Seminar--Asia and the IMF--Stanley Fischer

IMF News, September 19, 1997

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Published: September 19, 1997

Overview

Context: Annual Meeting and IMF discussions on an amendment of the Articles of Agreement to promote capital account liberalization and on increasing Fund resources.
Core questions raised by recent market turmoil in East Asia:
- Sustainability of the Asian miracle.
- Risks of capital account liberalization.
Author’s high-level positions:
- Rejects delaying capital account liberalization on grounds of recent turbulence.
- Argues three points for skeptics:
- The benefits of liberalizing the capital account outweigh the potential costs.
- Countries must prepare economic policies and institutions (especially the financial system) for liberalized capital markets.
- An amendment of the Fund’s Articles of Agreement is the best mechanism to promote orderly, non-disruptive liberalization.

I. The Growth of Capital Movements — key facts and projections

Average annual net capital inflows to developing countries exceeded US$150 billion in 1990–96.
Net total of US$235 billion in foreign capital flowed to developing countries in 1996; this rate appears to have been sustained in the first half of 1997.
That US$235 billion equals nearly 0.8 percent of world GDP and well above 2 percent of developing country GDP.
Asia specifics:
- Asia received more than US$60 billion per annum in 1990–96.
- Asia received a total of US$107 billion in 1996.
- Asia received 55 percent of total capital inflows as foreign direct investment.
- Net inflows to some countries in the region have averaged 5-8 percent of GDP over long periods.
Factors behind increased global capital flows:
- Rates of return in recipient countries.
- Liberalization of international capital transactions.
- Development of stronger financial systems in recipient countries.
- External factors, including declining longer-term interest rates in advanced economies and emergence of large institutional investors.
Outlook: Volume of gross international capital flows will continue to increase as information spreads, transaction costs decline, and markets liberalize and sophisticate.

II. Benefits and Risks of Capital Account Liberalization

Benefits (aggregate and country-level):
- Facilitates more efficient global allocation of savings, channels resources to productive uses, increases economic growth and welfare.
- Expands pool of investable funds and access to foreign capital markets.
- Supports the multilateral trading system by broadening finance channels for trade and investment.
- Enhances portfolio diversification and potential for higher risk-adjusted returns.
- Foreign direct investment and access to Euro-markets provide cheaper and more sophisticated financing; new financial technologies can upgrade domestic financial systems.
Risks and market behavior:
- Capital flows are highly sensitive to macroeconomic policy, banking system soundness, and unforeseen events.
- Markets can discipline policy but may overreact, react late, and then react fast.
- Contagion and spillovers can be rational (e.g., competitor depreciation) or excessive (as seen to some extent in East Asia and Argentina 1995).
- Risk of self-fulfilling attacks weakening banking systems via devaluation and higher interest rates.
Summary judgment:
- Liberalization offers major gains where countries can borrow/lend on favorable terms and strengthen financial systems, but increases vulnerability to swings in market sentiment which are "almost always" rationally based yet "may on occasion be excessive."

III. Managing a Liberalized System — policy priorities and instruments

Overarching aim: avoid policies that provoke rapid capital reversals and strengthen economic and policy frameworks to minimize vulnerability.

Minimum (well-understood) requirements:
- Pursue sound macroeconomic policies.
- Strengthen the domestic financial system.
- Phase capital account liberalization appropriately, retaining some controls during transition.

Controversial/critical issues to address:
- Provision of information to markets.
- Role and limits of surveillance.
- Potential need for financing and its consequences.

A. The macroeconomic policy framework

Goals: keep inflation low, budget deficit small, and current account sustainable.
Sustainability notes:
- As a formal matter, depends on growth rate and real interest rate.
- Large current account deficits — depending on growth, "in the range of 5-8 percent of GDP, and certainly any higher" — should be cause for concern.
- Current account deficits financed by longer-term borrowing and foreign direct investment are more sustainable; deficits financed largely by short-term capital flows are alarming.
Policy responses to short-term inflows amid constrained exchange rate flexibility:
- Tightening fiscal policy is the first line of defense.
- Increase exchange rate flexibility as a second response.
Exchange rate regime observations:
- No general agreement on optimal system; pegging to a basket preferred over a single currency when pegged.
- Exchange rate bands (possibly crawling bands) with wide margins may be appropriate depending on domestic inflation.
- Countries should be ready to move the band and adjust macro policy when exchange rates or balance of payments move out of desired ranges.

B. Strengthening the financial sector

Critical actions for healthy banking and financial systems:
- Improve supervision and prudential standards.
- Ensure banks meet capital requirements and provision for bad loans.
- Limit connected lending and publish informative financial information.
- Deal rapidly with insolvent institutions.
Political economy: reform implementation is difficult when political pressures hamper supervisors; urgency emphasized for both crisis recovery and prevention.
A weak banking system increases both the likelihood and severity of macroeconomic crises.

C. Phasing and the use of controls

Case for phasing liberalization based on macro situation, financial market development, and impact of existing controls.
Exceptions exist: some countries (notably Indonesia) liberalized early successfully.
Risks without coordination of liberalization and financial reform:
- Regulatory distortions and incentives causing instability in capital movements.
- Weak institutions unable to intermediate large flows; vulnerability to reversals.
General perspective on controls:
- Controls (except prudential ones) are generally inefficient and costly; prolonged use often associated with capital flight.
- Countries that removed controls rarely reimpose them except temporarily for emergencies.
- Removal generally gradual; possible refinement toward less distortionary, market-based controls (e.g., reserve requirements on foreign deposits).
- Controls on outflows often used for balance of payments reasons; gradual removal is generally desirable.
Prudential controls:
- Many countries already impose prudential controls (e.g., restrictions on banks’ open foreign currency positions).
- Similar measures could apply to corporate open positions; such controls could be part of internationally accepted prudential standards.
Hedge funds and speculators:
- Public anger is often misdirected; better information provision and improved prudential regulation might reduce occasional market excesses.

D. Information provision

Lessons from Mexico: crisis worsened by poor quality and late information on reserves and external debt structure.
IMF actions: data standards initiative and the Special Data Dissemination Standard (established early 1996); progress with the Dissemination Standards Bulletin Board.
Two arguments for better information provision:
- Better informed markets make better decisions; earlier withdrawals could hasten necessary adjustments.
- Publishing certain intervention information would affect intervention choices and prevent unwise decisions.
Tradeoffs: secrecy vs. transparency; need to determine optimal extent and timing of disclosures to influence policy choices and market discipline.
By September 1997, the electronic bulletin board had 43 subscribers, including Hong Kong, China.

E. The role of surveillance

IMF has increased emphasis on timely surveillance since Mexico; new procedures "worked well" in Thailand.
Limitations:
- Surveillance cannot be perfect; Fund will miss some crises and predict others that do not occur.
- Effectiveness limited when warned countries fail to act.
- Fund's privileged access to information constrains its ability to fully publicize concerns and enlist markets in surveillance.
Mutual/regional surveillance:
- Smaller groups (OECD, EU, regional Asian groups) can exert mutual pressure and benefit from Fund support.
Responsibility: primary responsibility for correct policies rests with national authorities; market participants also bear responsibility to appraise economic situations accurately.

F. The need for financing

Crises will happen despite better information, surveillance, and prudential regulation; private financing can evaporate in crises.
IMF purpose quoted from Article I: "To give confidence to members by making the general resources of the Fund temporarily available to them under appropriate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity".
Two interrelated questions raised by large capital flows and proposed amendment:
- Whether the scale of flows requires reexamining criteria that determine size of Fund loans.
- Whether the Fund’s willingness to lend creates moral hazard.
Answers: yes to both.
- Past practice: invoking the "exceptional circumstances" clause to provide loans large relative to quota.
- Need to review Fund lending criteria to ensure adequacy for potentially larger crises.
Moral hazard:
- Primary hazard is private sector lending too willing, knowing the Fund may provide financing; spreads in some markets are cited as supporting this view.
- The international community has not yet found a good solution; need to ensure private sector shares in financial costs of crises.
Regional financing:
- Role for regional groups in prevention (surveillance).
- Skepticism about large regional crisis funds: may reduce conditionality and increase moral hazard.
Lender-of-last-resort tradeoff:
- Classic rule: avoid being too clear about circumstances/amounts to reduce moral hazard.
- Tradeoff between known fund volumes and likely size of crises affects decisions on Fund limits and regional prepositioning.

IV. The Role of the Fund and the Capital Account Amendment

Rationale:
- Increased importance of capital movements affects balance of payments and demand for Fund resources.
- De facto Fund involvement in helping members liberalize; formal jurisdiction limited to right to require capital controls in certain contexts.
Interim Committee (April): agreed benefits from amending the Fund’s Articles to make liberalization of international capital movements a central purpose and to extend Fund jurisdiction to capital movements.
Amendment goals:
- Enable the Fund to promote orderly liberalization of capital movements.
- Develop analogies for the capital account to present Articles VIII and XIV that apply to the current account.
- Under Article VIII, members accept obligation to refrain from imposing restrictions on payments/transfers for current international transactions.
- Under Article XIV, members may "adapt to changing circumstances" existing restrictions until balance of payments position strengthens.
Proposed framework for capital account:
- Members might accept an eventual obligation to liberalize fully (precise meaning to be worked out).
- Transitional arrangements: controls in place when amendment takes effect could be adapted; new temporary restrictions could be approved for market/institutional evolution, prudential reasons, or macroeconomic/balance of payments problems.
- Acceptance would signal intentions and potentially strengthen access to international capital markets.
Fund responsibilities under amendment:
- Develop analysis and evaluation of control types to advise countries on most effective controls and methods of liberalization.
- Distinguish among:
- Controls on capital inflows vs. outflows.
- General vs. selective controls.
- Market-based vs. quantitative controls.
- Prudential controls vs. those for balance of payments or macroeconomic reasons.
- Controls on different types of capital flows.
- Encourage liberalization while paying regard to members’ varying circumstances.
- Establish a universally-applied code of good behavior in application of capital controls.
- Strengthen Fund surveillance over international capital flows and complement existing bilateral, regional, and multilateral initiatives.

V. Concluding remarks and policy implications

Capital account amendment with transitional arrangements would serve members’ interests by reflecting the increasing importance of international capital flows in laws and agreements.
Balance of opportunities and risks:
- Free international capital movements provide enormous opportunities but also significant challenges and risks.
- Recent East Asian developments underscore risks; historical benefits from capital inflows underscore costs of isolation.
Policy priorities reiterated:
- Pursue sound macroeconomic policies.
- Strengthen financial systems.
- Phase liberalization appropriately and design transitional controls.
- Improve information provision and surveillance.
- Ensure adequate crisis financing while addressing moral hazard and the role of regional funds.
Final argument: the proposed amendment will help bring order to international capital liberalization and assist member countries in managing benefits and risks.

Source: Seminar--Asia and the IMF--Stanley Fischer (IMF, September 19, 1997).