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THE WORLD FINANCIAL SYSTEM MUST ACT TO PREVENT CRISES
A Commentary
By Jack Boorman
Director of the International Monetary Fund's
Policy Development and Review Department

International Herald Tribune
June 28, 1999

Reproduced with the permission of the International Herald Tribune

The sense of crisis is receding from the world financial system. Economies from South Korea to Brazil have begun to rebound. Investors are returning to emerging markets.

But now that the worst fears about the global economy have passed, it is essential to push ahead with reforms that will improve the chances of avoiding a repeat of the recent crises, which have left millions of people facing hardship.

Considerable work has already been accomplished on reforms that have come to be known collectively as the ''new international financial architecture.'' These reforms aim to prevent crises and to contain any that will occur. At a meeting in April of finance ministers and central bank governors representing the 182 member nations of the International Monetary Fund, important progress was made on many of the key issues, although much remains to be done.

Some of the reforms call on governments and international organizations such as the IMF to improve the way they do business. Many proposals, however, also map out a crucial role for the private sector.

The question of how to better involve private investors, creditors and borrowers in crisis prevention and resolution is not a new issue. But the experience of the past two years in Asia, Russia and Brazil has given it an urgency that cannot be allowed to dissipate as the crises fade.

At its core, the effort to involve the private sector in crisis prevention and resolution must address the prospect of destabilizing movements of capital set in motion by the sudden loss of market confidence. Recent experience indicates that the speed and magnitude with which both domestic and foreign investors can move into and out of capital markets far exceeds the ability of individual countries - and the international community - to counter such flows.

One example, albeit a special one, of the positive contribution the private sector can make in resolving a crisis was demonstrated in South Korea in late 1997. Foreign banks agreed to roll over and then restructure tens of billions dollars of loans to Korean banks to avoid a collapse of the Korean financial system.

The resolution of other crises inevitably will be more complicated, especially if bondholders are involved, because many bond contracts do not permit a revision of terms so that debts could be rescheduled in an orderly way in the midst of turmoil.

The international financial community is discussing reforms that would set up interlocking lines of defense. They would operate across borders, within individual countries and even within corporations. Such defenses would combine the acceptance of common standards for running financial systems, markets and businesses with a new commitment to provide all parties with accurate information about developments that have the potential to move markets.

Within that broader effort, all classes of borrowers and creditors need to change the way they evaluate and price the risks they assume in investments and loans. For borrowers, broad - and in many cases unhedged - exposure of corporations and banks to short-term financing planted the seeds of disaster when confidence suddenly disappeared. Creditors were also too willing to accept bond repayment terms that sometimes bore little relationship to the underlying risks.

Steps toward reducing overreliance on short-term loans may emerge from the work of the Basel Committee on Banking Supervision, which is considering proposals that would make capital adequacy standards for international bank lending more risk-sensitive.

At the same time, mechanisms must now be installed so that foreign exchange liquidity can be provided to emerging market countries in times of turbulence to ensure breathing room to put reforms in place. To this end, private sector creditors and borrowers should consider establishing credible forms of market-based insurance.

To complement this effort, the IMF will offer its own contingent credit lines to help countries pursuing sound and sustainable policies. This will provide an incentive for countries to pursue such policies on an ongoing basis, before emergency measures are demanded.

One of the requirements of the new credit facility will be adherence to the international standards related to market-moving information. This will help assure nervous creditors that no dark secrets lurk in the books of banks, corporations and governments.

All this amounts to a major effort to prevent future crises. But it is unreasonable to assume that crises can be avoided altogether. So when they do occur, it is essential that all parties be prepared to take steps to ensure rapid recovery.

For the private sector, there are key changes that can be adopted in the international bond market. In future international bond issues, governments and state entities that borrow the money, and their underwriters, should consider new terms that would facilitate the orderly resolution of crises. It is essential to introduce collective action clauses in sovereign bond issues. This would allow terms to be modified by qualified majorities of bondholders to prevent individual bondholders from blocking debt workouts.

The basic outlines of such bond clauses are generally accepted. What is needed now is that these terms be refined and implemented. One possible starting point would be to include such terms in international bonds issued by industrialized countries, to be followed by all other sovereigns issuing bonds in international markets.

These proposals have led to some confusion among bondholders. The IMF is not advocating that existing contracts be abrogated. Indeed, it is essential that borrowers honor their debts. The challenge is to devise acceptable modifications to bond contracts that will facilitate a consensual rescheduling, but not make emerging-market debt unattractive to investors, or too expensive for issuers.

There will never be a single, clear-cut set of rules to avoid or resolve crises, but there is an urgent need to move forward with ideas that offer promise.

The writer, director of the IMF's Policy Development and Review Department, contributed this comment to the International Herald Tribune.