The debate on the international financial architecture
In this brief survey of the state of reform of the international financial architecture, Dr Yilmaz Akyuz reveals that despite the general consensus after the East Asian crisis that a fundamental reform of the global financial system was imperative, little or no progress has since been made. It is clear that despite a proliferation of meetings and communiques, the industrial countries are not prepared to accommodate the concerns of developing countries on the issue of international financial reform.
AFTER the recent bouts of turbulence and instability in international currency and financial markets - including the 1992/93 EMU crisis - large gyrations in the exchange rate of the dollar, and the emerging-market crises in Mexico, East Asia, Russia and Brazil, a consensus seemed to emerge that instability was global and systemic, national efforts would not be sufficient to deal with the problem, and there was a need to overhaul and indeed reconstruct the global financial architecture. The ensuing debate has concentrated mainly on the following areas:
(i) standards and transparency;
(ii) financial regulation and supervision;
(iii) management of the capital account;
(iv) exchange rate regimes;
(v) surveillance of national policies;
(vi) provision of international liquidity; and
(vii) orderly debt workouts.
Measures under these headings can help to prevent or manage financial crises, and sometimes serve both objectives simultaneously. Clearly, reforms in these areas generally imply significant changes in the operating procedures and governance of the Bretton Woods institutions (BWIs), notably the International Monetary Fund (IMF). Indeed, these issues are often addressed in the context of the reform of these institutions, as in the case of the recent Meltzer Commission Report presented to the United States Congress.
Status of Reforms
i. Standards and transparency
It was generally agreed in the wake of the Asian crisis that prevention and better management of financial crises required greater transparency and disclosure of information regarding the activities of the public sector, financial markets and institutions and international financial institutions, particularly the IMF. This was thought to be necessary for markets to make prudent lending and investment decisions, for governments to implement effective measures for regulation and supervision of financial institutions and activities, and for the IMF to improve its surveillance. While many observers argued that greater availability of information would not by itself be sufficient to prevent financial crises, it was nevertheless generally agreed that disclosure and transparency were necessary ingredients of an improved financial architecture.
Action in the international community has so far concentrated on setting standards for and improving the timeliness and quality of information concerning key macroeconomic variables, and transparency of public sector activities including fiscal, monetary and financial policies. Less progress has been made regarding the financial reporting of banks and other financial firms, and almost none in the case of highly leveraged institutions and offshore markets.
While the laissez-faire ideology has played some role in the slow progress regarding the transparency of financial institutions, there are also serious conceptual and structural problems. It is generally agreed that public disclosure of information submitted to supervisors could in some circumstances enhance rather than diminish instability. Nor is it clear what constitutes relevant information, since there is considerable variation among industrial countries in both the quantity and form of publicly disclosed information. Furthermore, the increased speed at which financial firms can now alter their balance sheet and off-balance sheet positions renders financial statements out of date almost before they can be prepared.
Even more contentious is the transparency of the IMF itself. New mechanisms have been introduced in the form of public information notices (PINs) following Article IV consultations and a pilot programme for voluntary release of Article IV staff reports. However, there are difficulties in attaining full transparency of the IMF since governments often find objectionable the disclosure of confidential information they provide to the Fund. Moreover, owing to the political sensitivities involved as well as the questions regarding its track record in macroeconomic and financial diagnosis, temptations to turn the Fund into a fully-fledged credit rating agency are rightly resisted. Within these limits, however, there is scope to improve the transparency of the IMF. Its prescriptions could be subjected to independent review, for instance by a commission constituted by the United Nations.
ii. Financial regulation and supervision
The official position here is to formulate global standards to be applied by national authorities, rather than to establish a global regulatory agency. In order to ensure that such standards be adopted and implemented by developing countries, IMF surveillance has now been extended to financial sector issues. However, it is generally agreed that the IMF itself should not become a global standard-setting authority in financial regulation and supervision, and that the BIS should not become a policeman of the international financial system.
Developments in the past few years have shown that the standards of the Basle Capital Accord are increasingly divorced from the credit risks actually faced by many banks, and are distorting incentives for banks regarding the capital maintained for a given level of risk. Moreover, while the short-term exposure of international banks has been a major feature of recent external debt crises, the Basle Capital Accord attributes a low risk weight for the purpose of calculation of capital requirements on interbank claims. Again, in the case of the majority of countries the same capital charge is assessed against a loan to a sovereign with an investment-grade rating as to one with a junk-bond rating. These have led to pressure for regulatory changes which would have the consequence of raising the cost to banks of such lending so that they better reflect its risks.
The new capital rules proposed in June 1999 include, inter alia, provision for risk weights for exposure to sovereign entities based on external assessment by rating agencies. However, such an approach is highly contentious for two reasons. First, past record suggests that private rating agencies cannot be trusted for the assessment of country risk. Secondly, as noted above, such an approach is generally resisted by developing countries on grounds that the introduction of differentiated sovereign risk weights would lead for many of them to an increase in spreads and reduce the volume of lending.
There seems to be consensus that tightened regulation and supervision should be extended to highly leveraged institutions (HLIs - of which the most important examples are hedge funds) as well as to offshore centres (subjects closely related since HLIs are often incorporated in offshore centres). In the case of HLIs, this consensus reflects partly the realization, since the narrowly averted collapse of Long Term Capital Management in 1998, that such funds can be a source of systemic threat to financial stability, so that the traditional argument for subjecting them to only light supervision based on their restriction to wealthy investors capable of protecting their interests no longer suffices. Moreover, the consensus is also a response to evidence assembled by certain Asian governments concerning the contribution of such institutions on occasion to the accentuation of volatility in the markets for currencies and other assets. However, so far little progress has been made in these areas. These issues are on the agenda of the Financial Stability Forum. Indirect control of HLIs (e.g., through their creditors on the basis of enhanced transparency) appears to be the preferred option. The extent to which such institutions may eventually be subjected to direct control will depend on the effectiveness of reforms so far proposed.
iii. Management of the capital account
The continuing incidence of financial instability and crises in industrial countries suggests that regulatory and supervisory reform and transparency are unlikely to provide fail-safe protection in this area. And if this statement is true even of countries with state-of-the-art financial reporting, regulation and supervision, it is likely to apply a fortiori to most developing economies. Thus, capital controls are increasingly seen as essential for greater stability.
There is broad agreement that the boom-bust cycle in private capital flows needs to be moderated, and this can be attained by controlling short-term, liquid capital inflows through market-based measures such as taxes or reserve requirements. Controls on inflows would also reduce the likelihood of a rapid exit. Nevertheless, as the Malaysian experience indicates, should a crisis occur, temporary controls on outflows, which constitute an essential complement of debt standstills (see below), can also be very effective.
Given that developing countries have no international commitment regarding the capital account, the position of international financial institutions on such matters may be thought to have little practical consequence. However, without an unqualified recognition by the IMF of the need for control over short-term capital flows, developing countries would generally be unwilling to apply such measures for fear of undermining market confidence and reducing their overall access to international finance. Indeed, only a few countries have so far resorted to such measures during the boom phase. Moreover, in order to effectively carry out its bilateral surveillance, IMF recommendations should include capital controls, particularly to countries where the financial system is not robust enough to channel short-term inflows without leading to a buildup of excessive currency risk and fragility. While retaining autonomy with respect to capital account policies remains essential for developing countries (as often reaffirmed in G24 communiqu’s), an official sanctioning of controls over certain types of capital flows would considerably strengthen their hand in managing their capital accounts.
However, there has been no agreement in the IMF Board on the use of capital controls. Some major shareholders still consider even moderate forms of control as exceptional and temporary, rather than essential components of capital account regimes in emerging markets. They seem to believe that sound macroeconomic policies and improved prudential regulations would do the trick. Thus, the IMF Progress Report states that the ‘Executive Board reached agreement on broad principles but differences remain on operational questions about the use and effectiveness of capital controls’, and they put ‘stronger emphasis than was previously placed on the need for a case-by-case approach and on the adoption of prudential policies to manage the risks from international capital flows’ (IMF (1999a), Report of the Managing Director to the Interim Committee on Progress in Strengthening the Architecture of the International Financial System, Washington DC).
iv. Exchange rate regimes
Recent debate on exchange rate policies in developing countries has concentrated on the question of connections between exchange rate regimes and financial crises. Pegged or fixed exchange rates have fallen out of favour on grounds that financial and currency crises in emerging markets have often been associated with such regimes. Accordingly, developing countries are increasingly advised to choose one of the two extremes: either to float freely, or to lock in their exchange rates to one of the major currencies, often the United States dollar, through such arrangements as currency boards, or even simply to adopt the dollar as their national currency.
However, there are strong doubts that, under free mobility of capital, either of these extremes will provide better protection against currency instability and financial crisis than nominal pegs. Moreover, there is a danger that neither will allow the exchange rate to be tailored to the requirements of trade and competitiveness. Contrary to some perceptions, countries with flexible exchange rates are no less vulnerable to financial crises than those with pegged or fixed exchange rates. Differences among pegged, floating and fixed regimes lie less in their capacity to prevent damage to the real economy and more in the way damage is inflicted: for instance, in real terms Argentina and Hong Kong (China) - both economies with currency boards - have suffered as much as or even more than their neighbours experiencing sharp declines in their currencies. There now appears to be a growing consensus that better management of exchange rates in developing countries requires targeting real exchange rates in combination with the control and regulation of destabilising capital flows. This is often seen to offer a viable alternative to free floating or to a complete ceding of monetary authority to a foreign Central Bank.
Developing countries have resisted the notion that adoption of a particular exchange rate regime should be part of the IMF conditionality for access to international liquidity. In any case, the IMF has not always kept to the newly emerging consensus among the mainstream economists to avoid pegged exchange rates. For instance, the Fund has been supporting an exchange rate-based stabilisation programme in Turkey, put in place at the end of 1999, with a preannounced exchange rate to provide an anchor to inflationary expectations.
But perhaps more fundamentally, it is open to question whether emerging markets can attain exchange rate stability simply by adopting appropriate macroeconomic policies and exchange rate regimes when the currencies of the major industrial countries are subject to large gyrations. Indeed, many observers (including Paul Volcker and George Soros) have suggested that the global economy will not achieve greater systemic stability without some reform of the G3 exchange rate regime, and that emerging markets remain vulnerable to currency crises as long as major reserve currencies remain highly unstable. However, various proposals for exchange rate coordination, including target zones for G3 currencies (an idea briefly supported by Germany), have so far been opposed by the United States.
v. Surveillance of national policies
A crucial area of reform is the IMF surveillance over the policies of creditors as well as debtors. In view of the growing size and integration of financial markets, every major financial crisis now has global ramifications. Consequently, preventing a crisis is a concern not only for the country immediately affected but also for other countries. This is why global surveillance of national policies is called for. So far, however, IMF surveillance has not been successful in preventing international financial crises. This reflects, in part, belated, and so far only partial, adaptation of existing procedures to the problems posed by the large private capital flows, and is closely related to serious shortcomings in the existing governance of the IMF.
Traditionally bilateral surveillance has concentrated on macroeconomic policies, paying little attention to sustainability of capital inflows and financial sector weaknesses associated with surges in such inflows. After the Mexican crisis, IMF surveillance was extended to include the sustainability of private capital flows, but this did not prevent the East Asian crisis. The need for strengthening IMF surveillance was again recognised by the Interim Committee in April 1998 which agreed that the Fund ‘should intensify its surveillance of financial sector issues and capital flows’. Clearly, to succeed, the IMF will need to pay greater attention to unsustainable exchange-rate and payment developments and, as already noted, its recommendations should include control over capital inflows. However, this would mean a major departure from the current official approach to capital account management.
But perhaps more fundamentally the failure of IMF surveillance in preventing international financial crises is due to the unbalanced nature of these procedures, which give too little recognition to the disproportionately large global impact of monetary policies in major industrial countries. Financial crises in emerging markets are not always home-grown; they are often connected with major shifts in exchange and interest rates in the major industrial countries. This was true not only for the debt crisis of the 1980s, but also for more recent booms and busts in capital flows to Latin America and East Asia.
Certainly, given the degree of global interdependence, a stable system of exchange rates and payments positions calls for a minimum degree of coherence among the macroeconomic policies of major industrial countries. But the existing modalities of IMF surveillance do not include ways of attaining such coherence or dealing with unidirectional impulses resulting from changes in the monetary and exchange-rate policies of the United States and other major OECD (Organisation for Economic Cooperation and Development) countries. Countries elsewhere in the world economy lack mechanisms under the existing system of global economic governance for redress or dispute settlement regarding these impulses. In this respect governance in macroeconomic and financial policies lags behind that for international trade, where such mechanisms are part of the World Trade Organisation (WTO) regime. But if such a function is to be performed effectively by multilateral financial institutions, it would be necessary to reform not only the surveillance procedures, but also the governance of these institutions, including the voting structure and decision-making procedures, to give greater weight to the views of developing countries. However, so far the only significant reform in this respect has been to rename the Interim Committee (International Monetary and Financial Committee) and to reaffirm that after 25 years of existence it is no longer interim but permanent!
vi. Provision of international liquidity
With the increased frequency of crisis in emerging markets, a consensus has emerged on the need to provide contingency financing to countries experiencing payments difficulties linked to the capital account, in addition to the traditional role of the Fund to provide current account financing. However, the modalities regarding the provision of liquidity, its adequacy, the conditions attached to it, and its funding remain extremely ad hoc and inadequate to address the problems associated with systemic instability.
Provision of liquidity to pre-empt large currency swings has not been the international policy response to currency crises in developing countries. Rather, assistance coordinated by the IMF has usually come after the collapse of the currency, in the form of bailouts designed to meet the demands of creditors, to maintain capital account convertibility, and to prevent default, thereby creating moral hazard for international lenders and investors, and putting the burden on debtors. Moreover, availability of such financing has been associated with policy conditionality that went at times beyond macroeconomic adjustment, interfering ‘unnecessarily with the proper jurisdiction of sovereign government’ (Feldstein, M. (1998), ‘Refocusing the IMF’, Foreign Affairs, vol. 77, No. 2 (March/April) p.26). Finally, provision of funds needed for bailouts often depended on ad hoc arrangements with the IMF’s large shareholders, which as creditors often have important interests to protect.
Efforts to eliminate these shortcomings in the provision of liquidity have been unsatisfactory. The IMF has taken several steps to strengthen its capacity to provide financing in crises, including the Supplemental Reserve Facility established in response to the deepening of the East Asian crisis, and more recently the creation of the Contingency Credit Line to provide a precautionary line of defence against financial contagion. However, none of these facilities have resulted in additional money, relying on the existing resources of the Fund.
A proposal has been made to allow the Fund to issue reversible special drawing rights (SDRs) to itself for use in the provision of international liquidity (Ezekiel, H. (1998), ‘The role of special drawing rights in the international monetary system’, International Monetary and Financial Issues for the 1990s, vol. IX, New York and Geneva, UNCTAD; UN (1999), Towards a New International Financial Architecture, Report of the Task Force of the United Nations Executive Committee on Economic and Social Affairs, New York; Ahluwalia, MS. (1999), ‘The IMF and the World Bank’: Are overlapping roles a problem?’, International Monetary and Financial Issues for the 1990s, Vol. XI, New York and Geneva, UNCTAD).But this would require an amendment of the Fund’s Articles of Agreement and would face opposition from some major industrial countries.
vii. Orderly debt workouts
The international community faces a major dilemma in formulating policies towards international capital flows. In the absence of capital controls, financial crises are likely to be increasingly frequent, severe and extensive. When a crisis occurs, defaults are inevitable in the absence of bailouts. But bailouts are becoming increasingly problematic. Not only do they create moral hazard, but more importantly, the funds required have been getting larger and are now reaching the limits of political acceptability. This is the main reason why the international community has been engaged in finding ways to ‘involve’ or to ‘bail-in’ the private sector in the resolution of currency and debt crises. However, in this area too no agreement has been reached, in large part because of the resistance of some major countries to involuntary mechanisms.
A way out of the dilemma would be recourse to the principles of orderly debt workouts along the lines of Chapter 11 of the US Bankruptcy Code, first raised by the United Nations Conference on Trade and Development (UNCTAD) in its 1986 Trade and Development Report (TDR) in the context of the debt crisis of the 1980s, and further elaborated in TDR 1998. These procedures are especially relevant to international currency and debt crises resulting from liquidity problems because they are designed primarily to address financial restructuring rather than liquidation. They allow a temporary standstill on debt servicing in recognition of the fact that an asset grab race by the creditors is detrimental to the debtor as well as to the creditors as a group. They provide the debtor with access to working capital needed to carry out its operations while granting seniority status to new debt. Finally they involve reorganisation of assets and liabilities of the debtor, including extension of maturities, and, where needed, debt-equity conversion and debt write-off.
Naturally, the application of bankruptcy procedures to cross-border debt involves a number of complex issues. However, the principles are straightforward and can be applied without establishing full-fledged international bankruptcy procedures. The most contentious issue is the standstill mechanism since the IMF now lends into arrears and it is heavily involved in debt workouts.
Clearly, to have the desired effect on currency stability, debt standstills should be accompanied by temporary exchange controls over all capital account transactions by residents and non-residents alike. According to one proposal, standstills would need to be sanctioned by the IMF. Canada has proposed an Emergency Standstill Clause to be mandated by IMF members. There could also be other arrangements including pre-qualification for unilateral standstill decision by the countries concerned, or empowering an independent panel to sanction such decisions similarly to the way in which WTO safeguard provisions allow countries to take emergency actions.
As noted by the IMF Progress Report, there has been no agreement over empowering the IMF to impose stays on creditor litigation: ‘Some Directors thought that amending Article VIII, Section 2(b) warranted further consideration; others did not see the need for, or feasibility of, such action’ (IMF (1999a), op cit.). A number of G7 countries, including Canada and the United Kingdom, proposed to establish a rules-based system for crisis resolution, with explicit rules on the respective roles of the public and private sectors. However, private financial institutions have been opposed to an involuntary mechanism of standstill or rollover. The United States continues to defend a case-by-case approach for the reasons already mentioned.
This lack of agreement has also meant placing greater emphasis on voluntary mechanisms (Group of 22 (1998), Report of the Working Group on International Financial Crises (mimeo), Washington DC, section 4.4; IMF (1999b), Involving the Private Sector in Forestalling and Resolving Financial Crises, Washington DC). The dilemma here is that the need for mandatory provisions has arisen precisely because voluntary approaches have not worked in stemming debt runs. On the other hand, while a number of proposals have been made to introduce mechanisms to provide automatic triggers, such as comprehensive bond covenants, automatic debt rollover options or collective action clauses designed to enable debtors to suspend payments, these are unlikely to be introduced voluntarily and would need an international mandate.11 Indeed, developing countries fear that such clauses would reduce their access to financial markets, hence their insistence that these first be introduced in sovereign bonds of industrial countries, an objective which may require an international mandate.
The above is an edited excerpt from the author’s The Debate on the International Financial Architecture: Reforming the Reformers published by the Third World Network under its series of papers on the global economy.(See page 23)
Yilmaz Akyuz is Director (Officer-in-Charge) of the Division on Globalisation and Development Strategies at UNCTAD.