fundamental solvency problems, debt restructuring is unavoidable. Such restructuring has taken place recently in Ukraine and Pakistan, and Ecuador too is seeking to restructure its external private debt. Eichengreen believes that this would be easier if restructuring-friendly collective action clauses were included in all bond contracts. These are already present in bond contracts drawn up under British law, but not those drawn up under New York law — which comprise the majority of emerging market bond issues. He presents evidence that these clauses increase the cost of borrowing for countries with poor credit rating, but not those with relative good ratings. Collective action clauses could indeed be helpful, particularly in the case of sovereign debt, and the official community is encouraging their use. But they do not entirely resolve the problem of creditors rushing to the exits.
In the event that investor panic creates a liquidity crisis, Eichengreen favors payments standstills sanctioned or endorsed by the IMF. This would give countries protection from a destructive creditor grab race until lenders calm down, thereby removing the need for large-scale financial rescue packages. The potential use of standstills opens up complex questions, including the possibility that they would make capital flows more volatile, as fear of a standstill could cause creditors to flee at the first sign of trouble. The more general use of standstills could also increase contagion as the imposition of a standstill in one country creates fears of standstills in other countries. The legal ramifications of such a change would also need to be considered.
Progress has been made on the topic of private sector involvement in financial crises. We have not dealt with the recent cases in Romania, Ukraine, Pakistan and Ecuador in the same way that we would have done five years ago. But nonetheless greater clarity about the rules of the game would be desirable. Whatever set of rules is developed, an element of discretion is bound to remain as the profile of the external debt and the macroeconomic situation differs between countries.
In the meantime we need to do what we can ex ante to prevent crises and put in place the conditions that will make them easier to resolve. This includes, importantly, encouraging constructive engagement in normal times among countries, their creditors and the international institutions.
The rules of the game governing the operation of the international financial system have evolved significantly since the Fund was created in 1944. From what appears a relatively legalistic beginning, we now have a system combining internationally-agreed standards of good behavior and enhanced supranational policy surveillance, both of which are facilitated by much greater transparency in policymaking.
Striking the correct balance between rules and discretion remains difficult in a number of areas, notably the role of the private sector. But even after the recent crises, almost every member of the international community remains committed to the fundamental principles of an open, market oriented world economy — principles that have served us so well in recent decades. The steadfastness of these countries in difficult times only increases the responsibility on those charged with helping to manage the international monetary system to make that system more stable and supportive of economic growth. That is why we must and will continue to press our efforts to reform the system.
IMF EXTERNAL RELATIONS DEPARTMENT