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The Policy Response to Financial Crisis: The Importance of Facing Ugly Trade-offs, Remarks by Agustín Carstens, Deputy Managing Director, IMF
November 11, 2004
As prepared for delivery
The Policy Response to Financial Crisis:
The Importance of Facing Ugly Trade-offs
Remarks by Agustín Carstens,
Deputy Managing Director, International Monetary Fund
at Tor Vergata University
Rome, Italy
November 11, 2004
The rapid integration of global capital markets has offered emerging market countries considerable opportunities for growth and development. At the same time, however, it carries with it risks of financial crisis that can inflict substantial damage and are difficult to manage. Throughout its history, the IMF and its member countries have worked to improve our collective ability to prevent financial crises. We must recognize, however, that despite best efforts at prevention, crises will continue to occur. Therefore along with enhancing efforts aimed at crisis prevention, the Fund and its members have struggled with the challenge of improving the policy response to financial crises. When a crisis does occur, resolution is almost always an arduous task. It involves difficult judgments and unpleasant trade-offs amid significant uncertainty, while some measures may have transitory, adverse side effects. And, over the longer run, a country can remain exposed to significant post-crisis vulnerabilities, especially if reforms are not fully carried through.
I would like to focus my remarks today on four issues that I think the international community must understand more fully, in order for us to improve the policy response to financial crises:
· first, the complexities involved in designing an appropriate policy framework;
· second, the considerable trade-offs that policy makers face in formulating policy options;
· third, the post-crisis vulnerabilities that can linger and should compel countries to persevere in their efforts and to reform and "crisis-proof" their economies; and
· last, the role of the Fund in this context.
Difficulties in formulating an appropriate policy response
Consider how difficult it is to identify the appropriate policy framework. Ideally, policy measures will aim to limit disruptions, stabilize the economy, and lay the groundwork for the resumption of long-term growth. Yet, such a policy response is complicated by uncertainty regarding the scope and impact of the crisis. In the midst of a crisis, key macroeconomic variables are often highly volatile and can overshoot considerably their long-run equilibrium values; the resilience of the economic system is uncertain; and the severity of the crisis may become clear only with the passing of time. In fact, once a crisis has erupted and the Fund's mission starts its groundwork, it is not unusual for preliminary assessments to be revised since hidden liabilities—both public and private—can pop up like rabbits out of a hat.
In addition, balance sheet interlinkages across sectors of the economy can amplify weaknesses in individual sectors and propagate a crisis—across sectors, to the balance of payments, and to the sovereign. Such interlinkages may complicate the policy response and magnify the costs of crisis resolution. The effectiveness of policies is also uncertain, since it depends critically on the perceived credibility of the corrective measures, and yet the reputation of the authorities tends to be at its lowest level during a crisis.
Moreover, there is uncertainty regarding the political support for reforms. Strong political commitment and ownership are key to the successful resolution of a crisis, and ideally country authorities will communicate clearly and convincingly to domestic stakeholders the pressures of the situation and the reasons for pursuing a particular strategy. Yet many of the policies that are imperative to resolving the crisis may have been necessary even before it started and, in fact, could have yielded more favorable outcomes had they been pursued earlier. Taking tough decisions—and quickly mobilizing the public support to implement them—at times of economic stress is even more challenging.
Unpleasant tradeoffs
Policy response is further complicated by the need to assess a variety of tradeoffs.
· A prime example is the fiscal consolidation that may be required to reduce imbalances or debt burdens. Such consolidation must be sufficient to strengthen confidence in the sustainability of public finances, but not so much as to undermine medium-term growth prospects.
· In cases where the financial position of banks is severely affected—such as the recent crises in Argentina, Turkey and Uruguay—public support will likely be required to safeguard the functioning of the domestic banking system. Yet this support can exacerbate debt sustainability concerns and make the previously mentioned trade-off even more difficult.
· Moreover, in extreme situations, administrative measures may be seen as unavoidable for quelling a banking crisis—although their use risks eroding confidence in the banking system and could trigger capital flight and undermine financial intermediation.
Furthermore, in the rare cases where sovereign debt restructuring is needed, the benefits of alleviating liquidity or solvency constraints, with a view to restoring debt sustainability, must be weighed against the implications for future access to capital markets and the possible adverse impact on the domestic financial system, particularly if banks are significantly exposed to government debt.
Post-crisis vulnerabilities and crisis-proofing the economy
Even if a credible adjustment restores confidence, a number of vulnerabilities can linger or intensify. For example, public finances may continue to remain vulnerable to shocks. In particular, in the aftermath of a crisis, public debt and gross financing requirements may remain at high levels, and so external shocks or constrained access to capital markets could quickly tip the balance toward unsustainability. Similarly, banks may remain vulnerable to debt servicing difficulties of the household and corporate sectors, or because of a large exposure to sovereign debt. And in the context of crisis resolution involving a restructuring of sovereign debt, a country may become vulnerable owing to a loss of access to international capital markets for a prolonged period of time.
Perhaps most importantly, there is always a danger of "reform fatigue." As countries move out of the critical stage in the process of crisis resolution, it is not unusual to see some slowdown in the drive towards reform as political capital is eroded, an early positive response from investors leads to complacency, or it becomes clear that many of the necessary reforms do not lead immediately to higher growth and public well-being. But here is precisely where recurrent crises have their genesis, and the message is clear: it is critical that countries persevere with reforms to "crisis-proof" their economies and avoid recurrence of financial distress. They must resist the temptation to implement only the most urgent measures, and put aside important ones for later.
The role of the Fund
Finally, let me say a few words about the role of the IMF in crisis resolution, and how we are working to improve it. A key role of the Fund is to work with members to achieve a durable exit from crisis. We help members to consider the relevant constraints and trade-offs and to design an appropriate adjustment program. Such a program must address underlying macroeconomic problems and, at the same time, anchor investors' expectations about the formulation and implementation of economic policies. And as part of the design process, the Fund has to form a judgment about the appropriate balance between the availability and scale of IMF financing, the amount of domestic policy adjustment, and support from other stakeholders (notably, official and private creditors). In forming this judgment, the Fund must also consider the implications that a crisis country may have on the stability of the international financial system.
A critical element of the Fund's approach to crisis resolution is therefore the nature of the financial crisis and the sustainability of the debt situation. When we are confident that the problem is driven by liquidity constraints, the Fund is prepared to lend—including in large amounts, under the conditions of the exceptional access framework—to help our members. If, however, the debt position is judged to be unsustainable, additional Fund lending would only overburden the member. In such situations, we encourage member countries to remain current on their contractual obligations, and to reach voluntary pre-emptive restructuring agreements with their creditors which can help members regain debt sustainability and maintain orderly relations with the financial community. If arrears to private creditors do arise, the Fund's lending into arrears policy allows the Fund to lend to a member that is pursuing appropriate adjustment policies and is making good-faith efforts to reach a collaborative agreement with its creditors.
Granted, while there is clarity at the two extreme ends of this spectrum, many countries fall into a gray zone, where it is very difficult to determine if their debt positions are sustainable. We must acknowledge that our lending can only be based on a judgment call and, therefore, it involves considerable risks. Yet we must also be mindful that the costs of not supporting a member in crisis could be very high.
Accordingly, we are continually examining policies that could help reduce the frequency and severity of crises, in the light of previous experience. We are focusing on several issues at present, including reinforcing the rigor of our debt sustainability analysis, especially through a more thorough analysis of contingent claims. We are working to raise awareness of balance-sheet vulnerabilities, to ensure that risks are properly assessed and effectively addressed. We have taken steps to improving clarity about IMF lending decisions, particularly in situations when exceptional access to IMF financing may be appropriate. And we are working to improve the process for restructuring sovereign debt within the existing legal framework. This includes encouraging the use of collective action clauses (CACs) in new sovereign bond issues, as well as supporting private sector efforts to formulate a voluntary Code of Conduct.
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