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Small economies, fragility and poverty

By Prof. Gerry Helleiner*

Toronto, July 2001 - - In the rhetoric of global political leaders, top officials of global institutions, not only of the UN proper but also its powerful quasi-independent specialized agencies, the World Bank and the IMF, the fight against global poverty is a matter of the very highest priority for the coming century.

The Plan of Action adopted at the Miami Hemispheric Summit in December 1994, reiterated at the Quebec Summit of last month, did not, as many seem to believe, simply promote a free trade area, an FTAA. From its outset, not to speak of earlier antecedents like the so-called Alliance for Progress in the 1960s and 1970s, it included in its objectives the eradication (not simply the alleviation or reduction) of poverty. Rhetorical pronouncements and commitments of this sort are easy to make, and may mean very little until the time comes for practical, and usually politically and economically costly, action. Still, it is for professionals and technocrats to take such words at face value, and consider more carefully their meaning and their implications.

There is now an emerging new consensus as to the true meaning of poverty.  Current conceptual interpretations of the meaning of poverty extend far beyond the traditional earlier emphasis upon sheer material or income poverty, sometimes buttressed by special attention to access to education and health.  Such basic aspects of poverty must obviously still be a primary matter of concern; and they are. But, it has now been realized that when poor people are consulted about their concerns, as they have not always been, they often emphasize other dimensions of their plight; and this has led to some analytical rethinking and expansion of official thinking about what poverty really means, and therefore what anti-poverty programmes should seek to achieve. Epitomized by the analysis in the World Bank’s World Development Report (2000/2001), these new approaches accord equal attention to other (non-income) dimensions of poverty which have been emphasized by poor people themselves: in particular, first, vulnerability and exposure to the risk of negative shocks to their income and welfare; and, second, voicelessness and powerlessness.

To policymakers in materially poor and small countries, these new interpretations of what it means to be poor should carry special resonance; since, for decades, they too have spoken, at length and repeatedly, of their own unique vulnerability and powerlessness in the global economy within which they must function. These new approaches seem not only to offer the prospect of improving upon previous policy approaches toward poor people but also to validate the longstanding representations of spokespersons for the small and poor countries in the international system. Because they are so vulnerable to exogenous shocks and so powerless, these countries do, in fact, suffer unique problems. Small countries evidently experience more “poverty”, as it is now understood, than had hitherto been broadly acknowledged. Certainly per capita incomes, literacy rates and infant mortality can no longer be regarded as the total “poverty” or “human development” story. The small countries of the Caribbean (and, of course, elsewhere) have every right to insist, in particular, upon recognition of their extreme vulnerability to negative shocks, via appropriate supportive measures in regional and multilateral agreements and in international institutions that purport to address and overcome poverty. The question of voicelessness and powerlessness is a little more complex, and I shall come back to it later.

Small economies are much more “open” to the rest of the world, other things being equal, than are large ones. Exports and imports of both goods and services in such economies account for much larger shares of total economic activity (or GNP); international factor flows (both labour and capital, but especially capital) figure far more prominently in their domestic labour and capital markets; because of the limited profit opportunities that small domestic markets afford, world market prospects are far more important in their investment decisions, and so on. It follows that small countries are much more vulnerable to shocks from the global economy than are large ones. (In the Caribbean one has to add that natural disasters (hurricanes, earthquakes, volcanic eruptions) are important further sources of potential exogenous shock. Obviously, the poorer the small country, the greater will be its difficulty in responding to such shocks. Of course, this external open-ness or dependence can be a source of opportunities and freedom from the constraints of domestic markets and circumstances; some small countries have done extremely well for themselves through their effective use of expanding global market opportunities. Still, even these “success stories” have reason for concern over their vulnerability and, typically, attempt to undertake protective measures, such as the holding of copious foreign exchange reserves, against it.

In an earlier age, this small country vulnerability to external events was seen as predominantly stemming from shocks in the current account of the balance of external payments - taking the form of sharp changes in the external terms of trade, unexpected closure of external markets because of protectionist measures, removal of previous preferences and the like. Today these external shocks are equally likely to be felt in the capital account.

The East Asian crisis brought new attention to the implications of the vastly increased flows of private international capital throughout the world, not least to many developing countries, and, in particular, the potential of their surges to generate major difficulties not only for developing countries but also for global macroeconomic management. It is now widely understood that financial crises can inflict severe social and economic damage upon countries even when their governments have been managing their budgets prudently and have had little prior indication of deficient macroeconomic conditions or economic mismanagement.

It is now clear that financial crises elsewhere can generate significant economic and financial spillovers across national borders. Some degree of contagion across countries and markets is inevitable. No country can be totally immune. The best that international policymakers may be able to achieve is some reduction in the frequency of crises and greater preparation for the modification of their consequences, including their potentially contagious effects.

International economic and financial contagion takes many forms. Direct links between financial institutions are the most obvious source of financial contagion. There is a long and sorry history of sequential domino-like consequences, even for apparently sound and significant financial institutions, flowing from what initially seemed fairly minor disturbances in smaller financial institutions. When loans and investments begin to turn sour, financial institutions have fiduciary and often legal obligations to call in their loans, increase their liquidity and reserves, raise risk premia on their credits, and exercise greater restraint in their credit and investment allocations. Financial institutions frequently have faced margin calls and liquidity pressures in one country that have forced them to sell perfectly sound assets, in a quasi-distress manner, in another.

In the new world of informatics, and absent adequate international supervisory or lender-of-last-resort facilities, such direct international financial contagion can spread extraordinarily quickly. Indeed the sophistication of current derivatives markets and the degree of (still poorly understood) linkages among international financial institutions and markets appear to have reached a stage well beyond the capacities of even the strongest financial supervisory authorities fully to understand. Many fear that current international financial markets, so technically advanced and so under-supervised, may already be inherently extremely fragile and highly volatile.

Perhaps a more familiar form of (international) contagion takes the form of psychological effects - the herd-like behaviour typical of asset markets with limited information, in which market actions themselves constitute important informational signals upon which the less well-informed base their own activity, thereby forcing even the well-informed to take such reactions into account in their own decisions. Such contagion may, at times, be based upon perceived similarities in policies or economic structures, and/or real links between countries. Hence it may be focussed on particular geographic regions, or particular types of economies, or particular types of asset.

There are also, of course, reasons for expecting old-fashioned “real” contagion effects through the existence of direct trade and other current account or international production links, and/or the prospect of intensified international competitiveness in their markets, competitive devaluations and the like. These different forms of contagion can all feed upon one another.

Sometimes forgotten in the continuing debate over the causes and implications of financial crises in middle-income developing or transitional economies are the ramifications of the new international financial scene for a large number of smaller, and often already highly vulnerable (to other exogenous shocks), developing countries in other parts of the world. Many of these countries have already experienced surges of capital flows, both inward and outward, of dimensions (relative to the size of their own economies) just as great as those experienced in East Asia, Mexico or Brazil. Because of their small absolute size and their more limited implications for the global economy, such surges and associated problems and events in smaller countries receive much less international press. The problems created by volatile private international capital flow are just as great, however, and arguably even greater, in smaller and “less consequential” countries as they are in larger countries with “deeper” financial markets and the potential to generate systemic consequences. Small countries were already extremely vulnerable to external shocks - an important dimension of their poverty - even before the new sources of potential shock in the capital account. The “bottom line” is that small countries are potentially highly unstable and, to make matters worse, their flexibility is typically quite limited.

It is clear that the resources of the IMF are quite inadequate to provide sufficient liquidity to address future financial crises of the dimension of those the world has recently experienced. The IMF’s General Arrangements to Borrow (GAB) and their New Arrangements to Borrow (NAB) are authorized, moreover, only in support of activities which threaten the stability of the overall system; and their activation requires (uniquely) the agreement of the lending countries rather than simply, as one would think it should in a fully multilateral body, that of the entire IMF membership. There is as yet no agreed mechanism for the provision of equivalent support for smaller countries whose difficulties are unlikely to constitute a threat to the international monetary and financial system.

Moreover, IMF resources are not at present available in the form in which they are required. In order to address a liquidity crisis it is necessary to insert liquidity, i.e. finance that is available at very short notice, in large amounts, and virtually unconditionally. Finance that is supplied only on the basis of negotiated conditions and which is released only on the basis of compliance with them, through successive tranches, may be very helpful in the resolution of a crisis. In some circumstances, it may be sufficient. But it is not liquidity. Future liquidity crises should be met with liquidity responses, and all countries should be treated equally in this respect. It is striking that the amounts quickly supplied to Mexico during its crisis far exceeded the amounts only very slowly made available to the East Asian countries in response to their crises.

There have been no special relaxations of previously agreed quota-based limits on assistance for small countries. Small IMF members cannot at present assume the availability of financial support in amounts or forms remotely approaching those required to address their problems during periods of liquidity (or other) crisis. There is therefore a very strong case for the creation, on an urgent basis, of arrangements to supply such support if or when it may be required.

There is little immediate prospect that smaller and poorer developing countries can acquire sufficient reserves or access to sufficient credit lines to protect them adequately against future financial crises of the kind that other emerging market economies have been experiencing.

New forms of regional cooperation are therefore another obvious new route to pursue. Under such agreements as the proposed FTAA or the Lom Convention there could and should be mechanisms for the support of all members, including those in which crises are unlikely to constitute threats to the global or even regional systems, in circumstances of contagion-induced or otherwise exogenously caused financial crisis. Such arrangements could take the form of special “stabilization funds” or agreements for direct central bank cooperation through swap arrangements or similar devices, to be activated in circumstances that are fully agreed in advance. Such supports could and should offer contingent support well in excess of that provided under the current terms of IMF financing arrangements. The inclusion of such arrangements would help national governmental promises to maintain liberalized external financial arrangements, whether in the current or the capital account, to carry real credibility. At the same time, such agreements should write in specific obligations as to increased two-way exchanges of information and technical cooperation among central banks and regulatory/supervisory agencies in the financial sector. The degree of direct bilateral cooperation among G-10 and BIS central bankers is much greater than that between any central bankers in the North and their counterparts in the South. Why cannot Northern financial authorities who have been both so demanding and so cooperative with their Southern counterparts in the sphere of money laundering not be equally cooperative and even active in the monitoring and control of short-term capital flows?

In the larger debates over the future of the international financial architecture, a central element is the relative weight to be assigned to (i) improved information, supervision and regulation as against (ii) the greatly increased provision of finance when required. The sheer magnitude of the amounts that would now be required effectively to influence global markets for most currencies in times of crisis and continued political unwillingness to contemplate a true lender of last resort have left reform advocates with little option but simply to press for improved supervision by national authorities, buttressed by norms established by the BIS, IOSCO or some new World Financial Authority; with, of course, some continuing debate over the efficacy of some forms of controls and/or taxes on capital flows. But, in the case of smaller and poorer countries the relative weight to be assigned to these two basically different policy instruments is not the same as in the conventional argument.

The expertise and experience required for the effective supervision of domestic financial systems is considerable. Even financial “booms” of (absolutely) modest dimensions can easily overwhelm (small) local supervisory authorities in small countries that are typically already hard-pressed to meet their normal responsibilities. External technical assistance may be called upon for some relief but it is likely to be slow to respond, inexperienced in the local environment, and, in any case, far from top priority among decision-makers in potential supplier countries during periods of overall financial turbulence when they may be most needed.

On the other hand, the emergency liquidity (or restraining influence) required to address the potential problem of surges in private capital flows out of (or into) small poor countries is rarely likely to be absolutely large in size - even in circumstances of considerable coincidence of small-country crisis (although, of course, as already observed, potentially far greater than currently permissible drawing rights in the IMF). While small poor countries obviously should continue to do all they can to construct sound and well-regulated domestic financial systems for themselves, there are therefore not only sound arguments but also real possibilities for building strong financial/liquidity defences for them within sub-global agreements. To do so would help to build confidence in these countries’ emerging domestic financial systems. The prospect of moral hazard, either for borrowing countries or for lenders, should, as always, be guarded against wherever possible; but, while not non-existent, it can, certainly in its possible absolute size, be taken as of second-order importance. Reducing small poor countries’ vulnerability is unlikely to cost very much in terms of global resources.

How exactly such extra liquidity can be provided to small poor countries offers many possibilities, including, for instance: a small country liquidity fund or facility operated by a regional monetary fund, a single large national monetary authority, the BIS or the IMF; a similar small country fast-disbursing fund administered by a regional or subregional development bank, a single aid donor, or the World Bank; more informal and even ad hoc agreements among monetary authorities, arranged either on a bilateral or multilateral basis; the conscious staggering of ODA programme disbursements in response to changing recipient needs.

The principle of comparative advantage, the principle of subsidiarity in the allocation of governance functions, and the greater prospect of political credibility and sustainability, all argue for greater decentralization of financial power and influence - a significant reduction in the roles of the IMF and the World Bank in development and crisis response in smaller and poorer developing countries. A parallel case can be made for a significant reduction in the roles of purely Northern credit rating agencies and other financial institutions in the private sector as well.

There exists a strong case for developing liquidity and crisis management systems that are based upon institutions more attuned to the realities of the particular countries in need of assistance. These could be based upon regional familiarity, similarities in economic circumstances (e.g. size or economic structure), linguistic links, or other legitimate likely bases for informed and objective peer review. The degree of overseas and distant (in every sense) concentration of power and influence over financial crisis management has become counterproductive and, in any case, politically unsustainable.

(* Prof Gerry Helleiner is at the Department of Economics and the Monk Centre for International Studies at the University of Toronto. The above is the first part of a two-part excerpt from the Second Demas Memorial Lecture delivered by him at the Annual Meeting of the Board of Governors of the Caribbean Development Bank, Castries, St. Lucia, 24 May 2001). – SUNS4928

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