- Alexander Swoboda, and Peter Kenen
- Published Date:
- December 2000
Interest in reforming the international monetary and financial system, like recent capital flows to emerging markets, tends to come in waves. It surges with crises and ebbs when calm returns, even temporarily. Interest in reform has thus surged in recent years, stimulated by the succession of crises that began with the European exchange rate mechanism (ERM) crisis of 1992-93 and continued with the “tequila” crisis of 1994-95 and, in the span of less than two years, the Asian, Russian, Long-Term Capital Management (LTCM), and Brazilian crises.
Although the specific proposals that are being considered to strengthen the architecture of the international financial system—the current buzzword for reform—reflect concerns arising from the particular characteristics of the recent crises, the fundamental issues are not new. This is not surprising, because the goals of the system remain the same: to foster trade in goods and assets, promote prosperity and growth, achieve an equitable distribution of income and wealth, and ensure the stability of the system itself. The main questions that need to be answered also remain the same: how to share the burden of adjustment, what is the desirable speed of adjustment and hence the appropriate scale of financing, what anchor can best serve the system as a whole and also individual countries, to mention just a few.
These enduring issues, however, arise in new guises as circumstances change. Thus, the current agenda for reform has been strongly influenced by the revolution in telecommunications and information systems that has facilitated financial market integration and by the widespread liberalization of financial markets. As a result of these developments, markets for goods, services, and assets have become even more unified, and developing countries have been drawn increasingly into globalized markets. Furthermore, private capital flows have come to play a dominant role in financing the current account imbalances of advanced economies, and an ever-increasing role in financing—and sometimes even causing—the current account imbalances of developing countries.
It was for the purpose of examining the institutional and policy responses required by these new circumstances that the Research Department of the International Monetary Fund convened the Conference on Key Issues in Reform of the International Monetary and Financial System. This volume provides a record of that conference, which was held at IMF headquarters in Washington on May 28-29, 1999. The conference had two purposes. First, it sought to broaden the debate on the international financial architecture by examining the effects of international financial integration on the nature and size of shocks to which countries are exposed, the implications for the balance between adjustment and financing and for exchange rate arrangements, and the consequences for the roles of the private and official sectors, including the role of the IMF. Second, it sought to broaden participation in the debate by soliciting the views of experts outside the usual policy forums, including experts from academia and the private sector. To achieve these two objectives, panelists participating in each session of the conference were invited to comment broadly on the subject of the session instead of directing their comments narrowly to the paper for that session.
The first day of the conference focused on the problem of mitigating instability in a world with highly mobile capital. The second day focused on the role of the IMF.
Instability has had several manifestations in the 1990s. First, the exchange rates of major currencies, notably those linking the dollar, the yen, the deutsche mark, and, more recently, the euro, have exhibited both short-run volatility and large medium-term movements. Although these phenomena have been with us for many years, they have attracted particular attention in the past few years. The introduction of the euro and of concomitant changes in the assignment of responsibility for European exchange rate policy have led some experts to warn that there may be more volatility in transatlantic exchange rates. In both Europe and Japan, moreover, concerns have been raised about the effects of exchange rate changes on prospects for sustained economic growth. In addition, changes in key-currency exchange rates have had significant effects on other countries, notably emerging market and developing countries, complicating the policy choices facing those countries. Second, capital flows to emerging market economies have been particularly volatile. Surges of capital inflows have been followed abruptly by equally large capital outflows. Inflows and outflows alike have posed problems for the conduct of exchange rate policy and for the maintenance of domestic financial stability.
Volatile exchange rates and capital flows are not new, and the crises of the 1990s bear many similarities to previous crises, including the debt crisis of the 1980s. Nevertheless, there are important differences: the much larger role of the private sector and, within that category, the increasing diversity of both issuers and holders of claims on emerging market and developing economies; more widespread and virulent contagion; the weaknesses of domestic financial systems in many capital-importing countries, which has made them especially vulnerable to liquidity crises; and the use of large-scale official financial assistance to crisis-stricken countries, which, despite the size, has not prevented large and abrupt current account adjustments and very large output losses.
These developments raise a number of key issues for the design and functioning of the international monetary and financial system. Five of them deserve mention here, in their own right and because of their role in the conference.
First, questions have been raised about the functioning of the exchange rate regime for key currencies—the dollar, the yen, and the euro. The exchange rates linking these currencies will continue to exhibit considerable volatility and large medium-term movements, barring a major policy initiative aimed at stabilizing them. Such an initiative is unlikely in the near future and, for that matter, may be undesirable, although some steps might be taken to limit extreme exchange rate misalignments. These matters were discussed at the first session of the conference, which began with the presentation of a paper by Benoît Cœuré and Jean Pisani-Ferry on the exchange rate regime among major currencies (see Chapter 3).
Second, questions have been raised about the reasons for the boom-bust nature of capital flows to emerging market and developing economies, because an understanding of the reasons is essential for crisis prevention. Much emphasis has been put on policy failures and structural weaknesses, especially in the financial systems of those economies affected, and weaknesses undoubtedly played an important role in recent crises. But other reasons have also been adduced, including systemic reasons. Borrowers and lenders may have been influenced by inappropriate incentives—the problem of moral hazard comes up—or misled by inadequate information, and they may have been swept up by perverse market dynamics.
Third, there is a need to reexamine policy responses to the instability of capital flows. What does it imply for the choice of exchange rate regimes by capital-importing countries? What does it imply for the prudential regulation of financial institutions in both capital-importing and capital-exporting countries? Is there a case for limiting capital inflows or, in extreme cases, limiting capital outflows? In recent years, many experts have come around to the view that, when faced with volatile capital flows, countries will move increasingly toward the ends of the spectrum of exchange rate regimes—pure floating exchange rates at one end or hard pegs, exemplified by currency boards, at the other end. Some even predict—and advocate—resorting to formal “dollarization.” But these “corner solutions” may not meet the needs of medium-sized open economies that, for various reasons, do not want to adopt a hard peg but do not have the institutions required to support a wellfunctioning float.
It is widely agreed that emerging market and developing countries must strengthen their financial systems and improve the prudential regulation of their financial institutions. That process will take time, however, and additional steps may be needed in the interim to cope with volatile capital flows. Views on this issue range widely—from belief in the sufficiency of market discipline, reinforced by fuller disclosure of economic and financial data, to belief in the need for tight regulation of capital account transactions. These two extreme views have the virtue of logical consistency but suffer from a decided lack of political realism. Yet less extreme measures, such as “market-friendly” restrictions on capital inflows, remain controversial.
When crises occur, moreover, there is a need to strike an appropriate balance between financing and adjustment, a need underscored by recent episodes in which, despite unprecedented official financing, there was abrupt and massive current account adjustment. Much emphasis has also been placed on the need to strike an appropriate balance between official financing and private sector financing. This fourth issue is indeed a central one in the current debate on involving the private sector in crisis prevention and resolution.
All of these interrelated issues were discussed during the first day of the conference, and the discussion was informed by three challenging papers. Members of the IMF Research Department, Michael Mussa, Alexander Swoboda, Jeromin Zettelmeyer, and Olivier Jeanne, provided a paper on moderating fluctuations in capital flows to emerging market economies (Chapter 4). Guillermo Calvo and Carmen Reinhart presented a paper on the balance between adjustment and financing, which also examined the benefits and costs of the corner solutions for exchange rate policy—floating rates at the one end and currency boards or dollarization at the other (Chapter 5). Barry Eichengreen presented a paper on involving the private sector in crisis prevention and resolution, which triggered a lively discussion involving, among others, private sector participants in the conference (Chapter 6).
A fifth issue was discussed on the second day of the conference. It concerns the evolving role of the IMF in the international financial and monetary system—its role as a provider of financial assistance and its role as a provider of policy advice. The IMF’s activities during the Asian crisis have been the subject of heated debate.
Critics of the large financial packages assembled under the aegis of the IMF believe that the packages contribute to moral hazard by encouraging expectations on the part of governments of emerging market countries—that they will be “bailed out” even if they pursue faulty policies—and expectations on the part of private investors—that they will be the indirect beneficiaries of large-scale official financing and can therefore lend or invest with impunity in emerging market countries. Other critics believe that the frequent provision of large-scale financing has undermined the credibility of official warnings that the private sector will also be expected to contribute financially to crisis resolution.
Critics of the IMF’s policy advice raise two issues. Some believe that the IMF attached too many policy conditions to its financial assistance, thus overburdening the governments of crisis-stricken countries and making it difficult for them to take “ownership” of the IMF’s advice. Others believe that the IMF attached the wrong conditions to its financial assistance, requiring the governments of crisis-stricken countries to tighten their fiscal and monetary policies at times when those countries were facing sharp reductions in output and rising rates of unemployment.
Whatever the merits of these assertions viewed in retrospect, the more urgent and relevant task is to derive lessons for the future—lessons regarding the appropriate scale of the IMF’s financial assistance and the content and scope of its policy advice. The papers prepared for the second day of the conference threw these issues into high relief. Takatoshi Ito presented a paper collating the principal criticisms of the IMF’s advice and asking why the advice did not always have the desired effect on capital flows and exchange rates during the Asian crisis (Chapter 7). David Lipton presented a paper on the financial role of the IMF in which he urged the IMF to reinstate strict access limits when providing ordinary balance of payments financing but also proposed the creation of a new trust fund to serve as a lender of last resort in the event of a systemic crisis (Chapter 8).
In their report to the Köln Summit, the finance ministers of the Group of Seven (G-7) countries seemed to suggest that they have completed their work on the reform of the international financial system. Rather than promising to submit a further report in a year, they said that they would report again “as necessary.” They did make new recommendations, but they left the implementation to others, including the IMF. It is far too soon to assess the adequacy of the reforms adopted thus far and other reforms may be implemented in the future. The papers and discussion at the conference, however, suggest that a number of key issues remain unresolved and that further debate—followed by action—will be necessary. It is therefore essential that the recent abatement of international financial turbulence not slacken efforts in addressing the unresolved issues. Crises will occur again, and the next ones will have unexpected dimensions—all the more reason to deal decisively with the problems that can be anticipated and to strengthen the capacity of the system to cope with problems that are bound to surprise us.