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BIS advocates moratorium threat to get banks to negotiating table
by Chakravarthi Raghavan
GENEVA: The threat of a unilateral stay on payments would help bring private banks to the negotiating table earlier and persuade them to undertake "burden-sharing" in crisis management, the Basle-based Bank for International Settlements (BIS), often called the central banks' central bank, has suggested in its annual report published on 8 June. Such a threat, BIS says, would be made more credible if international financial institutions announce in advance their willingness to provide finance by "lending into arrears", BIS adds, in its report permeated with references to the Asian crisis and its multifaceted negative effects on the international financial system. BIS, in proposing moves to pressure private-sector banks to share the burden, has noted that in the 1980s, the banks quickly negotiated and rolled over and rescheduled sovereign debts (and even reduced the debts) in Latin America, unlike as now in Asia where the process has been slow, and banks have not taken any losses. Several mainstream economists and other institutions, public and private, have been sharply critical of the way the IMF packages were negotiated and conditioned that has enabled the foreign creditors and banks to escape the consequences of their lending. End still not in sight In several places in the report, BIS underlines that the Asian crisis, which it blames on both domestic factors in the afflicted countries and international factors, is far from over and the worst may be yet to come. The BIS view challenges the fashionable Washington view (of the IMF, the US Treasury and so on) blaming the crisis on "crony capitalism" in Asia and suggesting that the worst of the crisis is over. Says BIS: "Although some difficulties had been foreseen, the suddenness with which the crisis began, the relentless process of contagion across countries and the magnitude of the collapse in exchange rates and asset prices, were all unexpected and unprecedented in recent times. And the shock was all the greater in view of the emerging consensus that Asia was the model for the future. Nor is it totally clear that the worst is over." While financial markets have stabilized somewhat, the full impact on domestic companies and the institutions that lent to them remains to be seen, as do the social costs. "The domestic sources of the crisis are, with hindsight, all too obvious. They might and should have been avoided. Excessive credit growth and associated over-expansion of capital stock, inadequately supervised banking systems, asset price bubbles and excessive rigid exchange rate regimes played roles of varying importance in all the countries affected." "Nevertheless," says BIS, "it would be a mistake to conclude that all the difficulties could have been easily avoided if only domestic policies had been somehow better. These events have occurred against a backdrop of international macroeconomic imbalances which contributed materially to developments in Asia and may yet have further manifestations." Despite the traumatic events in Asia, notes BIS, economic prospects for the rest of the world are still thought to look generally positive and, at a more fundamental level, they have even been interpreted as confirmation of the dominance of the market-driven model of economic growth that has become "increasingly fashionable since the 1970s." "Like fashion, however," says BIS, "economic circumstances can change quite quickly and all economic projections and judgements should be approached with a proper sense of humility." "One good reason for this, illustrated clearly by the Asian crisis, is that the economic and financial world is a highly uncertain place in which perceptions of liquidity risk, market risk and credit risk can interact to produce multiplicative effects and unpredictable outcomes. And if economic developments have social and political ramifications, the results can be more uncertain still. "A second reason for humility is that success seems all too frequently to contain within it the seeds of failure. Over- optimism, in a word, has commonly affected the judgements of markets and policy-makers alike." That lessons in political economy and the suggestion for humility should be coming out of a generally conservative group of central bankers is not without irony. But it may still serve as a reminder, which should perhaps be put up in plaques over desks at international organizations that produce reports promoting market-driven models of economic growth and the efficiencies of markets. Among the external forces behind the Asian crisis, BIS lists the prolonged divergence in the cyclical positions of the US, Europe and Japan; the low inflation and converging short-term interest rates in these markets; the greater contestability of internationally integrated markets and the cumulative effects of heavy investments in computer-based technologies and industries; and the impact of the Asian crisis on prices of electronic products and on oil and other commodity prices, reinforcing the disinflationary effects in the world economy even if the crisis spreads no further. Complementarity But there is the market-view that these disinflationary pressures would be beneficial for asset prices in industrial countries, and for the process of international financial intermediation and competition: This has resulted in banks and institutional investors undertaking some unusually risky business to increase or maintain profits and yields, "without adequate regard to the increased risks involved." The Asian crisis, like the Mexican and Nordic crises before, has underlined the complementarity between macroeconomic stability and financial stability; "temporizing with either, greatly increases the risks of undermining the other as well, threatening large multiplicative effects as well." While policy commitment to both fiscal restraint and price stability has received growing public support over the last two decades, and such objectives are now the norm in most advanced industrial countries and are increasingly accepted in developing economies as well, a recognition of the need to strengthen the banking and financial system has emerged only more recently and "indeed still seems to be subject to strong political resistance in some countries, reflecting both nationalist sentiments and entrenched interests." The fact that financial crises have continued to occur, and more frequently in the 1990s, clearly indicates that preventive measures to date have been inadequate. The international community, led by the IMF, has sought to stabilize the situation in Asia with successively larger packages of liquidity support, combined with traditional demand-side conditionality and financial reform, as also supply-side measures to support longer-term growth. In some cases, efforts were also made to encourage foreign banks to roll over or restructure maturing liabilities of Asian borrowers. Complexity and novelty And while some have questioned the appropriateness of a number of these policy initiatives, as well as the way they were implemented, the complexity and even novelty of the task undertaken by the IMF should not be underestimated. Many of the countries affected did indeed have relatively sound fiscal policies, but their exposure to the deterioration in market confidence on other grounds was nevertheless exceptionally great. Moreover, this was the first crisis in the post-war period featuring the combination of banks as the principal international creditors and private-sector entities as the principal debtors. How to manage and resolve a crisis of this sort was not known in advance and is still under discussion. In this, as well as in the area of crisis prevention, it will take some years before all the lessons have been understood and probably longer before they have all been accepted and applied. Referring to the over-optimistic judgements of markets and policy-makers, BIS notes that Mexico in the early 1990s was praised and rewarded for its deregulation and fiscal austerity, as were many Asian economies for their high savings and investment rates. But all of them were subsequently subjected to very rapid shifts in market sentiments. In Mexico, it was realized that deregulation had led to a consumption boom and an unsustainable current account position. In a number of Asian countries, the markets understood that high savings were not an unmitigated advantage, if they are associated with unprofitable investments likely to depress asset prices. Over-optimism could also affect policy decisions. Whether in emerging or industrial economies, it is always difficult to change policies incrementally so as to avoid crises, and even more difficult when the public is strongly of the view that economic prospects remain excellent. Even the broad success of policy-makers in reducing consumer price inflation may have attendant dangers, if the success inadvertently encourages asset price bubbles, while at the same time reducing policy scope to resist them. "When nominal and even real interest rates decline as inflationary pressures recede, investors may well search for higher returns elsewhere. Unfortunately, whether in domestic equities or in foreign investments, higher returns come only with commensurately higher risks." BIS notes that policy-makers focusing primarily on traditional inflation measures commonly argue that higher asset prices can be ignored unless their effects on consumer price inflation can be confirmed. While true, this has to be complemented with concern about the effects on the health of financial systems if intermediated credit is used to fuel asset price bubbles, BIS points out. The policy-makers' hard choice in such a situation is either to raise interest rates to resist the bubble and undershoot inflation targets a little, or to desist and eventually undershoot them a lot. This would be a particularly risky option, given the Japanese experience in this regard, which shows that reflating an economy may be difficult at low rates of inflation that leave little room for reductions in real interest rates. While the increase in property prices accompanying the rise in securities markets in most Western industrial economies has nowhere been near as great as that seen in Asia, "the recent acceleration of monetary growth in industrial countries nonetheless merits attention," BIS says. The message is not that economic growth, deregulation and low inflation should be avoided because of attendant risks, but rather that with better understanding of macroeconomic processes, problems can be headed off before they become too disruptive. Also, "market liberalization must be pursued vigorously, but prudently" and efforts must be made everywhere to strengthen the health of the financial system to ensure resilience in the face of large shocks. Referring to the prolonged cyclical divergences between the US, Europe and Japan, BIS points to the sharp currency appreciation in the US and UK and an associated deterioration in current account balances, matched by growing surpluses in Japan and continental Europe. Furthermore, the IMF/OECD forecasts that the US would provide most of the offset to the anticipated improvements in Asian trade deficits - pushing the current account deficit of the US as a proportion of GDP to near-record levels. This will entail two dangers, cautions BIS. Dangers of a strong dollar The markets will lose patience with the accumulation of US external debt and drive the dollar sharply lower, reversing the beneficial and significant disinflationary effects of an appreciating dollar and raising the probability of monetary tightening in the US. If this happens, an associated reduction in asset prices can be expected, with substantial knock-on effects on US consumer spending and confidence. The second danger of a strong dollar is the possibility of a resort to protectionist policies in the US. While its robust economy has kept such sentiments below the surface, a marked slowing of growth could easily change the situation. Any threat to continuing, non-inflationary growth in the US might also have broader implications. While the recent strengthening of demand in Europe could make those economies more resilient, the same cannot be said for Japan. And a general rise in interest rates, whether originating in the US or Europe, could provide an incentive for further withdrawals of funds from emerging-market economies, as well as an overdue credit risk reassessment in all markets. "It is not clear," says BIS, "what the full implications of this latter possibility would be in a world where the growth of international inter-bank deposits increased almost four- fold to over $700 billion last year, and where international securities issues have recently hit an all- time record high." While this is a scenario, and not a forecast which would be more benign on US current account problems, and while the dollar's unrivalled position as world reserve currency would help to protect its value, risks need to be identified and attention directed to policies to avoid them, says BIS. In principle, this would seem to come down to encouraging more demand in slower-growing industrial economies and the opposite elsewhere. Yet, there are obstacles in many countries to the practical implementation of such policies. Relying on fiscal policy to stimulate demand may come into conflict in some countries with the objective of fiscal consolidation; relying on monetary easing could run the risk of further fuelling asset prices. Policy prescriptions And while in the emerging economies of Asia, prompt and politically committed responses to the IMF prescriptions would do more to revive growth prospects, "clearly the likelihood of securing such political commitment would rise if the scope of the Fund's recommendations were to narrow towards re- establishment of financial stability and traditional measures required to ensure balance-of-payments equilibrium," says BIS. This appears to support the criticism by a range of mainstream economists of the IMF measures' embracing so-called "good governance" and other such "conditionalities", and opening up markets and competition in these countries by enabling takeovers of domestic production by foreign interests. Critics have said that however desirable these reforms, the IMF should focus on quick restoration of BOP equilibrium and shoring up currencies. BIS says that a further necessary step for many of the Asian economies would be an early, transparent and politically neutral restructuring of their domestic banking systems. It must also be recognized that optimal policies cannot be counted on in the first place and will take time to work in any event. Assuming an interim and perhaps prolonged period of slow growth, the World Bank and others have been quite right to emphasize the need to cushion the plight of the poorest, who are now bearing the heaviest burden of the Asian crisis, BIS adds. Rekindling growth in Japan will not be easy - after almost a decade of temporizing with underlying problems similar to those which have only recently emerged elsewhere in Asia. But it is still not too late to restructure the banking system, and to stimulate the economy through permanent tax cuts directed at those most likely to spend the extra income - a step made all the more necessary since monetary easing seems increasingly constrained by a sharp rise in domestic liquidity preference and fears a lower yen will aggravate trade tensions with the US. This last, BIS adds, may not be a valid reason - in that the US current account deficit is essentially the home-grown product of a fully-employed economy and a relatively low national savings rate - but is still a political reality. But the recent fall in oil and commodity prices, related to the Asian crisis, and amounting to a positive terms-of-trade shock for all larger industrial countries, would help support demand in Japan and many other countries, and many emerging economies as well, helping to raise disposable incomes. The downside to this is that the costs will be borne by a limited number of countries, particularly the main oil exporters, which may not find it easy to adjust, as well as Mexico and Russia, where oil exports still account for about a third of all government revenues. Saudi Arabia, Venezuela, Indonesia and Nigeria will also face similar problems. But on balance, given that those who lose are forced to adjust, and those who gain need not, the decline in commodity prices is likely to slow global demand overall. Structural changes in financial markets On the continuing financial liberalization and structural change confronting policy-makers, BIS notes three important developments in financial markets:
All these have implications for prudential policies. Non-bank financial intermediaries are receiving a growing proportion of savings in the industrial world; and with unfunded pension schemes in Europe and elsewhere unlikely to be able to meet future needs, this trend will likely accelerate. But the behaviour of those allocating such funds will be different from, though not necessarily better or worse than, the behaviour of traditional bankers. The increasing tendency of private savers to choose equity funds as a vehicle for longer-term savings may have contributed to the recent strength of stock markets worldwide. And it is not easy to predict what these savers might do in the face of a sharp correction in equity prices. Traditional banking intermediation is increasingly under threat from securities markets and, as a defensive mechanism, banks are increasingly involved in the securities business. Narrowing margins everywhere, only temporarily reversed by the Asian crisis, indicate the extent of these competitive pressures and explain why credit growth has been faster in some countries than might otherwise have been expected. The effective demise of the US Glass-Steagall restrictions (between banking and non-banking activities), the advent of the "Big Bang" in Japan from 1 April, and the likely spur to international competition from the advent of the euro, indicate that the process of structural change and heightened competition will intensify further. Emerging markets have already been affected by these trends, and the resulting search for higher returns. Capital swings Inflows of international capital, largely in the form of short-term bank credit, rose sharply from virtually zero in 1989 to a peak of $170 billion in 1996, followed most recently by major outflows. Coping with swings has been tremendously difficult, as foreign capital fuelled spending booms on the way in and precipitated crisis on the way out. While greater upward exchange rate flexibility would have helped restrict such flows, the Mexican experience shows that this is no panacea either. In the light of recent developments in Asia, there has been renewed debate about the merits of international capital controls, a debate given added vigour by the simultaneous proposal to amend the IMF articles to provide it with an explicit mandate to encourage capital account liberalization. Those proposing more controls point out that countries with high domestic savings rates often have problems in allocating even their own capital properly, and also emphasize the short- run problems of macroeconomic instability and that international financial markets are prone to destabilizing behaviour. The IMF's approach, in contrast, is focused on longer-run objectives of macroeconomic efficiency in capital allocation, along with the belief that there are less distortive ways of dealing with short-term macroeconomic problems. But in so far as these problems arise from herd-like behaviour on the part of banks, as has been the case in Asia, possible remedies may lie in the context of crisis prevention and management, BIS says (referring to its proposals for ensuring that private banks undertake burden-sharing and are brought to the negotiating table earlier through threat of stopping payments). But there is clearly no single answer to this traditional problem, which involves a trade-off between longer-run efficiency and stability. Nevertheless, a consensus is emerging that decontrol, while desirable, must be carried out extremely carefully, and that capital flows of longer maturity are preferable to short-term ones. If the proposals for the change in the IMF articles were to be accepted, the first fruits would be increased pressure on emerging economies to strengthen financial systems as a pre- condition for liberalization of capital flows. Dawn of the euro A third structural change that would affect financial markets will be the introduction of the euro. Initially, the European Central Bank will have to take account of a number of transitional issues in the conduct of monetary policy. A full understanding of the transmission mechanisms of monetary policy in the integrated market would take time to develop, and the increases in competitive forces may well prompt further changes in the underlying financial structure. This may affect the behaviour of monetary aggregates in the near term, and may need a rather eclectic mix of monetary and inflation targeting by the ECB. As it gains credibility, the associated effect on the process of wage and price formation will also change, in a beneficial direction. On crisis prevention, and from the experience of the Mexican and Asian crises, in both of which similar BOP difficulties interacted with weak domestic systems to produce calamitous effects, BIS recommends the adoption and practice of the Basle Core Principles for Effective Banking Supervision. It notes the great shortage of trained personnel among banks and supervisors alike, the many years and considerable resources that would be needed to rectify it, and the problem of political resistance from those who have benefited from the existing system. But if market discipline and peer pressure do not suffice to overcome obstacles, then withdrawal of the rights of establishment might eventually have to be contemplated, says BIS. But international standards, BIS adds, would be needed too in areas other than the banking sector, including those for internationally comparable and transparent accounting standards, and the need for greater transparency and more disclosure about the financial activities of both the private and public sectors in all countries. Referring to the fact that banks increased their exposures to the Asian countries when signs of problems had in fact emerged which had led institutional investors to reduce their investments from 1996 onwards, BIS says that studies are urgently needed to understand the mechanisms which led banks to increase their exposure despite the warning signals, including those emanating from within the banks themselves. A possible answer could be that the sums involved were relatively small from the perspective of individual investors, even if of a dangerous size from the viewpoint of recipients. If such externalities are proved, this would provide an argument for some form of public policy intervention. The public sector must also question whether its own incentive structures need improvement. A possible reason for the magnitude of international bank lending in Asia was the existence of public safety nets for both debtors and creditors, virtually attenuating every form of risk. With most foreign loans to domestic banks, normal credit risk was reduced by expectations of government support. And the fact that most of such Asian loans were short-term and denominated in foreign currency lowered perceptions of market risk as well. Another question raised is whether the detailed specifications of regulatory capital ratios had made short- term inter-bank lending look particularly attractive. If so, the arguments for such specification should be reassessed. Also to be addressed is whether proper incentives are in place in both lending and borrowing countries for supervisors to act expeditiously before a crisis erupts. Supervisors, BIS adds, need a clear and consistent mandate, powers to act in pursuance, and public accountability for their actions. And while the Asian crisis is not yet definitely over, some issues of crisis management can be identified. The first is the need for the private sector to take some responsibility for the ongoing provision of credit to customers to whom they previously lent all too freely. This is not merely to avoid moral-hazard problems, but to acknowledge a simple reality: capital flows are now so large that public- sector funds alone cannot fill all potential gaps in the event of capital-flow reversal. The threat of a unilateral payments stay would help bring banks quickly to the negotiating table. This would be made more credible if the IFIs announce in advance their willingness to lend into arrears for countries with acceptable domestic policies. (Third World Economics No. 187/188, 16 June-15 July 1998) The above article was originally published in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
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