Asian Financial crises

Chapter 38 Comment on “Bailing in the Private Sector” and “Does the IMF Have a Future”

International Monetary Fund
Published Date:
January 2001
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In my view both Robert Litan and Barry Eichengreen draw too sharp a distinction between the lender of last resort functions of a central bank and the potential role of the International Monetary Fund. In most countries when a commercial bank seeks last resort assistance from its domestic central bank some credit risk will usually be involved in making such loans, especially if the central bank has raised the interest rate at which it will lend to the penal levels advocated by Allan Meltzer, since then the commercial bank will already have pledged its best assets as collateral on the open market. Whereas the central bank can theoretically monetize without limit, its capacity to incur credit risk is strictly limited by the relatively small size of its capital.

Consequently, in almost all countries support activities have taken the form either of the central bank acting as facilitator, organizer and whipper-in of a quasi-coordinated rescue mechanism, mostly involving finance from the private sector, or more commonly in recent years, of acting as a first line of defense until taxpayers’ funds from government can be marshaled. Perhaps the locus classicus of last resort actions was the Bank of England’s 1890 rescue of Barings; in fact the vast bulk of the pledged support funds came from the other commercial banks. LTCM is a case nicely in point, where in addition the comparative speed with which the central bank can act in a partial crisis was a relevant factor. In practice, however, globalization and enhanced competition have made it increasingly difficult to arrange such private sector support operations domestically, since the commercial banks will often demur on commercial, competitive and legalistic grounds, so the other route of government recapitalisation has become increasingly the norm in most countries from Scandinavia to Japan and many countries in between.

Seen in that light, as an independent and impartial facilitator of concerted private sector actions and as a similarly independent and impartial interlocutor between sovereign countries, do we need an institution like the IMF? The answer must be, resoundingly yes. If such impartial international facilitation and coordination is not done, then as Robert Litan rightly worries, the world is more likely to fragment into blocs with smaller countries seeking the direct protection of the core country within their bloc. I should perhaps add that one undercurrent of the ongoing crisis is that the fund has been widely perceived as so concerned about the Congressional vote on its own funding, and with other U.S. pressures, that its impartiality has been doubted, as Bob Johnson said and it has been sometimes characterized as being a cats-paw for U.S.-designed proposals and remedies. This perception even tarnishes good policy proposals such as allowing easier entry of foreign banks. In a crisis this is often perceived as allowing the foreign vultures to descend on the crippled chickens in the domestic financial farmyard. And I might just add further that the fund’s political problems may become even harder yet when we move towards a more bipolar system between the euro and the dollar.

The problems of dealing with a financial crisis situation when the liabilities are denominated in domestic currency are hard enough, witness the problems in Japan. But the problems multiply when the liabilities are denominated in foreign currency (f.c), usually in dollar form. The domestic authorities as a generality do not have the requisite f.c., otherwise there would be no such crisis. Both the scale, and the speed of disbursement, of the Fund’s own resources are, as we have heard many times, limited. And the willingness and/or ability of foreign governments, notably in Washington and Bonn, to provide taxpayers’ funds are strictly limited.

Under these considerable constraints, the past success of the fund in dealing with crises occasioned by public sector financial crises has in my view been remarkable. Using the analytical cookbook of recipes devised by Jacques Polak and Marcus Flemming in the early 1960s, they pretty successfully managed scores of such crises from the UK in 1968 and 1976 to Mexico in 1982 and 1995. My first function as a bank official in 1968 was to write an article explaining the concept of DCE, and, somewhat less convincingly, how we in the UK had come to think of it. I do not really regard the recent Russian episode as a major blot on the escutcheon. The problem lay with a combination of the severe internal governance problems of Russia itself, and with U.S. geopolitical pressures, not with the fund’s advice or policies.

The particular problem of the recent Asian crisis was that the indebtedness burden was primarily in the private, not the public sector, and here the tried-and-true cookbook turned out to be insufficient and in some respects inappropriate. A concern that I have with Barry Eichengreen’s paper is that most of his constructive proposals on bond contracts, creditors’ committees, sovereign immunity laws, etc., while all worthy of consideration and discussion, relate primarily, in a few cases solely, to government sovereign indebtedness, and in all cases to bond, securitized, debts, whereas the crucial problem was how to handle private sector f.c. indebtedness, mainly to foreign banks.

Indeed the best advice of both Robert and Barry is to prevent any prior build-up of such large short-term f.c. private sector debt positions in the first place. And I feel reasonably confident that the fund will not now place any obstacles in front of a potential recipient country attempting to do just that. But are there any active steps that the fund can, and should, take to limit the build-up of such positions? Perhaps the first step is to encourage countries to obtain and to disclose more information on the stock/flow foreign currency indebtedness of their private sector, in addition to more data on their public sector positions. The drip-feed of ever worsening data on such Korean positions was a negative factor in handling that event.

The main debate between Robert and Barry is whether IMF lending should be made conditional on countries having a mandatory haircut clause on foreign banks lending in foreign currency to debtors in the recipient country. My own feeling is to side with Robert, though gingerly and uncertainly, that such a clause might be advantageous if applied universally in all cases and in all countries, but to go with Barry that the chances of getting such a clause universally adopted, in the USA as in Burkina Faso, is approximately zero.

So what do you do if you are in the IMF and a private sector f.c. indebtedness crisis nevertheless strikes? One good maxim is to know your own limitations. Robert Litan noted correctly that, and I quote, “The current financial crisis will not be resolved until the financial burdens borne by the debtors in the affected countries are addressed quickly,” but he went on to say that, “This obviously is not a job for the IMF.” But if this latter is correct, did the fund have any useful role in these cases in the first place, or did its intervention delay and perhaps worsen the necessary process of reducing the burden of such private sector debt to manageable and feasible proportions?

In this context I would also note that increasing interest rates beyond a certain, but unknown, point will discourage potential lenders since the rising risk of insolvencies will come to outweigh the potential extra return, as in Stiglitz/Weiss. This is just as applicable internationally as it is domestically. I surely do not envy anyone in having to guesstimate where the supply curve of international capital becomes backwards bending, but, in my opinion and with the benefit of hindsight, that level was probably considerably surpassed, and in some cases may even now remain so, in several Asian countries.

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