Chapter 3 Recent Financial Crises—Comments from the International Monetary Fund

International Monetary Fund
Published Date:
August 1999
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3A. Recent Financial Crises in Latin America


The topic of this paper—recent financial crises in Latin America—is in some ways illustrative of the connection between a sound economic system and a sound legal system, for the outbreak of financial crises in this as in other regions has often been associated with important weaknesses in the legal framework. As you certainly know, Latin America has had more than its share of financial crises over the past quarter century. Beyond describing these, the point I want to make here today is that these crises, although perceived to be highly painful and disruptive in political, economic, and social terms, have given Latin America two opportunities: an opportunity to learn how to react to crises so that when they break, their impact can be limited both in time and in scope (as was shown to be the case recently in the wake of the Asian crisis), and an opportunity to reduce the likelihood of their future recurrence through the extensive, determined reform of economic and financial structures.

To illustrate these two points I will discuss the two main financial crises experienced by Latin America since World War II: the debt crisis of the early 1980s and the “Tequila” crisis of 1994–95. I will briefly describe the causes of each of these crises, the forms they took, and the policy response they generated. I will argue that the lessons learned from the earlier debt crisis have helped the region in limiting the magnitude and the duration of the Tequila crisis; and that the lessons learned from the Tequila crisis have further helped in reducing the vulnerability of the region to other financial turbulences, including the recent financial turmoil in East Asia. I will conclude with a list of what I consider the key requirements to enhance both short-term crisis management and longer-term economic resiliency to external shocks.

The Debt Crisis of the Early 1980s

The debt crisis that engulfed Latin America starting in Mexico and Argentina in 1982 was likely the worst international financial crisis for the region since the depression of the 1930s. It was at the same time largely unanticipated (the IMF had expressed some concerns about the large-scale borrowing the countries were undertaking, but it was largely ignored in a world awash in recycled petrodollars), widespread in its impact (it had major consequences for everyone of the economies of the region and for many others in different continents), and severe in its outcome: output and income fell abruptly in its aftermath (most sharply in the case of Chile), and the subsequent recovery was slow and protracted. In fact, the 1980s has come to be called “the lost decade” for Latin America, because income growth was virtually nil in the region during this period.

As in many cases of major financial turmoil, the most immediate causes of the crisis were external: the simultaneous decline in key export prices (after an era of rapidly rising oil prices and production) and increase in international interest rates (after a period of seemingly unlimited financing) contributed to a marked widening in the region’s current account deficit from 2–3 percent of GDP in the late 1970s to 5½ percent in 1982 (and even more in the case of Mexico) and to a drying up of foreign financing (gross capital flows to the region dropped from a record US$52 billion in 1981 to less than US$8 billion a year over 1983–89).

But these external developments also unmasked a number of profound imbalances in the region’s economies themselves—brought about by inconsistent and unsustainable macroeconomic policies, including in particular the combination of fixed or semi-fixed exchange regimes in Latin America’s southern cone with overly expansive fiscal stances (the region’s fiscal deficit grew from 2 percent of GDP in 1975–79 to 4.5 percent in 1982). As a result, many currencies became seriously overvalued in the early 1980s—for instance, between 1979 and 1981 the Chilean peso appreciated by 37 percent in real effective terms, the Mexican peso by 27 percent, and the Argentine peso by 19 percent. With the sharp increase in foreign borrowing (particularly by the larger countries), the region’s foreign debt quadrupled from US$74 billion, or 19 percent of GDP, in 1975, to close to US$300 billion, or 43 percent of GDP, in 1982. In the structural area, for decades most of the economies of the region had followed a strategy based on import-substitution, pervasive state intervention and ownership in the economy, and extensive price and other quantitative controls. As a result, in the early 1980s exports accounted for barely 10 percent of GDP, compared with about 15 percent for OECD countries and 30 percent for Asia. Relative prices were highly rigid and productivity growth low. In this context, the Latin American economies were clearly unable to respond to a rapidly changing external environment without major economic disruptions.

The initial policy response to the debt crisis was in general hasty and often disorderly, and entailed in many cases the use of emergency measures such as further trade barriers and exchange controls (Argentina, Brazil, Mexico in 1982). The economic impact of the crisis was severe: output growth and investment dropped sharply and inflation surged to unprecedented levels, with often considerable strains on domestic financial institutions. However, a more consistent and comprehensive policy response gradually took shape, with the double aim of restoring international confidence and sustained economic growth. This approach combined three main lines of action.

  • Macroeconomic stabilization, through higher fiscal and monetary discipline. The fiscal effort was particularly impressive. It included deep cuts in public spending, extensive tax reforms aimed at increasing efficiency and reducing tax evasion, and the restructuring of public enterprises and public financial institutions to eliminate their operational losses. As a result, the region’s fiscal deficit declined dramatically from 4—5 percent of GDP in the late 1980s to about 2 percent in the 1990s. The improvements in public finances in turn supported a strengthening in monetary policy, including a sharp reduction in central bank credit to the government. In addition, direct credit controls were abandoned in most countries. Interest rates were deregulated and allowed to reach positive levels in real terms. On average, money growth slowed from close to 700 percent in 1989 to about 20 percent in recent years.

  • Structural reforms. The crisis of the 1980s highlighted in every painful way the shortcomings of the region’s traditional approach to macroeconomic policy, its reliance on heavy state intervention, and the closed nature of its economies. In such a context, beyond macroeconomic stability, deep structural reforms were necessary to develop the efficient and flexible markets required for faster, sustainable output and employment growth. The specific scope and pace of these reforms has varied among countries; but overall, the drive to structural reform in the region has been bold and comprehensive and has included the dismantling of price controls and the removal of other market distortions (Argentina, Mexico, Peru, Bolivia), the liberalization of trade and of foreign exchange regimes (for most countries), and the restructuring or privatization of public enterprises (Argentina, Brazil, Chile, Mexico, Peru, Venezuela). Let me give you some examples. In the area of trade, quantitative restrictions on imports have been virtually eliminated, and tariffs have been cut from an average of over 40 percent in the mid-1980s to less than 14 percent at present. With respect to privatization—another highly visible component of reform—close to 800 medium-and large-scale enterprises have been privatized since 1988, many of them in the utilities sector, which was traditionally closed to private sector participation and where the potential for productivity and efficiency gains was very high. Furthermore, efforts were started to reform the legal structure governing a number of activities (trading boards, domestic trade, foreign investment).

  • Coordinated debt rescheduling and debt relief. Structural reforms take time to bear fruit, and substantial amounts of foreign financing were needed to support the restructuring effort. This meant that substantial debt rescheduling and, in several cases, debt reduction were required. This was accomplished in various ways, with the active participation of international financial institutions. Initially, during 1982–84, the securing of debt relief involved considerable pressure on private creditors, through schemes coordinated by the International Monetary Fund and the governments of the major countries. Subsequently, the process evolved to concerted actions that preferably relied on the voluntary participation of creditors (the Baker initiative), and were as transparent and as close to market procedures as feasible. By then, the major countries and the main creditors had come to realize that the debt crisis went beyond a mere illiquidity problem and touched on solvency issues. New mechanisms were designed to address this issue, including debt conversion schemes (in which existing debts were swapped for new instruments in domestic currency); debt-for-equity swaps (in which foreign investors exchanged debt instruments for a stake in public enterprises); and, most prominently, the debt reduction agreements under the Brady initiative (in which old debt instruments were swapped for new instruments of a lesser face value but backed by solid long-term collaterals). In all, about US$75 billion of Latin American external debt was written off through these mechanisms.

The Tequila Crisis of 1994–95

The combined application of these three elements—sound stabilization policies, structural reforms, and debt relief in support of these efforts—allowed for a successful, albeit protracted, resolution of the debt crisis. In particular, the comprehensive approach helped restore the creditworthiness of the countries of the region and by 1990, about eight years after the initiation of the crisis, growth had resumed in the region at an annual rate of over 3 percent. Inflation, after reaching stratospheric levels of close to 900 percent on average, was declining. Most Latin American economies had regained voluntary access to international capital markets. In fact, foreign finance was being made available in large amounts: after experiencing a cumulative net outflow of US$116 billion during 1983–89, Latin America received a cumulative net inflow of US$200 billion during 1990–94.

By the end of 1994, however, the region appeared to enter a second, equally severe financial crisis, as the devaluation of the Mexican peso triggered a large wave of capital outflows that put severe pressure on most of the region’s foreign exchange and equity markets. Nonetheless, the Tequila crisis turned out to be very different from the debt crisis of the 1980s. In fact, it acquired the full dimension of a financial crisis in only two economies in the region, Mexico and Argentina, while its impact in the other Latin American economies was relatively limited, with the possible exception of Uruguay. Also, its resolution came relatively quickly. Although the immediate impact was severe, most financial indicators regained some stability after a relatively brief period, allowing output growth to resume.

What explains these very different outcomes between the 1980s and the 1990s? I would name three factors, all of which are in some way the products of lessons learned in dealing with the debt crisis: the higher resiliency of Latin American economies in the 1990s, the speed and consistency of the national policy responses, and the swift, large international support.

Higher Resiliency of Latin American Economies

Like the debt crisis, the Tequila crisis was precipitated in part by events beyond the control of national authorities (namely, the increase in international interest rates in early 1994 and major domestic political shocks, including the assassination of the presidential candidate and the Chiapas insurgency in Mexico). But again these events exposed domestic policy weaknesses and inconsistencies. In the case of Mexico, the maintenance of an exchange rate band was not supported by consistently tight monetary and possibly fiscal policies, serious fragilities in the domestic financial system were partly linked to outdated, inefficient supervision, and there was a dependence on short-term borrowing to finance a fast-growing external current account deficit. Argentina also had experienced a widening current account deficit (in this case in the context of a fixed exchange rate backed by a currency board), although the banking system had been strengthened in previous years.

However, the economic background against which the Tequila crisis developed was much healthier than that of the previous decade. The example of the banking sector is particularly relevant. The banking crisis that followed the debt crisis of the early 1980s was addressed in different ways in the region, and with uneven results. The Mexican government, for example, adopted a very radical approach, with the introduction from 1982 of comprehensive foreign exchange controls and the expropriation of the banks, with adverse results for confidence and economic performance in subsequent years. In Chile, the banks were not expropriated, but the government was forced to guarantee their external obligations and in the end had to absorb their debt, imposing a heavy burden on public finances and on the central bank’s balance sheet. (This issue was only resolved in 1996, over 14 years after the outbreak of the crisis.) The impact was largely similar in Argentina. While the management of these banking crises entailed heavy costs for most of the Latin American economies, it nonetheless had a positive fallout since it induced the authorities to reform their banking sector, although to various degrees.

  • In Chile, the banking legislation was fully revamped, and stringent prudential standards were introduced together with a powerful, efficient, and well-respected supervisory institution. This has doubtlessly contributed to the subsequent strengthening of the Chilean banking system and its ability to weather later financial disturbances.

  • In Mexico, a new supervisory authority was also established after the reprivatization of the banks, but its oversight capacities were limited and its enforcement power limited. Thus, it was not sufficient to prevent a severe banking crisis in 1995.

  • In Argentina, the reform of the banking sector introduced in the wake of the establishment of a currency board in 1991 helped domestic banks withstand the financial pressures that erupted in 1995, thus allowing for the maintenance of the currency arrangement.

Market Deregulation and Trade Opening

Market deregulation and trade had fostered more flexible and diversified economies, which remained attractive to foreign investors despite the crisis, so that the falloff in foreign financing to the region was more limited than in the early 1980s. Even in cases where the fiscal stance had been relaxed prior to the crisis, the underlying public finances had benefited from extensive reform in earlier years, including a thorough restructuring of the tax system and the privatization of many enterprises. In this way, sound adjustment policies were generally able to restore financial stability and generate a supply response over a relatively brief period.

Speed and Consistency of the Policy Responses

As mentioned above, the failure of the Mexican authorities to deal with economic and political shocks with sufficient determination and to address developing macroeconomic imbalances resulted in the outbreak of the crisis. Their initial response was also somewhat tentative and lacked credibility, contributing to an abrupt nominal depreciation of the currency (it lost half of its value in barely two months). The policy response in Argentina also was somewhat slow, giving way to a decline of over 20 percent in bank deposits and a substantial loss in international reserves. In both countries, however, within less than three months of the onset of the crisis, comprehensive policy packages were announced and implemented with a view to restoring domestic stability and rebuilding international confidence.

  • In the case of Mexico, there were three main elements:

    • A significant fiscal adjustment, including increases in public sector prices, an increase in the value-added tax rate from 10 to 15 percent, and lower growth in public spending;

    • An aggressive monetary stabilization combined with a floating of the exchange rate; and

    • Extensive bank reform, including through an increase in capital requirements and loan loss provisions, a revamped supervisory framework and gradual tightening of accounting rules, and the establishment of several mechanisms to mitigate the impact of the increase in domestic interest rates on the already weak domestic banks. (Financial support was provided in particular for the restructuring of nonperforming loans and the issuance of subordinated debt instruments to strengthen the banks’ capital.)

  • In Argentina, the currency board arrangement severely restricted the amount of financial support that the central bank could provide to banks. Nonetheless, the maintenance of the arrangement was crucial to protect hard-won price stability. In March 1995, the government announced an adjustment package consistent with this objective, including:

    • A revised economic program, involving a significant fiscal stabilization effort, backed by substantial amounts of foreign finance;

    • The temporary relaxation of reserve requirements for banks and the creation of a privately financed bank support fund; and

    • An extensive bank restructuring program, including the privatization of most provincial banks and the establishment of a deposit insurance scheme.

Swift, Extensive International Support

Finally, the swift reaction of the international community, led by the International Monetary Fund, and accompanied by the World Bank and the Inter-American Development Bank, and the large amount of financial support provided to both Mexico and Argentina, contributed to limiting the impact of the crisis. The international financial support to Mexico in 1995 was of an unprecedented magnitude—close to US$48 billion—and was clearly instrumental in forestalling a financial meltdown and limiting the spread of the crisis to other emerging markets.

These elements combined to limit the spread of the Tequila crisis both in time and place. Inflation rose in Mexico after the devaluation but soon declined. The exchange rate stabilized, and with strong export growth there was a rapid turnaround in the trade balance, a rapid renewed access to international capital markets, and a relatively swift rebound in output growth. In Argentina, renewed confidence resulted in a reflow of deposits to banks, a decline in interest rates, and a rebound in credit and output growth, while the preservation of the convertibility arrangement prevented a surge in inflation. Access to capital markets was also swiftly regained. Overall, private financial flows to Latin America fell somewhat in 1994 and 1995, but rebounded in 1996–97. Output growth slowed markedly in 1995 but went back to 3½ percent in 1996 and 5 percent in 1997, one of the highest rates since 1980, and with about the lowest average rates of inflation in recent memory.

Lessons and Implications for the Future

The Tequila crisis has sometimes been called “the first crisis of the 21st century” because it was the first that developed against the backdrop of truly global financial markets, to which emerging markets of this and other regions are integrated in major ways. In that respect, it was the forerunner of the Asian crisis, with which it effectively shares some characteristics. Looking now to the future, I would like to share with you some thoughts on what we have learned from the Tequila crisis and what I see as the remaining tasks to continue reducing the vulnerability of Latin America and other emerging markets to external shocks.

The first lesson is that a prompt, determined policy response is key to limiting the spread and the depth of a potential financial crisis. The swift restoration of investor confidence in Latin America after the Tequila crisis was in large part brought about by the demonstrated willingness of most countries in the region to undertake extensive adjustment while maintaining their openness to trade and capital flows. Let me take as an example the impact of the recent Asian turmoil on Latin America. So far, it has been mostly limited to short-lived movements in asset prices (stock markets and Brady bonds) and foreign exchange markets. The main reason these were relatively short-lived is that the authorities have not hesitated to take the monetary and fiscal adjustment measures required to maintain stable currencies, for example, in the cases of Brazil, Mexico, and Chile. More generally, I think that in the future the willingness of the authorities to react quickly to signs of emerging imbalances, before market pressures build up, will be an ever-more central factor in averting financial crises. With global markets, latent imbalances can swiftly become manifest and trigger sudden changes in market sentiment, and the room for even temporary policy slippages has thus been greatly reduced. We learned this in Mexico in late 1994, when delays in the policy response led to a marked overshooting of the exchange rate. In contrast, the recent prompt reaction of the Brazilian authorities through aggressive monetary and fiscal stabilization rapidly eased market pressures in the wake of the Asian crisis. It is thus imperative for all countries in the region to further enhance their capacity to address underlying weaknesses swiftly and decisively if they want to reduce their potential vulnerability to external financial shocks.

More generally, globalization places new, heightened demands on the policy and institutional frameworks of countries. Needed actions in this area belong to what is now called “the second generation of reforms,” whose importance is increasingly recognized for the smooth and efficient functioning of globalized markets. Their list of reforms is long and I cannot discuss them all, but let me mention several that are particularly relevant for Latin America.

The first, and the one that has attracted most attention lately, is governance. In Latin America, reforms are needed to increase the transparency of government operations and limit the opportunities for corruption. The timely provision of comprehensive economic information is also important. Incomplete reporting of macroeconomic developments in Mexico in 1994 was widely blamed for the magnitude of the reversal in investor sentiment, and it is now recognized that reliable, timely economic data is a crucial (although not sufficient) instrument for the development of efficient and stable financial markets. A complementary and crucial area is the establishment of simpler, more transparent regulatory systems that are equitably enforced. Finally, as you very well know, it is critical to strengthen the professionalism and independence of the judicial system, with a view to fostering a sounder and healthier business and social climate based on the rule of law.

Another important task is labor market reform, an area in which progress has been very limited so far in Latin America. In fact, most labor markets in the region remain highly regulated, with continued reliance on employment protection mechanisms (particularly in the public sector) and high payroll taxes. Regulated labor markets contribute to high nonwage labor costs, low employment growth, and the development of segmented labor markets. They also reduce employment opportunities for unskilled labor, reinforcing the region’s already wide income disparities.

Another key objective for Latin America should be the buildup of human capital. The region’s lag in educational attainment—the average educational level of its labor force is two years below that of economies of other regions with similar income levels—is a significant hindrance to higher output growth; it is also a key factor in Latin America’s large income disparities. To address this problem, the countries of the region must both reorient the composition of their public spending in favor of health and education (particularly basic preventive care and primary education) and increase the efficiency of these programs, to boost productive employment opportunities and reduce poverty.

Last but not least, there is a need to continue with banking reform. As I mentioned earlier, in recent years a number of countries in the region—let me mention, for instance, Argentina, Mexico, Peru, Venezuela—have taken important steps to strengthen their banking systems: banking laws have been updated, supervision strengthened, and many banks have been restructured, merged, or privatized. Still, in many countries the causes of unsound banking practices persist, including weak accounting practices, poor internal management, a lack of transparency regarding banks’ operations and financial condition, and inadequate supervision. Also, off-balance-sheet operations often escape regulatory oversight even though they can significantly alter the banks’ effective exposure to risk. It is important to avoid complacency in this area and redouble efforts to enforce internationally accepted prudential standards, accounting practices, and risk-assessment rules.

3B. Asian Crisis: Causes and Remedies


I am pleased to be here today to share with you my assessment of the Asian crisis, what has been done to correct the problem, and what the prospects are.

Looking back, the Asian-crisis countries, which include Indonesia, Thailand, Korea, Philippines, and to some extent Malaysia, have had an impressive record of economic performance over the past three decades. These countries enjoyed high growth rates—close to 10 percent—relatively low inflation rates, especially during the 1990s, macroeconomic stability and strong fiscal positions, very high rates of saving, openness, and high export orientation. They had also undertaken quite a number of reforms. So one should not forget that these countries were referred to as the “Asian miracle” only a year ago.

It is fair to say that no one predicted this crisis. That is not to say that in its work with these countries the IMF did not point out some underlying problems, but it did not predict the crisis and certainly not its magnitude.

The real question is what went wrong? Now that the crisis has unfolded, it is, of course, much easier to identify its causes. In fact, there is a general consensus on the causes of the crisis, in contrast to a diversity of views on the appropriate remedies. To a large extent, these countries were victims of their own success. What do I mean by that? Because of their success throughout the early 1990s, all these countries went through a denial stage when signs of the problems first emerged.

We have all heard the arguments about why the problems that existed in Latin America in the 1980s did not apply to Asia: the Asian countries didn’t suffer large government deficits and public debt, rapid monetary expansion, and structural impediments. Consequently, these countries did not deal in earnest with the emerging problems until too late in the game.

The Thailand story is probably most telling in this regard, particularly since Thailand started the whole process of contagion, beginning in 1996. I know for a fact that we warned the Thai authorities in early 1997 of the emerging problems, but it was difficult to get them to accept that serious problems were lurking behind the scenes.

Moreover, we were not aware of the full extent of potential problems, partly because, as is now generally known, the Bank of Thailand continued to support the exchange rate by intervening heavily in the forward exchange market. So we were looking at the level of international reserves, which indeed seemed quite comfortable, not knowing that pretty much all of the international reserves had already been committed in the forward market. Intervention went on until mid-1997 when the authorities realized that usable reserves had been all but depleted. At that stage, they came to the IMF, and we had to negotiate a program under tremendous time pressure. Similarly, we were not aware that Korea’s foreign exchange reserves had been depleted until we were called to the scene.

What underlying problems led to this crisis? Perhaps the most important element was the dynamic relationship in the capital markets. On the external side, this was a period when substantial funds were available at relatively low interest rates. There were not that many investing opportunities in Europe or in other developing countries, where rates of growth were relatively weak. At the same time, Asian countries were doing very well and growing very rapidly. So the funds shifted into Asia—in retrospect, recklessly. Investors in the industrial countries thought that this was a fantastic opportunity. And, of course, in the early stages, as in all classic boom cases, stock and real estate prices went up, attracting even more funds. No one seemed worried.

At the same time, the process of borrowing from abroad and allocating the resources domestically was being undermined by a weak domestic banking system that had not developed as rapidly as the rest of the economy. There were also serious problems of governance and transparency. In the absence of clear economic criteria, funds were often not used for productive investment. With hindsight, it’s clear that a big problem was just waiting to happen, and it was just a question of what was going to trigger it at what stage. This rapid overheating came to a boil in the mid-1990s.

Also contributing to the influx of funds into these countries was their pursuit of a fixed exchange rate policy. Borrowers in these countries found it very attractive to borrow dollar-denominated debt at low interest rates under the illusion that they did not have to worry about exchange rate risk. So instead of paying domestic interest rates of, say, 15 to 20 percent, they could borrow at 6 percent or 7 percent without making allowance for the exchange rate risk.

The rigidity of exchange rate was, of course, an issue of concern to the IMF. In fact, in most of these countries we were advocating more exchange rate flexibility, which during this period would have resulted in an appreciation. But if a flexible policy were pursued, borrowers would realize the consequences of overreliance on a fixed exchange rate. Removing the security of an implicit guarantee would have eliminated the one-way bet that may have motivated excessive reliance on foreign financing.

Other elements also made the competitiveness of the export sector less competitive in these countries. Since mid-1995, the U.S. dollar, to which most Asian currencies were linked, was appreciating against the yen. China devalued and then NAFTA was put in place, expanding the markets for Mexico. Both these factors made it more difficult for other Asian countries to place their exports. Exporting started to weaken around 1996.

In the meantime the substantial capital inflow was, of course, absorbed through a widening of the current account deficit, which was the counterpart of increased borrowing. Furthermore, much of this borrowing was done at short term, amplifying vulnerability.

So you can see a situation was developing rapidly in which all these countries were becoming vulnerable to any sudden shift in capital inflows. Once the Thai crisis emerged in the middle of 1997, the Asian countries were all vulnerable. And then the markets, of course, having not reacted to the underlying problems for a long time, overreacted in the fear that, if this can happen in Thailand, it was bound to happen in the rest of Asia, too. Market participants looked at the problems Thailand was facing—weak financial and corporate sectors, large current account deficit, and large external debt (particularly short-term)—and realized that all these countries shared the same problems to varying degrees. As the market overreacted and withdrew funds from the region, the Thai crisis spread to the Philippines, Indonesia, and Korea.

Let me now turn to the adjustment phase and the role of the IMF. I will briefly outline the main elements of IMF programs, which have a fair bit in common, although there are also differences between countries.

The immediate issue in all these countries was, of course, to provide adequate financing to deal with the liquidity crisis created by the sharp withdrawal of funds. Thus, the main element common to all these programs was for the Fund to provide substantial resources, larger than usual. At the same time, we tried to persuade other countries in the region as well as the Group of Seven to provide additional funds, both to substitute for diminished capital inflows and to give confidence to the market.

In addition to their traditional focus on monetary and fiscal policies, IMF programs with the Asian countries also included an important structural element because the root of the problem was essentially structural. Regarding monetary policy, our programs have ironically been criticized from both sides: some have held the view that interest rates should have been raised more to defend the currency, while others have advocated—I’m sure you all have heard the views of Jeffrey Sachs and even of some of our colleagues in the World Bank—that interest rates should have been reduced in view of the problems of the banking system and the corporate sector.

Frankly, it’s very difficult to see how interest rates can be reduced in the middle of a currency crisis. After all, the exchange rate is the relative price of a country’s money and depends to a certain extent on domestic interest rates. Lowering interest rates during a crisis would make domestic money even more unattractive to foreign investors and exacerbate pressures on the currency. To be sure, the weakness of the banking and corporate sectors did constrain the scope for raising interest rates sharply for a prolonged period. Thus, the strategy pursued in these countries was to raise short-term interest rates to reverse the deterioration in the exchange rate, and then gradually reduce it as the exchange rate stabilized. We have already seen the success of this approach in Korea and Thailand. I may add that Indonesia’s reluctance to maintain higher interest rates initially contributed to the subsequent plunge of the rupiah, which now necessitates much higher interest rates.

Fiscal positions of these countries were strong initially. The original fiscal targets envisaged a small surplus to help external adjustment and provide a cushion for financing the instabilities of the banking system. However, as economic conditions have deteriorated, the IMF has been quite flexible on revising the initial fiscal targets to provide some economic stimulus and to finance additional social spending to protect the poor. The fiscal targets now show substantial deficits.

On the structural side, the most important elements were financial sector reform and corporate restructuring. In the case of Indonesia, additional reforms were designed to improve governance and to signal to the market that resources would not continue to be channeled to connected groups.

The role of structural reform in these countries has also been a point of debate. Some have argued that the IMF should have focused only on macroeconomic policies, rather than structural reform, which is a medium-term process. But I would remind you that the main source of the problems in all of these countries was structural—the weakness of the financial and corporate sectors as well as unsatisfactory governance and transparency. And, as the situation got worse, markets focused intensely on these problems. So the argument that “these problems were always there, why do we have to worry about them now” does not hold. Markets were worrying, and if these programs did not give assurance to markets that important initiatives were being put in place, it would be very difficult to regain market confidence. That is not to say that the structural problems can be solved overnight, but enough has to be done up front to establish the conviction that people accept that you recognize the size of the problem and you are committed to correcting it.

Second, and this was particularly relevant in the case of Indonesia, the authorities themselves were keen to take advantage of the crisis to push through important reforms. The myth that the IMF pushed unpopular reforms on the Asian countries is indeed a myth. Domestic support for IMF reforms was, in fact, strong and, ironically, criticisms were voiced mainly from outside.

The next question is, where do we stand now? In Korea and Thailand, the situation has turned around drastically. I wouldn’t say the crisis is over, but certainly these countries have turned the corner. Exchange rates have appreciated considerably, and these countries have lowered their interest rates well below their pre-crisis level, thus allowing investment to continue and growth to resume. But having said that, the difficult period is still ahead, much like the patient who feels worse for a period after the surgery before he starts to recover. The important task now is to manage the situation correctly so that unemployment does not get out of hand and undermine the programs. Both these countries will emerge from the crisis considerably healthier owing to their substantial reforms.

The case of Indonesia, however, has proved to be much more complicated because of the volatile interaction of political and economic problems. The IMF program got off to a very good start in November 1998 as the rupiah began to appreciate, but this early success was short-lived and the rupiah crisis reemerged with a vengeance. This turnaround reflected a number of factors. Initially, the monetary authorities relaxed interest rates under instructions from President Suharto. Pressures on the rupiah intensified owing to various public statements by those close to the president, which undermined market confidence. Funds began to flow out of Indonesia as the public concluded that in the internal conflict between reformers and vested interests, the president was not prepared to lend his support to the reformers. Subsequent political events further undermined market confidence as a series of agreements with the Fund fell apart. As you know, the new government eventually reached agreement with the IMF on a new program that attempts to reverse the serious economic deterioration that had occurred in that country, prevent inflation from spiraling out of control, and extend the social safety net, so as to cushion the impact of the crisis on the poor.

Finally, let me just say a few words about what lessons are to be learned and what we can do to avoid such crises in the future. I should first emphasize that we will not be able to avoid crises. As long as we have financial markets, we will continue to have boom-bust cycles. A better question is, what can we do to limit vulnerability.

First, we need better information to monitor the situation and act in a timely fashion. For example, if policymakers and the public had known how weak the financial systems in these countries were, something could have been done much earlier. If it were known how rapidly international reserves were falling in Thailand and subsequently in Korea, policy adjustments would not have been made only at absolutely the last second.

Second, in all these boom-bust cycles—and this is not unique to developing countries, we have also seen it in industrial countries—the financial sector plays a critical role. It is important that we have appropriate prudential and supervisory procedures in place and banks are in a position to assess risk. There’s nothing wrong with taking large risks in the hope of larger returns, if you know that’s what you are doing. So financial sector reforms are extremely important.

Third, one important lesson we have learned is that it is a mistake to have a fixed exchange rate unless you are prepared to do what it takes to defend it. Hong Kong SAR, for example, has been successful in fighting off speculation, but it has a healthy banking system and very strong macroeconomic policies. Thus, any attack on Hong Kong SAR’s exchange rate is clearly speculative and Hong Kong SAR certainly has enough reserves to defend it. But there are not many countries that can hold onto a fixed exchange rate when things go wrong.

Finally, an issue being debated actively is the matter of capital market liberalization. One common theme has been that Asian countries should not have liberalized their capital market so early. I think that the debate is linked to the whole process of financial intermediation. After all, let’s not forget that these countries grew by 9 or 10 percent a year largely because they had access to foreign capital. Even if output declines by, say, 5 percent in 1998, and remains flat in 1999, they would still have an impressive growth average over the last 20 years. When the capital market is opened, it is important to have appropriate sequencing and a process in place to ensure adequate channeling of capital into productive investment.

3C. The International Monetary Fund’s Response to the Asian Crisis


Confronted with the unfolding crisis in Asia, the IMF faced three tasks. The first was to respond quickly—the nature of the financial crisis, based on the dissolution of market confidence, required that the IMF act sooner rather than later. The second was to mobilize financial packages, involving as appropriate the participation of the private sector, of sufficient scale to help restore market confidence. And the third was to identify the underlying causes of the loss of confidence, and then to support programs in each country designed to address these problems. Especially with regard to the first two tasks, the IMF had to meet requirements very different from those demanded by more traditional “customers.” They were, however, reminiscent of the Mexican experience in 1995.

Speed of Operation

In the case of Mexico, the time that elapsed between the initiation of program negotiations and the Executive Board meeting to approve the arrangement was only one month. This was much shorter than the usual length of time between initiating program discussions and Board approval of an arrangement, which is typically of the order of three months, and sometimes much longer. Recognizing that the IMF might need to act this fast again, the Emergency Financing Mechanism was approved in September 1995. This is not, in fact, a mechanism or facility, as its name might suggest, but rather an accelerated procedure that would formalize the truncated timetable—speeding up the internal review process and shortening the time given the Executive Board for its consideration. This procedure was activated in recognition of the fact that, in circumstances of deteriorating market confidence and evaporating reserves, speed was of the essence in seeking a resolution. The procedure operated in each of the three successive large access Asian cases in 1997.1 Thailand was the first, with the time between the mission’s departure and Executive Board approval of an arrangement with the IMF being, like Mexico, only one month. Indonesia followed. With the snowballing of the crisis, negotiations sped up, and the time between the mission’s departure and the approval of the arrangement shrank to only three weeks. Finally, there was Korea. This time the gap between the mission’s departure and the Executive Board’s approval of the arrangement was only 11 days. Inevitably, when a program has to be designed this fast, a lot more fine-tuning than usual in terms of program design has to be left to subsequent reviews. Again, reflecting the nature of the case, reviews tended to be brought forward and be more numerous than is usual in IMF programs—at least at the outset.

Financial Packages

In addition to accelerating its procedures for Mexico, the IMF also made available what was then the largest stand-by arrangement (or, for that matter, extended arrangement) in the IMF’s history. The $18 billion that was committed under the 18-month stand-by was heavily front-loaded. It was also equivalent to 688 percent of Mexico’s quota, substantially exceeding both the annual and cumulative “access” limits (which were at 100 percent and 300 percent of quota, respectively). These limits, set by the Executive Board, could only be exceeded in “exceptional circumstances”—circumstances that only once—again for Mexico (in 1990) had been invoked before and for a much smaller excess over the limits. The nature of exceptional circumstances was deliberately not defined by the Board—though it was made clear that “risk of contagion” was not a sufficient criterion in and of itself. The latter stipulation might seem odd, since the risk of contagion could appear to warrant a larger than usual arrangement, in order to forestall the need for even larger sums later on to deal with a spreading crisis. But the reason why this was not, of itself, a sufficient condition for exceeding the limits was the IMF’s principle of uniformity of treatment—beyond the natural scale of their quotas, large members should not be favored over small. Yet the former were more likely to involve systemic risk than the latter. The Mexican package, which totaled some $53 billion in its headline amount, including contributions from the United States and other contributors, did much to help the IMF overcome “sticker shock” when it came to dealing with the more recent Asian crises.

In Thailand, a large stock of private sector foreign-currency debt was projected to fall due during 1997 and 1998. In addition, the Bank of Thailand had accumulated sizable short-term foreign-currency obligations on its forward book. It was estimated that, in the context of a credible program, most of the private debt would be rolled over, and that the reserve loss from expiring forward contracts could be limited to $17 billion. Accordingly, the package that was put together in late August was $17 billion, of which $4 billion was from the IMF and $4 billion from Japan. However, the Thai package only momentarily restored confidence: political problems quickly raised questions about the authorities’ commitment to the program. The continuing unease over Thailand spread to Indonesia and then manifested itself in a particularly violent attack on stock markets all over the world, including in the industrial countries, in late October. The attack on world stock markets proved short-lived, but the attack on Indonesia continued, making it clear that a request for an arrangement with the IMF could not be avoided.

In Indonesia, the prospective external debt-service burden of the private sector in 1997–98 was also very heavy. In particular, the stock of short-term debt was initially estimated to be somewhat over $30 billion, of which about two-thirds was thought to be at risk. The package that was put together amounted to $18 billion ($10 billion from the IMF), with a further $5 billion to be drawn from Indonesia’s own relatively comfortable stock of reserves. In addition, to provide additional confidence, a “second line of defense” was established, with some $20 billion pledged from governments around the world to be made available if the first line of defense was exhausted. Again, for a while (and we will come back to the Indonesian program in a minute), this package seemed sufficient. But still the flames spread.

With the ignition of Korea, things began to unravel with alarming speed, and the sums involved—to the extent they could be ascertained—took on awesome dimensions. In addition, much of the “reserves” held by the Bank of Korea turned out not to be reserves at all, but illiquid claims on Korean overseas subsidiary banks. Korea’s short-term debts had been estimated at end-September 1997 to have exceeded $100 billion. Some of this had already been paid down during October and November, and some was the liability of foreign banks—which could be expected to stand by their subsidiaries. To deal with the rest, and allowing for some rollover, the package that was put together—in the space of little more than a week—amounted to $55 billion, of which the IMF provided $21 billion—the largest-ever commitment under an IMF arrangement—and other multilateral institutions put up $14 billion. In the event, the available financing and the program proved insufficient to reassure the markets. Spooked by leaks about the size of Korea’s external debts and the low level of reserves, and unconvinced of the Korean authorities’ commitment to reform (which seemed undermined by the impending elections), the markets began to fear that Korea’s reserves would run out by Christmas. The IMF responded by agreeing to bring forward the availability of some its resources and by seeking activation of the so-called second line of defense, in return for strengthened commitments from the Korean authorities and, most important, the engagement of commercial banks around the world in a coordinated voluntary rollover of Korea’s short-term debts.

The massive sums of money involved in all these programs departed completely from the IMF’s usual access policy. Thus, the Thai stand-by arrangement was for 505 percent of quota, while the Indonesian arrangement was for 490 percent—both well in excess of the 100 percent annual and 300 percent cumulative limits currently in force. The Korean arrangement was an unprecedented 1,938 percent of quota. Even before the Korean crisis erupted, it had become clear, with the advent of the Thai and Indonesia crises, that the Mexican precedent was not to be a one-off event after all. The “exceptional circumstances” that had given rise to these cases, and permitted the usual access limits to be exceeded, were exceptional no more. The IMF needed a facility that could treat these cases systematically, yet apart from the usual cases.

Reflecting this, a new facility—the Supplemental Reserve Facility (SRF)—was introduced in December 1997, just in time for Korea’s second purchase. This facility was designed specifically to deal with so-called twenty-first century crises—where there has been a sudden and large-scale loss of confidence in capital markets and where a member is thereby faced with the prospect of large-scale capital outflows. The sums of money required to deal with situations of this type were clearly quite outside the normal amounts needed to deal with the IMF’s more traditional customers and could not be formalized according to any pre-set access limits—clearly if Mexico’s access had been treated as the outside limit, Thailand and Indonesia would have complied, but not Korea. The new facility was not therefore subject to any formal access limit. Access would nonetheless still be judged according to the usual criteria—balance of payments need, strength of program, and capacity to repay. It would also, of necessity given the potentially very large sums involved, have to be mindful of the IMF’s liquidity.

The second feature of the facility derived from the recognition that these crises of confidence, violent though they were, could be expected, with an appropriate financial package and supporting economic program, to blow over much more quickly than more conventional balance of payments difficulties. The IMF’s traditional stand-by arrangement was designed with traditional customers in mind—repurchases are made over a three-to-five-year period. As the case of Mexico demonstrated, twenty-first century customers could be expected to repay much sooner than this—Mexico voluntarily began making repayments earlier than scheduled, one and a half years after the arrangement went into effect. In consequence, the new facility establishes a repurchase expectation in two parts—the first at one, and the second at one and a half years after the purchase. To deal with the uncertainties involved regarding the timing of the restoration of confidence, these repurchase expectations can, at the request of the authorities and with the approval of the Board, be extended for up to one year. At the same time, as the Mexican experience demonstrated, the cost of funds can be an important determinant to the choice of which lenders are repaid first—it is noteworthy that the U.S. funds extended to Mexico, which were more expensive than the IMF’s stand-by resources, have now been fully repaid, even though substantial sums still remain outstanding from the IMF arrangement. Accordingly, the resources provided under the SRF are more expensive than regular resources—the rate of charge is set at the basic rate of charge plus a surcharge—300 basis points for the first year and rising thereafter by 50 basis points every six months until a maximum surcharge of 500 basis points is reached. By the second year—assuming the crisis has been resolved—the combination of falling market risk premia and rising IMF surcharges should create a powerful incentive for the member to resume market access and repay the IMF according to expectation.

The final feature of the SRF is based on the assumption that, while the immediate crisis derives from loss of market confidence, such losses of confidence do not exist in isolation—they are based ultimately on some fundamental macroeconomic or structural problem. Such problems must be addressed if the crisis of market confidence is not to recur. The SRF must therefore be linked to a program of adjustment and reform designed to deal with the fundamental problems that have given rise to the loss of confidence. And this link must be strengthened by the application of conditionality—prior actions and conditions linked to phased purchases. Such programs would normally be expected to take longer to implement and complete than the financial crisis itself, in its immediate manifestation, may last. Because of this, the SRF, which is available only for one year, can be provided only in the context of, and in conjunction with, a regular arrangement more closely aligned to the duration of the adjustment and reform program.

The Economic Programs

This brings us to the adjustment and reform programs. Although all three Asian cases found themselves in a similar situation at the outset of their crises—a heavy reliance on short-term external foreign-currency debt and banking systems shot with bad loans—they each got there by different routes. The programs they adopted attempted both to repair the damage done to the banking systems—common to all—and to prevent their recurrence through reforms tailored to each individual case, as well as adjustments to aggregate demand as necessary.


The Thai crisis was born of conditions that were the closest of the three Asian cases to what the IMF has traditionally had to deal with. Explosive domestic demand had resulted in a current account deficit of 8 percent of GDP and a growing market view that the exchange rate was overvalued. Although a significant proportion of this domestic demand derived from investment, much of this investment was going into the nontradeable sector, in particular property, itself experiencing a speculative bubble, as well as other projects with increasingly dubious potential returns. Much of the financing of this investment came from abroad—increasingly in the form of short-term debt—and was channeled through a poorly regulated financial sector. Eventually, the scene of declining property values, stagnant exports, and reports of financial institutions getting into difficulties began to induce speculation against the baht by both foreign investors and residents. The authorities initially attempted to defend the exchange rate by intervening in the forward market—building up huge forward liabilities in the process—before finally floating the exchange rate and raising interest rates to stem the decline.

The Thai program therefore included two chief components: (i) the maintenance of a tight monetary policy and a (modest) fiscal contribution toward shrinkage of the current account deficit (most of the adjustment was expected to come from the private sector), and (ii) structural reform of the financial sector. These reforms included both a restructuring/recapitalization exercise and reform of financial-sector regulations and of banking supervision.


The Indonesian economy suffered less from overheating than from problems of corporate governance and poor banking supervision. The economy was encumbered by preferential monopolies and prestige projects likely to generate negligible or even negative returns. Enterprises were subject to little financial discipline—banks were all too often pressured into making risky loans—and bankruptcy legislation was largely unenforceable. As well as borrowing from banks, enterprises borrowed directly from abroad, encouraged by an implicit guarantee that the rupiah would depreciate only very gradually against the U.S. dollar. The result was a large buildup of bank and nonbank external debt, much of it short term. Eventually, enterprises began to find it difficult to service their debts. When the crisis hit, the result was a dramatic decline in the exchange rate, which far exceeded the depreciations seen elsewhere and which compounded the debt-servicing problems of enterprises. This, in turn, forced the banks to sell rupiah in order to repay their own liabilities, which put more pressure on the exchange rate.

Given the extreme movement of the exchange rate, the program aimed to stop, and if possible reverse, the depreciation through a tightening of monetary policy. At the same time, an ambitious program of reform was initiated toward (i) ending monopolies and prestige projects, (ii) reforms to bring about transparency in corporate accounts and governance, (iii) restructuring and bank recapitalization of the banking system, and (iv) maintaining an adequate social safety net, including through continued subsidies on essential items, notably rice. Given the expected costs of recapitalization, efforts were also made initially to protect the fiscal accounts from slipping into deficit.2 From the outset of the arrangement until the first review, program implementation was constantly in question, and concerns over President Suharto’s health (especially in December 1997) put political stability in doubt. The resulting erosion of confidence led to a resumption of outflows, especially with respect to corporate debts. Accordingly, as well as seeking a strengthening of the authorities’ commitment to the program, the first review also initiated various efforts at debt restructuring. Negotiations were initiated toward a voluntary restructuring of interbank debt, maintenance of trade credit lines, and government involvement in a corporate-debt restructuring scheme, along the lines of the FICORCA scheme employed in Mexico in the early 1980s. The object of this scheme was to draw the private sector (chiefly foreign banks) into rescheduling obligations, in return for the government providing an exchange rate guarantee for the rescheduled amounts. Although the program had to be recalibrated again after the social unrest in May that resulted in a change of government, the strategy remained intact.


The Korean crisis had its roots in weaknesses in Korea’s corporate and financial sectors. The chaebols were in many cases pursuing unwise expansion strategies in an environment where corporate governance was weak. This weak corporate governance resulted from insufficient transparency in accounts and operations and from a lack of effective oversight from boards of directors, shareholders, and creditors. The chaebols were also subject to significant government interference. Limitations on foreign participation in the bond and equity markets, meanwhile, meant that Korean corporations had to draw in funds indirectly through the banking system, itself limited by controls on long-term borrowing. This contributed to an extremely high debt/equity ratio and a heavy short-term external debt burden. Excessive investment and weakening profitability eventually resulted in a sharp increase in corporate bankruptcies since the beginning of 1997. These corporate bankruptcies severely weakened the financial system and nonperforming loans rose sharply during the course of 1997. These developments exacerbated the existing weakness in the banking system caused by a general lack of commercial orientation and limited experience in pricing and managing risk, combined with lax prudential supervision that led to a large accumulation of short-term external debt.

These problems created a tinder box waiting to ignite, as it duly did in the fall of 1997. The effect was a generalized calling of foreign short-term loans, as investors doubted the ability of Korean banks to honor their (unhedged dollar) debts when their own claims were on weak and unprofitable chaebols. While the organization of the concerted short-term debt rollover dealt with the generalized withdrawal of funds, this rollover could only be secured if the fundamental problems were addressed so as to prevent a renewed loss of confidence in the future. Hence, key elements of the Korean stand-by arrangement focus on (i) corporate restructuring, (ii) restructuring the banking sector and strengthening supervision, and (iii) liberalizing the corporate financing market (foreign participation in equity and bond markets and in mergers and acquisitions). Since the current account imbalance was small, little was programmed by way of fiscal retrenchment, beyond covering the likely interest cost of the bank restructuring/recapitalization. Because of the weakness of the won, however, interest rates were kept high to contain the depreciation and thereby prevent the burden of dollar-denominated debt from triggering further difficulties in the banking sector.

Issues in Monetary and Fiscal Policy

All three programs initially involved efforts to prevent the fiscal accounts from worsening. But as it became clear that growth was slowing much more sharply than at first expected, the fiscal targets were soon adjusted to permit the operation of the so-called automatic stabilizers, which allowed revenues to decline and social spending to rise as the recession took hold. Subsequently, the fiscal targets were adjusted again to incorporate stimulatory measures. Reflecting the uncertainties involved, the Korean program never incorporated a performance criterion on the fiscal balance, and performance criteria on fiscal balances were dropped early on (for a time) in the Indonesian program and later also in Thailand.3 Moreover, in all three Asian program cases, fiscal deficits with respect to fiscal balance ceilings have been consistently smaller than programmed; the emphasis has shifted from deficit containment to ensuring full implementation of spending plans, especially for social expenditures. Criticisms that the IMF has been too rigid on fiscal policy seem therefore rather wide of the mark.

More controversial has been the IMF’s insistence on the maintenance of high interest rates in the three programs. While it is undoubtedly true that high interest rates are a burden on enterprises, interest rates are also an important support for the exchange rate. The exchange rates of all three countries had suffered undue depreciations of varying magnitudes, sharply raising the domestic currency cost of servicing the private sector’s dollar debts. Exchange rate weakness therefore risked generating a far greater debt burden for the private sector than the high domestic interest rates used to resist this weakness: hence the priority accorded to the prevention of further depreciations through the maintenance of a tight monetary policy.

As noted, all three of the Asian cases also involved action in the financial sector, with measures to close insolvent banks, restore confidence in the remaining banks, and improve the regulatory and supervisory arrangements. These measures, which can be considered the core of the structural reform program now under way in Asia, are described in more detail in the paper by Mr. Charles Enoch of the Monetary and Exchange Affairs department of the IMF.4

3D. Recent Financial Crises: Institutional Responses


Financial crises have occurred in many countries in recent years, in all regions. A commonly quoted statistic is that more than half the membership of the IMF has experienced banking sector problems in one form or another in the last ten years. The extent of these crises has varied. In some cases, there was just a series of simultaneous banking failures—serious enough, but manageable through taking actions with regard to only the banking sector. In other cases, the financial crises were more pervasive—involving also a combination of one or more of debt crisis, fiscal crisis, and currency crisis. The various aspects of these crises are deeply interrelated. They feed on, and reinforce, each other. In such cases, action solely on the banking side would not have been sufficient. A country facing such a combination of problems will have had to adopt a comprehensive program covering the range of economic and financial policies.

Financial crises have varied also in the extent to which they could be regarded as one-off—that is, they came out of the blue and resolution could be expected to be once-and-for-all—and the extent to which they were recurrent. The more pervasive the crisis, and the more that it was recurrent—that is, the country had been through such a crisis before and there might be an expectation that, even if it got through the crisis at hand, it was likely to be only a matter of time before such a crisis recurred—the more that mere changes in policies—whether on the banking side or even if they were undertaken more widely—might not be seen as sufficient.

Institutional Responses

Effective remedial action requires credibility in the institutions through which policy is effected. The more the public has already experienced crises in the past, the less the credibility of the institutions handling the crises, and the greater the need, therefore, also to address possible problems in the institutions themselves.

In considering financial or monetary policies, the most critical institution involved is the central bank. Financial crisis is often seen as a central banking failure, both because it may reflect a failure of supervision and because there is likely to have been a failure of monetary management. The latter factor is particularly evident where the financial crisis is accompanied by high and persistent inflation, or by collapse of the domestic currency. Prudential and monetary failures are interlinked: high inflation is often fueled by excessive credit growth, deriving from lax banking supervision; this is likely to have led to decline in the quality of banks’ loan portfolios, which might not have been recognized quickly, especially if classification and provisioning standards are not at best-practice international levels. Also, high inflation may serve to cloud information as to the quality of a bank, permitting, for instance, a bank to show profits from unrealized valuation gains, and thus perhaps to decapitalize itself through dividend payments. Unexpected depreciation of the domestic currency may lead to banking problems, if the banks have open foreign exchange positions or if they have been lending in foreign exchange to unhedged customers. All these factors will be familiar to those who have been watching the financial crises of recent years, whether in Asia, Latin America, the transition economies, or elsewhere.

Conventional Responses: Central Bank Independence and Separation of Supervision

One increasingly recognized form of institutional change in response to financial crisis is establishing central bank independence. This follows, on the monetary side, from the well-known finding that inflation is lower in those countries where the central bank is independent in the operation of monetary policy than in those countries where it is subservient in this regard to the government.1 Such independence provides a solution to the so-called time-inconsistency problem, and enables formulators of monetary policy, when working with a clear mandate for price stability as the primary objective, to focus solely on that objective, and not be subject to direction by the government. This reform was adopted, for instance, by Chile in 1990, and is becoming the norm in central banks around the world. The European Central Bank has its independence from government embedded throughout its Articles.

Concerns on the prudential side also lead to recommendations for central bank independence from government, when supervision is in the central bank. In many cases, financial sector crises can be seen to have derived from government pressures for supervisors to give favorable treatment to particular banks, or to have the prudential standards weakened or left unenforced. Concerns in this area also lead to recommendations for bank privatization. While the government owns a bank, it will be tempted to use its authority to press its interests as owner of a bank over those of the agency responsible for the soundness of the banking system. Hence, privatization of state-owned banks is a conventional element of the response to financial crisis, even if it cannot be effected immediately and, indeed, in the short run, the government is even likely to increase its holdings in the banking sector.

A further reform in this connection may be the separation of the supervisory function from the central bank, both because the financial crisis may be seen as reflecting a lack of competence to undertake this role, or because of the possible conflict of interest between the monetary and prudential objectives of a central bank. In some European, and many Latin American countries, therefore, a separate supervisory agency has been established, leaving the bank to focus solely on monetary policy. Overall, however, the dominance of this model has not been clearly established, and in many other countries the central bank remains responsible for supervision.

An Institutional Alternative: The Currency Board Arrangement

The establishment of central bank independence, or taking the supervision function out of the central bank, may not be sufficient where the central bank itself has lost credibility—why give independence to central bankers if they have shown that they cannot use it properly? Central bank independence, on its own, may serve to give discretion to those people for whom one does not wish discretionary power. Changing central bank management is a conventional aspect of dealing with a banking crisis, but where the framework of central bank action is inadequate, new management may be expected to perform much like the old. Hence, in recent years, there has been a growing interest in establishing a rules-based system for a central bank, in particular nowadays, a currency board arrangement (CBA).

A CBA, in its pure form, is a commitment that the currency board, conventionally now the central bank, will exchange domestic currency for a specified amount of a designated foreign currency. In formal terms, this translates into commitment that the stock of domestic money will not be permitted to exceed the level of foreign exchange reserves. The concept of a CBA originated in the British colonies of the nineteenth century. It provided for a simple-rules-based system under which monetary conditions could be tied into those of the colonial power. The adjustment process in such a system was much in line with that in the wider world economy, when most of the world was on the gold standard. Several of the currency boards served effectively almost up to the end of the Bretton Woods era. The East African Currency Board, for instance, provided a single currency arrangement for up to seven East African and Middle Eastern territories until the late 1960s. Indeed, the East Caribbean Currency Board, and—with somewhat more flexibility, the BCEAO and BEAC in Francophone Africa today—are institutions with similar characteristics.

Although the CBA’s role in the world economy had seemed to be declining, there has been a revival of interest in them, since the 1980s. CBAs have been introduced, under a variety of circumstances, in Hong Kong SAR, Argentina, Estonia, Lithuania, Bulgaria, and other countries. Some other countries have seriously considered establishing a CBA in recent years, in the face of monetary and financial problems, but have so far determined against it—these countries include Mexico, Russia, and most recently, Indonesia. The remainder of this paper will look largely at the role of a CBA as a response to financial crisis. In that context, it will first look at reasons for adopting CBAs in various countries, and their experience with their CBAs; it will then look at the main characteristics and why they are attractive; the paper will then survey the prior actions and policy decisions necessary for establishing a CBA; thereafter it will briefly consider possible alternatives and will finally present some conclusions.

Causes and Consequences of Establishing a CBA

Although each country has different reasons for establishing a CBA, and the consequences of its adoption differ, lessons for other countries can be learned from looking at some of these experiences. In this connection, I will look briefly at four of the countries that have taken this route: Hong Kong SAR, Argentina, Estonia, and Bulgaria. These contain regional and institutional diversity, and thus provide much of the historical experience for other countries wishing to embark on this route.

In Hong Kong SAR, a CBA was introduced in October 1983, in the face of exchange rate pressure following the agreement that Hong Kong SAR would revert to Chinese sovereignty in 1997. The reasons for the takeover were therefore in some sense different from those concerning other modern CBAs, since the objective was essentially to give assurance as to the preservation of existing economic institutions. It was largely politically driven. Nevertheless, since then the CBA has served to give confidence in the continuity of the economic institutions, both in the face of banking problems in the early years of its existence, then in the wake of the “Tequila effect” in 1995, and in 1997 in the light of both the reversion to Chinese sovereignty and the Asian crisis.

The ability of Hong Kong SAR to weather the Asian crisis during this period may be regarded as a validation of the system, in that it has been successful in maintaining economic stability, including preserving Hong Kong SAR from the worst of the Asian crisis. Economically, the territory has done very well during its period with a CBA, although there has been some concern with the high levels of interest rates that have had to be imposed from time to time, and the observation that the CBA may have prevented as good an inflation performance as has been experienced by other countries in the region.

Argentina has experienced high and volatile inflation since the 1940s. From the late 1970s, annual inflation never fell below triple digits. At the end of 1989, short-term interest rates rose to around 1,500 percent at annual rates. A succession of government plans—most notably the austral plan of the late 1980s—gave short-term relief, but collapsed into growing hyperinflation and continuing declines in output. With generally negative real interest rates, financial intermediation declined. By 1990, the ratio of M2 to GDP had fallen to only 5 percent of GDP compared with 45 percent about 40 years earlier.

There was a total loss of credibility in the central bank and other public institutions. From 1991, the government passed a succession of laws, including most importantly, the Law of Convertibility, which provided for the exchange of local currency for U.S. dollars at a fixed rate, and provided that foreign exchange and gold holdings would cover the entire monetary base. Foreign currency was to be permitted as a means of payment. Shortly thereafter, the government began an aggressive program of privatization; in 1992, a new central bank charter gave the central bank operational independence and provided for increased transparency, including daily publication of its balance sheet. Deposit insurance was initially replaced by high reserve requirements.

The adoption of the CBA has led to inflation at rates comparable to those in the United States; real GDP growth of at least 6 percent per annum was achieved. The nature of the CBA has been progressively modified, to allow a share of the backing to come from dollar-denominated government bonds, and to permit some open market operations. The system was put under severe pressure when fallout from the Mexican crisis (the Tequila effect) led, in 1995, to substantial withdrawal from the banking system. The central bank responded by relaxing liquidity conditions through lowering reserve requirements; also a stand-by credit line with foreign commercial banks has been put together. Even insofar as the recent Asian crisis has led to some contagion into Latin America, this has not been principally to Argentina.

In Estonia, after the country regained its independence, there was very little expertise at the central bank, which essentially was created out of the branch of the former Gosbank. Economic conditions at the time were desperate, with hyperinflation in Estonia in common with the other countries in the region. Within these constraints, the authorities were keen to show their commitment to integrate the economy more with those of western Europe and that they were prepared to adopt the necessary discipline. In this connection, in June 1992, the government announced the establishment of a CBA, with the national currency pegged to the deutsche mark (DM). The Estonian economy has grown strongly since the introduction of the CBA. The country also suffered a banking crisis, which was handled in part through the use of the cushion of foreign exchange reserves above the minimum that was required to cover the monetary base. To what extent the good performance of the economy has been due to the CBA is subject to debate. Neighboring Latvia, which has not introduced a CBA, has similarly achieved a good performance.

In Bulgaria, there was a serious banking crisis in early 1996, with widespread runs on insolvent commercial banks. Somewhat belatedly, the authorities closed 16 banks in two waves, amounting to almost one-third of total deposits outside the state savings bank. Nevertheless, it was not possible to restore confidence, because of the clearly unsustainable debt and foreign exchange burdens, as well as the limited progress being achieved on fiscal consolidation and structural reforms. There was a loss of credibility in public institutions, including both government and the central bank. This was greatly exacerbated when political problems led to the fall of the government and hyperinflation in the early months of 1997. At the April 1997 elections, all political parties campaigned in favor of a CBA; the former opposition party, which won those elections, introduced the CBA—with the local currency pegged against the DM—in July 1997.

Bulgaria’s economic performance since then has been favorable, although it is probably too early to reach a definitive conclusion as regards the effect of the CBA. Growth has resumed, while inflation has fallen, from quadruple digit annual rates in the period before the CBA, to only 15 percent in recent months.

Overall, the conclusion from looking at these countries with CBAs is that they have been successful in terms of macroeconomic performance—in the first case, usually by bringing down interest rates rapidly, thus leading to a revival of investment and growth. In most of the countries, CBAs were, in fact, introduced after inflation had started coming down. Hence, the main finding with regard to inflation has been that they consolidated the fall in inflation and prevented the subsequent resurgence—thus marking a clear break from earlier experience in a country such as Argentina. Some observers have drawn stronger conclusions as to the impact of a CBA on inflation, and there is some evidence now that they are associated with lower inflation.2

Characteristics of a Currency Board Arrangement

As noted above, under a CBA, the authorities are committed to provide a specified amount of a designated foreign currency in exchange for domestic currency. This, of itself, requires that there are limitations on the amount of domestic currency in the economy. It means, therefore, that there can be no (or only limited) central bank lending to government. In a pure form, it may mean that the central bank cannot act as banker to the government.

Why is a CBA different from any fixed exchange rate regime? The latter too involves a fixed parity and may also involve a prohibition on lending to government. The key difference is generally taken to be the characteristic that the fixed parity under a CBA, as well as the convertibility provision, is enshrined in the law. Neither the central bank nor the government is able simply to change the parity. Although it is worth noting in passing that in some countries, including, for instance, Lithuania, the prohibition is not symmetric, and the central bank has the power to appreciate the currency. Hence, there can be much greater confidence among the public, and among possible outside investors, that the existing parity will be maintained. Any change in the parity would involve a major loss of face by government, since it would be a very visible change in its economic policy stance; also, in many countries, any change in the parity cannot be done very quickly.

The traditional Bretton-Woods-era modality of announcing parity changes without forewarning over a weekend is unlikely to be feasible. Hence, a parity adopted in a CBA is likely to hold for a significant period of time; the corollary is that the CBA should be prepared carefully, and in full public view, so that a national consensus is established. A CBA is not something that can be brought together and dismantled easily and quickly. Indeed, in those countries where a law can be passed overnight without much popular discussion, clearly a CBA too can be reversed without much discussion, and so a CBA in such a country will have less credibility. Perhaps in such a country the provisions for the CBA would be best established through enshrinement in the country’s constitution or, in some cases, as a “fundamental law” that would require a super-majority to change it in the legislature.

This process of building a consensus may be an important element of its own in ensuring that a reform program underlying the establishment of a CBA is widely understood, so as to increase the chances that the authorities have “ownership” of the CBA—even if it is being introduced as part of an IMF-supported program—and that they maintain commitments to the CBA and their underlying reform programs, even when the conditions become difficult. In Bulgaria, for instance, every party was in favor of the CBA by the time of the April 1997 election and the subsequent introduction of the CBA. Public opinion too had become fully in favor of it and of what it involved. Interestingly, a newspaper poll on the eve of the introduction of the CBA in Bulgaria found that 40 percent of respondents wanted foreigners on the Board running the CBA; the next largest category, 30 percent, wanted only foreigners on the Board.

Also, the credibility of a CBA hangs on the simplicity of the arrangement. This means that its workings should be very visible, both in terms of the central bank being visibly involved in making the CBA transactions, and in the financial implications of those transactions, to demonstrate that they will be sustained. Hence, in many countries adopting a CBA there is a concomitant introduction of greater transparency in the central bank’s financial transactions—for instance, in Argentina there is a requirement of daily publication of the balance sheet of the central bank.

Overall, the adoption of a CBA is not an “easy” option. A CBA essentially removes the central bank’s power to print money, and adjustment occurs solely through market signals. When operating without the conventional cushions, for instance, very high interest rates may be needed if the arrangement comes under pressure—if there is a need to draw in funds from overseas to match some outflow of reserves. Also, there is generally very little scope for the central bank to act as lender of last resort, since the provision of liquidity will be possible only to the extent that there is foreign reserve cover. Hence, a central bank operating under a CBA will generally be able to do little to protect banks in difficulty. As noted above, the central banks in Estonia and Argentina survived incipient financial crises in the early years of the CBAs by being willing to adjust aggressively on both the fiscal and financial sides. Neither country had depositor protection at that stage. Only once the credibility of their CBAs was established could these countries refocus their policies, using both their financial cushions and their ingenuity to achieve flexibility within the CBA constraints.

It is worth stressing also that the pressures likely to result when operating a CBA mean that, in many cases, there is also a need for structural reforms outside the financial sector. For instance, there may also be a need for a greater degree of flexibility in other markets, including the labor market, since any fixed exchange rate puts the burden of adjustment onto internal price adjustment, and a CBA puts on that burden a fortiori.

Generally, one would expect that establishing and successfully maintaining a CBA would be acceptable to the public only if conditions in the economy are dire, and everything else has been tried. It is also more likely to be acceptable if the public has already lost almost everything—through hyperinflation or the blocking of bank deposits—as in Bulgaria and Argentina. As suggested above, the deeper and more recurrent the crisis that a country is facing, the more likely these conditions are to hold. Also, in such cases the actual loss of discretion through introducing the constraints of a CBA is not likely to be significant in practical terms. In both Argentina and Bulgaria, the central bank had already lost all monetary control. The establishment of the CBA was thus seen as a means to reestablish such control.

Main Actions Before a CBA Can Be Established

The actual introduction of a CBA requires a number of prior decisions and actions. Although a CBA may well need to be introduced in a crisis, and thus within as short a time as possible, premature introduction is dangerous and may threaten the success of the entire operation. The following items are among the necessary prior actions; they need not all be undertaken in the order discussed.

First, the authorities need to choose a currency peg. It should be noted that the effective exchange rate of the domestic currency will fluctuate as the peg currency fluctuates against other currencies. It should also be noted that the peg is, in all cases so far, only to a single currency, since otherwise the advantage of simplicity would be lost, and indeed since the authorities are only committed to changing domestic currency into that currency. If the peg currency is not that in which most foreign exchange reserves are denominated, it will be necessary to change the composition of reserves to avoid the foreign exchange coverage being significantly affected by fluctuations between foreign currencies.

It would be, at a minimum, courteous to keep in close contact with the central bank of the country issuing the peg currency. The U.S. authorities appear to be quite relaxed about countries introducing a CBA with the domestic currency pegged to the dollar, and indeed about dollarization in general, but other countries may be more concerned—particularly, if there were a sizable country adopting such a peg—about the possible loss of monetary control. For instance, Brunei has a CBA where the domestic currency is pegged to the Singapore dollar. In the hypothetical case that some larger Asian countries were to adopt a CBA and choose this peg, there would be monetary implications also for Singapore.

Second, the authorities must determine the definition and level of the foreign exchange cover that will be required in the CBA. There is no absolute answer to this question, although one can derive guidelines from countries’ experiences. Foreign exchange reserves should comprise useable gross reserves; thus, one should subtract short-term liabilities, including forthcoming debt obligations. There is some question as to whether longer-term obligations, and indeed repurchase obligations with the IMF, should also be deducted. Generally, the answer is no, although there were some questions about the sustainability of the Lithuanian CBA when it was recognized that a part of the foreign exchange backing was provided by resources from the IMF. There is also a question whether one should deduct reserves of uncertain value or liquidity, in particular gold, especially if the gold is held within the country. Greater assurance is provided if the gold is held overseas and is valued conservatively and revalued regularly—a better alternative might be if the gold were sold.

As regards liabilities, generally CBAs involve coverage of all liabilities of the central bank, rather than of the banking system. This involves reserve money (currency and banks’ deposits at the central bank) plus government deposits at the central bank. But coverage just at this level would give absolutely no scope for any lender-of-last-resort facility, which could jeopardize the credibility of the CBA, especially if the banking system is weak. Hence, in practice, a CBA generally also seeks to cover a share of bank deposits. Coverage for these may be segregated and available for use only under clearly specified and restrictive conditions—for instance, in Bulgaria, they can be used only for banks that are solvent and are deemed to be systemically important. The higher the degree of such coverage, the greater the credibility of the CBA may be, and the less likely the testing. On the other hand, high coverage may not be feasible, or only feasible at high cost. Indeed, some have argued that excessive coverage would be undesirable, since it would serve to reduce the incentive for the banks and the authorities to undertake needed adjustments—precisely the objective of establishing the CBA in the first place.

The degree of coverage is a function of the exchange rate: the more depreciated the exchange rate, the higher the level of cover, but also the higher the likely initial rate of inflation. At the same time, the more appreciated the rate, the lower the level of cover, and the greater the risk of competitiveness problems, especially as the nominal exchange rate is intended to be fixed for the foreseeable future. It is not easy to say what the appropriate level of cover should be, but one rule of thumb would be that there should be sufficient excess cover above the legal minimum to be able to meet a worst-case withdrawal scenario. In the case of Argentina, roughly 18 percent of total deposits were withdrawn from the banking system in the face of the Tequila effect, so one might expect that coverage of around 25–30 percent of M2 would be adequate. In Bulgaria, the CBA had substantially greater coverage of M2 at the outset, as a result of the prior hyperinflation that substantially reduced the real value of the domestic liabilities. In Lithuania, by contrast, the initial coverage was much lower. This, in turn, may have undermined the credibility of the arrangement from time to time.

Third, the government has to resolve any excessive fiscal deficit. The central bank will be unable to lend to it, so the government should have a deficit equal only to what it can borrow in the markets. Prudence in this regard, and the need to avoid crowding out other borrowers, would argue for a small, if any, deficit.

Fourth, the authorities need to resolve problems in the banking system and to reestablish confidence in the system. It is very difficult to run a CBA when the banking system is unsound, since only limited support can be made available to weak banks, and thus banking failures are likely. In Bulgaria, for instance, 16 banks had been closed before the CBA was introduced, and measures had been taken to foster recapitalization in the remaining banks. Also, the hyperinflation that occurred in the months before the introduction of the CBA largely eliminated domestic deposits, thus serving to strengthen the banking system. The more one can restructure and recapitalize the banks beforehand, the more one can protect them from problems deriving from possible insolvencies and losses in confidence, and the more likely that the banks will survive, and thrive, in a CBA.

Fifth, the introduction of a CBA will require legislation. A new central bank law is generally needed, which may include also new provisions to improve governance—for instance, rules for the frequent publishing of relevant data, for the independence of the governor and board, perhaps a new board structure to improve oversight over the bank, and prohibitions on certain types of activities. The law may also involve a financial restructuring of the central bank. For instance, there may be a division of the central bank into an Issue Department and a Banking Department, where the Issue Department is the core currency board and the Banking Department performs the remaining central banking functions, with its activities constrained by the excess cover available over the minimum stipulated legal cover to back the liabilities of the central bank. The central bank also should not have excessive contingent liabilities, such as from backing underfunded deposit insurance schemes.

Two specific issues are worth mentioning in this context. First is the question whether the peg currency should be legal tender. This is not necessarily the case, but it can be—for instance, in Brunei. Other countries prefer to insist that the national currency be the only legal means for effecting domestic payments. Second is the mechanism by which the exchange rate can be changed. Conventionally, this is not specified, that is, the law just gives the exchange rate. This underlies the fact that a CBA is intended to be in place for the foreseeable future. Thus, since the rate is set in the law, changes in the rate can be made only by changing the law. Lithuania, incidentally, announced only that its CBA would be in place for the duration of its IMF-supported program; this weaker commitment was thought to be one reason why the Lithuanian CBA was periodically challenged by the market.

The involvement of central bank legal departments in the drafting of CBA legislation varies from country to country. In Bulgaria, for instance, expertise was in the central bank, and the government deferred on what it saw were essentially technical issues, so the drafting was coordinated through the central bank. In other countries, the ministry of finance or other government legal departments have a more direct role at an early stage.

Adaptations in Existing Currency Board Arrangements

It is worth noting that none of the principal modern CBAs is fully in line with the “pure” description of a CBA. All are thus, in some ways, hybrids between a pure CBA and a conventional monetary institution. Among the ways in which the CBAs deviate from the pure form are the following:

  • The use of ceilings above the specified minimum reserve-money coverage to maintain some scope to provide lender-of-last-resort support to banks.

  • The definition of reserves to include foreign currency bonds issued by the government up to a specified maximum share of total foreign exchange cover; for instance, in Argentina, under certain conditions, up to one-third of total coverage can be maintained in this way.

  • Ability of the central bank to manage monetary conditions through open market operations; for instance, in Argentina, such operations are quite substantial.

  • The use of changes in reserve requirements to manage monetary conditions without sole reliance on interest rate movements.

  • The negotiation of stand-by lines with commercial banks overseas for the central bank to draw down in the event of liquidity crisis.

Ultimately, it may not be possible in all cases to specify unambiguously whether a country is operating under a CBA. Ireland modified very gradually, during the 1960s and 1970s, the constraints under which it had been operating its CBA since independence, while still maintaining the peg of the Irish pound to the U.K. pound. This gradual exit from the CBA enabled Ireland to break its peg with the U.K. pound smoothly in 1979 and join the Exchange Rate Mechanism of the European Monetary System, while the United Kingdom remained outside. Similarly, Lithuania is gradually exiting from its CBA in anticipation of redirecting its monetary and exchange rate policies toward EU accession.

These modifications may be thought to water down the benefits that derive from a CBA. On the other hand, however, they may be regarded as attempts to maintain those benefits while mitigating the negative effects of these arrangements. The fact that all CBAs have been designed with such modifications indicates that policymakers see it as important to have them. Overall, it seems to be the case that modifying a “pure” CBA, as long as the authorities are committed to the objectives of the CBA, will add to the resilience of a CBA in the face of shocks—for instance, it will be better able to handle banking sector weakness and hence should increase the credibility of the arrangement itself.

CBAs in Crisis Countries: When Is a CBA Not Appropriate?

In the wake of the Asian economic crisis, and particularly when it was seen that the IMF-supported programs agreed to with the authorities would take some time to have their desired effects, there were serious discussions about the possibility of introducing CBAs, particularly in the case of Indonesia.

Some of the arguments used in this context were familiar from discussions concerning the other CBA countries, while others were new. Among the (interrelated) arguments put forward by proponents of CBAs in Asia were

  • increasing corporate and banking sector problems with continuing currency depreciation;

  • the apparent overdepreciation of the currency and the risk of free fall, with the likelihood of resultant hyperinflation;

  • the need for an anchor for policy stabilization;

  • as the crisis passes and there is credibility in the CBA, there will be rapid declines in interest rates (often to negative levels in real terms), which should give a boost to investment and growth;

  • the purported culpability of the central bank, because of lax supervision and liquidity infusions to banks;

  • nontransparent approach to monetary and financial sector management; and

  • lack of credibility in the commitment of the authorities to addressing the situation.

While there was clearly some merit in some of these arguments, there were also important arguments against introducing a CBA into the country at this time. Most important, there was seen to be an inadequate level of reserves at the desired exchange rate, particularly when seen against the country’s short-term debt obligations. This problem was accentuated because of the total lack of any interest by the Indonesian government in introducing a CBA at a rate significantly more depreciated than their desired level of 5,000 rupiah to the U.S. dollar, notwithstanding the fact that the then-prevailing market rate was around 10,000 rupiah to the U.S. dollar. Thus, the CBA was, in essence, intended as a means to achieve an immediate jump to a nonmarket exchange rate. It is worth noting in this context that all countries with existing CBAs initially pegged their currency at the market rate prevailing at that time.

Other problems included the absence of clear domestic consensus. The CBA was pressed as a strategy by particular groups, including those especially dependent on imports. There was also, at the time, no evidence that, if a CBA was established, there would be the commitment to carry out the severe adjustment measures that would be necessary. In short, proponents of the CBA may have tended to see it as a substitute for a comprehensive program, and a “quick fix” to restore the exchange rate to the desired level. There was a widespread concern that, if the authorities established the CBA at the proposed level, those groups with good access to the foreign exchange market would simply use the opportunity to acquire foreign exchange at the peg rate, thus exhausting the country’s reserves, and forcing the rapid abandonment of the arrangement.

In any case, any attempt to set up a CBA in the middle of a banking crisis, without comprehensive measures to address that crisis, would be particularly risky. There were already deposit runs, being held in check by the blanket guarantee announced by presidential decree in late January 1998. This guarantee would clearly not be compatible with the CBA constraints, so there was the likelihood of early testing of the CBA before the overall situation of the country had stabilized. Thus, the authorities might rapidly have to choose between breaking the CBA and withdrawing the guarantee. If they undertook the latter course, it was to be expected that the situation would revert to that prevailing just before the guarantee was announced. At that time, there were deposit runs across the system—any repeat of such an experience would likely have led to widespread banking failure and the threat of financial meltdown. Indeed, some commentators were already analyzing the consequences of such an eventuality.

After considerable thought, it was decided by the government that it would be too risky to introduce a CBA at that time. More recently, the government embarked on a more orthodox IMF-supported program that should achieve an exchange rate appreciation gradually, and sustainably, as confidence is generated in the overall stance of policies.

Thus, while it is pointed out that none of the CBAs established in recent years has so far failed, it is also the case that they have so far all been introduced after careful planning—generally for a period of up to a year—and where at least a good start had been made in addressing the necessary areas that were discussed earlier in the paper.

Would a CBA Be Suitable for the Crisis Countries Today?

There is no single model of an exchange rate system that would fit all countries. In Latin America, for instance, while Argentina seems to benefit from its CBA, Chile has a floating exchange rate based on central bank independence, and Brazil has a fixed rate under its realplan. In Asia, at this time, there is perhaps not generally a sufficient level of distrust of the institutions to call for changes along those discussed in this paper, and the various countries have not gone through the major traumas faced by Argentina, Bulgaria, and the Baltic countries, which would make acceptable the strong discipline and major adjustments implied by the adoption of a CBA.

Introducing a CBA can have a real cost, that is, the central bank gives up what are generally regarded as desirable powers, including the ability to smooth fluctuations in domestic monetary conditions. Also, if a CBA is successful, it may lead to rapid remonetization. In that case, substantial increases in reserves will be necessary; this, in turn, will require that a country run a sufficient balance of payments surplus. The costs of maintaining the constraints of the CBA may be considered increasingly burdensome as the crisis passes. Given that most of the Asian countries seem now to have turned the corner in their management of their crises, it seems unlikely that the introduction of a CBA by these countries is imminent. It is worth noting, in this context, that Thailand, in fact, is moving in the opposite direction. The Thai authorities are amending the central bank law and the currency act to reduce the foreign cover requirements in the central bank, so that the country’s foreign exchange reserves can effectively be at the disposal of the authorities for use in their management of the foreign exchange market.

Alternative Institutional Changes

It is worth looking briefly at alternative institutional changes to the introduction of a CBA. One approach is to decompose the elements of the CBA, to consider if some of these are worth introducing on their own.

A CBA is a coverage requirement plus a fixed exchange rate, plus central bank independence and prohibitions on money-creating functions. The last two of these are certainly seen as useful in their own right; fixed exchange rates are also appropriate for certain countries at certain times. The coverage requirement is less fashionable now than earlier, since unless a country is using the reserves to gain the credibility benefits from the CBA, beyond a certain point there may be better things that one can do with one’s reserves than just have them earning interest overseas.

In some cases, a country might instead go further than a CBA in constraining its central bank. One way would be to go into a currency union: another country might have monetary authorities more professional, or not, as subject to the local constraints as one’s own, or the international dimension of such an institution might mean that the independence provisions could more easily be maintained. These considerations may underlie the success of the Eastern Caribbean Central Bank (ECCB), as well as of the Banque Centrale des Etats de l’Afrique de l’Ouest (BCEAO) and the Banque des Etats de l’Afrique Centrale (BEAC), both of which share many characteristics of a CBA. Reportedly, monetary unions may be on the cards within parts of Latin America. Of course, currency union need not be on the basis of a CBA: in the European Monetary Union, the European Central Bank will have a full range of monetary instruments at its disposal.

The final possibility in this regard is the simple adoption of the foreign currency. Dollarization is already very pronounced in much of Latin America. There are benefits from seignorage from having one’s domestic currency, but beyond a certain point a country, anyway, has a very limited ability to manage an independent monetary policy. So far, however, giving up one’s own currency has only been accepted by some of the smallest countries—including, for instance, Panama, Bahamas, and Vanuatu. A national currency is clearly seen as part of nationhood.


A CBA may be a useful institutional innovation for countries where there is a loss of credibility in the official institutions, especially in the central bank. Such a loss of credibility occurs usually after a political upheaval, a hyperinflation, or a financial crisis. While it is not clear that any of the countries in crisis, that do not at present have such an arrangement, would benefit from having one at this stage, one can envisage conditions under which a move to such an arrangement would be appropriate.

Establishing a CBA requires careful legal planning. A new central bank law has to be passed through parliament designating the peg currency and the exchange rate peg, and committing the authorities to being willing and able to exchange specified units of the domestic currency for units of the designated foreign currency. This, in turn, requires defining what liabilities are covered by what foreign exchange assets. Also, the central bank’s accounts must be segregated so that one can see easily that the coverage requirements are being met at all times. Adoption of a CBA requires also a number of important measures, including resolving banking sector problems and ensuring an appropriate fiscal position. Any country that wishes to adopt a CBA needs to ensure that the concomitant measures are prepared thoroughly and carried out effectively.


    Alexander, William E., Jeffrey M.Davis, Liam P.Ebrill, and Carl-JohanLindgren, 1997, Systemic Bank Restructuring and Macroeconomic Policy (Washington: International Monetary Fund).

    Baliño, Tomas J. T., CharlesEnoch, AlainIze, VeerathaiSantiprabhob, and PeterStella, 1997, Currency Board Arrangements: Issues and Experiences, IMF Occasional Paper No. 151 (Washington: International Monetary Fund).

    Central Bank of the Argentine Republic, 1992, Charter General Provisions, September 23.

    Enoch, Charles, and Anne-MarieGulde, 1997, “Making a Currency Board Operational,” IMF Paper on Policy Analysis and Assessment 97/10 (Washington: International Monetary Fund).

    Fischer, Stanley, 1994, “Modern Central Banking” in The Future of Central Banking: The Tercentenary Symposium of the Bank of England, ed. by ForestCapie and others (Cambridge: Cambridge University Press).

    Ghosh, Atish R., Anne-MarieGulde, and Holger C.Wolf, 1998, “Currency Board: The Ultimate Fix?”IMF Working Paper 98/8 (Washington: International Monetary Fund).

    Hanke, Steve H., and KurtSchuler, 1994, Currency Boards for Developing Countries: A Handbook (San Francisco: ICS Press).

    Lindgren, Carl-Johan, Gillian G. H.Garcia, and Matthew I.Saal, 1996, Bank Soundness and Macroeconomic Policy (Washington: International Monetary Fund).

    Pou, Pedro, 1997, “Bank Restructuring: Comments” in Banking Soundness and Monetary Policy, ed. by CharlesEnoch and JohnGreen (Washington: International Monetary Fund).

    Santiprabhob, Veerathai, 1997, “Bank Soundness and Currency Board Arrangements: Issues and Experiences,” IMF Paper on Policy Analysis and Assessment 97/11 (Washington: International Monetary Fund).

    Williamson, John C., 1995, What Role for Currency Boards? Policy Analyses in International Economics, No. 40 (Washington: Institute for International Economics).



I would like to add one element to the complex jigsaw puzzle presented to us earlier. It concerns the law reform that is under way in two of the Asian countries most affected by the current crisis, namely, Korea and Thailand.

In Korea, the IMF assisted the Government in preparing amendments to central bank and banking legislation in support of a wholesale restructuring of the financial sector. In providing this assistance, the staff of the IMF was made to recognize that it is unrealistic to expect a country to adopt institutional arrangements developed in other countries that conflict with domestic traditions. The failed attempt to establish an autonomous financial sector supervision agency in Korea may serve as an illustration.

It was clear from the start that foreign creditors characterized the Korean financial crisis as a crisis of confidence. The question before the authorities was therefore what measures had to be taken to restore confidence. The Government decided that these measures had to include a fundamental restructuring of the financial sector. The decision responded to criticism from foreign investors that the crisis was largely due to what were deemed improper Korean business practices, granting the Government a significant role in guiding important commercial policy decisions and causing corporations to cooperate with each other in associations marked by webs of cross-ownership arrangements and other common interests designed to make their members economically dependent on each other. The same investors had argued, not entirely without merit, that as a by-product of these traditions prudential supervision of banks had been inadequate and that the resulting weaknesses in the banking system had contributed to the crisis.

Even though the Korean authorities argued that these customs reflected the socioeconomic heritage of the nation and that foreign investors should accept that not all countries are alike, it was feared that foreign investors were no longer willing to tolerate the risks associated with prudential standards and practices that they did not understand or that they perceived to differ markedly from those to which they themselves were accustomed at home. In consonance with the search by international financial institutions, including the IMF, for international standards and codes of good practices in the areas of banking, corporate governance, and the rule of law, it was concluded that the international investment community had begun to enforce global compliance with such standards by withdrawing from countries where they were not honored. Somewhat surprisingly, no attempt was made to reconcile this stance with the fact that these same foreign investors had, until recently, helped fuel the phenomenal economic growth of Korea with growing amounts of foreign capital under conditions that were not different from those of which they now complained.

Under the pressure of rapidly deteriorating conditions, the Korean Government and the IMF quickly agreed on an IMF-financed economic restructuring program designed to meet these concerns. As the crisis demanded immediate action, many details of the program were hidden behind broad statements of principle. A central element of the program was the structural reform of the Korean financial sector. In particular, banking supervision would be moved out of the Bank of Korea to a new financial supervision agency to be responsible for the prudential oversight of all financial institutions. A key aspect was that, in order to insulate banking supervision from the political involvement of which it had suffered, the new agency would be endowed with financial and operational autonomy from the Government.

As the crisis was characterized as a crisis of foreign investor confidence fueled by distrust in Korean customs, it was not entirely illogical to expect that, in order to overcome the distrust of foreign investors, the proposed financial supervision agency would not be merely autonomous but would be more autonomous than similar agencies in other countries under normal circumstances. However, as the very concept of a public agency whose financial condition and operations would be autonomous from the Government was rather novel for Korea, it was predictable that a degree of autonomy greater than usual would be deemed unacceptable by the authorities, and so it was. To cut a long story short, the end result was that the task of banking supervision was transferred to an agency with less autonomy than the Bank of Korea, where it came from. The lesson learned was that a small dose of realism at the start would have avoided much disappointment later.

In Thailand, the authorities received assistance from the IMF in strengthening the legal framework of the financial sector, especially in the areas of bankruptcy legislation and collateral legislation, in order to help protect the value of assets of financial institutions available for their creditors and to help restore confidence in the financial system.

A study of the bankruptcy law of Thailand had identified several areas of the law that would benefit from reform. However, it soon became clear that bankruptcy law reform alone would be insufficient. Major impediments to the efficient restructuring or liquidation of financial institutions were found to exist in the administration of the law where creditors encountered serious delays in liquidating their portfolios of real estate loans or in exercising their rights under real estate mortgages.

Like the law in other countries, the Thai Civil and Commercial Code requires that mortgage foreclosures be carried out through the courts. However, in Thailand, it was found that mortgage foreclosures take on average more than five years to complete, mainly owing to delays in their judicial processing and in the release of auction proceeds by the Ministry of Justice. This finding led to a review of the judicial and administrative procedures and practices in enforcing mortgage loan claims. A proposal to permit the foreclosure of mortgages through public auction under the control of the creditor without judicial administration was rejected by the authorities on the ground that poor real estate owners must be protected from unscrupulous creditors. Instead, several procedural changes are under review, including a proposal to make foreclosure of mortgages eligible for expedited court proceedings and measures to ensure the prompt release of mortgage auction proceeds for distribution to creditors.

In both countries, the IMF was confronted with some old truths. Legal institutions are like living organisms; to be healthy and effective, they must remain firmly rooted in the social and moral history of the nation. Generally, their reform must be gradual, building on traditions, generating from the inside out; transplants, though not always harmful, are often rejected. Finally, law reform must be holistic in that it addresses not only the letter but also the practice of the law.

The first activation of the new procedures had in fact been for another Asian case—the extension and augmentation of the Philippines extended arrangement in July 1997.

As noted below, the fiscal targets were quickly loosened as it became clear that the economic downturn was going to be much deeper than originally expected. By mid-1998 the program allowed for a deficit of 8.5 percent of GDP in the fiscal year 1998–99.

For Indonesia, performance criteria on the fiscal balance were dropped at the time of the first review, though subsequently reintroduced when the stand-by was replaced with an extended arrangement.

See herein Charles A. Enoch, Recent Financial Crises: Institutional Responses, Chapter 3D.

See generally, Stanley Fischer, “Modern Central Banking” in The Future of Central Banking: The Tercentenary Symposium of the Bank of England (Cambridge University Press, 1994).

See Atish R. Ghosh, Anne-Marie Gulde, and Holger C. Wolf, “Currency Board: The Ultimate Fix?,” IMF Working Paper 98/8 (1998).

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